When bubbles burst

History is a guide as to whether hot plays such as Bitcoin and cannabis will change the world or are manias destined to die

Over the holiday season I was lucky if I escaped a social function without someone buttonholing me about lithium stocks, cannabis stocks or, of course, Bitcoin. I believe these are all potentially powerful illustrations of something that investors should be keenly aware of. That is, how financial bubbles form and grow, and the aftermath of their bursting.

The first key point is that almost every bubble is built on a kernel, if not a bedrock, of truth and logic. Take the British railway mania of the 1840s.

The world’s first modern inter-city railway was opened between Liverpool and Manchester in 1830. Apart from the death of parliamentary member William Huskisson, who was accidentally hit by the line’s locomotive during the opening ceremony, it was a tremendous success.

The railway was originally built for the transportation of goods but an unexpected enthusiasm for passenger travel quickly developed. This led to financial success well beyond initial expectations. The potential for expansion and future profits was obvious and a great investment boom began.

At this point, investors’ money was being transformed into useful, profitable infrastructure. Thousands of miles of lines were constructed, benefitting the nation and many early investors who were earning good dividends by the middle of the 1830s.

By the 1840s the industrial revolution was driving increased commercial activity and interest rates were going down. This meant investors were open to alternatives that might provide higher returns and the railways seemed a sure thing – a truly “disruptive” technology.

The second key point about bubbles is that, at some point, the beneficial investment boom morphs into a financial boom. The focus shifts away from investment fundamentals to a simple “fear of missing out” on further speculative profits. This is a key phase. It’s the point where the buying activity shifts away from knowledgeable early investors to the broader, less-well-informed public. As Warren Buffett once wrote, “What the wise do in the beginning, fools do in the end.”

Each new rail line required authorisation by an act of parliament and in 1846 at least 272 such acts were passed. That same year a combination of higher interest rates and a growing realisation that many railroads were unlikely to be particularly profitable, or perhaps even viable, saw the bubble begin to burst.

The deflation revealed widespread fraud and financial mismanagement. Almost a third of railroads authorised by parliament were never built. The likes of Charles Darwin and the literary Bronte sisters were reportedly caught out in the collapse.

So the extensive British railway system is a legacy of both a fundamental change in technology and a financial mania that cost many investors dearly. Which brings us back to our currently fashionable trinity.

CRYPTO REALITY

“Something can change the world but still prove a bad investment,” I recently suggested to a friend visiting from Silicon Valley after he told me how smart some of the strongest Bitcoin evangelists over there are.

He was too young to remember the tech boom of the late 1990s, so we revisited some history together. We agreed that Amazon.com is one of the world’s greatest business success stories. So I punched up the Amazon share price chart on my phone.

In December 1999, at the height of the first tech boom, Amazon.com shares hit $US113 each. Less than two years later they were trading below $US6, a 95% fall. This could have been fatal for a business that reported a $US417 million net loss for the prior year and burned $US130 million in its operations.

Even if Bitcoin and other cryptocurrencies prove to be valuable technologies over the long term, a setback of the same magnitude that Amazon.com suffered is possible. And it would sorely test the resolve of those who’ve bought in on a speculative basis without a clear understanding of the underlying technology, its risks and potential benefits.

LITHIUM LEVITATES

How about lithium? The frenzy here is around the surging demand for the commodity due to it being an essential cathode material for long-life lithium-ion batteries. Those joining the rush point to demand from hybrid and electric vehicles as well as mass energy storage systems like the giant lithium-ion battery deployed by Tesla in South Australia.

This is the bedrock of truth for this investment boom. But the question today is whether we’ve crossed the threshold into a financial bubble after share price surges have sent the valuations of Galaxy Resources and Orocobre (hardly household names) to more than $1.5 billion each. More junior lithium stocks like AVZ Minerals and Kidman Resources have also “gone vertical” as investors chase the next big things in this area.

To work out if these stocks can deliver sustained returns from here, we’d need to get a good handle on their resources, the efficiency of their mines, political risk, the size of future global demand and the potential for additional supply to be brought on over the coming years.

All of that is beyond me. But there may be a historical precedent in the 10-year share price charts of “rare earths” stocks like Lynas, Greenland Minerals and Energy and Arafura Resources. They went through a terrific boom in 2010 (rare earths are also essential to rechargeable batteries). So far it hasn’t worked out well for long-term investors who bought during the hype.

ROCKY MOUNTAIN HIGH

Last year I spent some time in Colorado, where cannabis is legal not just for medicinal use but also for recreational purposes. Let’s just say that there are some problems with that development. (You haven’t lived until you’ve been the client of a cannabis-affected Uber driver.)

My initial research into North American cannabis stocks concluded it was a complex business with issues around cultivation (strain selection, climate control, pest and disease management to name a few), certification (both government regulations and potentially consumer-facing branding) and distribution (how to get your product to market).

In Australia, federal legislation has cleared the path for cannabis cultivation and in some states medical practitioners can prescribe it. But the take-up has been slow. Not so in the sharemarket, where investors are lighting up the stock prices. MGC Pharmaceuticals, Creso Pharma, Cann Group and AusCann have a combined value on the ASX of more than $1 billion. Their combined revenue in the past financial year? Less than $500,000. This is truly “buyer beware” stuff.

I would wager that a portfolio purchased today consisting of the cannabis and lithium stocks mentioned in this column, plus Bitcoin, would work out poorly over the next decade. The problem is that between now and the likely bust there may be one heck of a party.

Sitting on the sidelines watching others make “easy money” in such conditions isn’t much fun. Yet it sure beats joining the likes of Charles Darwin and the Bronte sisters in ruing the day you were sucked into a speculative mania after the party ends.