In Search of Multibaggers: The Ultimate Guide to Investing in Technology Stocks

Reading today’s financial headlines can make any long-time investor feel like they’ve stepped into a time machine.

In the trend-driven world of investing, certain periods captivate the imagination of established and bandwagon investors to drive market frenzy. We are currently in such a period. Fueled by the launch of Chat GPT, an Artificial Intelligence (AI) based chatbot that has taken the world by storm, today’s AI-driven stock mania echoes the excitement and uncertainty reminiscent of the late 1990’s dot com boom.

The similarities between the two eras are striking. Just as the internet sparked a period of unimaginable innovation, AI is now poised to transform the economy, business, and society. Both periods started off with unbridled enthusiasm, as investors sought to identify the companies at the forefront of innovation and disruption. However, with excitement comes inherent risks, as witnessed during the dot com bubble's boom and eventual bust 25 years ago.

A lot happened 25 years ago. It was the start of Bill Clinton’s presidency. Kurt Cobain, the grunge music pioneer, died. Nelson Mandela was inaugurated as South Africa’s first black president. And, Jeff Bezos, working from his basement, founded Amazon, albeit with the original name Cadabra. It was also the start of my career and my first tryst with stocks. Both early adulthood adventures gravitated around technology for me, more specifically the Internet. In 1998 I had landed my first post university job with a fast-growing Internet professional services firm that built web sites for bricks and mortar retailers, major product brands and large industrial companies. It was this first job that led me to discover the rush of stock investing, unfortunately for me early on it was a path wrought with bubbles, broken business models, greed, and unfortunately costly and wildly bad investment decisions that left major scars on my investing psyche.

The dot-com bubble of the late 90s were the days of “growth over profits”, pets.com, and “prefix investing” where companies looking to boost their stock prices added “.com” to the end of their name. Like other technology-inspired booms of the past including bicycles in the late 1800s, automobiles in the early 20th century, electrification in the 1920s, microchips in the 1950s and 1960s, and home computers in the 1980s, the dot-com boom attracted new investors not wanting to miss out on what appeared to be an Internet gold rush.

In 2000 when the dot-com bubble burst, many dot-com startups were caught swimming naked when the tide went out. However, a select few not only survived but have since thrived. In fact, dot-com startups Amazon and Priceline (now Booking Holdings) are amongst the top performing stocks of the last 20-25 years. Rising from the ashes of the dotcom fueled broadband infrastructure spending, two other tech stalwarts and investing success stories would emerge, Netflix (IPO’d in 2002) and Google (IPO’d in 2004). Each of these companies have created immense shareholder wealth for those that had the foresight to identify these companies as potential Multibaggers (a stock that has provided returns several times its initial investment, often significantly outperforming the broader market or sector) and the fortitude to hold onto their shares during rocky times.

However, technology investing can be punishing. While technology investors are very well rewarded when they are right, they can be severely punished when they are wrong. For every Amazon or Google, there are a dozen more Pets.com’s, Yahoo’s or Blue Apron’s. Bankruptcy, selling to a large telco for “pennies on the dollar” and 97% drawdowns are the fates technology investors face when they get things wrong.

So, how can you increase your odds of capturing more of the technology sectors outperformance by helping you separate the Amazon’s, Google’s and Netflix’s from the Pets.com’s, Yahoo’s and Blue Apron’s.

Over the decades I’ve spent learning about and investing in technology stocks, I’ve identified a set of characteristics to help me identify Multibagger technology stocks. It’s not good enough to identify wealth altering potential. With technology-based investing in particular, your nerves will be tested. My framework has also helped me build the conviction necessary to endure the inevitable drawdowns that occur throughout the long duration required for the thesis of these investments to fully materialize. In this post I will share the six characteristics I seek when searching for my next Multibagger technology stock, providing signposts to look for and sharing relevant examples from the riveting and disruptive world of the technology sector.

1. Riding a megatrend that has arrived

2. Market opportunity

3. Better mouse trap

4. Optionality

5. Reasonable valuation and strong fundamentals

6. Strong and visionary leadership

1. Investing in Technology Stocks: Riding a megatrend that has arrived

“If you're looking for a home run -- a great investment for five years or 10 years or more -- then the only way to beat this enormous fog that covers the future is to identify a long-term trend that will give a particular business some sort of edge.”

- legendary investment manager Ralph Wanger

When looking for the next tech Multibagger stock, tailwinds matter. There is no greater tailwind for technology stocks than a mega trend. A mega trend causes significant transformational change to the economy, business, or society. Mega trends create significant value over an extended period. The most obvious examples of mega trends include electricity, automobiles, and the Internet. Mega trends are not limited to technological breakthroughs, they can also include broader trends such as shifting economic power from one region of the world to another, changes in demographics, or climate change.

