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More well known than The South Sea Company is perhaps the "South Sea Bubble" (1711 - September 1720) which is the name given to the economic bubble that occurred through overheated speculation in the company shares during 1720. The price collapsed the same year after reaching a peak in September.
The company, formed in 1711 by Robert Harley, was granted exclusive trading rights in Spanish South America. The trading rights were pre-supposed on the successful conclusion of the War of the Spanish Succession, which did not end until 1713, and the actual granted treaty rights were not as comprehensive as Harley had originally hoped. In return for these rights, the company took on around £10 million of government bonds, exchanging them with the bondholders for stock in the company at 6% interest.
The company did not undertake a trading voyage to South America until 1717 and made little actual profit. Furthermore, when ties between Spain and Britain deteriorated in 1718 the short-term prospects of the company were very poor. Nonetheless, the company continued to argue that its longer-term future would be extremely profitable. In 1717 the company took on a further £2 million of public debt.
Buying the public debt
In 1719 the company proposed a scheme by which it would take on the entire remaining national debt of Britain (£30,981,712), offering its own stock at 5% in exchange for government bonds in a deal lasting until 1727. The Bank of England proposed a similar deal. The company hoped to make a considerable profit and did much to advertise the proposal which was accepted in a slightly altered form in April, 1720. The Chancellor of the Exchequer, John Aislabie, was a strong supporter of the scheme.
The total government debt in 1719 was £50 million:
- £18.3m was held by 3 large corporations.
- Privately held redeemable debt amounted to £16.5m.
- £15m consisted of irredeemable annuities, long fixed-term annuities of 72-87 years and short annuities of 22 years remaining maturity.
The company acquired 85% of the redeemables and 80% of the irredeemables. Interest paying government debt to the company was now approximately £35.2 million (9.5+14+11.7).
The company then set to talking up its stock with "the most extravagant rumours" of the value of its potential trade, and there was an enormous wave of "speculating frenzy". The share price had risen from the time the scheme was proposed: from £128 in January 1720, to £175 in February, £330 in March and, following the scheme's acceptance, to £550 at the end of May.
What may have increased its valuation was that it was known to the market that a fund of credit of £70 million available for commercial expansion which had been made available through substantial support, apparently, by Parliament and the King.
A number of other joint-stock companies then joined the market, making usually fraudulent claims about other foreign ventures or bizarre schemes, and were nicknamed 'bubbles'.
In June, 1720, the Bubble Act (repealed in 1825) required all joint-stock companies to have a Royal Charter. The grant of a charter to the South Sea Company was an added boost, its shares leaping to £890 in early June. This peak encouraged people to start to sell; to counterbalance this the company's directors ordered their agents to buy, which succeeded in propping the price up at around £750.
The price finally reached £1,000 in early August and the level of selling was such that the price started to fall, triggering bankruptcies amongst those who had bought on credit and increased selling (i.e. short-sellers). The price fell slowly throughout August down to around £700. The attempts by the company directors to talk up the price failed, and it continued to fall into September; the stockholders had lost confidence and a run started.
Also, in August 1720 the first of the installment payments of the first and second money subscriptions on new issues of South Sea stock were due. This may have created a liquidity squeeze and generated pressure to sell shares. Furthermore, the scramble for liquidity appeared internationally as "bubbles" were also ending in Amsterdam and Paris. The collapse coincided with the fall of the Mississippi Scheme of John Law in France. As a result, the price of South Sea shares began to decline.
By the end of September the stock had fallen to £150. The company failures now extended to banks and goldsmiths as they could not collect loans made on the stock, and thousands of individuals were ruined (including many members of the aristocracy). With investors outraged, Parliament was recalled in December and an investigation began. Reporting in 1721, it revealed widespread fraud amongst the company directors. Robert Walpole, who had argued against the scheme from the beginning, was forced to introduce a series of measures to restore public confidence.
For the purposes of valuation, stock holders are primarily concerned with the future cash flow (dividends and capital gain) on which the stock provide a claim. Valuation is thus dependent on future expectations, and a company does not necessarily require positive earnings or cash flow to be highly valued. The valuation of the South Sea Company was perhaps nothing outrageous - it likely had financial ratios similar to those of many publicly traded companies today for which investors have high expectations.
An £8 million annual profit would perhaps justify a market cap of £200 million, if the earnings are "discounted" with a discount rate (an interest rate used in determining the present value of future cash flows) of 4% (200 * 0.04 = 8). This would be a 7% return on tangible assets (= 8 / 107). That would give the stock a price/earnings ratio of 25 (= 200 / 8), above the mean, but nothing unusual.
South Sea share price (in £):
- 1720 January: 128
- 1720 February 1: 75
- 1720 March: 330
- 1720 May: 550
- 1720 July: 950
- 1720 August: 1000
- 1720 August 31: 775
- 1720 October 11: 290
- 1720 September: 150
The business could later be restructured and a company with the name The South Sea Company stayed in business until the 1850s.
Last updated: 10-23-2005 01:03:42