STERNbusinessInformation Nation

S P R I N G / S U M M E R 2 0 0 2

Combatting Strategic Surprises

Financial Secrecy and the New War

Why the Internet Stock Bubble Burst

Baruch Lev Gets in Touch with Intangibles

Cotton’s Comeback

owners. By December, morethan 60 businesses –restaurants, bars, retailshops, limousine services,and professional servicesfirms – had submittedrequests for assistance toStern Rebuilds.

A similar impulse echoesthroughout this issue of

STERNbusiness. For in it,we see not only the excep-tional range and intellectualimagination of our faculty,but the ways in which theyapply their knowledge tocontemporary problems.More broadly, faculty andmembers of the Stern com-munity have contributed toour understanding of thecurrent economic andnational security situation,and have offered solutionsas well.

I’m confident you’ll findthis issue as thought-pro-voking as I did.

George DalyDean

STERNbusinessA publication of the Stern School of Business, New York University

President, New York University � L. Jay OlivaDean, Stern School of Business � George DalyChairman, Board of Overseers � William R. BerkleyChairman Emeritus, Board of Overseers � Henry KaufmanAssociate Dean, Marketing

and External Relations � Joanne HvalaEditor, STERNbusiness � Daniel GrossProject Manager � Caren PielaDesign � Esposite Graphics, New Orleans

Letters to the Editor may be sent to:NYU Stern School of BusinessOffice of Public Affairs44 West Fourth Street, Suite 10-83New York, NY 10012

http://www.stern.nyu.edu

dean

Following the events ofSeptember 11, one of themost remarkable aspectsof our national experiencehas been the way thatAmericans from all walks oflife have contributed notjust money and time, buttheir intellectual resources.Relief workers flooded into

lower Manhattan fromacross the country, Pashtun-speaking translators haveenlisted in the army, andfinancial planners andlawyers have providedservices for families of thevictims. The Stern Schoolresponded by providingknowledge.

Perhaps one of the bestexamples of our ability tooffer knowledge as a formof aid has been the forma-tion of Stern Rebuilds. Thestudent-initiated group,comprising faculty, stu-dents, alumnae, and localbankers and lawyers, wasformed last fall to offer pro-bono consulting and adviceto small businesses affectedby the World Trade Centerattacks. In November, Sternhosted a “Back to Business”forum, which was attendedby more than 300 business

a l e t t e r f r o m t h e

contents S P R I N G / S U M M E R 2 0 0 2

2An Interview with Dean Daly

Cover illustration by Michael Gibbs

20 DotCom Mania:The Rise and Fall ofInternet Stock Prices:by Eli Ofek and

Matthew Richardson

26 Out of Touchby Baruch Lev

4 Data Mineby Daniel Gross

6Sneak Attacksby Joseph Lampel

and Zur Shapira

14Secret Agents:Financial Secrecy andthe War on Terrorismby Marti Subrahmanyam and Ingo Walter

18Going the Extra Milesby Lawrence J. White

32 Departmentof InformationSystems: AnInterview withKenneth Laudon

36 BrandingCotton: HowFarmers CultivateDemand on MadisonAvenueby George David Smith

and Timothy Curtis

Jacobson

44 Endpaper:The OriginalInformationSuperhighwayby Daniel Gross

Illustrations by:michaelgibbs.com©ARTIST(S)/SIS

Michael Caswell

Information Graphics by:Robert O’hair

I N F O R M A T I O N N A T I O N

In late 2001, Dean George

Daly announced that he

would step down as Dean in

August 2002 after a highly

productive and eventful nine-

year tenure. But Daly won’t be

leaving campus. He will

remain in his post for a transi-

tion year, and continue to

teach "Models of Leadership."

In late January, he spoke with

Joanne Hvala, Associate Dean

of Public Affairs at Stern,

about his tenure, his legacy,

and his plans for the future.

Joanne Hvala: Your predeces-

sor, Dean Dick West, had the

vision to combine the graduate

and undergraduate business

schools at the Washington

Square campus. How has that

decision affected the growth

and development of Stern in

the subsequent nine years?

George Daly: The move to the

Square has been a huge plus

for Stern. It has placed the

entire School in the heart of a

truly unique neighborhood,

Greenwich Village; it has unit-

ed us with other parts of the

University, leading to many

productive collaborations; it

has given us a much stronger

sense of place and community;

it has provided us with a physi-

cal facility that is one of the

best in the country. It’s hard to

imagine that we could have

made the progress we have

had we remained in the old

location.

JH: How does the school’s

location in New York City affect

the learning process?

GD: The first years of my

Deanship involved instituting

and imitating best practices of

the very best institutions. By

the late nineties it was becom-

ing evident that, while that

strategy had yielded great

returns, we had reached "state

of the art" in most areas and

that further progress would

require that we increasingly

distinguish ourselves from

other leading schools rather

than imitating them. The pur-

pose of the Strategic Plan was

to produce a blueprint for that

task.

JH: In 2000 you initiated a

comprehensive Strategic

Planning process that brought

together all the School’s major

stakeholders. What are the

results to date?

GD: The plan has three major

themes: using New York City

as a unique and rich educa-

tional resource; universal

excellence in all that we do;

and a culture that demands

excellence and innovation. I

think the early returns are most

promising. We are using the

city in new and remarkable

ways – like when our entire

first year class spent a day at

the Metropolitan Opera learn-

ing about the complexity of its

operations. Every one of our

academic departments has

been strengthened. Most

important, I think that we have

instituted processes and

instilled beliefs in our faculty,

staff and students that will con-

tinue to propel us forward.

A N I N T E R V I E W W I T H

DEAN DALY

2 Sternbusiness

JH: How have Stern students

changed in the last decade?

GD: They‘ve changed in two

principal ways. First, people

like Associate Dean Mary

Miller and Director of

Admissions Julia Min were

able to recruit some of the

best and brightest MBA stu-

dents. Vice Dean and Dean

of the Undergraduate School of

Business Fred Choi has also

recruited some of the best

undergraduates in the world

to Stern. The growth in test

scores was simply phenome-

nal. Even more important,

though, they instilled in those

students a deep sense of

pride and commitment.

JH: The Stern School has

many outstanding faculty

members, who are especially

strong in research. What

advantages does this research

strength bring to the education

process?

GD: The fundamental premise

of a research university is that

research and teaching are

complementary activities. I

deeply believe in this premise.

Good research is useful in its

own right because it keeps a

faculty member and his or her

students on the cutting edge.

But it also signals qualities of

mind that are very important to

the long run success of a pro-

fessor – the ability to assimi-

late, translate and build on the

ideas of others.

JH: One of your important ini-

tiatives was establishing an

executive education program.

Why did you take that step?

GD: First, Stern is located in

the center of the world’s largest

executive education market.

Frankly, it would seem rather

odd if we didn’t play a leading

role in this market. Second,

executive education puts us in

constant contact with leading

executives and firms. This is an

influential constituency that can

serve as a "relevance check"

for us as well as one with

which we can engage in a

learning process that is mutual-

ly beneficial and supportive.

JH: Stern prides itself on hav-

ing a very international student

body and faculty. How does

that contribute to the educa-

tional process?

GD: Stern was a pioneer in

international education long

before it became fashionable.

This was the result of some

pioneering efforts by some

exceptional faculty members as

well as the School’s location in

one of the world’s great cities.

As we have progressed, I think

we have learned that the

greater the variety of nations

and cultures represented in our

faculty and student body, the

more enriching the educational

experience. So we work hard to

recruit the best students from

around the world and expose

them to some exceptional

experiences in our School and

city and, most important, to

each other.

JH: One of your principal

accomplishments has been to

boost the amount of private

gifts to the School so that the

amount raised in the last 10

years surpasses what was

raised in the School’s previous

90-year history. What have

those resources enabled Stern

to achieve?

GD: The progress we have

made over the last decade

simply would not have been

possible without the great

financial support we have

received. What did it make

possible? The move to the

Square, the recruitment of so

many terrific students, faculty

and staff, the initiation of some

wonderful and innovative pro-

grams, the great expansion in

the quality of our facilities and

technology. We are competing

with a very different set of

schools than we were a

decade ago. This would not

have been possible without

our private financial support.

JH: What do you see as the

major challenges facing busi-

ness education today?

GD: Education at top busi-

ness schools has become

very expensive. This will

encourage other institutions to

enter this marketplace and

students to seek alternative

paths to the relevant skills

and expertise. Schools that

want to remain at the top will

have to seek constant

improvement in all of the fun-

damental dimensions of what

they do. Only in this way can

they assure the validity of

their "value proposition."

Universities are more tradition-

bound than most other institu-

tions. Somehow, we must

seek a sensible compromise

between some of these tradi-

tions and the needs of an ever

more demanding and competi-

tive marketplace.

JH: As you reflect on your

tenure as Dean of the Stern

School of Business, what are

you most proud of?

GD: I’m most proud of the

people who I have gotten

involved in the School,

whether as faculty, students,

staff, Overseers, or alumni,

and the pride and commitment

these people feel about the

institution. They are the ones

who have propelled the School

on its current trajectory and

they are the ones who will

take it to the very top.

JH: You have dedicated the

last nine years to moving Stern

forward by every measure.

How will you continue to work

for the advancement of Stern?

GD: I haven’t plotted my future

in detail but I’d be astonished if

it didn’t include a strong affilia-

tion with Stern – as a teacher,

(relatively young) elder states-

man, cheerleader, fundraiser

and contributor. I may do some

other things as well but I

expect New York and Stern to

be part of my life for the rest of

my life.

Sternbusiness 3

uch has been made inrecent years of thenotion of business aswar. In the late 1990s,

executives and management gurustook to quoting from Sun Tzu’s TheArt of War. The business pressjoined in, with headlines aboutmortal combat in the e-commercesector, “death-spiral” financing,and trench warfare in investmentbanking.

In light of the events ofSeptember 11, a day on whichmany people engaged in utterlypeaceful business became victims ofa new and horrible form of warfare,the metaphors seem remarkablyless apt.

Nonetheless, we are remindedthat studying past conflicts can helppresent-day executives improvetheir management. In their article(p. 6) Zur Shapira and JosephLampel argue that lessons learnedfrom the debacle of Pearl Harbor in1941 can inform the way managersdetect or prepare for sneak attacks.After all, they note, “strategic sur-prises can occur in business aswell.” The best defense for compa-nies – and for nations as well – isnot necessarily a massive physicalshow of strength or the rollout ofa conspicuous deterrent threat.Instead, the authors convincingly

argue, it lies in using and processinginformation about threats betterand more intelligently.

This article aptly sets the tonefor this issue of STERNbusiness,which focuses on the role, impor-tance, and use of information – inall its forms – in complex manage-ment challenges. The focus couldn’tbe more timely.

For in the current war on terror-ism – a remarkably complex globaloperation – bits and bytes of infor-mation are as crucial as horses andcrossbows were to combatants in theMiddle Ages. Consider the role ofmoney. Today, cold hard cash hasessentially been transformed intodata – it pulses through global net-works in bits of binary code, justas photographs and intelligenceanalayses do. As seen, this flow canhelp undermine security. “Just as theterrorists took advantage of our rel-atively open and porous educational,aviation, and immigration systemsto plan and execute their attacks,they also likely took advantage ofour financial systems,” write IngoWalter and Marti Subrahmanyam.(p. 14) They argue that as part ofthe war on terrorism, governmentsmust use financial intelligence toshut down the secret flows of terror-ist-abetting capital.

The events of September 11

have also altered the dynamicbetween government and the pri-vate sector, with industries rangingfrom hotels to insurance asking forfederal help. Nowhere has the inter-action been more intense than inthe battered airline industry. LarryWhite offers some intriguing sug-gestions on how airlines canimprove customer relations in thistime of crisis and perhaps coax peo-ple back to the air (p. 18). Theanswer lies in the innovative use offrequent flier miles.

In wartime, national resourcesare the key to a successful effort.Heroic U.S. industrial production inWorld War II helped set the stagefor victory. In this environment,however, information can be a cru-cial resource – for governments andfor businesses. Consider the veryterm data-mining. It intimates thatfor companies, information hasbecome as important as coal, gold,or oil.

Tapping into rich veins of datadoesn’t lead simply to profits orbusiness advantage, it can also leadto enhanced understanding ofrecent events. In their article (p.20), Eli Ofek and MatthewRichardson suggest a comprehen-sive and compelling argument as towhy the .com bubble of the late1990s formed, and why it burst.

D A T A

By Daniel Gross

M

4 Sternbusiness

ILLUSTRATION BYMICHAEL GIBBS

Contrary to the prevalent view,which lays the blame squarely atthe feet of malignant underwriters,hype-prone analysts and failed.coms, Ofek and Richardson con-clude that optimistic investorscrowded pessimistic investors out ofthe stocks, leading prices to rise farabove fundamental values. Whenlock-up agreements expired, acrowd of less optimistic sellersflooded into the market, alteringthe dynamics of a frenzied market.“Without an influx of optimisticnew capital to snap up the new sup-ply, the Internet stocks suffered adecline that quickly turned into arout,” they conclude.

Just because the .com investingbubble has burst doesn’t mean thatinformation technology’s influenceon business is over. Far from it.“Now we’re in E-commerce II, inwhich established players are usingthe lessons learned from the firstmovers to transform their business-es.” said Kenneth Laudon, in aninterview that hits on themes fromhis recently published textbook one-commerce. (p. 32) Regardless ofthe vicissitudes of the NASDAQ,Laudon notes, companies will con-tinue to use information technologyto redesign their businesses, theirmarkets, and their relationships toconsumers.

The fact that information has, inmany ways, replaced physical assetsas the driver of value, is a themethat Baruch Lev has been develop-ing for years. An expert on the roleof intangibles – assets you can see,but can’t necessarily touch, such aspatents, brands, and organizationalstructures – Lev has laid out his the-ories in a new book, Intangibles:Management, Measurement, andReporting, which we are proud toexcerpt here (p. 26). Lev arguescompellingly that the increasingprominence and value of such infor-mation-based assets should leadinvestors, managers, and anlaysts tore-examine the way we account forcorporate assets and liabilities.

Of course, even in the informa-tion age, old-fashioned commodi-ties are still important cogs of theeconomy. Cotton is one of the old-est, and most historically importantto the United States. Throughoutthe 1950s and 1960s it lost marketshare to foreign competition andthe relentless growth of syntheticfabrics. But in the 1970s and1980s, as George David Smith andTimothy Curtis Jacobson show (p.36), cotton growers managed toturn their fortunes around. How?By relying on up-to-date informa-tion-based strategies. A brilliantlyconceived and executed marketing

and advertising campaign aimed atconsumers changed the way peoplethought about cotton, and researchand development helped make thesnowy white stuff more appealingto industry. At the dawn of the 21stcentury, this crucial industry reliesas much on favorable weather as itdoes on the savvy use of informa-tion. Staying competitive, theauthors note, “requires investmentin technology, management, andmarketing, and a broad-basedknowledge of world affairs, fromthe weather in Australia to politicalconditions in Pakistan, from what’sfashionable in Paris to what’s hap-pening in the world’s genetic andbiochemical laboratories.”