The relevance of mega trends to investors is that they present a significant opportunity to personally gain financially from expected transformations, if played right.

So how can tech investors capitalize from mega trends successfully? Before pouncing on the latest technology fad, be skeptical and make sure all the elements of an investment ready mega trend are in place before pushing that buy button.

Be skeptical: Separating megatrends from fads

The most over hyped technology of the last two decades, the Segway (a personal mobility device), never came close to realizing the grandiose promises from tech insiders that it would be more transformative than the PC. In a highly ironic conclusion to the story, nearly ten years after the Segway was first launched to much hype, the CEO of the company James Heselden fell off a cliff to his untimely death while riding a Segway. It was a morbid chapter in the story of an invention that was supposed “to be to the car what the car was to the horse and buggy”. It didn’t take long after its launch to realize that the Segway was never going to have a market beyond mall cops and tour groups. The well proven method of walking around is just fine, thank you very much.

So, given the importance of separating megatrends from fads, how can the average investor rise above the hype to distill what is a true megatrend that will change the world and create an economic engine to power growth over the long run. According to the Copenhagen Institute for Futures Studies (“CIFS”), a globally recognized authority on defining megatrends, three criteria must be met to distinguish megatrends from short term fads:

• A broad scope, with the potential to impact businesses, economies, cultures, and human beings globally.

• A long-time horizon of 10 years or more.

• Potential to cause a seismic shift in economics, politics, technology and/or society.

The megatrend vs. fad debate is happening today amongst technologists and investors alike with the metaverse. The metaverse is a digital parallel universe that places people inside a 3D version of the Internet. A sort of 'embodied' internet, the metaverse offers persistent and synchronous experiences that make it feel like you are “in” the internet and not just accessing it in a 2D manner, like we do today on our PCs and phones.

It was only two years ago that the metaverse hype reached its height. Business Insider reported that in 2021, 158 CEOs of public companies mentioned metaverse on their earnings calls. While it feels like the new shiny object, ChatGPT, has faded the metaverse into the background, the growth of the metaverse continues. Roblox, the co-experience platform and most perceptible version of the metaverse today, continues to grow its daily active users and engagement. New interoperability standards are being launched by Decentraland. Metaverse fashion shows are preparing for the fall season. And brands such as Nike, Gucci, L’oreal, Tommy Hilfiger, Heinz, Visa, P&G, Unilever, and WalMart continue to pour money into building their brands in the metaverse. In fact, 46% of consumer brand marketers say they will increase their metaverse budgets this year (2023) according to Forrester Research.

Despite the hangover from overhype in 2021, the Metaverse appears to be persisting. That’s because its impact to business, the economy and society appears to be real.

The full vision of the metaverse is creating another place where people can socialize, play, work, conduct commerce, and learn. The kicker is that the metaverse enables people to do things they cannot, or easily, do in the real world. The changes to the economy, business and society will be immense. The metaverse will have its own, independent, economy; in fact, Roblox already has its own widely used currency - Robux. New jobs in the metaverse have already been created, with many more expected to be added over the years. With the much more immersive experiences the metaverse can offer, commerce will be done differently.

During the pandemic we saw firsthand the potential for the metaverse to transform society. People gathered on Roblox to celebrate their birthdays, go to concerts, attended graduation and even get married. While some of this behavior persists post pandemic, the long-term impacts to society are much more difficult to predict, but likely no less profound. What does it mean that the metaverse will bring about a degradation of the boundaries between the real world and the virtual world? With the level of abundance in the metaverse that is possible (duplicating virtual goods like a digital house is trivial), what will this do to today's wealth gap? With the lure of abundance and a better life in the metaverse, will some people spend most of their time in the virtual world at the expense of time spent in the real world?

Readiness for megatrend: Get the timing right

To be successful investing in a technology related mega trend, it is important to assess where the technology is in its adoption lifecycle. Is it just hype or has the technology fully arrived? Are there significant bottlenecks remaining that are blocking mainstream adoption of the technology? Has the business model been figured out? These are all important questions to ask so that you avoid investing in hype and instead invest in a true technology mega trend whose time has come.

We have seen it many times, a new technology arrives and promises to change the world, only to disappoint early expectations. True ground-breaking technologies often exceed those early expectations, but not on the timeframe it was first promised. Gartner has famously depicted this all to common hype cycle.

There are many examples of new technologies that arrive with a boom, appear to be a bust, only to return with a vengeance. A great example of this boom, bust, and rebirth cycle is the Internet. The boom period of the Internet began with the Netscape IPO, when the maker of the first widely adopted Internet browser went public in 1995. This was not only the launch of Netscape’s public stock, which doubled in value on their first day of public trading, but the launch of the most hyped era of the tech industry – the dot com boom. This boom period reached its peak in 2000, when the Nasdaq (the primary public market dot.com businesses) reached 5,048 in value. What followed was a nose-dive that took 15 years to recover from when in 2015 the Nasdaq finally reached its prior high of 5,000+.

