Internet Dynamics and Expansion of European Financial Markets: Issues from a Behavioral Finance Perspective

Abstract

The Internet is one of the most dynamic sectors in nearly every developed country. It is closely linked to the information and communication technology (ICT) sector, which has been the driving force for the recent outstanding productivity and growth figures, especially in the U.S. The rate of path breaking innovations in the last years is very high, and so is the uncertainty of future marketability of these innovations. Many of these innovations were developed in small start-up firms, which need huge capital infusions for completing and marketing the resulting products. The process from innovations to final ICT products or services normally needs a very long time without positive net cash flows. That time period needs to be bridged with external cash infusions. The main problem here is the high uncertainty about the long-term success of the underlying business plans. Indeed, risky projects must be undertaken in the first place in order to make profits. It is especially the very dynamic character of the competition in the Internet and ICTsectors that made reliable mid to long-term forecasting for both — the entire market and individual firms — almost impossible. On the other hand, the uncertainty made short-term speculation based on past developments “reasonable”. In recent years the capital markets have stood ready to finance prospects, which seemed “reasonable” in the first place. There was virtually no shortage of capital until March 2000. The high valuation level in the secondary markets attracts a lot of firms to get external equity finance by business angels, venture capitalists and initial public offerings. Other firms want to broaden their capital base with seasoned equity offerings in order to get “acquisition currency”, i.e. to pay in acquisitions with one’s own high valued stocks. Moreover, most of the cash proceedings were invested in mergers and acquisition activities in order to reach larger market share. This contributed to the rapid expansion of the world capital markets in terms of listed firms, market capitalization and share turnover. Especially the European Financial Markets benefited from these developments. There is now a change underway which will transform continental Europe from a more bank-oriented financial system into a more market-oriented system (see e.g. ALLEN/GALE, 2000). Anglo-American investment banks stood ready to offer their services in the course of creating a single European market and the introduction of the euro. Moreover, the competition among the leading exchanges in Europe fostered the creation of the so-called New Markets for young innovative growth firms. A very positive sentiment for the potential success of Internet and ICT firms was created in this environment. Last but not least, everybody wanted to have the “new Microsoft“ in the own portfolio. This mobilized huge amounts of risk capital in the IPOmarket. However, there may be major shortcomings with that development. When assets are mispriced the available funds are allocated inefficiently. Moreover, firms rush to go public or offer additional capital in seasoned offerings when stocks are overvalued; this situation is called a “hot issue”-market. In the short run there are high growth rates because of tons of money being available, which may lead to overinvestment. However, the high growth rates may not be sustainable in the long run when eventually the bubble bursts and funds dry up as they did in 2001.