With the decline of the NASDAQand a slowdown in the growth oftechnology spending, many pun-dits have been quick to proclaimthat the much ballyhooed infor-mation age was coming to an end.For investors soured on the promiseof upstart companies, that may betrue. But as the wide array ofarticles in this issue suggest, forexecutives and managers in indus-tries ranging from cotton to bank-ing, the information age is justbeginning.

DANIEL GROSS is editor of STERNbusiness.

M I N E

Sternbusiness 5

6 Sternbusiness

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istory records manyinstances of deadlystrategic surprises.Hitler’s invasion ofthe Soviet Union in

1940. Japan’s attack on PearlHarbor in 1941. The September 11,2001, terrorist attacks on New Yorkand Washington.

Fatal strategic surprises canoccur in business as well, as compa-nies find that customers or clientsmay switch suddenly from coopera-tive to predatory behavior.

Like governments, businessestry to defend themselves throughdeterrence, and by constantly gath-ering and interpreting information

and intelligence. But guardingagainst strategic business surprisesis difficult, because they are rela-tively rare. In any given relation-ship they are likely to happen onlyonce. What’s more, in order to esti-mate the risk of a strategic surpriseone must engage in the tricky taskof focusing on behavior that is likelyto signal opportunistic intent.

When companies encounterbehavior that deviates sharply fromestablished patterns of interaction,they have to decide whether to ter-minate the relationship, or regardthe unexpected behavior as randomor accidental. Because they have toact quickly, companies sometimes

react mistakenly. They might termi-nate a relationship unwarrantedly –a mistake that eliminates the risk ofstrategic surprise, but also couldend a valuable relationship. Orthey might underestimate the riskof opportunism and thus makethe firm more vulnerable tostrategic surprise. We define thosemistakes as Type I and Type IIerrors, respectively.

Also, most companies do not relysolely on past behavior when mak-ing inferences about the threat ofstrategic surprise. They also tend torely on behavioral norms, whichconstrain opportunism and shapegeneralized expectations about how

SneakAttacks

By Joseph Lampel and Zur Shapira

In business, as in war, strategic surprises can prove devastating. But

operating at a permanently high level of alert carries its own potentially

damaging costs. Savvy managers can occupy a safe and effective middle ground.

H

Sternbusiness 7

business partners are likely tobehave. But since there is also onlya small amount of data available onhow strongly partners adhere tonorms, inference is likely to ampli-fy errors in judging the trustworthi-ness of partners.

Given these constraints, howcan companies guard againststrategic surprises while avoidinghasty judgments and maintainingvaluable business relationships?The answer lies in using tools andtheories from economics, psycholo-gy, and sociology.

Judgment and StrategicSurprises: A Model

Strategic surprises occur whenan actor switches from behaviorthat reinforces cooperation andfriendliness to one that expresses anaggressive or non-cooperativeintent. The surprise results fromspeed, which allows little time forwarning or defensive measures, andfrom the contrast between assump-tions held before the action and theintent revealed by the action. Thegreater the contrast, the greater thesurprise.

Companies try to insulate them-selves from such surprises by gath-ering information and processing it.When they do, executives routinelyclassify information either as asignal (a legitimate warning) or asnoise (irrelevant information). Inacting wrongly on these judgments,they may commit errors.

Gathering more information canhelp reduce – but not eliminate –judgmental errors. And at the timeof decision, it is impossible toreduce the probability of one errorwithout increasing the probabilityof the other. To expand on thispoint further, we turn to a modelthat has its roots in Signal Detection

Theory. It is described in Figure 1. The horizontal axis depicts the

severity of the signal – say the num-ber of delays in fulfilling an order –and whether those involved apotentially low or high cost. Herethe input is primarily information.When the severity reaches the valueX , defensive action is warranted.The vertical axis depicts the degreeof surprise, which varies with thedegree of speed and the contrastbetween previously held assump-tions and revealed action. Here theinput is primarily interpretation.Events above yc are defined asstrategic surprises and those belowit are regarded as “noise.”

As seen in the grid, there arefour possible outcomes: (1) Truealarms are cases in which precau-tions are taken that are justified by

subsequent events; (2) False alarmsare cases in which precautions arenot justified by subsequent events;(3) Strategic surprises are cases inwhich no alarm was followed by anevent that shows precautionsshould have been taken; and finally(4) True noise are cases in whichthere are no alarms and no eventsto suggest that precautions shouldhave been taken.

Looking at Figure 1, it is clearthat one can err either by respond-ing to a false alarm (a Type I error)or by failing to interpret the signalproperly and falling victim to astrategic surprise (a Type II error).

The challenge for executives anddecision-makers, then, is to simulta-neously reduce the frequency andcost of both false alarms and strate-gic surprises. The historical example

8 Sternbusiness

c

ALARM TRIGGER

FIGURE 1.THE RELATION

BETWEEN SEVERITYOF SIGNAL, ALARM

THRESHOLD ANDSTRATEGIC SURPRISE.

yc

NOIS

ESU

RPRI

SE

NO DEFENSIVE ACTION DEFENSIVE ACTION

TRUE ALARMSSTRATEGIC SURPRISE

TRUE NOISE

FALSE ALARMS

xc

of the 1941 Japaneseattack on Pearl Harborillustrates how difficultthis can be.

A Date That WillLive in Infamy

In Pearl Harbor:Warning and Decision,Roberta Wohlstetterconcludes that: “Neverbefore have we had socomplete an intelligencepicture of the enemy.”Before the attack,Japanese codes hadbeen broken, and infor-mation from Britishintelligence, diplomatsand journalists washighly accurate. In spiteof the constant flow ofinformation pointing toan imminent Japaneseattack, American forceswere caught entirely bysurprise. The surprise isconsistent with ourmodel in two respects. Informationindicating a Japanese attack led toa series of false alarms, which ulti-mately undermined vigilance. And,assumptions about the low likeli-hood of a surprise attack ledAmerican intelligence to discountinformation pointing to an attack.

On three separate occasions – inJune 1940, in July 1941, and inOctober 1941 – information aboutJapanese intentions led to the decla-ration of a state of alert in PearlHarbor. The third alert, on October16, 1941, directed American com-manders to deploy forces in readi-ness to repel such an attack Whenan attack did not materialize, thesealerts were seen as costly and dis-ruptive false alarms. By the timethe third alert was issued, there was

a strong tendency to discount warn-ings and relax vigilance.

Pearl Harbor was also a failureof interpretation in the face of pow-erful evidence. The possibility of aJapanese attack on Pearl Harborhad long been part of Americanstrategic thinking in the 1930s. InApril and July 1941 two separatereports forecast the Japanese attackin some detail. Nonetheless, theAmerican military discounted thispotential outcome because theybelieved the risks involved (for theJapanese) to be too great.

It is tempting to argue that ifAmerican intelligence had beentruly excellent, it would have sur-mised the date of the attack andpossibly even the target. But there isalways a gap between the informa-

tion available and theinformation needed forcompletely accurate pre-diction. And closing thatgap requires not justextraordinary foresightbut also a major commit-ment of resources.

Indeed, reducing therisk of strategic surprise,either by taking precau-tionary defensive meas-ures or by investing incomprehensive intelli-gence systems, can bevery costly. The SovietUnion discovered thatguarding against a sur-prise nuclear attackimposed crippling andpotentially fatal costs.This holds true to aneven greater extent forfirms that have limitedresources at their disposal.

BalancingDependence Against

the Risk of SurpriseThe limits of reducing the risks

of strategic surprises are especiallyevident when in businesses regulat-ed by non-contractual relation-ships. In many industries, includingautomobiles, textiles, publishing,and movies, such relationships aredisplacing contracts as the mainconduit for transactions betweenbuyers and suppliers.

As a stream of orders producesmutual understanding and expec-tations, the relationships deepen.But these understandings andexpectations in turn have impor-tant implications for decision-making. Firms are more likely toinvest in specialized machineryand production processes if theycan rely on future orders from

"On three separate occasions –in June 1940, in July 1941, and in

October 1941 -- informationabout Japanese intentions led tothe declaration of a state of alert

in Pearl Harbor. . .When anattack did not materialize, thesealerts were seen as costly and

disruptive false alarms.

Sternbusiness 9

certain customers, forexample.

An excessive relianceon a single partner canopen companies up tostrategic surprises. In the1990s, TCI ManufacturingLtd., a Canadian firm,was the sole supplier ofcomputer cases and powersupply systems to PowerComputing Corp., whichproduced Macintoshclones. The relationshipwas governed by a stan-dard purchasing agree-ment with a thirty-daytermination clause. InSeptember 1997 Applepurchased Power's coreassets and its license tomanufacture clones for$100 million. In shortorder, Power severed itsrelationship with TCI,forcing the supplier toshutter most of its opera-tions. The prospect of such an out-come haunts all firms in contract-ing-subcontracting relationships.

In the 1980s, researcher E.H.Lorenz studied how 10 industrialmachine-producing firms locatedaround Lyons, France, dealt withsuch issues of dependence in non-contractual relationships. The firmsdeveloped profitable relationshipswhereby the manufacturers out-sourced the production of key com-ponents, while suppliers invested innew technology. But this arrange-ment carried certain risks. The pro-ducer ran the risk of late delivery orpoor quality parts, and the supplierran the risk that after it made thecostly investment the producerwould fail to place sufficient orders.

The obvious way of reducingsuch risks is to stipulate them con-

tractually. But drafting contracts isexpensive and may foster risk aver-sion. An excessive preoccupationwith the possibility of opportunisticbehavior inevitably leads to a pro-liferation of hypothetical contin-gencies under which opportunisticbehavior could be advantageous.And that produces a heightenedsense of risk and a defensive pos-ture.

Instead, Lorenz found that theparties dealt with risks informally,often by making commitments thatare intended to build confidence.For example, producers agreed tobuy at least 10% of the subcontrac-tor’s output but no more than 15%.This meant specialized investmentby subcontractors would be worth-while, but that no subcontractorwould be excessively dependent on

a single customer. Thesubcontractor agreedto invest in new tech-nologies, to be pricecompetitive relative toother suppliers, and todeliver quality compo-nents on time. Inreturn, the producersinformally guaranteedthat they would notinstantly drop the sub-contractors if competi-tors were to offer betterterms.

The expectationsand promises were notalways spelled out incontractual language,which preserved flexi-bility for all parties.But this constructiveambiguity also opensthe way for strategicsurprises. Confrontedwith a request for post-ponement of delivery,

firms will be unsure how to inter-pret the move. Does the lapse repre-sent a clear signal that the subcon-tractor is behaving with oppor-tunistic intent? And how late does alate delivery have to be before itdeserves close attention?

Answering these questionsbecomes particularly difficult whenan event falls into that ambiguousarea in which events are regardedas outside acceptable norms, butnot sufficiently serious to requireaction. And this is the momentwhen entities become vulnerable tostrategic surprises.

False Alarms and StrategicSurprises

During the Cold War, both theU.S. and the U.S.S.R. built immenseearly warning systems to guard

"An excessive preoccupationwith the possibility of

opportunistic behavior inevitablyleads to a proliferation of

hypothetical contingenciesunder which opportunistic

behavior could be advantageous.And that produces a

heightened sense of risk and a defensive posture."

10 Sternbusiness

against surprise, full-scale nuclearattacks. Initially, the greateramount of information that thesesystems collected reduced vulnera-bility to surprise attacks. But as thesystems became more sophisticated,each side faced a new dilemma.Various innocent activities could beinterpreted by an overly sensitivesystem as the initial stages of an allout attack. So to reduce the risk oflaunching a false preemptiveattack, the superpowers built alertsystems that decreased the sensitiv-ity of the system to incoming infor-mation.

Let us assume that businessesdevelop similar early warning sys-tems, with three states of alert. Thefirst state, green, represents busi-ness as usual. The second state, yel-low, is characterized by increasedvigilance by certain managersdirectly involved in sales or pur-chasing. The third state, red,denotes a high level of attention onthe part of managers, includingmeetings to decide on what actionsare called for. These alerts are sim-ilar to the areas marked in Figure 1,where green equals true noise, redequals true alarm, and yellowmarks both false alarms and strate-gic surprise. The yellow alert stageis marked by ambiguity, whichmust be resolved by a judgmentaldecision.

So, should a subcontractor adopta green, yellow, or red alert status ifan established customer reducesorders? The answer depends onwhere you draw the lines betweenthe three alert states. Let us assumethat a subcontractor emulates aCold War superpower. She sets theyellow and red alerts at relativelylow levels during initial dealingswith an unfamiliar client. If theclient’s behavior remains below the

yellow alert level, she will inevitablyincrease trust and raise the thresh-old. If a client violates the thresh-old, this may result in less trust.The supplier becomes more vigi-lant, and spends more time inter-preting cues that previously wouldhave been ignored.

However, the supplier may thinkthat it is the alert that is unreliablerather than the client, and thereforedecide to raise the threshold level.After all, lowering the alert thresh-old raises costs to managers andorganizations. A yellow alert forceskey managers to rearrange sched-ules and priorities, while a red alertmay force organizations into costlypreemptive actions. And if theybelieve that the violation of the yel-

low alert threshold is accidental anddoes not reflect their partners’trustworthiness, they will adjust thethreshold upward. This dynamic,illustrated in Figure 2, leads us tothe following conclusion:

Proposition. In non-contractualrelationships, the estimation of theprobability of a strategic surprise ishighly sensitive to false alarms.This sensitivity arises from thenecessity of inferring the probabili-ty of strategic surprise from a smallsample of available data on falsealarms. In addition, when recentfalse alarms are associated withhigh costs, there is a tendency toraise the alarm threshold, therebyincreasing the probability ofstrategic surprise.

Sternbusiness 11

ALARM TRIGGER

xc

yc

NOIS

ESU

RPRI

SE

TRUE ALARMSSTRATEGIC SURPRISE

NO DEFENSIVE ACTION DEFENSIVE ACTION

FIGURE 2.RAISING THE

THRESHOLD FORTHE ALARMTRIGGER.

TRUE NOISE

FALSE ALARMS

NEWALARM TRIGGER

xc1

Norms and StrategicSurprises

Competition and cooperationbetween companies would not bepossible without a variety of explic-it norms and sanctions that arerooted in legal and regulatory struc-tures. The assumptions, however,are often also informal and tacit.Industries, after all, are social sys-tems in which repeated interactionsgive rise to informal norms coveringareas such as avoidance of pricerivalry and mutual forbearance ofentry into each other’s market.

In dependency producing inter-actions, repeated interaction canchange the basic character of therelationship from a casual arms-length relationship to one of part-nership. Lorenz noticed the devel-opment of “moral contracts” insome cases he observed, a seriesof undocumented understandings.And for the most part, the effective-ness of such “moralcontracts” dependson relatively ambigu-ous norms.

Because normsthat govern coopera-tive relationships arestructurally morecomplex, their viola-tions are susceptibleto multiple interpre-tations. A deliverythat is late by a day,or a batch that hasseveral more defec-tive parts than usual,can be explainedaway. A problemarises when we enterthe aforementionedyellow zone, wheredelays and defectrates may give cause

for concern. It is at this point thatmanagers often begin to suspectthat their partners are only payinglip service to the agreement andmay not be truly bound by norms.