What can we learn from this era that created and wiped-out billions of dollars in value in a few years, and then created a platform that would be a significant engine of more sane growth for decades?

• Sometimes it takes a while for all the necessary elements of the technology to arrive. Typically, they aren’t all there on the same day. For example, mobile computing has been an important catalyst for embedding the Internet into all facets of the economy and society. The promise of the Internet was “information at your fingertips”. Well, this was hard to realize when people spent most of the day away from their desktop computers. The arrival of smartphones kicked off the next wave of adoption of the Internet.

• All bottlenecks need to be removed for mainstream adoption to occur. With the arrival of the Internet came the promise of the Internet as a platform for TV. Companies such as Broadcast.com and RealAudio Player promised we would be watching TV thru the web imminently. While that kind of hyperbole worked for investors, Yahoo paid $5.7 billion for Broadcast.com which now does not exist, the required technology was just not there for an acceptable end user experience. Because of Moore’s Law, exponential advances in optical communications and storage, the necessary technology infrastructure was in place for streaming. Now, providers such as YouTube and Netflix have all been able to reward their investors significantly because of broadband and ubiquitous devices all stacked with high resolution displays, significant storage, optimized graphics processing and advanced connectivity, available at affordable prices.

• Megatrend investing success is not just about technology innovation. Business model innovation is an important catalyst to value creation and stock returns. Streaming and peer-to-peer file sharing technology innovation brought us Napster, the popular music sharing platform, but it took significant business model innovation from the technology and music industry to find a formula for sustainable monetization.

The pattern for these mega trends to materialize in a way that investors can benefit often takes longer than was projected by most analysts. That may be changing. While history can often be a helpful guide for what’s to come, there are special times when the exponential rate of growth makes a step change and prior expectations for the pace of change are no longer valid. I believe we are entering such a period thanks to the recent launch of Chat GPT, the revolutionary new large language model (LLM) from Open AI. It took only two months for a BETA version of Chat GPT to reach 100 million monthly active users, beating the previous champ TikTok by seven months.

So, why is this time different and what are the implications of this faster rate of technological advancements? We are now in what famed Internet blogger Tim Urban (of Wait but Why) would describe as the Law of accelerating returns. AI and therefore technology advancements are taking on a new trajectory of exponential growth thanks to the increase in computer power and how AI systems are programmed. The power of computing has come so far that we are basically at or near having an affordable computer that rivals the power of the brain. Secondly, an AI system is programmed with the goal of improving its own intelligence. After several iterative improvements, AI is expected to become so smart that it will have an easier time learning and will therefore make bigger leaps in intelligence. Chat GPT-4 has likely pushed AI closer to this frontier. It performs amazingly well on a variety of tests, including the Uniform Bar Exam where it scores higher than 90 percent of humans, and the Biology Olympiad which it beats 99 percent of humans. Now that Chat GPT-4 has cleared these intelligence hurdles, it may not be that long before it becomes as smart as humans, which will allow it to make even bigger leaps than we could ever imagine. As these leaps grow larger and happen more rapidly, Artificial General Intelligence continues to get smarter and soon reaches super intelligent levels. Tim Urban expresses this as the ultimate example of The Law of Accelerating Returns.

Everything we used to think of as the likely pace of change should be rethought. What we thought would take a few years to accomplish technically, will likely happen sooner. Winners and losers will still be made but technology will likely progress much faster than we could have ever imagined.

2. Investing in Technology Stocks: Market opportunity

A significant market opportunity exists when a company can fill a critical need in a better and less costly way, relative to the alternatives. To find technology companies that will deliver the premium revenue growth their heightened valuations demand, our search must focus on disruptive technologies. Technologies that deliver marginal improvements or sustain existing innovations will not suffice. Smartphones were a disruptive technology to many industries – the PC market, music and entertainment, and gaming to name just a few. The smartphones days as a disruptor are gone. Marginal improvements in the form of slightly faster processers, brighter screens, or a few more megapixels in the camera are not going to grow the total addressable market (TAM) in any material way.

The key to finding high growth technology companies is to find ones that participate in a big enough market of buyers that can be reached in a scalable manner. This is measured as the total addressable market (TAM), the overall revenue size of the entire market opportunity. As one of the biggest determinants of a company’s growth rate it is critical for investors to have their own point of view of the TAM size that goes beyond what the CEO themselves and/or analysts tell the financial markets. While it won’t come as a surprise to learn that CEOs may embellish or creatively estimate their TAMs, it is just as important to not miss out on outstanding growth potential due to underestimating the market size. Considering examples of both overestimation, and underappreciation, can be instructive here.

