Sound the retweet

FOR want of a letter, a fortune was lost. Shares in Tweeter, a bankrupt electronics retailer, briefly soared 1,800% on October 4th because some investors mistook its ticker symbol TWTRQ for TWTR, the shorthand chosen by Twitter ahead of the microblogging service’s planned stockmarket flotation. Trading was halted after the regulator stepped in. But those who bought at the peak price will be regretting their foolishness.

So what happened to the idea of an efficient market, in which prices are set by rational investors in command of all pertinent public information? Those who piled into the stock failed to grasp two important facts: first, Twitter has yet to float and second, when it does list, the issue price is highly unlikely to be a few cents.

Academics accept there will always be irrational, or foolish, investors but argue that these will be driven out of business by arbitrageurs who can profit from mispricings. In theory, there was money to be made on October 4th by shorting Tweeter stock (ie, betting on a falling price). In practice, however, arbitrageurs may not be able to take advantage of such opportunities: it may be impossible to borrow the stock needed to establish a short position.

Furthermore, regulators tend to dislike short-sellers, fearing that they transform market downturns into routs. So they impose all sorts of restrictions on the practice. But short-selling is a precarious profession. Dedicated short-sellers need to make money in falling markets so they can be around to contain “irrational exuberance” in rising ones. If it were easier to sell short, there would be fewer bubbles.

The dotcom boom of the late 1990s contained some classic examples of investor irrationality. Companies could add millions to their market value merely by adding the letter “e” to the start of their name, even though they had no coherent internet strategy. 3Com, an electronics company, floated a stake in its subsidiary Palm, a maker of hand-held computers; its remaining holding in Palm was soon worth more than 3Com itself. In other words, investors were applying a negative value to the underlying business of 3Com, which was profitable at the time.

Investors flocked to buy internet incubators, the 20th-century equivalent of the South Sea bubble’s “undertaking of great advantage but no one to know what it is”. The incubators promised to buy stakes in unspecified dotcom companies. They resembled closed-end funds and might expect to trade at a discount to their asset value, to allow for tax and other costs. But often they commanded huge premiums: one company, Oxygen, floated on the market with 2p per share in cash and closed the first day at 65p. In effect, investors were buying pound coins for £32.50 a throw.

Nor were these mispricings as temporary as the Tweeter affair. The 3Com/Palm discrepancy persisted for months. Those fund managers who stood aside from the dotcom foolishness, such as the late Tony Dye at Phillips & Drew, lost clients and eventually their jobs as a result.

Of course, when a new technology such as the internet bursts upon the scene, a great deal of uncertainty is inevitable. Investors will feel sure that some companies will emerge as stockmarket giants, but will not know which. That will encourage the tendency to spread their bets, backing almost any company with a plausible strategy. The net effect will be that, in aggregate, the valuation of the sector will be ridiculously high; dozens of companies will be priced as if they will become the next Microsoft or Google, even though only a couple will manage it.

There are fewer flotations these days but the uncertainty remains. Take Twitter itself. It may still be losing money but its revenues are growing rapidly: $253m in the first half of the year, up from $317m in the whole of 2012. How long can such doubling of revenues last? Two years? Ten years? A lot depends on how responsive Twitter users are to the advertising that is the main source of the company’s revenues. When people search for a product on Google, advertising may guide them in the right direction; it is less clear that the combination of news, conversation and opinion that defines Twitter is as suited to targeted marketing.

One thing is for sure. A lot of future growth is already baked into the price. No price for the shares has yet been set but an indicative value of $9.7 billion for the whole company is mentioned, or more than 21 times the group’s revenues for the past 12 months. It may not be irrational to buy shares in the group but it certainly requires a degree of optimism. And the ability to pick the right stock symbol.

^{Economist.com/blogs/buttonwood}