Indeed, it is not safe simply toassume that a partner will adhere tonorms without also evaluating theextent to which he embraces them.But evaluating the degree to whichpartners embrace norms as opposedto simply following them is diffi-cult. Decision makers tend to relyon the tendency of norms governingone kind of behavior to be relatedto norms governing other types ofbehaviors. For example, it is gener-ally believed that a subcontractorwho is willing to make last minutechanges to an order without extracharge is likely to embrace normsthat constrain taking advantage inother situations. Norms can there-fore be regarded as social and cog-nitive constructs that link different

populations of events. In any industry where norms are

in place, norm espousal usually pre-cedes norm adherence. Talkingabout norms makes it easier tobehave according to them. In ourterms, norms can be conceived asaverage behavior resulting fromlong-term interactions that can pro-vide at times a better guide forbehavior than judgment based on afew recent events. This moralgrounding is reinforced by thesocial nature of the interaction.Lorenz found that the friendly lan-guage used by the companies hestudied, conveyed to subcontractorsthat “when in doubt they should actas if their actions were guided bythe norms of friendship.”

Acting “as if” norms are in forceis easier if there is sufficient historyto suggest that norm espousal isstrongly correlated with normadherence. And this line of rea-

soning leads us totwo important con-clusions regardingnorms and strategicsurprises. The firstis depicted graphi-cally in Figure 3. Itholds that in indus-tries where normshave developed overa short period oftime, firms are morel ike ly to regardbehavior that iscontrary to normsand expectations asvalid indicators ofopportunistic inten-tions. That, in turn,makes them moreprone to lower thealarm threshold thanfirms in industries

"Firms should scrutinize theirenvironments continuously in anattempt to detect changes thatmay affect their partners’ goals

and intentions."

12 Sternbusiness

in which norms have developedover a long period of time. In otherwords, when companies move thealarm criterion to xc2 on the left,this increases the probability offalse alarms, but decreases theprobability of strategic surprises.

The opposite problem exists inindustries with a longer history ofnorm espousal and norm conformi-ty. Since there is more evidence tosupport the belief that norms are inforce, there is a greater tendency toconclude that norm following is astrong index of norm embracing.Accordingly, firms place moreweight on norms when interpretingtheir partners’ intentions and lessweight on recent evidence of poten-tially opportunistic behavior. This

tendency leads firms to downplaythe importance of recent evidenceand false alarms. If, in addition, thecost of recent false alarms has beenhigh, firms may raise the level ofthe alarm trigger. Doing so reducesthe probability of false alarms, butalso making firms more vulnerableto strategic surprises.

ConclusionsWhile it is not possible to elimi-

nate strategic surprises, there arepotential measures firms can taketo reduce their frequency. From aneconomic perspective, firms shouldattempt to diversify their depend-ence on buyers and suppliers so asnot to reach an extreme level ofdependence. Furthermore, compa-

nies should include enforcementcosts in assessing the probability ofopportunistic behavior by partners.Many relationships are built onlegal agreements that can deterpredatory opportunistic behaviorby partners if they are enforceable,and especially if they are enforce-able at relatively low cost.

From a sociological perspective,companies should not rely too muchon history in predicting their part-ners’ intentions. Even if historicalevidence is systematically collected,it is not a guarantee against poten-tial changes in partners’ intentions.Firms should scrutinize their envi-ronments continuously in anattempt to detect changes that mayaffect their partners’ goals andintentions. Finally, they shoulddevelop a sound process of inter-preting the information that isgathered from several differentsources.

The global marketplace, like theworld itself, is fraught with oppor-tunity and danger. And even themost cleverly designed strategiescan leave companies and countriesvulnerable to strategic surprise. Thechallenge for government policy-makers and corporate decision-makers is not, then, to eliminaterisk – that may prove too difficult –but to manage it.

JOSEPH LAMPEL is currently professorof strategic management at the CityUniversity Business School in London, UK,and was an assistant professor of man-agement at NYU Stern from 1989 to 1996.Z U R S H A P I R A is research professor ofmanagement and organizational behavior atNYU Stern. This is an abridged form of anarticle that appeared in Organization Science,Vol. 12, No. 5, September-October 2001.

Sternbusiness 13

ALARM TRIGGER

xc

yc

NOIS

ESU

RPRI

SE

TRUE ALARMSSTRATEGIC SURPRISE

NO DEFENSIVE ACTION DEFENSIVE ACTION

TRUE NOISE

FALSE ALARMS

NEW ALARMTRIGGER FIGURE 3.

LOWERING THETHRESHOLD FOR

THE ALARMTRIGGER.

xc2

The global f inancial network provides both a means for terroristsauthorities can track, isolate and attack wrongdoers. In the war on

14 Sternbusiness

Secret Agents:

FinancialSecrecyand theWar onTerrorismBy Marti Subrahmanyam and Ingo Walter

The attacks on New York City and the Pentagonon September 11 set the United States and itsallies on a new, and unprecedented, war footing.Like previous global conflicts, the battle against terrorism will be waged

on many fronts. Initially, much of the press and public attention has

rightly focused on the military front in Afghanistan. Other crucial theatres

of operat ion received attent ion as wel l , including the f inancial f ront.

to gain resources and an avenue through which law enforcementterrorism, we must also activate troops on the f inancial front.

Sternbusiness 15

ILLU

STR

ATI

ON

S B

YMIC

HA

EL G

IBB

S

ince September 11, policy-makers have focusedresources on developingthe means to anticipate and

prevent such incidents in the future.And across the board, experts andpoliticians agree that more resourcesmust be devoted to gathering andanalyzing intelligence. As a result,the Central Intelligence Agency, theFederal Bureau of Investigation, andmilitary intelligence units are likely toreceive greater funding.

Ironically, the discussion has notfocused quite as much on financialintelligence. After all, authoritiescould – and should – use financialsystems to cut off the air supply ofterrorists. Even though the attacksof September 11 were reportedlycarried out on a relatively modestbudget – about $300,000 – theycould not have been carried outwithout adequate and timely fund-ing. And just as the terrorists tookadvantage of our relatively open andporous educational, aviation, andimmigration systems to plan andexecute their attacks, they also tookadvantage of our financial system.

Indeed, there is now plenty ofevidence to suggest that terrorists,and those who support them, areusing the global financial network asa conduit for funding mayhem.There have been reports of financialsupport to extremist organizationsfrom businessmen and companies ina number of countries. And one ofthe more intriguing – and bizarre –trails of the September 11 attacksfocused on the unusual activity priorto the attacks in financial instru-ments such as put options on thestocks of airline and insurance com-panies. The value of these instru-ments appreciated considerably asstock market indexes and the stockprices of severely-impacted compa-nies fell after September 11. There

remains a suspicion that some asso-ciates of the terrorists were, in fact,aware of the impending attack andits possible financial market conse-quences.

Regardless of the scope andambition of their goals, terroristsneed financial secrecy to achievetheir aims. Of course, virtually alllegitimate businesses need financialsecrecy as well. In fact, secrecy

forms an integral part of the marketfor all banking and financial servic-es, fiduciary relationships, and regu-latory structures. Secrecy is a “prod-uct” that has intrinsic value, andthat can be bought and sold sepa-rately or in conjunction with otherfinancial services. This means thatas we activate troops on the finan-cial front, we must distinguishbetween the need to penetrate thesecrecy needed by terrorists from theimperative to protect the financialsecrecy needed by other users of thefinancial system, most of whom aretotally legitimate. Since terrorism-related financial flows are most like-ly a drop in the ocean of legitimatefinancial flows, they need to be tri-angulated, attacked and throttledwith least possible damage to thefinancial system as a whole.

The longstanding desire forfinancial secrecy stems from severalpowerful imperatives, and the phe-nomenon has several different man-ifestations. Personal financial secre-

cy usually remains in substantialcompliance with applicable lawsand regulations, and in many coun-tries has been well served by long-standing traditions of banking con-fidentiality. Likewise, businessfinancial secrecy involves the gener-ally legitimate withholding financialinformation from competitors, sup-pliers, employees, creditors and cus-tomers. Such financial informationis proprietary and capitalized inthe value of a business to its share-holders.

Other forms of financial secrecyskate closer to the edge of the law.Capital flight normally refers toan unfavorable change in therisk/return profile associated with aportfolio of assets held in a particu-lar country thought sufficient towarrant redeployment of assets.Capital flight may or may not vio-late the law, but is usually done insecret. Tax evasion – illegally avoid-ing payment of fiscal levies – is aclassic source of demand for finan-cial secrecy, and requires varyingdegrees of financial secrecy to work.Finally, there’s criminal activity.Drug traffickers and smugglers notonly accumulate large amounts ofcash, but also regularly deal in avariety of financial instruments andforeign currencies. So do gun run-ners and terrorists. All require waysto launder funds and eliminatepaper trails that might be taken asevidence of criminal activity; theirill-gotten gains need to disappearand stay hidden.

egardless of the moti-vation, the value ofsecrecy depends onwhat may happen ifthe cover is blownand the probability

of subsequent exposure of the par-ties and transactions concerned.Damage can range from criminal

S

R

"Just as the terroriststook advantage of our

relatively open andporous educational,

aviation, and immigrationsystems to plan and

execute their attacks,they also took advantageof our financial system."

16 Sternbusiness

prosecution, exile, and politicalostracism to confiscation of assets,fines, taxes and penalties, socialopprobrium, and familial tension.The avoidance of damage is whatthe secrecy-seeker is after. And sincedamage usually is a matter of prob-abilities, the attitude toward the riskof exposure is a critical factor in howthis benefit is valued. In the case ofterrorism, a serious financial systemreform can affect these odds andchange the perpetrators’ attitudes toundertaking such activity.

In order to combat terrorism-related financial flows, we mustuncover the financial conduits beingused and then close them. This is anadmittedly ambitious goal. And it ismore than likely that the measureslaw enforcement authorities andfinancial institutions employ cannotpossibly be granular enough toidentify only the targeted flows.Consequently, they are likely to pullin a lot of financial “by catch.”Some of these efforts will producecollateral dividends, such as root-ing-out criminal financing in thedrug business or the illicit armstrade. And some will make tax eva-sion much more difficult, andimprove tax compliance – especiallyin countries with poorly structuredfiscal regimes.

If governments now get seriousabout going after the terrorists’secret financing channels – and gov-ernments have plenty of leverage onbanks and other financial firms ifthey decide to use it – everyone elseinvolved in the illicit funds flows(estimated to be $1.5 trillion annu-ally) will start squirming. Chancesare the dragnet will come up withmuch more that the authorities bar-gained for. Secrecy-seekers of theworld should fasten their seat-belts!

To be sure, there will be negativeoutcomes on the financial front. The

new campaign will impose costs onpeople who want to move funds toless risky political or economicregimes, who want to keep thingsconfidential for business or familyreasons, or who simply considertheir own financial situation to benobody else’s business. These costsare hard to measure, but they aredoubtless significant and have to beconsidered “collateral damage” inthe war on global terrorism.

As always, the trick is to limitthat damage by using finely-honed,“surgical” regulatory techniques.Unfortunately, we are in unchartedterritory here. So as they designthe new anti-terrorism financialweaponry, policymakers must try todevise financial early-warning sys-tems that bolster the public interest

while limiting the adverse conse-quences.

It is clear that we need to developtechniques that can monitor terror-ist activities as well as enforce secu-rities laws and combat drug-relatedcrime. Any anti-terrorism task forcecertainly needs the kind of manpow-er, financial and technical, that isfully up to the task and capable ofcoping with the inevitable unintend-ed consequences. Looking for nee-dles in a haystack rarely leaves thehaystack the same.

M A R T I S U B R A H M A N YA M is CharlesE. Merrill professor of finance, economics,and international business at NYU Stern. I N G O WA LT E R is Charles Simon Professorof international business, economics, andfinance at NYU Stern.

"If governments now get serious about goingafter the terrorists’ secret financing channels

everyone else involved in the illicit fundsflows will start squirming. Chances are the

dragnet will come up with much more than theauthorities bargained for."

Sternbusiness 17

lmost instantly after theattacks the picture lookeddismal for the industry.

They were not allowed to fly forfour days. And when they couldagain take to the skies, with air-ports gradually opening, it wasclear that demand would be sub-stantially reduced. Potential pas-sengers were afraid: of flying, ofbeing away from home, of facinglong hassles at the airport. Evenhardened business “road warriors”were pulling back from their fre-quent flying patterns.

It was a time for a bold visionand bold actions by the airlines’senior managements. Instead, theiractions were tentative and timid atbest.

After some delay, the airlinesembarked upon modest efforts tocoax their customers to return tothe skies. The most common effortsinvolved some fare promotionsaimed at business flyers, plus someextra frequent-flyer miles thrown

in. Also, some airlines eased theirrequirements for the redemption offrequent-flyer mileage for travelawards – cutting the standardrequirement from 25,000 miles to15,000 for a few weeks.

Such reductions were a goodstart. But the airlines needed to gomuch further much faster. From thefirst day of the resumption offlights, the airlines should haveoffered flight awards at even lowerlevels: redemptions of only 10,000miles, or perhaps even 5,000 miles– a fifth of normal requirements –but valid only for the next month ortwo. In addition, the airlines shouldhave opened up larger allocations ofseats that would have been eligiblefor the use of these awards. And, ofcourse, they needed to publicizewidely these expansive actions.

At first blush, giving away moreairline seats would seem like anexpensive proposition for the strug-gling airlines. But this strategywould in fact have carried little cost

and would have brought them con-siderable benefits. The carriers hadfar too many empty seats on theirflights. If they quickly filled thoseotherwise empty seats with addi-tional frequent-flyer passengers,the extra costs would have beensmall – a few more meals and a fewmore gallons of jet fuel for the addi-tional weight – so long as the extrapassengers did not displace payingcustomers. Given the decline inbusiness travel and the low loadfactors on most routes, this prospectwas not a serious problem.

Now consider the benefits. First,the airlines would instantly havehad more customers, who wouldthen have informed their friendsand family that it was indeed safeto fly again. That would surely havestimulated greater subsequentdemand for paying tickets. Second,the airlines could have reduced – atvery small cost – the huge overhangof potential frequent-flyer awardsthat customers have accumulated

By Lawrence J. White

Few industries were harder hit by the terrorist attacks of September

11 than the U.S. airlines. In the weeks after the hijackings, plummeting

bookings forced airlines to cancel flights and reduce their carrying

capacity by up to 30%. The industry laid off tens of thousands of

employees. And even though Congress rapidly passed a $15 billion

package of grants and loan guarantees, the financial outlook is grim.

Battered by the events of September 11 and the recession,U.S. airlines are ailing. The prescription: coax travelers backto the air by relaxing the rules on redeeming frequent flier miles.

A

Going the Extra Miles

18 Sternbusiness

and that industry analysts haveoften described as a sizable futureliability for the industry. Third, theairlines would have built substan-tial goodwill and customer loyaltyamong their customers, many ofwhom have been frustrated in thepast by the unavailability of seatsfor frequent-flyer award travel.