Yext: Never blindly trust management TAM estimates

While there are many well known TAM overestimations, such as Uber’s claim at IPO that their $5.7 trillion TAM (which was inclusive of total vehicle and public transportation miles), I will share a more personal example. Back in early 2020 I became enamoured with a Software-as-a-Service (SaaS) company called Yext, which helps brands ensure digital services (e.g., (e.g., voice assistants, Instagram, Google, etc.) are using accurate information (e.g., store locations, store hours, etc.) when answering questions about their brand from consumers (“Google: Where are the best Greek restaurants in my area”).

Digging into their 10-K at the time I trusted managements estimate of TAM which was built on shaky assumptions about its ability to monetize its service for each location of a brand’s store on an “assumed annual revenue per location”. The shakiness of their TAM calculation was hidden in plain sight. Their 10-K went on to disclose the assumed annual revenue per location “may not be comparable to and differs from annual revenue per license”. Translated this means “assumed annual revenue per location is a totally made-up concept and it probably has zero relation to what our revenue could be”. When estimating its TAM using miles travelled, Uber at least used a measure that had some relation to the service they were offering.

My second mistake was a failure to think critically about the importance of the problem Yext was trying to solve. Yext wanted to help brands keep their digital information accurate so they can be properly represented in the digital world. While Yext offered an effective way for companies to keep tabs on and manage their digital information, it turns out it wasn’t a big enough problem for most companies to pay money for the convenience Yext offered. The first clue, if I had stayed skeptical and did my own due diligence on management’s TAM claims, was the lack of discussion about the “problem” companies had managing their digital information. Yext executives were in an echo chamber with their claims this was a big problem. Where were the digital analysts or customers speaking publicly about this important problem? They weren’t speaking about it because it wasn’t enough of a problem to worry about solving, let alone build a $20 billion market around. It was also telling that there were no real competitors to Yext, beyond prospective customers doing what Yext offered in a manual way. While I favor investments into early-stage companies which do not yet have competitors to steal share, there is a doubled edged sword effect. In hindsight, the lack of competitors was more of a sign that Yext was not in a compelling enough a market that would naturally draw in competitors.

Smartphone market: Avoid the bad product fallacy

It is easy to underestimate the impact of a new technology. The tech industry is littered with dumb predictions because pundits were quick to dismiss a new technology as a toy for a strange niche, or because new technologies often undershoot user needs. For example, the very first telephones could only carry a voice call a mile or two away. This led Western Union to pass on acquiring Alexander Graham Bell’s patent on the telephone when it was offered to them in 1876, stating that the phone had “no commercial possibilities”. Their failure was not being able to imagine how telephones and infrastructure would improve over time.

It is often a lack of imagination that leads to underestimating a new technology market. Continuing with the phone example, a massive market underestimation caused AT&T to miss out on early mover advantages and left a stain on the world’s most prestigious consultancy as recorded in the annals of business folklore. In the early 1980s AT&T hired McKinsey to estimate how many cellular phones would be

in use by the turn of the century. The so-called smartest business minds in the world forecasted a paltry 900,000 cell phones to be in use by 2000. In their report, the consultancy accurately noted all the problems with cell phones at the time. They were too heavy, the batteries ran out quickly, the coverage was poor, and the costs were exorbitant. What they failed to imagine was how the technology would continue to miniaturize, how networks would improve and how costs could be driven down thru scale economies. Just how far off was McKinsey with their estimate? By more than 99%. In 2000, the global cellphone market had grown to 738 million. Turned out to be a costly mistake for AT&T because McKinsey, on the back of this projection, convinced AT&T to leave the cell phone market. AT&T re-entered the market years later having lost out on hundreds of millions of dollars in profit and any first mover advantages.

Just because the current use cases for a new technology may not appeal to you, it doesn’t mean it will never appeal to you or to the mainstream. It’s an easy trap to fall into, to predict a new product will fail because it does not currently apply to your personal use case. This is called the bad product fallacy, where you incorrectly conclude that just because you don’t like it means it’s a bad product and will therefore fail. In the 1980s most analysts dismissed personal computers as being only for hobbyists since it undershot user needs at the time.

"There is no reason anyone would want a computer in their home."

- Ken Olsen, founder of Digital Equipment Corporation

Amazing companies can also expand their TAM by removing friction in a market so that more customers can buy from them. This can be done by lowering costs thru scale and democratizing the technology so that it spreads to every corner of earth and entire societies can access it. Microsoft originated this concept of democratizing technology in the 1980s when it embarked on its now fully realized mission to “put a computer on every desk and in every home”. Microsoft is now running this same democratization playbook for Artificial Intelligence (AI). Microsoft CEO Satya Nadella has said that OpenAI and Microsoft have a ‘shared ambition’ that revolves around ‘responsibly advancing cutting-edge AI research and democratizing AI as a new technology platform’.

