Hindsight 1720: What Can We Learn From The South Sea Bubble

 

Today marks the 300th anniversary of the penultimate moment of the South Sea Bubble. On August 22, 1720, following the wild bull run from 128 pounds to over 1,000 pounds per share, the fourth and final share subscription of the South Sea Company took place. It proved to be the tipping point of the South Sea Bubble. Many attempted to become wealthy through the stock. Most failed. 

On August 22, South Sea shares were offered at 1,000 pounds, and by October they were 290 pounds. Families were reduced to beggary. This article outlines what today’s investors look out for, in order, to not suffer the same fate as the average citizen in England in 1720.

Understand what you are investing in

There are many things to look out for in investments, however, the most basic and important one is understanding the business. In the case of the South Sea Bubble, although the investors knew it was a trading company, but if they had dug just a little bit deeper then they would have found that only a single trade voyage ever occurred. Since Spain ruled South American trade, the prospect for more English trade was dim indeed. 

Investors were not buying because there was a compelling business model, they were mainly buying out of jealousy and FOMO. This behavior was brought on by others' supposed success in the scheme and further validated by powerful political and professional leaders also investing in the South Sea. Fortunately, history often repeats itself, therefore, you can learn from past investors' mistakes by not speculating with the herd and instead think for yourself. Always do your own research.

Easy Credit

Credit was important in two ways in the case of the South Sea Bubble. First, the South Sea Company took on debt from the British government in the form of annuities and converted them into shares. So in effect, the company was founded upon debt. 

Second, when influential company director John Blunt wanted to raise the share price even higher so he only required investors to put 20% down on their shares allowing them to buy five shares for the price of one. As a result, the already absurd share price of 300 pounds was boosted to new heights, reaching 1,000 pounds in the 3rd share subscription after Blunt’s leverage scheme. Later, this leverage led to a far messier crash of the share price, because investors were effectively buying on borrowed money. 

Credit can “raise the stakes” by making it seem like the investor owns more than they think on the way up. Only on the way down are the cracks in leverage revealed. Credit fuels the confusion and accentuates the bubble's extreme nature on the way up and the way down. In many of today’s markets, the risks of too much money looking for too few good ideas are very similar to those faced by 18th century South Sea investors. Investors should always avoid using borrowed money to invest. Easy credit and leverage will do investors what wax did to Icarus.

High Dividends

Along with making investing appear cheaper through leverage, the South Sea Company fooled investors by promising artificially high dividends. At the South Sea’s peak, it advertised a dividend of 25%.  Even for a profitable company, this is an absurd yield, much less for a company with no apparent prospects. This abnormally high dividend yield should have been a warning signal to investors. Instead, it served the intended purpose of the South Sea directors by drawing more gullible investors into the scheme. 

Today, many investors reach for yield, looking for high dividends and not considering whether the business can sustainably pay it out. All investors should research where the cash comes from to pay the dividend and avoid "sucker yields." For example, many investors buy REITs because they pay high dividends, but how sustainable are they? In 2020, many REITs have had to cut their dividends. 

Why does the company need your money?

Most investors judge investments by how much money they will make, however, in order to avoid investing in bubbles you must also look for why does the company need your money in the first place? Are they investing to reach new markets, building new factories? Or is the share offering just an attempt to juice the share price? Although this would have been extremely hard to fully understand the South Sea Companies' motives in 1720 if investors had kept an eye out for the viability of the plans the company had to put the money to work, this would have saved a lot of investors’ money.  

One person who wasn’t so enticed to the South Sea directors’ dreams of potential riches was Archibald Hutcheson, a statesman who was one of the most prominent critics of the company at the time. He pegged the intrinsic value of South Sea stock at 150 pounds meanwhile by August it had already reached 1,000 pounds. Investors should learn from Hutcheson and objectively calculate what they think a company is worth before investing. 

A competitive moat can contribute to more consistent long term returns

The South Sea was a purely financial bubble which meant the value of the stock wasn’t tied to any physical assets, which could have potentially stabilized it. Because the company didn’t have any real assets, there wasn’t much-stopping others from copying this scheme. So in the midst of the South Sea bubble,  new bubble companies emerged, which had far from legitimate business models. This is one of the reasons why value investors place such an emphasis on a strong competitive advantage and avoid businesses without them. Always look for a moat.

Don’t invest because other of people(No FOMO)

The biggest reason for the South Sea bubble’s size and impact was the FOMO. Once the ball was rolling at the beginning of 1720 just about every citizen that could scrape together enough money to invest in the scheme did. Because of this anxiety to invest the bubble grew, and fast. People were seeing their friends getting rich(on paper) by investing and wanted the same for themselves. Prominent citizens like Isaac Newton and even the King were investing. The moral of the story is “don’t invest because of other people” or “Don’t be sucked in by FOMO” even Isaac Newton and the King can get it wrong. FOMO can impede your investing success, therefore, separate your emotions from your investing and you will be years ahead of most British investors in 1720.

Conclusion

Investor behavior repeats itself across centuries.  Some of the market mechanics and industries change, but investor behavior is quite similar. My detailed piece looking at the South Sea Bubble goes into month by month actions of the company and investors. Investors can always profit by reflecting upon the past as well as they plan for the future.

Twitter - @soreninvesting