This strategy would also haveproduced beneficial effects forrelated parts of the vacation travelindustry, which have also been hardhit. Though these additional travel-ers would not have been paying fortheir airline tickets, they would stillhave spent money on hotel rooms,rental cars, restaurant meals, andtaxis while on their travels. Theairlines wouldn’t have benefiteddirectly from that spending.Nonetheless, it would certainly haveearned them additional friendsand goodwill – and maybe someadditional paying flights – fromemployees and executives inthose industries.

Of course, there were and stillare other preconditions for revivingrobust air travel in the U.S., such asimproved security procedures andreduced airport delay and hasslefactors. But stimulating demandhas many facets, and radicallyexpanded frequent flyer awardsshould have been among them.

By now (March 2002) the win-dow of opportunity has closed.Awash in red ink, the airlines havecut back substantially on theirflight frequencies and availabilities.With their reduced flight schedulesthere are fewer empty seats. Theopportunity costs of drasticallywidening their frequent flyerawards have risen, while the likelybenefits have diminished.

In sum, September was a timefor the airline industry to have beenbold and expansive in an areawhere it was perceived as timid andstingy. By liberalizing frequent flyerreward programs, airlines couldhave reaped substantial benefits at

quite modest costs. Easing theserequirements would surely havebeen a win-win proposition for theairlines, their customers, theiremployees, and their travel industrybrethren. That’s a combination thatwould have been hard to beat. It’s apity that the opportunity was notgrasped.

Perhaps the current senior man-agements of the industry will sur-vive the current crisis; perhaps not.In any event, some companies,under some brand names, withsome managements, using someaircraft will surely be flying in thefuture as the economy revives andtravelers’ fears of flying recede. Letus hope that those managementsnever face as severe a crisis asoccurred on September 11. But letus also hope that they will face anyfuture crises with fresher ideas andless restricted outlooks.

L AW R E N C E J . W H I T E is Arthur E.Imperatore professor of economics at NYU Stern.

Sternbusiness 19

©ARTIST(S)/SIS

THE RISE AND FALL OF

20 Sternbusiness

INTERNET STOCK PRICES

DOTCOM MANIABy Eli Ofek and Matthew Richardson

Combine an exc i t ing new techno logy, a soar ing s tock market ,

and masses o f h igh ly opt imis t ic ind iv idua ls investors . Then

add an immense new supp ly o f shares o f fe red by somewhat

l e s s e x u b e r a n t o w n e r s . W h a t d o y o u g e t ? A s t o c k b u b b l e .

y any measure, the run-up in the price andtrading in Internet-related stocks between1998 and the spring of

2000 was extraordinary. Companieswith little revenues and no profitscommanded billion-dollar marketcapitalizations. In February 2000,the largely profitless Internet sectorequaled 6% of the market capital-ization of all U.S. public companies,and 20% of all publicly trade equityvolume. In just a two-year period oftime, the entire sector earned over1000% returns on its public equity.All is well documented now, the.com bubble burst in the spring of2000 with an eventual decline backto 1998 levels.

Scholars, pundits, and analystshave put forward many explana-tions for the stunning rise – and

stunning fall – of Internet stocks.But most have failed to get the rootof a perplexing question. How didthe apparent mispricing of Internetstocks persist in the presence ofwell-funded, rational investors?

We’ve got a hypothesis. As pricesrose and the bubble was created, themarket became dominated by opti-mistic individual investors, whocrowded pessimistic investors out ofthe market. The shift in investor sen-timent created a frenzy of demand forthe initial public offerings ofInternet-related stocks, which in turnboosted prices to untenable levels.And when so-called “lock-up peri-ods” ended – which meant companyinsiders were suddenly able to sellportions of their large stakes – a mas-sive new supply of Internet stocksbecame available for trading.Without an influx of optimistic new

capital to snap up the new supply, theInternet stocks suffered a decline thatquickly turned into a rout.

It’s a relatively simple proposition,but one that must be backed by data.

Were Internet StocksOvervalued?

A graph of the index of an equal-ly-weighted portfolio of a universeof Internet stocks and the S&P 500and the NASDAQ between January1998 and December 2000 showssubstantial divergence in relativepricing. (Figure 1 ).

The data further shows that thesehigher prices were real – i.e. that sub-stantial amounts of trading took placeat such levels. We studied some 400Internet-related companies betweenJanuary 1, 1998 to February 29, 2000,the majority of which went public in1999 and early 2000. While they had

Sternbusiness 21

B

©A

RT

IST

(S)/

SIS

an average price ($56) and averagemarket value comparable to those ofnon-Internet firms, these NewEconomy stocks were far more volatilethan their Old Economy peers. Theaverage volume per stock in this periodwas three times higher for Internetfirms than for non-Internet companies.

What did the market have to expectin order to justify the high valuationsaccorded Internet stocks at the heightof the .com frenzy? We calculated theaggregate earnings of each of 11 sepa-rate Internet-related sectors – portals,b2b commerce, infrastructure, etc. –using Compustat. Because many ofthese companies had negative earn-ings, even the aggregate earnings num-

bers were negative. So we measuredearnings potential by backing out theimplicit earnings of the sector, assum-ing that the companies in the sectorhad already achieved income marginsof their industry counterparts. The“earnings” were calculated by multi-plying aggregate revenues by theassumed income margin. Then, weestimated the price-to-earnings (P/E)ratio by dividing a sector’s aggregatemarket value by its implicit earnings.

Figure 1 reports the findings forthe eleven sectors. To take one example,in February 2000, the 50-company e-commerce sector had an aggregatemarket capitalization of $72.675 bil-lion, aggregate revenues of $4.459 bil-

lion, and net income of negative $3.565billion. Using the comparable non-Internet industry margins of 1.9%, webacked out implied earnings of $85million, which gave the industry animplied, New Economy P/E ratio of856. The vast majority of the Internetfirms had P/E ratios that were similar-ly high. Almost 20% of the firms hadP/E ratios greater than 1500, whilemore than 50% exceeded 500.

To grow into such valuations, thesecompanies would plainly have to out-perform the overall market by a signif-icant factor. Simply to support an his-torically high P/E ratio of 20, theInternet sector would need to generate40.6% excess returns for a 10-yearperiod to justify its current implied P/Eratio of 605. How large is 40.6% for10 years? When they examined the dis-tribution of earnings growth over a 10-year period from 1951-1998,researchers Louis K.C. Chan, JasonKarceski, and Josef Lakonishok foundthat the top two percentiles reportedgrowth rates of 31.3% and 22.6%,respectively. Thus, the required growthrates for the entire sector – not just afew individual companies – would haveto be between 50-100% higher thanthe highest 2% of existing firms. By

22 Sternbusiness

NASDAQS&P 500Internet index

1200

1000

800

600

400

200

12/3

1/97

2/28

/98

4/30

/98

6/30

/98

8/31

/98

10/3

1/98

12/3

1/98

2/28

/99

4/30

/99

6/30

/99

8/31

/99

10/3

1/99

12/3

1/99

2/29

/00

6/30

/00

8/31

/00

10/3

1/00

4/30

/00

Figure 1Returns on: equaly weighted internet index, S&P 500, NASDAQ

IndustryAggregateMarket cap

Aggregatesales

Agg.NetIncome

Industrymargins

Targetearnings

TargetP/E

27,429

6,090

2,172

3,354

1,219

4,459

3,038

3,658

192

2,267

590

390

(9,888)

(1,181)

13

(2,846)

(457)

(3,565)

(501)

(57)

394

(1,054)

(390)

(244)

0.0568

0.0452

0.0474

0.1169

0.0436

0.0190

0.0436

0.0927

0.0436

0.0558

0.0436

0.0436

1,557

275

103

392

53

85

132

339

8

127

26

17

605

1035

980

356

1800

856

474

91

6400

342

1216

1643

942,967

284,565

100,910

139,442

95,617

72,675

62,697

30,968

53,620

43,264

31,278

27,931

All

Portals

Infrastructure

Infrastructure services

B2B Software

Commerce

Consulting

Financial Services

Multi-sector

Vertical portals

Direct marketing/advertising

11bsb commerce

All sales, income, and market capitalization figures are in billions of dollars.

DOTCOM MANIA

Table 1

any stretch of the imagination, it wouldhave been exceedingly difficult forthese companies to post the sort ofgrowth and performance over the long-term to justify their prices.

Who Was Willing to Pay?So who was willing to pay wildly

inflated prices for Internet companies?The answer may help explain whyprices grew so out-of-whack in thefirst place.

We found that, on a relative basisthere were more retail (i.e. individual)investors than institutional investors inthe Internet sector. In March 2000,institutions held about 40.2% of non-internet stocks, but only 25.9% ofInternet stocks. This strongly signifi-cant difference is probably understat-ed, because 1999 and 2000 saw theformation of many Internet-orientedmutual funds, which act as pass-throughs to retail investors. In addi-tion, we found that while in March2000, the Internet sector accounted forabout 4.38% of the aggregate market,such stocks accounted for only 2.38%of pension funds’ assets. If more retailinvestors were in the market thanunder normal conditions, then onemight reasonably argue that the mar-ket was more prone to the types ofbehavioral biases that lead to overlyoptimistic beliefs.

Public Feeding FrenziesTo further test the hypothesis that

optimistic individual investors helpedboost prices for Internet-relatedstocks, we examined the torrent of ini-tial public offerings (IPOs) during theera of .com mania. The first day oftrading for an IPO represents the firsttime the price reflects the distributionof the beliefs across all investors. Ifoveroptimistic investors dominate themarket for such stocks, then onewould expect them to rise explosively

on the first day. During the 1998-2000 period,

IPOs commanded a great deal ofattention among the media andinvestors. Numerous financial websitesfocused solely on IPOs, and the stan-dard financial websites includeddetailed analysis of both upcomingand past IPOs. Between the secondquarter of 1999 and the first quarterof 2000, there were a stunning 400IPOs. Of these, 70% were Internet-related; they raised more than $33 bil-lion dollars.

It has long been an accepted factthat IPOs are underpriced – they arepriced and brought to market in sucha way that they are likely to rise intheir first trading days. Tim Loughranand Jay Ritter of the University ofNotre Dame and the University ofFlorida, respectively, found thatbetween 1990 and 1998 the first-dayreturn for IPOs was 14%. Between1975 and 1997, the highest average inany year was 21.2%, in 1995. Butwhen we looked at the sample betweenJanuary 1998 and February 2000, wefound that the mean first-day returnon Internet IPOs was 95.5%, with amedian of 63.1%. The mean andmedian first day returns for non-Internet IPOs in this time period werefar smaller: 33.6% and 10.4%, respec-tively.

Between the first quarter of 1999and the first quarter of 2000, 146 IPOissues doubled in price on the first dayof trading. In contrast, over the twodecades from 1975-1997, this effectoccurred for only a handful of the6,500 IPOs. These large first-dayreturns are consistent with a sudden

shift towards optimistic investors. Onthe first day they could, legions ofinvestors – most of them individuals –who believed the stock was going to goever higher voted with their wallets.

The Quiet PeriodSEC rules stipulate that for 25 days

after an IPO, Wall Street underwritersand company executives must refrainfrom hyping the stock or discussingthe company’s financial prospects. Atthe end of this so-called “quiet peri-od,” underwriters almost invariablyrelease favorable research reports onthe company.

Now, an overly optimistic investorcan be characterized as one who basi-cally ignores public information. If so,then one manifestation of this opti-mism might be the belief that such(utterly expected) news from theresearch report is new. In fact, WallStreet conventional wisdom holds thatretail investors buy – and institutionalinvestors sell – on the release of thesepositive research reports. Knowingthis, institutions tend to buy, andtherefore bid up the price of the shares,in the days before the quiet periodends.

Because the date signifying the endof the quiet period was known andpublicized in documents and on web-sites, there should be no price responseon average around that date. Instead,investors should incorporate that moveinto the stock price when it first trades.

We examined the average daily andcumulative abnormal returns for theInternet IPO sample leading up to theend of the quiet period. The dailyreturns are all positive for the last 10days of the quiet period, with a cumu-lative effect of a 13% excess return. Bycontrast, a sample of non-Internetrelated firms for the period prior to1998 turned in just 3.5% in excessreturns, or about one-fourth the mag-

"By any stretch of the

imagination, it would have

been exceedingly difficult for

these companies to post

the sort of growth and

performance over the long-term

to justify their prices."

Sternbusiness 23

DOTCOM MANIA

nitude of our Internet sample. How do we explain that differen-

tial? Well, if we assume that retailinvestors are more optimistic thaninstitutional investors, we could con-clude that the Internet sector is moreprone to quiet period trading. In addi-tion, we found that the average dailyvolume around on the day before, theday of, and the day after, the quietperiod end is 60% higher than in priordays. That finding is consistent withincreased buying of the firm’s shareson the release of the underwriter’sresearch report.

A Shortage of Shorts?The increased volume on or around

a known, predictable event suggests agreater degree of irrational activity. Ofcourse, while many investors did getcarried away, there was always a con-siderable amount of “rational” capitalin the marketplace. And it begs thequestion. Why didn’t such investorsdeploy their capital against the over-valued Internet sector by selling themshort?

Selling short involves borrowing astock, selling it, and then buying itback later, ideally at a lower price.Now, it is possible that many investorswere unwilling to short Internet stocks.After all, mutual funds, which areamong the biggest holders of stocks,are generally reluctant to sell stocksshort. Researchers Joseph Chen,Harrison Hong, and Jeremy Stein citework that shows just 2% of mutualfunds do so. Hedge funds, which arefrequently aggressive traders of stocks,could have been important short-sellers. But the performance andvolatility of Internet stocks may havemade it difficult for them to do so.Over 90% of Internet firms had amaximum monthly return of morethan 80% over the period we exam-ined. Shorting stocks that perform in

that manner is an extremely dangerousendeavor.

An alternate explanation may bethat it was not possible to shortInternet stocks in sufficient volume tobring the prices back down to rationallevels. But our investigation shows thatthis isn’t the case. Indeed, in February2000, short interest – the percentage ofthe total amount of shares outstandingthat are sold short – was considerablyhigher for Internet stocks than for theircorresponding Old Economy counter-parts. The mean short interest forInternet stocks was 2.8%, comparedwith 1.8% for non-Internet stocks,while the median short interests were1.6% and 0.7%, respectively. In otherwords, short interest in Internet stockswas nearly double that of the typicalnon-Internet stock.

Limits on Shorting StocksThere are reasons why the height-

ened presence of individuals in theInternet stock sector may have madeshorting such stocks difficult in prac-tice. First, in order to short a stock, theinvestor must be able to borrow it. Forwhatever reason, individuals tend tolend shares less than institutions do.Also, there was no guarantee that theshort position would not get called,either through the lender demanding itback or through a margin call.