Meta has democratized ad buying for small businesses by providing them with accessible tools and platforms to reach their target audiences with personalized and tailored ads. Many small businesses rely on Facebook to place ads that are relevant to the niche demographics likely interested in their products, lowering ad costs, and helping small businesses avoid wasteful advertising spend. Meta would have much lower revenue if only the world’s largest brands could afford to buy ads on Facebook or Instagram.

The bigger the TAM the better. But I also prefer companies whose total revenue is a small slice of the overall market, with no to few competitors around to steal share. A low penetrated market gives you a much longer runway of growth.

3. Investing in Technology Stocks: Better mouse trap

"Build a better mousetrap, and the world will beat a path to your door"

- Attributed to American philosopher Ralph Waldo Emersonin in the late 19th century

Pre-Google search engine

Can a 19th century quote have relevance to the topic of picking a Multibagger stock in today’s technology industry? When it explains why some companies succeed in a technology market where others do not, yes! How else can one explain why Google beat out a dozen competitors in the nascent search market back in the late 1990s. Competitors such as Excite.com, Lycos, AOL, Go.com, Yahoo, AltaVista, Magellan, Infoseek, Webcrawler, HotBot, Open Text and Ask Jeeves were all left in the dust when Google came out with its search engine. Google simply had a much better mouse trap for the search problem.

In the world of technology investing do not expect to ride a long-term winner on the back of a bad product. What it means to have a good product in the context of technology investing has some nuance. The product must offer a better overall value proposition than the alternatives. It must solve the problem better than anyone else. In search of Multibagger technology stocks, ideally, we can find tech companies that don’t just have a great product but one that is, or has the potential to evolve into, a platform. Companies with a true platform benefit from network effects and high switching costs. These are advantages that give an investment a long duration to compound and deliver long-term sector beating returns. I also want to own companies that have the leadership, talent, culture, and structure that fosters innovation so they can continue their product excellence beyond their original product.

Better value proposition

In the late 1990s, what made Google a much better search engine than the incumbents at the time? It’s a simple answer but a complex innovation. Google’s search algorithm was more sophisticated and far superior to what competitors provided. If you wanted to find relevant search results, there was simply no alternative that would come even close to what Google provided. They had invented a PageRank algorithm that ranked results based on those with the most links to them from the most relevant web pages on the Internet. Existing search products ranked results by simply counting the times the search term appeared on a page. Once Google was formally launched in 1997, users flocked to the better mouse trap and Google tapped into a self-reinforcing loop that eventually created a monopoly in search. Every search request made on Google provides them with more data to make their search algorithm smarter. Their lead widens as better search results attract new search queries, adding more data to Google’s already massive treasure trove of user preferences. Google has ridden these network advantages to a winner take all outcome, possessing a 90%+ market share and a 50X stock return since its IPO in 2004. That’s what solving the problem better than anyone else, and always improving, gets you.

A problem like finding information on the Internet attracted a lot of entrepreneurs and venture capital funding. How do you pick the winners? Try to build some buffer into your selection by finding the sectors where the “better mousetrap” is very apparent. Easier said then done, but there are some ways to get a sense:

• Use the product itself. Doing a side-by-side comparison of the search results provided by Google to any of the incumbents at the time of Google’s launch would have made it super obvious that Google had the best search engine by a mile.

• Taking the product for a test drive is not always an available option. This is especially true with enterprise software. You probably aren’t going to setup a Salesforce instance and do a side-by-side comparison with their closest competitors. There are many third-party experts such as Forrester or Gartner that can provide a thorough perspective on which provider has the best solution. I often check out community forums where the IT professionals who are using these enterprise technology solutions themselves will share their unvarnished and informed opinion. One software product community rating site I use for unbiased product evaluation is G2.

• Follow investing analysts and publications that provide thorough and unbiased perspectives on a variety of technologies and vendors. For example, I’ve come to rely on Software Stack Investing, CML Pro, Hhhypergrowth and Stratechery.

Platform

It’s no coincidence that the six largest technology companies in the world (and 6 of the 10 largest companies by market capitalization – as of summer 2023), Apple, Microsoft, Alphabet, Amazon, Nvidia, and Meta Platforms, are all platform companies. Platform companies create an economic pie that far exceeds what is typical for stand alone product companies, or any conventional company for that matter. Platform companies bring together individuals and organizations outside of the boundaries of their company into an ecosystem to interact and innovate in ways not otherwise possible. And with the outsized value creation that emanates from platform companies, it should be no surprise that platform owners are able to capture more than their fair share of that value, rewarding their shareholders with above market returns. In the preeminent book on the subject, "Business of Platforms", the authors analyzed the stock returns of platform companies versus a control sample of non-platform companies and found that platform companies outperformed the control sample over a 20-year period with 14% annualized returns versus 8%.

