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Lessons from past: South Sea bubble - Views on News from Equitymaster
 
 
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  • Feb 27, 2009

    Lessons from past: South Sea bubble

    Over the last thirteen months, the BSE-Sensex has fallen by more than 57%. If you think that is scary, look at the past. This is not the first time the stock markets have crashed so much after a bubble has burst. If we look back in history, we will find that bubbles have been created many a times that ultimately burst creating gloom all around. It is vital to realise that time and again markets are going to have these (and different) kind of bubbles which are bound to bust.

    It also is vital to explore how bubbles have been created in the past and how badly they have affected investors. None of us can control what the markets do to us, but we can control how we handle our money, and we need to learn from our ancestors who survived the crashes of the past to tell the tale. In this series of article, we will discuss some of the famous bubbles and crashes in history, which would help us think how to respond when the next one comes in the future.

    The South Sea bubble

    In the year 1720, the whole of England got involved in a bubble known as the 'South Sea Bubble'. Many investors, including Sir Isaac Newton and Jonathan Swift lost substantial amounts in this bubble.

    The South Sea Company was founded in 1711. In 1720, the company was granted the monopoly of trade with Spain's South American by the British government in return for a loan of 7 m to wage a war against France. The monopoly of trade and the company's relationship with the government helped the South Sea company in attracting large numbers of investors. Shares immediately rose by 10 times, further attracting more investors towards the stock. To satiate the investors' appetite, the company issued fresh equity in four subscriptions, at higher and higher prices. It also lent generously against its own shares, thereby increasing demand for them.

    The success of South Sea stirred the British market and investors started believing that British companies are the best. Taking cue from the South Sea Company, several other companies launched their IPOs and they all sold like hot cakes.

    Nobody questioned the repeated re-issue of stocks nor did anybody check the quality of the company's management. Investors kept on buying expensive stocks as fast as they were offered. Interestingly, the company's directors set up opulently furnished offices in the most extravagant localities to attract further investments.

    Very soon, the massive trading started putting pressure on the settlement process. The South Sea Company closed its books in order to catch up with the backlog and to prepare for the future subscriptions. Meanwhile, rumors about the company's bad financial state started circulating in the market. As a result, a large number of investors started selling when the books were reopened. The company was found short of cash to pay the debt holders. The stock price declined.

    The directors promised dividends of 50% of the stock's face value in a desperate bid to push up the sinking stock price. For this, the company used its financial arm "The Sword Blade Company". But very soon, in September 1720, Sword Blade became insolvent. Following this event, the price of South Sea stock plummeted. This sent shock waves in the market and stock prices started declining across the board creating a terrible financial mess.

    Conclusion

    Speculation can inflate stock prices to unbelievable levels. Investors find these escalating prices very enticing. As an investor, one's focus must be on the intrinsic value of a company and not its fluctuating market prices. Those who pay attention to intrinsic values might underperform during bubbles, but they often have the last laugh. As Benjamin Graham says "The individual investor should act consistently as an investor and not as a speculator. This means... that he should be able to justify every purchase he makes and each price he pays by impersonal, objective reasoning that satisfies him that he is getting more than his money's worth for his purchase."

     

     

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