We aimed to measure the difficultyof shorting Internet stocks by lookingat some related data. When an investorshorts a stock, he must place a cashdeposit equal to the proceeds of theshorted stock. That deposit carries aninterest rate known as the rebate rate.When there is an ample supply ofshares to short, the rebate closelyreflects the prevailing interest rate. But

when supply is tight, the rebate rate islower. This lower rate reflects compen-sation to the lender of the stock at theexpense of the borrower, and thus canact as a mechanism to even out supplyand demand.

A financial institution, which is oneof the largest dealer-brokers, providedus its proprietary rebate rates for theuniverse of stocks on a selected num-ber of dates. We found that the averagerebate rate was approximately 1.08%less for Internet stocks than otherstocks. While it is difficult to knowwhat this means precisely about theability to short on the margin, it isclear evidence that shorting was moredifficult for Internet stocks. We alsofound that there is generally a correla-tion between the level of short interestand the rebate rate. The higher theshort interest, the lower the rebaterate, and presumably the more diffi-cult to find significant number ofstocks to short sell.

Who Let the Stocks Out?So, why did the so-called Internet

bubble burst? Given our model, wecan think of two possibilities. First,perhaps fundamental news came outabout Internet stocks that shocked thebeliefs of the optimistic investors. Butwhile there certainly was bad news, wecould find no particular single eventthat could have caused the drop. Asecond explanation is that perhapspessimistic investors suddenly wereable to short a considerable amount ofInternet stocks.

We believe that there is evidence tosupport this latter explanation – oncewe realize that shorting stocks andselling stocks have the same economiceffect. At the end of 1999 and in thespring of 2000, a large number ofinvestors – insiders, venture capital-ists, institutions, and sophisticatedinvestors – were suddenly free to sell

"While it is difficult to know

what this means precisely

about the ability to short on the

margin, it is clear evidence that

shorting was more difficult for

internet stocks."

24 Sternbusiness

DOTCOM MANIA

their Internet shares. As the amount ofpotential selling increased, this newclass of investors (whether they werepessimistic or agnostic) began to over-whelm the optimistic ones. The triggerfor this selling was the end of the lock-up period.

In an IPO, only a small portion –15% or 20% – of the shares are soldto the public. The rest remain in thehands of existing shareholders. And inthe case of the .coms, these shares werefrequently held in larger quantities byventure capitalists, company officers,and employers. Generally, underwrit-ers and such insiders agree not to selltheir shares for a given period of time.This so-called lock-up period is oneway of aligning the incentives of thecurrent owners and new owners. Themajority of lock-up periods last 180days, or approximately six months,and are stipulated in the prospectus.Thus, the end of a lock-up period is acompletely observable event thatresults in a permanent shift in theamount of available shares in the mar-ketplace. As important, it may repre-sent the advent of a new class ofinvestors and traders who may havedifferent beliefs than the current mar-ginal retail investors.

When we charted Figure 2, thedollar amount of shares beingunlocked by month and the cumula-tive effect over the sample period

January 1998 to September 2000, theresults are quite striking. By lateSpring of 2000, over $300 billion ofshares had been unlocked. As theseunlocked shares were eventually sold,there had to be sufficient capitalinvested by new optimistic investors tosupport the Internet price levels. Afterall, the price levels were plainly notjustified by the companies’ cash flowfundamentals. To the extent some ofthe $300 billion in capital was ownedby investors who were less optimisticinvestors than the marginal individualinvestors, prices could have beenexpected to drop as this huge amountof capital worked its way through themarket.

From November 1, 1999 to April30, 2000, the value of unlocked sharesrose from $70 billion to $270 billion.And what happened to the level ofInternet stock prices over this sameperiod? Between November 30, 1998to November 30, 1999, the Internetindex rose from 200 to 830. But whilethe index still rose over the next sever-al months, it did so at a much slowerrate. The slowdown in the rise ofInternet prices may have been due tothe beginnings of less optimisticinvestors selling their unlocked shares.And as prices stopped rising, opti-mistic investors’ “bubble-like” beliefsabout future prices were also affected,leading to a twofold effect on Internet

prices. The fall of the index from 1030to 430 from March 1 to April 30, 2000coincides with the simultaneousincrease in unlocked shares. Once thebubble burst, optimistic investors’beliefs were permanently altered.

Indeed, our research showed thatafter the lock-up period ended on agiven stock, there was a downwarddrift in the price. In many cases, infact, the drift started even before thelock-up ended. We hypothesize thatthis may be due to the gradual shifttoward pessimistic investors. Thispost-lock-up drop is not found in pre-vious studies of lockups for non-inter-net firms. And the decline in Internetstock prices around the lockup expira-tion is consistent with our hypothesisabout the introduction of sellers to themarket causing prices to drop.

Our evidence is admittedly circum-stantial. But it is nonetheless com-pelling. The disproportionate numberof optimistic individual investorshelped drive Internet stocks up tountenable levels. And when the supplyof stock available for sale by investorswho may not have been quite as opti-mistic rose suddenly, the results werepredictable.

E L I O F E K is associate professor of finance,entrepreneurship, and innovation at NYU Stern.M AT T H E W R I C H A R D S O N is associateprofessor of finance at NYU Stern.

Sternbusiness 25

$300,000

$250,000

$200,000

$150,000

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$50,000

$0

$60,000

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$40,000

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$10,000

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monthly unlocked cumulative unlock

Figure 2Total dollar value of shares that were removed from lockup

From time immemorial,wealth has been measuredin things that people cantouch and see, like King

Croesus’ gold, or J.P. Morgan’s artcollection, or Donald Trump’s tro-phy office towers and casinos. Andeven in an economy powered by bitsand bytes, such hard assets stillmatter. The Forbes 400 is filledwith oil barons, retail magnates,and industrial titans.

But with each passing year, thepower of such assets to generate newwealth may be declining. In fact,physical and financial assets arerapidly becoming commodities,which yield at best an averagereturn on investment.

Increasingly, economic wealthand growth lie in, and are driven by,assets that are more intangible –brands, software, patents, businessmodels, organizational systems. Ifyou really want to hit it big in the21st century, don’t head toCalifornia in search of gold or oil.Instead, go to Silicon Valley andestablish a dominant competitiveposition, nail down a temporarymonopoly, or create a compellingbrand – by writing pioneering soft-ware, like Bill Gates, or by develop-ing an innovative business model,like Jeffrey Bezos of Amazon.com.

In recent years, intangibles havecome to loom ever larger in the con-sciousness of managers andinvestors. Unfortunately, when itcomes to intangibles, our businessinfrastructure is behind the times.The traditional accounting system isnot equipped to reflect the value andperformance of intangible assets.Investors systematically undervaluethe shares of intangibles-intensiveenterprises, particularly those thathave not yet reached significantprofitability. The rise of intangiblesrenders some traditional financialinformation and metrics less rele-vant. And the confusion can lead toboth increased volatility and themanipulation of financial informa-tion through intangibles. The aston-ishing rise – and even more aston-ishing implosion – of Enron, a tangi-ble asset (pipelines and power) com-pany that turned itself into a super-charged intangible asset company(bandwidth and energy tradingplatforms) serves as a dramatic casein point.

There is a great deal of confusionsurrounding the use and abuse ofintangible assets. And since I’vespent portions of the last severalyears thinking, writing, and talkingabout intangibles, I thought it would

Out ofTouchBy Baruch Lev

Factories, stores, and pipelines still have

substantial worth. But the assets that create, drive, and preserve value in our economy are

increasingly hard tosee and touch.

Valuing these new corporate crown jewels

accurately requires a new understandingof the past, present,

and future of intangible assets.

26 Sternbusiness

F

Different disciplines use differentterms to identify such assets.Accountants refer to intangibles,economist calls them knowledgeassets, and management and legalscholars prefer intellectual capital.When the claim is legally secured,like a patent, the asset is generallyreferred to as intellectual property.

Intangibles are produced throughthree major methods – discovery,organizational practices, and humanresources. The bulk of pharmaceuti-cal giant Merck & Co.’s intangibleswas obviously created by Merck’smassive and highly successfulresearch and development effort($1.82 billion in 1998) aimed at dis-covering new products. In contrast,Dell’s major value drivers are relatedto its unique organizational design –direct customer marketing of built-

to-order computers via telephoneand the Internet. Brands, a majorform of intangible assets prevalentparticularly in consumer products –think Sony electronics and Coca-Cola – are often created by a combi-nation of innovation and organiza-tional structure.

Intangibles that relate to humanresources are generally created byunique training, incentive-basedcompensation, and collaborativelearning programs. Such initiativescan reduce employee turnover, pro-vide incentives to workers, and facil-itate the recruitment of highly qual-ified employees. Xerox’s Eureka sys-tem, which allows the company’s20,000 maintenance personnel toshare information, enhances thevalue of the human resource-relatedintangibles by increasing employee

be useful to offer a primer of sortson intangibles.

What are Intangibles? Merriam Webster’s International

Dictionary defines intangible as“incapable of being defined ordetermined with certainty or preci-sion.” I believe that intangible assetscan be defined, but they cannotbe determined with certainty orprecision. Assets are claims tofuture benefits, such as the rentsgenerated by commercial property,or cash flows from a productionfacility. Intangible assets are claimsto future benefits that do not have aphysical or financial embodiment.Patents, brands, or unique organiza-tional structures – i.e. Internet-based supply chains – that generatecost savings are intangible assets.

Sternbusiness 27

©ARTIST(S)/SIS

productivity.Of course, intangible assets

are often created by a combina-tion of all three sources. And itshould be noted that the linesseparating intangible assets andother forms of capital are oftenblurry. Intangibles are frequent-ly embedded in physical assets(for example, the technologyand knowledge contained in anairplane) and in labor (the tacitknowledge of employees).

Why Do They MatterNow?

Intangible assets are not arecent invention. Over the cen-turies, intangibles were createdwhenever ideas were put to usein households, fields, and work-shops. Breakthrough inventions suchas electricity, internal combustionengines, the telephone, and pharma-ceutical products have createdwaves of intangibles.

But starting in the mid-1980s,two related economic forces havedriven a surge in the value andimportance of intangibles. The firstis intensified business competition,brought about by the globalizationof trade and deregulation in key eco-nomic sectors such as telecommuni-cations and financial services. Thesecond is the advent of informationtechnologies, most recently theInternet. These two developments –one economic and political, theother technological – have dramati-cally changed the structure of corpo-rations. And a case study of FordMotor Company, as told in Forbes,demonstrates precisely how thesetwo trends have led to a greaterfocus on intangibles among twenty-first century businesses – and howbusiness observers have come tospeak the language of intangibles.

In April 2000, Forbes reported,Ford decided to return $10 billion toshareholders, “capital that wouldnot be needed by the new, leanerFord.” The company was spinningoff its parts plants into a new entity,called Visteon, which would supplyFord. As it shed physical assets,Forbes continued, Ford was boost-ing investments in “intangibleassets.” It paid $12 billion over theprevious few years to purchase pres-tigious brand names like Jaguar,Aston Martin, Volvo, and LandRover. “None of these marqueesbrought much in the way of plantand equipment, but plant andequipment isn’t what the new busi-ness model is about,” the magazinenoted. “It’s about brands and brandbuilding and consumer relation-ships.” Moreover, Ford was usingthe Internet to substitute “an outsidesupply chain for company-ownedmanufacturing,” and to facilitate a“continuous interaction with con-sumers that offers myriad ways toenhance the brand value.” Forbesconcluded, as it wondered whether

Ford could be the new Cisco,that “decapitalized, brand-owning companies can earnhuge returns on their capitaland grow faster, unencum-bered by factories and massesof manual workers.”

The emergence of intangi-bles – like brands – as themajor driver of corporate valueat Ford is thus the direct resultof the two forces mentionedabove: competition-inducedcorporate restructuring facili-tated by emerging informationtechnology.

Ford is not an aberration.Driven by severe competitivepressures, the rapid pace ofinnovation, and the deregula-tion of key industries, compa-

nies in practically every economicsector started in the mid-1980s torestructure themselves in a funda-mental and far-reaching manner.Vertically integrated industrial-eracompanies, intensive in physicalassets, had been designed primarilyto exploit economies of scale. But, asCarl Shapiro and Hal Varian notein Information Rules, these produc-tion-centered advantages were ulti-mately exhausted and could nolonger be counted on to provide asustained competitive advantage inthe new environment.

Companies responded in twoways. One response was to deverti-calize – to outsource activities likeparts production, or payroll process-ing, that do not confer significantcompetitive advantages. The secondwas to strengthen the emphasis oninnovation as the major source ofsustained competitive advantage.These two fundamental changes inthe structure and strategic focus ofbusiness enterprises gave rise to theascendance of intangibles.

"Unfortunately, when it comes to intangi-bles, our business infrastructure is behindthe times. The traditional accounting sys-

tem is not equipped to reflect the value andperformance of intangible assets. Investors

systematically undervalue the shares ofintangibles-intensive enterprises."

28 Sternbusiness

OUT OF TOUCH

firms in the Inc. 500 list – a group ofyoung, fast-growing companies –were established by persons whoreplicated or modified innovationsdeveloped within their formeremployers. Meanwhile, as Universityof Chicago professor Luigi Zingaleshas noted, the expansion of globaltrade has opened the door for inde-pendent suppliers.

The increasing rate of employeeturnover in many sectors highlightsthe deteriorating bonds betweenemployers and employ-ees. Obviously, firmsthat are able to main-tain a stable laborforce and reap a signif-icant portion of thevalue created byemployees possess valu-able employee-relatedintangibles. Specifictraining programs, com-pensation practices suchas substantial stock-based compensationawarded deep down thecorporate hierarchy, andefforts to establishentrepreneurial centerswithin corporations help stabilizethe work force. Like organizationalcapital, such employee-relatedintangibles were not prominent inindustrial-era enterprises.

The Urgency to InnovateInnovation has always been an

important activity of both individualsand business enterprises. Theprospects of abnormal profits ormonopoly rents, protected for a cer-tain period by patents or “first-moveradvantages,” have always providedstrong incentives to innovate,whether it was Thomas Edison andEdison Electric in the 1880s or BillGates and Microsoft in the 1980s.

The difference between then andnow is the urgency to innovate.

Given the decreasing economies ofscale and ever increasing competi-tive pressures, innovation hasbecome a matter of corporate sur-vival. Accordingly, there has been asharp increase in the number of pro-fessional workers engaged in inno-vation. As shown in Table 1, duringthe first 70 years of the twentiethcentury the number of creativeworkers rose by 2.4 million; duringthe next thirty years the numberrose 5 million. Note also the corre-sponding increase of creative work-

ers in proportion to all employees,from 3.8 % in 1980 to 5.7 % in1999.

Many nineteenth- and earlytwentieth-century innovations weremade by individuals and were sub-sequently developed by corporations– the telephone, electricity, and thetelevision, to name a few. But in thepast 50 years, innovation became amajor corporate activity. In 1998,U.S. corporate expenditures onR&D, one of several forms of invest-ment in innovation, reached $145billion. Even in traditional indus-tries, success and leadership cannow be secured only by continuousinnovation. Wal-Mart, with its state-of-the-art inventory managementsystem, and Corning, which trans-

Intangible Linkages andHuman Resources

The vertical integration of indus-trial-era companies is increasinglysubstituted by a web of close collab-orations and alliances with suppli-ers, customers, and employees.These arrangements are facilitatedby information technology, and par-ticularly by the Internet. And theycan help produce economies of net-work, in which gains are primarilyderived from relationships with sup-pliers, customers, and sometimeseven competitors. Such networkeconomies can complement andsometimes substitute for traditionaleconomics of scale.