According to the authors of “Business of Platforms” there are two types of platforms. The first type, innovation platforms, provide a set of technology building blocks that the platform owner and its ecosystem partners can collaborate on. Complementary products and services get developed, add functionality or assets that increase the value of the overall platform and its ecosystem. I own several innovation platform companies in my portfolios, including Amazon, Google, Digital Ocean, Palantir and one of the originals, Microsoft.

Microsoft’s dominance as one of the leading platform companies in all of technology can be traced back to a fateful and savvy decision by its then young CEO Bill Gates. Just five years into its existence, executives from Big Blue itself, IBM, paid a visit to the modest offices of Microsoft in Bellevue, Washington. IBM wanted Gates and Microsoft to provide the operating system for their planned personal computer. The fact that IBM miscalculated the importance of software over the hardware is a tale for another day. IBM let Gates get away with what is now considered the most consequential negotiation concession in all of technology history. Microsoft was able to retain the rights to also license the same operating system it was developing for IBM to other PC manufacturers. Gates had the foresight to know that if he had the exclusive right to license the operating system to IBM compatible PCs (i.e., clones) Microsoft would become the dominant platform for the entire PC industry. Today, the PC ecosystem Microsoft’s Windows platform built has created millions of complementary software titles and peripheral devices that are used by more than a billion users. The negotiation prowess of Bill Gates was able to parlay a contractor assignment with IBM into a $2.4 behemoth.

The other type, transaction platforms, are “intermediaries that make it possible for people and organizations to share information or to buy, sell, or access a variety of goods and services”. I also own several transaction platform companies, including Uber, Meta, and one of my more bullish investments, Airbnb. With over 4 million hosts and a cumulative 1 billion+ guest arrivals since its inception, Airbnb has created one of the best platforms and networks in all of tech.

With more hosts and guest using Airbnb, the value for everyone increases. As more hosts add their rooms or houses to Airbnb, more unique accommodations are available in more places, which in turn attracts more guests to Airbnb. As more guests use the Airbnb platform, more hosts are compelled to list on Airbnb to serve the growing demand on the platform and optimize their earnings. A virtuous cycle was long ago established that increases value for both new and existing users (hosts and guests) as the network grows.

There is a third and rare type of platform, the hybrid platform. Hybrid platform companies are an exclusive group of mostly mega cap peers that offer both an innovation and transaction platform. These special companies bake two pies, so shareholders have more slices to take.

One of my favorite hybrid platform companies and investments in my portfolio, is Roblox, a place where you can create an infinitely customizable avatar to be yourself, or to be who you feel like being. You can create and experience nearly anything you or the millions of Roblox creators can imagine. Roblox is a third place (beyond home, school or work) to find others with shared interests, or connect with your "offline" friends, and then share experiences together from the millions available on the platform. As I detail in my deep dive, Roblox is similar to Microsoft Windows, Google Android and Apple iOS, as their innovation platform offers tools, services, and a growing user base for outside developers and creators to be compelled to build games and experiences on it. The Roblox transaction platform makes it easy for users to buy avatars and virtual goods and for advertisers to reach millions of consumers in highly immersive experiences. The transaction platform Roblox has built includes a thriving economy and currency.

Network Effects

One of the most defining characteristics of platform companies is the network effects they generate. Network effects describe the phenomenon that can make or break platform companies, which is the concept that the value one user experiences from a product increase as more people use the product. The world’s most valuable and important technology platform companies, not coincidently, have the world’s largest networks, Apple with its 1.6B iOS install base, Google’s 3B users, Meta’s 3.6B users of its family of apps, and Microsoft’s over 1.5B Windows install base. Network effects are not new to today’s technology giants. In 1900 AT&T’s annual report mentioned the importance of network effects, without using today’s contemporary name:

“A telephone without a connection at the other end of the line is not even a toy or a scientific instrument. It is one of the most useless things in the world. Its value depends on the connection with the other telephone and increases with the number of connections.”

Just as network effects can generate non-linear growth in utility and value, companies that do not achieve defensible network effects can experience rapid declines in usage and ultimately have their business evaporate. The tech graveyard is filled with once promising platform companies that saw their early leads disappear quickly because of negative network effects. Friendster, MySpace, Nokia and Blackberry are just a few examples of tech companies that saw rapid declines in their business after negative network effects kicked in.

With network effects being so consequential to compounding growth, and yet so fragile, how do investors evaluate the intrinsic value and durability of a platform company’s network?

1. Winning the hard side of the network: Every network has what is often referred to as the hard side. Paramount to the sustained success of a network, the hard side is made up of a minority of users that create disproportionate value and thus are critical to winning over the entire network. Participants on the hard side do the heavy lifting of the network, contributing way more to the network than any other group. As tech investors we want to find platform companies that are on the path to, or already have, won over the hard side of the network. Great examples of this theory are how Uber won over the multihoming drivers to its ride sharing network, how Airbnb stayed true to its values to beat out a European copycat and won over the all-important host, and how Microsoft won over application developers during the personal computer platform war.

