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[Matthew Lynn] How to avoid the pitfalls of a new tech bubble

Initial public offerings. Big takeovers. Nerdy 20-somethings getting rich quickly. To borrow a phrase from an old Prince song, the markets are suddenly partying like it’s 1999 again.

The tech bubble is back. Facebook Inc. is commanding an enormous valuation. So are Groupon Inc., Twitter Inc. and Even Rovio Mobile Oy, the small Finnish company behind the hit app Angry Birds, looks like it will soon be worth a fortune.

The trouble is, everyone still remembers how the bubble burst last time around. Investors know there is a lot of money to be made from technology. They also know there is just as much to be lost when the bubble bursts.

To steer a way through that ― backing the winners, and avoiding the obvious calamities ― there are some simple rules we should draw from the last tech boom: Don’t worry too much about business models; look for emerging monopolies; back the greediest entrepreneurs; and buy after the hype subsides.

That way, one should still be able to make money out of what remains the world’s most lucrative growth industry.

There is little question that some verve and excitement have returned to the technology markets. It might not be quite back to the levels of mania that surrounded the dot-com boom ― but it is getting close.

Facebook is valued at $50 billion, on the basis of its most recent stock sales. Groupon, the Chicago-based daily-deals site, has held talks about an IPO that would value it at as much as $25 billion, according to people familiar with the matter. Its competitor LivingSocial may follow it to the market. Twitter valued itself at $3.7 billion at the end of last year, and may be worth a lot more by now.

AOL Inc. (AOL), a company that knows a fair bit about Internet bubbles, has pumped some excitement into a moribund media industry with its $315 million purchase of the Huffington Post website. Even humble app designers are now hot properties. Rovio Mobile is preparing itself for an IPO, and last month received $42 million in funding. At this rate, it may one day overtake that fallen star of the Finnish technology industry: Nokia Oyj.

Not everyone thinks it will end happily.

“Most of them will be overpriced,” said Warren Buffett, chairman and chief executive officer of Berkshire Hathaway Inc., speaking about social-networking valuations last month.

True enough. Among investors with a memory stretching back more than a decade, the simple combination of words “tech” and “IPO” conjure visions of valuations spinning out of control ― and everyone losing a fortune on a lot of companies that, looking back, were about as solid as a bowl of chicken broth. It is certainly possible that this tech boom will end up with more Angry Stockholders rather than Angry Birds.

Against that, the likes of Google Inc. (GOOG), Inc. and Apple Inc. (AAPL) are now among the biggest companies in the world. The Internet economy is expanding all the time. If you invested in the right businesses last time around, you made a lot of money.

So the trick is to back the right horses ― and to do that you need to learn the lessons of the last tech bubble to steer your way through this one.

Here are four good places to start.

First, don’t worry about business models. Google didn’t have one to start with. Neither did Facebook. The advertising followed later. Both concentrated on making a great product that would have a huge audience, and figured that so long as they had that the revenue would follow. So don’t spend too much time fretting about how the business doesn’t make any money yet. So long as the audience is there, it will be fine.

Two, look for monopolies. The Internet has an in-built tendency to create companies with massive market share. There is a simple reason for that: the network effect. We all use Microsoft operating systems because everyone else does. Likewise, we go to Facebook because that is where all our friends are. So it’s best to look for sites or software systems that everyone flocks to ― not because they are necessarily that great but just because everyone else does.

Three, skip the companies selling shares too soon. The best Internet entrepreneurs are greedy. They know they are on to something good, and they won’t be giving away equity until they have to. Watch for the businesses where the founders are only selling stock when they really need to ― and skip the ones where they are cashing out too early.

Four, buy after the IPO. There is an inevitable cycle of hype and disappointment before the really strong businesses emerge. The company goes public on a wave of excitement, then there is disappointing news, and the shares crash. Make sure you buy on the disappointment rather than the hype.

It remains the case that technology is where the real fortunes of the next decade will be made. Investors just need to make sure they tread carefully ― because there will be some spectacular turkeys out there as well as some great businesses. 

By Matthew Lynn

Matthew Lynn is a Bloomberg News columnist and the author of “Bust,” a book on the Greek debt crisis. The opinions expressed are his own. ― Ed.

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