In the industrial era, linkagesbetween different units were mostlyphysical and relied on tangibleassets, like conveyor belts thatlinked auto parts divisions to rail-road networks. Today, the essentiallinkages between firms and theirsuppliers and customers are mostlyvirtual and rely upon intangibles.Examples include Cisco’s web-basedsystem of product installation andmaintenance; Merck’s one-hundredresearch and development (R&D)alliances; and Wal-Mart’s computer-ized supply chain. These highlyvaluable intangibles, often termedorganizational capital, were notmajor assets before the 1980s.

The highly connected twenty-first century corporation is alsomore dependent on its employeesthan its industrial-era predecessors.Economic developments have con-siderably weakened firms’ controlover human resources, as skilledemployees enjoy greater alterna-tives. With easier access to financ-ing, employees have far greateropportunities to leave and start theirown companies, or to join otherstart-ups. Amar Bhide found in TheOrigin and Evolution of NewBusinesses that some 70% of the

Sternbusiness 29

TABLE 1 Professional Creative Workers, 1900-99Units as indicated

YearProfessional creativeworkers (millions)

Proportion of allemployment

(percent)

1999199019801970196019501900

7.65.63.72.61.61.10.2

5.74.73.83.32.31.90.3

Source: Leonard Nakamura, “Economics and the New Economy: The Invisible HandMeets Creative Destruction” Federal Reserve Bank of Philadelphia, BusinessReview, July-August 2000, p.17.

lated expertise gained in producinghousewares into producing fiber-optic cable, are prime examples ofthis trend.

The new products, services, andprocesses generated by the innova-tion process (new drugs, automaticteller machines, Internet-based dis-tribution channels) are the outcomesof investment in such areas as R&D,acquired technology, and employeetraining. When such investments arecommercially successful, and areprotected by patents or first-moveradvantages, they are transformedinto tangible assets creating corpo-rate value and growth.

Who Should Care? There are several groups of pro-

fessionals who should take a partic-ular interest in the implications ofthe rise of intangibles. They include:

Corporate managers and theirshareholders. Evidence indicatesthat intangible investments are asso-ciated with excessive cost of capital,beyond what is called for by thehigher-than-average risk of theseinvestments. The excessive cost ofcapital, in turn, hinders investment

and growth. Investors and capital market

regulators. Research has docu-mented in intangibles-intensivecompanies the existence of anabove-average gap in informationabout firms’ fundamentals betweencorporate insiders and outsiders.Economic theory suggests that suchlarge and persistent informationasymmetries between parties to acontract or a social arrangementlead to undesirable consequences,such as systematic losses to the lessinformed parties and thin volume oftrade.

Accounting standard settersand corporate boards. Empiricalevidence indicates that the deficientaccounting for intangibles facili-tates the release of biased and evenfraudulent financial reports. Thisshould obviously be of concernto the Securities and ExchangeCommission, the Financial AccountingStandards Board, and to corporateboard members who rely heavily onaccounting-based information tomonitor managerial activities.

Policymakers. The variousintangibles-related deficiencies in

financial information adverselyaffect public policymaking in keyareas. These include areas of fiscalpolicy like the research and develop-ment tax incentive, the optimal pro-tection of intellectual property, andthe desirability of industrial policy.

The Future of IntangiblesIn the wake of the sagging stock

market, the current recession, andparticularly Enron’s debacle somecritics have been quick to proclaimthe end of the New Economy, whichwas built, in large part, on intangi-bles. Since I never joined the NewEconomy-Information Revolution fanclub, I do not feel compelled to par-ticipate in the current soul searchingbrought on by the bursting of thetechnology bubble. I am concerned,however, that intangibles – to whichI have devoted much of my researchand professional activities in recentyears – will be swept by the tide ofdisillusionment and ridicule sur-rounding the New Economy.

I am concerned that people willlump together the permanent phe-nomenon of intangible investmentsas the major source of corporategrowth and value with transitoryeconomic downturns, stock marketvolatility, and the financial difficul-ties currently encountered by certaintechnology sectors. And that theexaggerated, often unfounded claimsabout technological revolutions andnew business models, now in disre-pute, will overshadow real and fun-damental economic developments inwhich technological change andinnovation, ushered by intangibleinvestments, play such a major role.

But the trends that have poweredthe growth in intangibles – globalcompetition and increases in the useof information technology – havenot been negated by the bursting ofthe .com bubble. Surely, the rate of

30 Sternbusiness

FIGURE 1THE ASCENDANCY OF INTANGIBLES

Intensified competition,induced by globalization, deregulation, technological changed

Fundamental corporate change,emphasis on innovation, deverticalization, intensive use of information technology

Human resource

intangibles

Innovation-related

intangibles

Organizationalintangibles

OUT OF TOUCH

Source: Lev, 2001

intangible investment may be affect-ed, to some extent, by economic cir-cumstances and capital market con-ditions. But intangibles will remaincentral to corporate success, eco-nomic growth, and the enhancementof social welfare – whether theNASDAQ is at 2000 or 6000.Pharmaceutical and biotech compa-nies will continue to direct most oftheir resources toward intangibleinvestment in scientific discoveriesand drug development; chemicalcompanies will continue to devotesignificant capital to develop newproducts. Retailers with their razor-thin margins and transparent priceswill create value by expandingonline operations and institutingimproved supply chain processes.Financial institutions will growmainly through creating new prod-ucts and improved customer rela-tions. Old Economy or NewEconomy – it doesn’t matter which –an enterprise’s competitive survivaland success will primarily dependon smart intangible investmentsleading to innovation and effectivecommercialization. Economic slow-downs and capital market declinesdo not change these fundamentals.

What is changing, though is theurgent need to gain a thoroughunderstanding of the role of intangi-ble capital – along with tangible andfinancial assets – in the process ofvalue creation by business enterpris-es, to improve managerial processesfor coping with the idiosyncraticchallenges posed by intangibles, andto develop measurement and valua-tion tools for both managers andinvestors. In the fall of 2000, an articleby New York Times columnist PaulKrugman may have articulated thecentral challenge facing us: “Theintangibility of a company’s mostimportant assets makes it extremelyhard to figure out what the compa-

ny is really worth.”In the booming econ-

omy and roaring capitalmarkets of the 1990s,crude measurement andvaluation models couldbe tolerated, at least fora while, and speed andagility carried the day. But in today’senvironment, with its slow-growtheconomy and stagnant capital mar-kets, managers and investors mustadopt different mindsets when itcomes to intangibles.

Managers must pay meticulousattention to corporate resource allo-cation. In particular, they shoulddevelop the capability to assess theexpected return on investment inR&D, employee training, informa-tion technology, brand enhance-ment, online activities, and otherintangibles and compare thesereturns with those of physicalinvestment. Managers should alsocontinuously monitor the efficiencyof intangible asset deployment.Licensing patents, for example, maynot be a top priority when earningsare ample, but they can be an impor-tant source of income during periodsof slow growth. Human resourcepractices, such as incentive-basedcompensation, require careful plan-ning and monitoring when the goingis tough. At this time, most businessenterprises simply do not have theinformation and monitoring toolsrequired for the effective manage-ment of intangibles.

Investors must change theirmindset, too. Superficial investmentanalysis with a focus on short-termcorporate earnings will no longersuffice in a volatile but generally flatstock market. The crude valuationmodels currently used by most ana-lysts lack the capability to provideearly warning signals of impendingproblems and will have to be

Sternbusiness 31

replaced by ani n - d e p t hanalysis of theenterprise’s busi-ness model, with afocus on the capacity of the firm tolearn, innovate, and secure maxi-mum benefits from products andservices. A continuous assessment ofmanagers’ deployment of intangibleand tangible resources will have toprecede and underlie the currentprediction of next quarter’s earn-ings.

In short, in this climate, I foreseea need for both managers andinvestors to pay more, rather thanless, attention to intangibles. Indoing so, The emphasis, however,should shift from superficial clicheslike the New Economy to seriousanalysis of the economics of intangi-ble assets and their role in corporatevalue creation and the enhancementof social welfare. It is now time tomove from exclusively dealing with“low-hanging fruit,” such as patentlicensing and intranet systems, tothe full incorporation of intangiblecapital in the managerial strategicand control processes; and fromessentially ignoring key intangibles(human resources, in particular) inthe analysis and valuation of invest-ments to fully recognizing their rolein corporate value creation.

B A R U C H L E V is Philip Bardes professorof accounting and finance at NYU Stern andchairman of the Vincent C. Ross Institute ofAccounting Research. This article is adapted,with permission, from his book, Intangibles:Management, Measurement, and Reporting(Brookings Institute Press).

"Given the decreasing

economies of scale and

ever increasing com-

petitive pressures,

innovation has become

a matter of corporate

survival."

Information Systems:

32 Sternbusiness

Department of

an interview with Kenneth Laudon

Kenneth C. Laudon is professor ofinformation systems at Stern. Agraduate of Stanford Universityand Columbia University, he joinedStern’s faculty in 1982. Since then,he has taught courses on e-com-merce, managing the digital firm,IT and corporate strategy, and thelinks between technological devel-opments and society. Laudon is theauthor, or co-author, of a dozenbooks, including the most widelyadopted textbook on ManagementInformation Systems in the world.His latest volume, E-Commerce:Business, Technology, Society (co-authored with Carol G. Traver)was published in January byAddison-Wesley. In this book,Laudon uses case studies to chartthe development and spread ofdigital commerce in the globaleconomy, primarily by examiningcases of U.S.-based Internet firms.Two years after the Internet bubbleburst, Laudon believes that theinformation technologies thatinspired the .com mania of the late1990s continue to influence busi-nesses large and small. And whilethe seeming obsession with e-com-merce may have subsided some-what, he believes the trends andforces that underlie it are as potentas they were when the NASDAQsoared above 5000. In an interviewwith STERNbusiness, Laudon dis-cussed these and other provocativeissues raised in his book.

STERNbusiness: Why did youdecide to write this textbook?Ken Laudon: I taught an e-com-merce course for three years atStern. It’s a difficult course formost professors because there is nosingle discipline behind it. E-com-merce is a technology story, it’s amarketing channel story, it’s obvi-ously about finance, and it is alsoobviously about management andentrepreneurship, not to mentionlegal and social issues. When apublisher asked if I would like towrite a book about this material, Ithought it would be a good way forme to deepen my knowledge of thefield and help my students under-stand a very complicated story.

SB: Did you believe there was adearth of good material?KL: There were no solid textbooks,and materials were spread all overthe Web. And much of what hadbeen written about e-commerce wasnot well grounded in empirical fact.Many proponents of e-commerceseemed to be speaking a privatelanguage, filled with hype. Writingthis book was an effort to clarifythe discussion of e-commerce formyself, my own students, businessprofessionals and, ideally, for otherprofessors. As it ended up, the bookis a critical but sympathetic essayon the recent past of e-commerce,and a hopeful but well-groundeddescription of the near term futureof e-commerce.

SB: Many textbooks rely on casestudies. So does this one. Was thata difficult approach given the shorthistory of e-commerce companies,and the failures of many promi-nent e-commerce companies?KL: The book is extraordinarilycase driven. There are 14 chapters,and there are five cases in eachchapter, and an additional 16 “e-commerce in action” cases thatprovide detailed financial andstrategic analysis of e-commercefirms. For our case studies, weonly chose publicly held companiesand relied heavily on SEC data toanalyze the operating results andbalance sheets over a three-yearperiod. We use a very commonsen-sical, straight-forward analysiswith these companies

SB: Do you differentiate betweenstages of development in e-com-merce?KL: Yes. The book identifies twoperiods: E-commerce I and E-com-merce II. Our book is about E-commerce II. E-commerce I coversthe period from 1995 to March2000. It was characterized byexplosive growth of Web sites, theformation of thousands of e-com-merce companies, the spread ofnew technologies, new businessmodels and strategies. There wasalso new corporate and financialbehavior that challenged existinglegal and social norms, especiallyin the areas of intellectual proper-

With the NASDAQ down and Internet companies struggling from Silicon Valley to

Silicon Alley, it’s tempting to bury the much-touted digital revolution. We shouldn’t,

says Kenneth Laudon, author of a new textbook on e-commerce. Information

technology is still transforming the way people manage, work, and consume.

Sternbusiness 33

ty, privacy and financialreporting. For economists, thisperiod was very exciting. Theysaw these developments as theharbinger of nearly perfectmarkets. And we began to hearthe now familiar buzzwordslike “friction-free markets,” “per-fect information,” “price trans-parency,” “disintermediation,” and“first-mover advantages.”

SB: These predictions seemed tobreak down first with the online,pure-play retailers. What wentwrong?KL: There were basically two rea-sons why it didn’t work in retail.The first was that the costs ofbuilding a national brand and theinformation technology infrastruc-ture were just so much higher thanwhat everybody figured. On therevenue side, the numbers of cus-tomers willing to pay reasonableprices was greatly overestimated.So these companies ended up withcosts that far exceeded revenues.And the whole thing ran for fiveyears because of one of the largestinvestments of venture capital inAmerican history. Much of thatinvestment – about $200-300 bil-lion – is now gone.

SB: Is all the news from E-com-merce I bad?KL: No. It was a tremendous tech-nological tour de force, and the epart, the electronic or digital part,really did work, and continues towork. There’s a lot of long-haulfiber-optic cable installed, a lot ofcomputing horsepower deployed,and a huge global network. Theseare lasting legacies, and E-com-merce II will use these assets togreat advantage. Secondly, thisfirst period represented a tremen-dous outpouring of entrepreneurialand innovative behavior. This peri-

od created entirely new distribu-tion channels. In the retail area, itis worth about $60 to $70 billion ayear. And on the industrial side,it’s worth about $900 billion annu-ally. Taken together, that’s about10% of the GNP that courses overthe Internet each year, and it con-tinues to grow. Recent studies putthe impact of the Internet on pro-ductivity at about 1/4 to 1/2 apercent that in a decade willtranslate into several thousanddollars in additional income for theaverage American.

SB: And what defines E-commerceII?KL: E-commerce II starts inJanuary 2001. It is being definedby existing name brand companieswho have the brand, the customerlists, the business relationships,and the supply chain and fulfill-ment infrastructure to operate suc-cessfully in a digital environment.These firms using the Internetinfrastructure in combination withtheir existing expertise stand achance to make real money in e-commerce. In retail, we’re talkingabout Land’s End, L.L. Bean,Victoria’s Secret, Wal-Mart, Searsand J.C. Penney.