Uber had to battle fierce competition to get to its current dominant position. The battleground in the rideshare market is the hard side of the network – drivers. If you could win over more drivers, prices would drop, and more riders would be attracted to your network. Attracting more riders means more drivers because they can earn more, sparking the magical self-reinforcing growth flywheel. Uber applied its creativity and aggressiveness to every play in the growth toolkit, including financial incentives and adding features to optimize the app experience for drivers. According to Andrew Chen, former driver growth lead at Uber and author of the book The Cold Start Problem, the most impactful tactic Uber used to win over the hard side was targeted bonuses. Appealing to drivers’ primary motivation of making more money, Uber targeted bonuses at competing network’s most valuable drivers (MVD). MVD’s were known for being active on multiple ride-sharing networks and so Uber went about identifying these multihoming drivers using a combination of sophisticated data science methods and plain old guerilla warfare, and then offered them multiple financial incentives. It wasn’t good enough for these top drivers to be on Uber’s network, they had to be off competitive networks, and so the incentives were structured in a way that it would be less profitable to drive for other networks. The direct consequence of Uber’s effective use of the billions raised from its funding rounds to winner over the hard side of their network is why Uber has 75% of the US ridesharing marketing and Lyft only has 25%. Platform businesses are often winner take all due to the compounding effects of the battle for the network, and with Uber’s stock up 13% since its IPO (as of September 1st, 2023) and Lyft down 84% since its IPO, the ridesharing market is no different.

On their way to developing one of the best networks in all of technology Airbnb had to beat out a more, well funded competitor. In 2011 Airbnb faced its first real direct competition, a Berlin based startup called Wimdu. Wimdu was started by the infamous Samwer brothers, who had earned a reputation for cloning US Internet businesses. They built and sold a Euro auction site to ebay for $50M, as well as their second company Citydeal, which was inspired and acquired by Groupon for $170M. Not surprisingly, Wimdu launched with a similar look and set of taglines to Airbnb.

Armed by a fresh round of $90M and 400 employees at launch, as compared to Airbnb's $7M round and 40 employees at the same time; Wimdu was 10X larger than Airbnb. The problem with Wimdu's war chest was that it did not translate into strong network effects. To increase their supply, Wimdu tried deploying bots to scrape Airbnb listings and present on their own site. They also recruited slumlord property managers who oversaw shitty hostels. They burned through a lot of their VC funding on paid marketing campaigns to temporarily boost demand.

At the same time Airbnb was focused on handcrafting their product experience to exceed the expectations of both hosts and guest. Amazing product experiences led to word of mouth, search engine optimization earned marketing and PR. Airbnb ran an amazing ground game to win over the hard side of the network - hosts. Rather than trying to buy a network of guests and host like Wimdu was doing, Airbnb earned it market by market.

Airbnb with its rock-solid network beat the more well funded competitor by listening to its users, hustle and building the best product experience. It took only two years after its inception for the defeat to be official with Wimdu approaching Airbnb to be acquired. CEO Brian Chesky saw the flimsiness of Wimdu's business and declined. Today, Airbnb is worth $84B (as of September 1st, 2023) and Wimdu is worthless.

Winning over the elusive developers was how Microsoft was able to build Windows into the dominant PC platform with over 85% market share and relegate the Mac operating system (OS) into its persistent single digit share position. Microsoft swooped into the nascent PC market in the mid 80s with an affordable option for the average consumer, driving mass adoption and thus incentivizing developers to build on a platform that reaches more than a billion users. Despite the superior end user experience, the Mac’s premium priced and more difficult developer experience prevented mass adoption and disincentivized developers to build the breadth of apps that were necessary to keep users locked into Apple ecosystem. This 1980’s PC market case study is a good example of a technology product truism that persists today, the best products don’t always win. It’s usually the good enough product, plus the best network that win. Despite being the better PC, because of its ease of use and elegant design, the Mac has been relegated to niche status because its smaller ecosystem of developers and third-party apps have limited the overall product experience.

Microsoft solidified its dominance as the personal computer platform to build on by introducing proprietary standards that required developers to choose Windows over Macintosh. Because of these proprietary standards, third party developers could not simply port over the Windows based application to the Macintosh. Building on multiple platforms, each with its own proprietary standards was simply not feasible for up-and-coming developers. They had to choose. And, with its many times larger user base, the choice was often to build on Windows.

2. Limit multihoming: Multihoming, the ease at which users engage with multiple, similar platforms at the same time, can have negative network effects and limit the ability for a platform to grow revenue and profits. Uber has only become profitable now that they’ve been successful limiting multihoming by winning over the drivers and thus putting an end to the margin diminishing price wars with Lyft.

