Do this before the bubble bursts

“Is this an AI bubble?”

It’s a question being asked more frequently as share prices rise, optimism grows and investors become increasingly excited about artificial intelligence.

And fair enough, too.

We’ve seen this movie before. A genuinely transformative technology appears. Investors imagine the possibilities. Capital pours in. Share prices rise. And, eventually, enthusiasm gets ahead of reality.

The dot-com boom is the obvious comparison. The internet really did change the world, just as its champions predicted. But that didn’t stop investors losing fortunes when the bubble burst.

So, is history repeating?

Maybe.

But maybe not.

There’s no rule that says rapidly rising share prices must fall. Nor that excitement must end in disaster. Sometimes businesses grow into apparently expensive valuations. Sometimes the optimists are right.

And AI is already producing real products, real revenue and real productivity gains. Some of today’s leading companies are immensely profitable, rather than hopeful start-ups with little more than a web address and a breathless business plan.

That doesn’t mean their shares are cheap. It doesn’t mean every AI-related investment will succeed. And it certainly doesn’t mean prices can’t fall.

It simply means we should resist the temptation to confidently predict what happens next.

(It’s possible AI continues its rise, and the losers are those businesses most exposed to that disruption!)

A better approach?

Prepare, don’t predict.

Use today’s enthusiasm – and the possibility that it ends – as a prompt to check what you actually own.

Not just AI, though.

Everything.

Because tough times tend to reveal what the good times hide.

When share prices are climbing, almost every investment seems smart. The ‘rising tide lifts all boats’.

(That phrase apparently goes back at least to the 1600s – a reminder that while technology advances, there really is nothing new under the sun!)

It’s easy to get caught up in the story… and to convince ourselves that it’s skill, not luck.

It’s only when conditions change that the differences become obvious.

Consider retail.

A good retailer can have a tough year. We might reduce our spending and costs might rise. 

As a result, sales can slow and profits can fall.

But short-term troubles don’t necessarily make it a bad business.

The important questions are whether customers still value what it sells, whether it is taking or losing market share, whether its stores remain productive and whether management can sensibly navigate the downturn.

Because a healthy retailer can emerge from a difficult period in a stronger competitive position, particularly if weaker rivals close stores, cut investment or… disappear altogether.

A structurally challenged retailer is different, of course. Customers may not want its products, or might prefer shopping at the competition. Margins might be permanently shrinking. A cyclical recovery won’t necessarily rescue a business whose competitive position has deteriorated.

Here’s the thing: the share price might fall in both cases. But they’re not the same business.

Your job is to know which one you own.

Then there’s debt.

Borrowing can make a good business look even better when times are favourable. It can fund expansion, lift margins and improve returns on equity. Things that are otherwise hallmarks of a successful business.

But banks don’t care whether the economy is strong or weak. The interest bill still needs to be paid. Loans still need to be refinanced.

And lenders tend to be least generous when borrowers need them most.

That’s when the difference between a strong balance sheet and a fragile one becomes painfully clear.

A financially strong company can keep investing through a downturn. It might acquire a competitor, open new locations or buy back shares at attractive prices.

A heavily indebted company usually doesn’t have those choices. It can be forced to cut investment, sell assets, sack staff, or raise capital at exactly the wrong time.

We learned that during COVID.

The time to think about these things is before things get messy.

What things? Ask yourself some of these questions:

Does the company generate positive cash flow?

Does it earn attractive returns on capital?

Does it have a strong balance sheet?

Do customers genuinely value its products?

Does it have an advantage competitors will struggle to copy or beat?

And does it have room to grow?

Then consider what you’re paying. A wonderful business can still be a poor investment if its share price assumes everything will go perfectly.

The thing is, those fundamentals don’t seem to matter when prices are rising. They get ignored when everyone is focused on growth, and optimism, and when ‘what can go wrong?’ is a rhetorical question, not a real one.

And then… things go wrong.

The economy stutters. Rates go up. Investors get nervous. Prices fall.

It can be hard to remember that when the highly leveraged, high risk companies are flying high. 

It can be tempting to abandon disciplined investing and join the party.

Until the music stops.

And when it does, it’ll be too late to realise you own a collection of exciting stories, ephemeral profits, overleveraged balance sheets, and ‘hopes and dreams’.

You’ll realise you should have prioritised quality and value over high-risk and high hopes.

No-one can know what will happen, when. 

No-one.

And when you really understand that, you stop playing Russian roulette.

You make sure you’re prepared.

The time to make sure? Before the bad times come.

When will that be? No-one knows.

That’s why you should be prepared.

Fool on!

The post Do this before the bubble bursts appeared first on The Motley Fool Australia.

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Motley Fool contributor Scott Phillips has no position in any of the stocks mentioned. The Motley Fool Australia’s parent company Motley Fool Holdings Inc. has no position in any of the stocks mentioned. The Motley Fool Australia has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Scott Phillips.