SB: What did they learn from theearly period?KL: Well, at first many of themwere just fearful that if they didn’tmove quickly, they would be leftbehind. Some of them then tried toget into it directly and failed. Wal-Mart had a series of failures. Butby 2000 they became convincedthat this was a fast-growing chan-

nel, and that they shouldmake substantial invest-ments. When they saw thedot-coms fail a lot of seniorexecutives became more andmore confident that theycould move some of their

catalog operations and other directsales lines onto the Web. Wal-Martand Sears were advantagedbecause they had warehousing anddistribution systems that could beleveraged to the Web. Lands Endand L.L. Bean were advantagedbecause they had an existing orderentry and fulfillment operation. Inother words, established firmscould leverage their existing busi-nesses to the Web for a much lowercost than a startup could build aparallel infrastructure.

SB: So far we’ve spoken mostlyabout retail. What other sectorsare important and have survivedE-commerce I? KL: Services will be strong on theWeb. Travel services, likeTravelocity and Expedia are bothin the book, and they both eitherbreak even or turn small profits.These businesses are beginning toscale – as traffic picks up revenuegrows faster than costs. That hasproven to be a very successfulbusiness model. Another area iscareer services like Monster.comand Hotjobs.com. Finally, financialservices companies like E-Tradeare likely to be profitable. Andthere’s always E-Bay.

SB: Are investors and analysts stillvaluing the surviving e-commercecompanies using different criteria?KL: Yes. Yahoo! comes to mind.Now there’s a company that wasprofitable, then experienced somelosses, and its price-to-earnings(P/E) ratio is still pretty high. Butpeople are willing to pay that high

Many of the proponents ofe-commerce seemed to be

speaking a private language,filled with hype."

34 Sternbusiness

price. For many of thesecompanies, the stock priceshave fallen sharply, thereare still no earnings, but thecompanies have consolidat-ed their positions in themarket, acquired competi-tors, and are developing strongbrands. WebMD comes to mind.There is still a significant growthpremium that people are willing topay for these companies.

SB: So what comes after E-com-merce II?KL: There is no doubt there willbe an E-commerce III, but for nowuntil 2005 E-commerce II willfocus on making the technologiesand business models developed inE-commerce I into profitableenterprises. We have to get on withthe fact that our economy isbecoming a digital economy withdigital firms and digital market-places, and we will spend the restof this century working that out.There will be spurts of growthdriven by new technologies, andthere will be contractions. For nowwe can safely say that we have abetter understanding of digitaltechnologies, we understand betterthe business risks and opportuni-ties, and we have begun to focusmore on how to make these onlineventures profitable. We did learnfrom E-commerce I, admittedly atgreat cost.

SB: Many have argued that thedelays in rolling out broadbandInternet connections to homes andoffices has stunted the developmentof e-commerce firms. Do you agree?KL: I think that that argumentdoesn’t hold any water. Thatwould presume that the failure ofmany online retail and servicefirms was caused by absence ofbandwidth, especially in the lastmile. But for the most part, the

technology worked. That was oneof the beauties of the Web that itcould scale so easily by adding big-ger servers and bigger pipes. But incertain sectors where bandwidthdemands are particularly high, youcould make that argument – incontent for instance. For example,we might have seen an earlier roll-out of Hollywood feature filmsavailable through pay-per-viewover cable modems or even DSL.AOL Time Warner, Disney, andVivendi are building alliances withcable firms for Internet delivery offeature films and they are current-ly held back by the slow growth ofhome broadband connections. Butoutside of the content and enter-tainment areas the solution to theproblems of many e-commercecompanies isn’t more bandwidth.The solution is to charge peoplemore money for what they buy onthe Web so companies can covertheir costs, and to keep reducingcosts by building infrastructure forsupply chain and fulfillment oper-ations.

SB: Has student interest in e-com-merce declined?KL: I’ve been here for 20 years,and I’ve always taught digitalcommerce and e-business. We justdidn’t call it that. In the ISDepartment we have always taughtabout how digital technologieswere going to change the way peo-ple run companies and markets.We had an explosion in demand in1998 and 1999, and businessschools responded by rapidlyexpanding courses and whole newprograms. Enrollments at someschools may be lower now than

these early, unusually highenrollments of the last twoyears, but from what I’veseen around the country,enrollments in e-business,e-commerce, and manage-ment information systems

courses are stable, or perhapsslightly up because student popu-lations are up. Look, if you wantto talk about what’s happening inthe next century, you have to talkto students about digital technolo-gy – especially if they want towork for a Fortune 1000 company.It is those companies that arebuilding E-commerce II, and theywant to hire managers who knowwhat this is all about.

SB: What do you want people totake away from this book? KL: They learn that we just livedthrough the first 30 seconds of thee-commerce revolution. It was ahell of a ride! There’s more tocome, a lot more, but probablyalong a more reasonable develop-ment path of fast growth but notspeculative growth. People learnthere are many successful (i.e.profitable) e-commerce firms, andmany more that are close.Significant permanent structuralchanges have occurred in someindustries, and more industrychange will occur in the next fiveyears. And people learn once againthat it can be better to be a follow-er – even a slow follower – ratherthan an entrepreneur. People learnto look at the numbers when eval-uating the long-erm survivabilityof firms. And as Enron taught us,our book also teaches people tolook at the accounting rules andbusiness practices that generate thenumbers.

K E N N E T H L A U D O N i s professor o f

information systems at NYU Stern.

"We have to get on with the factthat this is basically becoming adigital economy with digital firmsand digital marketplaces, and wewill spend the rest of this century

working that out."

Sternbusiness 35

36 Sternbusiness

BRANDING COTTON:

How FarmersCultivateDemand on MadisonAvenue

By George David Smith and Timothy Curtis Jacobson

I n t he 1960s , t he dec l i n i ng U .S . co t t on i ndus t r y

grapp led w i th s t i f f compet i t ion f rom syn the t ic fabr ics ,

compe t i t i ve i n te r na t i ona l marke ts , and an ou tda ted

image . An un l i ke l y a l l i ance be tween ru ra l g rowers

and u rban admen he lped res to re Amer ican co t ton to

i t s h is to r ic prominence. The co-au thors o f a new book

a b o u t c o t t o n ’s c o m e b a c k s p i n a c o m p e l l i n g y a r n .

Sternbusiness 37

©A

RT

IST

(S)/

SIS

otton was the miracle fiberof the nineteenth century,when textile manufacturingwas the high-tech, high-

growth business of the day. Like allfarm products, cotton was subject tothe vagaries of the weather, pests, andpolitical risks, but for decades it soldinto fast growing and weakly contest-ed world markets. On the eve of theCivil War, cotton was “King”.Compressed in dirty white bales,upland cotton from the AmericanSouth was the developing nation’slargest export, earning the lion’s shareof its foreign exchange. It providedthe “satanic mills” of England with 92percent of their supply, and fueled theheart of industrial enterprise in theAmerican Northeast.

One hundred years later,300,000 American cotton growers(cotton farmers are “growers”) werebeset with severe threats to theirlivelihoods. As the crop’s cultivationhad gradually expanded throughoutthe world, U.S. cotton had lostground in the global market. Athome, in their biggest market, man-made textile fibers – rayon, nylon,and polyester – had launched a fear-

some assault on cotton’s fabric andapparel business. Synthetics produc-ers were giant corporations, and hadthe financial muscle to supportresearch and promotion.

Independent and small-scale asbusinesses go, cotton growers werewell organized for political purpos-es. Their main concerns were tokeep themselves from growing toomuch cotton and to seek govern-ment support for research and relieffrom hard times and market fluctu-ations. The National CottonCouncil, created in 1939, and itsoffspring, the Memphis, Tenn.-based Cotton Producers Institute(CPI), had proven adept at influenc-ing national farm policy. But as the1960s wore on, these organizationswere not able to help growers com-pete. Cotton’s share of the marketfor retail apparel and home fabricsplummeted from 63% in 1960 toabout 45% in 1970, on the way toits historical low of 33% in 1975.

Farmers supply, but their fate ismuch more the story of demand. Itwas clear that this most traditionalof American industries would needto embrace a fresh approach. Cotton

growers, always attentive to theproblems of supply, would have tolearn how to market their crop. Theindustry was entrenched in 18 statesspanning the Old South and newrural Sunbelt, but its new champi-ons would emerge from the urbancorporate world: an advertisingexecutive from Connecticut, agraphic designer in San Francisco,and marketing gurus of MadisonAvenue.

In April 1970, half a dozen entre-preneurial growers moved to savetheir industry. Through the agencyof the CPI, they sought professionalhelp, and found it in the unlikelypersona of Dukes Wooters, an adver-tising executive at Readers Digest.Wooters had a classic New Englandpedigree: the Taft School, LehighUniversity, military service in WorldWar II, and Harvard BusinessSchool. He knew next to nothingabout cotton.

Blessed with an unforgettablename and a deep arresting voice,Wooters was a hard-driving sales-man, a marketing man with greatinstincts for what would move offthe shelves. At 53, he had justturned-around the Digest’s saggingoperation in Brazil and was lookingfor one last great career challenge.“Dukes had style,” one grower said.He shopped at Brooks Brothers, butto prepare for his interview with theCPI leadership, he cruised throughMacy’s. “I looked around,” he said,recalling his surprise, “and therewas hardly any cotton.” BrooksBrothers was the carriage trade;Wooters wanted to move cotton backinto the mass market by the train-load.

Clearing the GroundNo city was more closely identi-

fied with a commodity than

C

38 Sternbusiness

1961

Per

cent

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30

40

50

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70

1963

1965

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1973

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Actual market shareTrend line, 1972

BRANDING COTTON

Memphis was with cotton. CPI’sresearch staff was based there, and asmall marketing organization, com-prising mainly Memphians, waslodged in tatter-down offices in theEmpire State Building. Wooters letthem go, all but one. As Wooterstried to explain to one nonplussedcotton grower, “you’re not just rais-ing a crop, you’re selling fashion onSeventh Avenue.”

To compete, growers would haveto embrace the big-city, consumer-driven culture of marketing. CPI’sheadquarters were moved to NewYork. Its research operations weretransferred to Raleigh, near NorthCarolina State University’s textileschool and near many of the coun-try’s major cotton textile manufac-turers. Wooters determined thatCPI would have to change itsname, too. It was a publicly fundedbody, but Wooters chose “Cotton

Incorporated.” He intended to runCotton Incorporated as if it were “areal company,” like Readers Digestor, for that matter, cotton’s nemesis,that great innovator in syntheticfibers, DuPont.

Cotton Incorporated had a totalannual operating budget of just $20million to pay for marketing,research and administration. Itsfunds came from a voluntary contri-bution of cotton growers channeledto it by the Department ofAgriculture’s Cotton Board (Todaythe assessments are mandated bylaw.) Yet the company’s mission wasambitious, embracing almost everyaspect of production and distribu-tion. Wooters saw the cotton marketas a continuous loop that boundthousands of growers to millions ofconsumers through the good officesof textile mills, clothing manufac-turers, and retailers. The relation-

ships all along the loop were dynam-ic and interdependent. A “total mar-keting” approach was necessary.

Total marketing meant develop-ing plans to link the mills, clothingmanufacturers, retailers and con-sumers together into a mutuallyreinforcing chain of profit maxi-mization. The mills were the firstcustomers, and they would beoffered technical assistance free ofcharge. Caring for them was crucialbecause they preferred synthetics.Cotton, like wine, was highly vari-able in quality; synthetics were uni-form, easier and cheaper to processin volume.

Total marketing meant convey-ing back to those engaged inresearch and technical services ideasfrom the marketplace for new andimproved fabrics and finishes. Itmeant arming manufacturers andretailers with new fashion ideas that

"The old association ofcotton with everything

that was ‘real,’ first triedout in the 1970s but with

a hard edge aimed tobash the ‘plastic’ world ofsynthetics, blossomed inthe mid-1990s in a softer,

multicultural form."

Sternbusiness 39

could be interpreted in cotton andcotton-synthetic blends.

All that would be possible if, andonly if, mills, manufacturers andretailers were confident that thedemand for cotton was there. Mostdramatically and publicly, CottonIncorporated would stimulateconsumer demand with adver-tising and promotions, not ofcotton as an agricultural com-modity – “that funny lookingwhite stuff,” as Wooters calledit – but of cotton as a brand.

Cotton’s SealThe first step in converting

cotton from an agriculturalcommodity into a consumerbrand was the creation of anew image. Cotton, Wootersfelt, had an image problemgoing back a lot farther thanthe stodgy dungarees-andfaded-cotton-frock-memories ofrural America. Ironically, the imageof rural work clothes would prove tobe a key to cotton’s salvation.

While visiting Levi Strauss in1971, Wooters called on the noteddesigner Walter Landor in SanFrancisco, who presented 12 versionsto Cotton Incorporated. The chosendesign for the “Seal of Cotton” – onethat Lander’s daughter, Susan, hadconceived, would become one of themost successful trademarks in theannals of marketing. It was simpleand engaging – a white cotton boll,rising up from the two T’s of theword “cotton,” laid against a back-ground of earth-tone brown.

The seal appeared in 1973, andalmost instantly gave cotton a newidentity, making a deep impact onpublic awareness, a rare masterpieceof graphic design-as-communica-tion. The design conveyed severalpositive messages. If nature was

good, then cotton was good. Cottonhad roots, but it also had bloom.Cotton was pure, soft, comfortingand natural. Cotton was somethingfamiliar that you wanted to haveand to keep around.

Creating ConsumptionFrom its inception, the seal would

stand at the center of an intensiveand innovative advertising campaigndesigned to “pull” cotton back intoconsumer consciousness. The broadmiddle class of consumers ofWooters’s generation – those whocame of age in the 1930s and 1940s– had largely forsaken cotton for thewash-and-wear convenience andeconomy of synthetics. But it hap-pened that their children, however,the baby boomers born between1946 and 1964, were clad in cotton,or, to be more exact, in denim.

Denim’s history reached backinto the nineteenth century. Thoughnot indigenous in origin, denim –used in dungarees or overalls – hadbecome the quintessential Americanfabric. In the 1960s, denim took ona new appeal for the young. Bluejeans looked unkempt, required lit-tle care, were comfortable and, most

important, projected an image thatrebuked the buttoned-down fashionstatements of the boomers’ parents’generation. An emblem of protest,jeans were bound up with rebelliousacts ranging from recreational druguse to civil rights and antiwar

demonstrations.The worry for cotton

growers was that boomersmight abandon denim as theyaged. The problem, then, wasnot just to sell jeans to con-temporary customers, butto do what synthetic manu-facturers had done so well:sell “fiber consciousness.”In order to craft its ownapproach to advertising,Cotton Incorporated’s mar-keting staff spent monthsstudying the master, DuPont,the leading synthetic-fibermanufacturer. What they

learned was that they must focus themarket’s attention on the per-formance characteristics of cottongarments.

Television GuidesCotton’s consumer advertising

began in 1971. The medium wasalmost exclusively network televi-sion. This tactic set cotton apartfrom other agricultural marketingprograms. The first ads in 1971,created by the Jack Byrne Agency,honed in on a budding culturalnotion that had its origins in theboomers’ counterculture of the1960s: if something was “natural,”then it must, somehow, be better.These ads carried the tag line“Cotton: It’s a Natural Wonder”(with “Brought to You by CottonIncorporated and America’s CottonGrowers” tucked in at the bottom ofthe screen). Viewers learned thatthey liked those scruffy old blue

"O&M co-optedan idea from

the syntheticsmanufacturers,of identifyingcotton as a

‘performance’fiber."

40 Sternbusiness

BRANDING COTTON

jeans because “Levi’s‚ still makesthem – all 100 percent cotton.”

The effectiveness of CottonIncorporated’s advertising can beascribed to the company’s long run-ning relationship with the advertis-ing agency, Ogilvy & Mather(O&M), whose co-founderDavid Ogilvy was an evangel-ist for branding. CottonIncorporated had little tospend by large corporatestandards, and the dispersionof its funds was politicallysensitive. Hence, O&M faceda dilemma. How could it cre-ate ads for cotton that werehigh impact yet cost effective,carefully targeted and yetuniversally appealing? Theseal was key. Animated fortelevision, it grew in a fewseconds before the viewer’seyes, up from the good brownearth into a full-blown soft,white cotton boll.

O&M found selective, high-impact venues for cotton withoutbreaking the bank. For example,Cotton Incorporated focused most ofits 1976 advertising dollars on theOlympic Winter Games at Innsbruckin Austria. A fruitful media tie-inwas cotton’s regular appearance,starting in 1977, on NBC’s TODAYShow, an association that vaultedCotton Incorporated into the frontranks of consumer advertising. Asmore cotton products were selectedfor promotion, familiar televisionpersonalities delivered live commer-cials on the set. Viewers saw BarbaraWalters in a bright Hawaiian shirtposed beside the Seal in a tropicalsetting, exuding confidence that cot-ton was “doing a lot to make yourlife more comfortable. I know it’smaking my life comfortable rightnow.”

It all worked like a charm, pro-ducing brand awareness and stimu-lating consumption. After one year,18% of consumers could identify theseal. By the end of 1976, whenawareness of the seal jumped to

46%, cotton’s market share edgedupward to 36%. (Today more than70% of American consumers recog-nize the symbol, even without theword “cotton.”)

The seal was used, for a transi-tional period, to mark cotton-domi-nant “blends,” one way to help re-capture market share. The 60/40%cotton/synthetic shirt became com-monplace on men’s store shelves.Then in 1977 and 1978, LeviStrauss attempted a denim blend.The mix was modest (never morethan 15% polyester), but the strate-gy was a marketing disaster for thejeans maker. An aroused CottonIncorporated pounded away at theheresy, reminding consumers thatthe denim they had known andloved since childhood was“100% cotton.”

A revised denim campaign fea-tured pretty young women viewed

from the rear, in tight denim jeans,available – along with lawnmowers,washing machines and power tools –at your friendly hometown Sears.The implication was clear: in aworld filled with fakery, cotton was

real. It performed the way youwanted. Wearing it made youlook and feel good, not justphysically, but emotionallytoo. The long-term messagewas: “Come home to cotton!”

Touting PerformanceCotton’s market share took

off in the 1980s, from 36 to50%. The nation was emergingfrom a decade that had includ-ed defeat in Vietnam, two oilshocks, rampant inflation, anddeteriorating competitiveness.The economy and corporateAmerica were now in theprocess of repair, and thenation’s mood edged toward a

new confidence. Cotton’s advertisingvoice grew more confident, too.

O&M co-opted an idea from thesynthetics manufacturers, of identi-fying cotton as a “performance”fiber. (This was a claim made possi-ble by technical improvements incotton fabrics, driven partiallyby better breeding programs.)Television viewers were wowed asballerina Heather Watts pirouettedin front of New York’s LincolnCenter and proclaimed the wondersof her 100% cotton Ship’n Shore™shirts: “All cotton plus permanentpress: now that’s high performance.”

The “True Performance” cam-paign, originated at CottonIncorporated and developed andexecuted by O&M evoked probablythe most compelling image of cottonsince coining of the phrase “KingCotton” in the 1850s. Cyclists,sailors and pole-vaulters strenuously

"The seal appeared in 1973, andalmost instantly gave cotton anew identity, making a deep

impact on public awareness, arare masterpiece of graphicdesign-as-communication."

Sternbusiness 41

“performed” in their cotton duds,as “True Performance” dominatedCotton Incorporated advertisingthrough the eighties. The campaignincluded an elaborate labeling effortat the retail level. Attractive “TruePerformance” hang-tags, depictingthe slogan and the Seal, appeared onmillions of garments in the biggestretailers and smallest specialtyshops, alike.

“True Performance” was a water-shed campaign. But demand for par-ticular types of cotton apparel andhome furnishings, like demand formany other consumer products,inevitably varied with fashion andthe whim of consumer tastes. Thechallenge therefore was to even-outthese peaks and valleys by cultivat-ing loyalty to cotton as an essentialcomponent of the good life.

“The Fabric of Our Lives”Dukes Wooters left Cotton

Incorporated in 1982, and in 1987,its president Nicholas Hahn took anew approach to advertising. Infocus groups and one-on-one inter-views, people were invited to talkabout fiber, fabrics, garments, cot-ton, wool, polyester, and anything todo with clothing. Something surpris-ing was discovered. Intervieweessaid that wool was warm andscratchy, and that polyester wassticky, hot and did not breathe. Butthey also professed “something”(they did not know what exactly)“about the feel of cotton.” Whiletalking about cotton, they tended totouch themselves, whether or notthey were wearing it. Some prompt-ing got subjects to talk about howthey liked having cotton close totheir skin, and how little babies getwrapped in cotton, and other emo-tion-laden images connecting cottonwith life’s various stages.

Based on this news, O&M con-cocted the deceptively simplephrase, “The Fabric of Our Lives‚”for a campaign that would becomeone of the most memorable in adver-tising history. The documentaryfilmmaker Leslie Dektor’s avant-guard realism, aimed at showingpeople as they were, did not talkabout performance features at all.The target audience had changed, sonow the message was intergenera-tional. Cotton was authentic, from“cradle to grave,” not just for thebaby boomers, but their parentsand, before long, their children, too.

For the launch of the Fabric ofOur Lives campaign, Hahn author-ized an expenditure of $2 million ofthe company’s $7 million advertis-ing budget in one day –Thanksgiving 1989, the day beforethe single largest shopping spree ofthe year. It was the day when fami-lies watched television dawn todusk, from the Macy’s Paradethrough professional football gamesto the “Sound of Music.” Cottoncommercials blanketed the screen,as one hundred fourteen million

viewers saw and heard them, overand over again.

The size of Cotton Incorporated’sexpenditure enabled O&M to negoti-ate for reinforcing billboard space.“Macy’s Thanksgiving Day Parade,Brought to you [in part] by CottonIncorporated. Cotton: The Fabricof Our Lives.” Subsequently,O&M sought to sustain CottonIncorporated’s media “presence”with key franchise positions – twicea week with Willard Scott onTODAY; beside Peter Jennings onABC News; on Late Night with JayLeno; and on other highly ratedshows.

Getting EmotionalCotton and the good life went

together, like parents and children inhappy homes. Cotton’s unvarnishedadvertising “reality” confoundedsome critics, but it was, in O&M’sword, “emotionally relevant.” In thelate 1980s and 1990s, the linkagebetween liking a product and per-ceiving it as authentic accounted forsome of the great brand successes ofthe era, like Starbucks™, The Body

42 Sternbusiness

20,000.0350

300

250

200

150

100

50

0

18,000.0

16,000.0

14,000.0

12,000.0

10,000.0

8,000.0

6,000.0

4,000.0

2,000.0

01964 1969 1974 1978 1982 1987 1992 1997

Year

Farms

Bales

Far

ms

(000

)

Bal

es (

000)

BRANDING COTTON

Shop™ and Virgin Atlantic™. Theold association of cotton with every-thing that was “real,” first tried outin the 1970s but with a hard edgeaimed to bash the “plastic” world ofsynthetics, blossomed in the mid-1990s in a softer, multiculturalform.

In the 1990s, the Fabric of OurLives‚ campaign embraced moremodish themes. One ad featured anAfrican-American family, sittingaround the dining room table in areprise of the Norman Rockwellimage of Thanksgiving dinner.There are multiple generations, nat-tily turned-out, nice up-market sur-roundings, lots of smiles. “How dif-ferent can we be,” went thevoiceover for a spot featuring a rain-bow coalition of cotton-clad actors,“when we all love to wear the samething?” The actors in the adsappeared younger. Research showedthat turn-of-the-millennium teensand young adults liked cotton wellenough but displayed lower “fiber-consciousness” than their parents.The job of educating the market wasnever-ending.

On the cusp of the twenty-firstcentury, an abrupt change occurredin workaday fashion that was tailor-made for cotton. Corporate Americawent casual, and cotton supplied thealternative, as male corporateAmerica doffed its woolen suits andfemale corporate America its linensand silks, for open collared shirtsand comfortable-fitting khakis.“What would it be like,” came thequestion as the screen filled withdiverse hard-working Americans, “ifwe all dressed as if work were fun?”

Corporate casual dress, of course,was a hallmark of the dot-com era.Yet while that particular bubble hasburst, cotton’s staying power hasnot. Consolidating the gains it had

made in the 1970s and 1980s,cotton closed the millennium with amore than 60% share of the marketfor retail apparel and home fabrics.What other industry (or company,for that matter) has ever lost nearlyhalf its market share and won itback?

Competition and SurvivalThe story of cotton’s renaissance

is not solely a story of consumermarketing. Dukes Wooters had envi-sioned from the outset that CottonIncorporated would have to meetrising consumer expectations withever-improving fiber quality, orgains in market share could not besustained. Competitive threats –from low-cost synthetics and low-wage foreign producers – wouldhave to be checked with relentlessquality improvements and cost-reductions on the farm.

The practical result of his vision isthat the American cotton one wearstoday is far superior to the cotton offorty years ago. It’s easier to fabricateand to care for.The industry invests inresearch and development spanningfundamental agricultural science tofarm-level technological improve-ments. Today, cottonseed researchtraverses the cutting edge of geneticengineering. Cotton can be grown incolors. Enterprising growers invest inautomated tractors that can till theland to fine precision, locating theirpositions with within two centime-ters, day or night, in all weather,increasing yields, lowering laborcosts. And hungry textile mills(though they have mostly movedoverseas) get what they want most:American cotton that is longer,stronger, finer, cleaner, and cheaper.

It’s a good thing, too. Cottongrowing is a ruthlessly competitiveglobal enterprise. Cultivated in more

places around the world, cottontrades more freely than ever.American growers have learned tomanage demand but cannot admin-ister price. As quality has improvedand as costs, and prices, have comedown, it has been a boon to con-sumers, a challenge to growers.Despite mounting subsidies from thegovernment, to compensate them forlosses in low-price commodity mar-kets, the pressure on cotton growersto deliver higher quality for lessis unabated. Staying competitivedemands a high level of scientificand business sophistication. Itrequires investment in technology,management, and marketing, and abroad-based knowledge of worldaffairs, from the weather inAustralia to political conditions inPakistan, from what’s fashionable inParis to what’s happening in theworld’s genetic and biochemical lab-oratories.

In this dynamic environment,only the strongest survive. Farmshave consolidated to increase capitaland scale economies. Marginal landhas been abandoned, given over toother crops, converted into housingdevelopments and shopping malls.That some 30,000 cotton growers(just a tenth of the number in 1960!)are still in business in the U.S., pro-ducing more and better cotton atlower cost, is testimony to their col-lective mastery of the market.

G E O R G E D AV I D S M I T H is clinical

professor of economics and international

business at NYU Stern. He is a member of the

faculty of the Berkley Center for

Entrepreneurial Studies.

TIMOTHY CURTIS JACOBSON is a

partner in The Winthrop Group, Inc. This arti-

cle is adapted from their new book, Cotton’s

Renaissance: A Study in Market Innovation

(Cambridge University Press).

Sternbusiness 43

Two years after the .com melt-down, wreckage continues to pileup on the information superhigh-way. Companies that set out toconstruct and manage the 21stcentury Internet – ExodusCommunications, Global Crossing,360Networks, and Winstar – nowlanguish in Chapter 11. In all, net-work builders plowed some $30billion into laying 90 million milesof fiber-optic cable. But the vastmajority of those tiny glass strandslie dark, unused.

It turns out, in the end, that theNew Economy turned out to be notso new. For the cycle we have justseen in fiber-optics – overbuilding,excess capacity, ruinous competi-tion, falling prices, bankruptcy andconsolidation – is eerily familiar.Indeed, a remarkably similar set ofcircumstances surrounded theintroduction of the first informa-tion superhighway: the telegraph.

Author Tom Standage aptlyrefers to the telegraph as “theVictorian Internet.” Just as was thecase with today’s fiber-optic net-work operators, revenues wereslow in coming to early telegraphowners. In 1845, inventor Samuel

in fivestates in the

Midwest. In 1856, itchanged its name to WesternUnion.

By the mid-1860s, acquisitiveWestern Union was the undisputedmaster of the telegraph, which,with the advent of trans-Atlanticcables and automatic telegraphy,had emerged as a crucial businesstool. In the late 1990s,. CiscoSystems CEO John Chambersboasted that the data on his desk-top PC shed enormous light on thestate of the New Economy. Just so,Western Union president WilliamOrton told Congress in 1870 thatthe telegraph “is the nervous sys-tem of the commercial system. Ifyou will sit down with me at myoffice for twenty minutes, I willshow you what the condition ofbusiness is at any given time inany locality in the United States.”

Like the early telegraph com-panies, today’s fiber-optic networkcompanies may have failed asinvestments. But both groups ofentrepreneurs succeeded in layingdown a highly useful infrastruc-ture. By the 1870s, a farmer in asmall town in Iowa could send amessage to a distant relative inNew York by using the telegraph.Today, a farmer in a small townIowa can send a message to adistant relative in New York byusing the Internet.

Traffic may travel on the infor-mation superhighway at the speedof light. The fundamentals ofinvesting in information infra-structures change at a somewhatslower pace.

DANIEL GROSS is editor of STERNbusiness.

endpaperBy Daniel Gross

The

OriginalInformation Superhighway

44 Sternbusiness

Morse helped form the MagneticTelegraph Co., which linked NewYork with Washington. In its firstsix months of operation, it talliedrevenues of $413.44 againstexpenses of $3284.12. LikeInternet builders, early telegraphpioneers found connecting the “lastmile” to be a tough chore. By mid-1846, you could send a message onthe Magnetic Telegraph Co’s linefrom Washington to Jersey City,New Jersey. But the message had tocross the Hudson – that mythiclast mile – by boat. And through-out the 1840s and 1850s, linespopped up, only to be taken downand sold for scrap a few monthslater – much the same way asWinstar’s once well-capitalized net-works were sold in bankruptcycourt for pennies on the dollar.

The natural follow-on to theperiods of overbuilding and failureis consolidation. That’s what ishappening with the fiber-optic net-work companies. And that is pre-cisely what happened in thematuring telegraph market. TheNew York & Mississippi ValleyPrinting Telegraph Co., formed in1851, quickly snapped up 11 lines

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