A market is unlikely to consolidate on a single platform, and tip towards a “winner take all” outcome, if multihoming persists. The social media market is ripe with multihoming, which has limited some companies from reaching their full monetization potential. A prime victim of the multihoming behavior of social media users is Twitter (now X). Tweeters have multihomed over the years, communicating on competing platforms such as Instagram, Facebook, Snapchat, WhatsApp and now Meta’s new messaging platform Threads.

Look for companies that have done an effective job of limiting multihoming. Locking in users through high switching costs or offering incentives that encourage exclusivity can minimize multihoming. The high switching costs for enterprises that have adopted platforms such as SAP, Salesforce, or Microsoft 365 to help run their business make it very difficult to move off once adopted. Enterprises invest heavily in data migration, integration, custom applications built on top of the platform and employee training.

3. Defensible moat

Network battles never end. Even when a network appears to have tipped in favor of one platform over another, a whole host of problems can emerge. Market saturation, overcrowding, spam, fraudsters, and churn can cause networks to hit a ceiling. Platforms must break through these ceilings through new products, innovation, and ultimately defensible moats.

For platform companies with network effects, the defensibility of their moat comes down to how easy or how hard it is for competitors to replicate their network. And cloning networks that have reached escape velocity can often take too much effort, capital, and time for most would be competitors. Just think about it in terms of the social networks you use every day. If you wanted to stop using Facebook or LinkedIn, you’d have to convince all your personal or professional network of contacts to move with you, otherwise there won’t be value for you to make the move yourself.

The battle of networks amongst platform companies often results in a “winner take all” outcome. Once a company starts to gain momentum in winning over each atomic network, a vicious cycle for competitors starts to kick in. Not only does the winner get a boost from network effects but the losing network experiences major negative effects. When users started to flock to Facebook, they were leaving MySpace and Friendster. When drivers were offered attractive incentives to stop multihoming by Uber, they stopped driving for Lyft. As people leave the losing network, it can lead to a death spiral of epic propositions and solidify the winner’s moat to fend off future would be competitors.

Investors benefit greatly from the economics of “winner take all” dynamics when they select the winning horse in the battle of networks. Score platform companies that are winning the important atomic networks and that are effectively scaling their acquisition and engagement loops higher. Facebook was able to beat MySpace by winning over college and university students across the US on a school-by-school basis, and then encouraging students to invite their friends, families, colleagues, and acquaintances outside of their school network.

Innovative

To justify the higher valuation ratios placed on technology stocks, sustained premium revenue growth over the long run is required. This means investing in companies that can gain market share and grow into new markets. For technology-based companies especially, innovation is the fuel of this growth. I have a checklist of innovation signals I use to find companies with a high innovation quotient:

• Competitors copying features: Imitation is the sincerest form of flattery, and the technology industry is filled with shameless admiration. Whether it’s Microsoft copying Apple’s iPod with the Zune, or Google copying Amazon’s personal home assistant Echo a year after its release with its Home device, copying can be a validation that the originator is an innovator.

• Agility in shipping code: Shipping new features or products quickly is an important organization competency that feeds a healthy innovation flywheel and drives growth. If companies don’t ship code fast, they can’t experiment and iterate. And if they don’t experiment there is a high probability a new feature or product will miss the mark.

• Ambitious use case enabled: The most challenging problems facing the economy, healthcare, businesses, governments, and society at large is good fodder for technology innovation. One of the reasons I’m bullish on data platform company Palantir is the ambition and achievement of customer use cases on Palantir’s software. They are helping their customers pursue or achieve moonshot goals, including building safer cars, uncovering human trafficking rings, preventing money laundering, fighting hunger, delivering lower carbon energy, accelerating cancer research, even helping the Ukraine battle the much larger Russian army. This level of ambition demands the most innovative technology solutions.

• Innovate in new areas: Companies that can innovate in a seemingly new area as compared to what their first act was, show signs of a persistent innovation culture that can likely propel growth for decades. Amazon was able to apply its innovation muscle to take the lessons it learned running the world’s largest ecommerce site as its first act to creating one of the most important technology innovations over the last twenty years, Amazon Web Services, as its second act.

• Follow the money: Digging into the numbers can help validate how much a company is investing in innovation and what the payoff of that investment is. While the size of a company’s R&D budget does not guarantee successful commercialization of innovation, it can be useful to evaluate the productivity of a technology company’s R&D spending. Assess how much revenue or gross profit (known as Return on research capital) is generated for every dollar of R&D spent in recent years. Another good signal, if the data is available, is to look for companies with a meaningful proportion of revenue coming from products introduced over the last three to five years.

Willingness to invest

Innovation needs investment and that can sometimes mean sacrificing short term financial goals in favor of longer-term payoff. In a world where most investors trade quarter-by-quarter, it takes courage for companies to look past investors short term demands so they can continue to innovate and retain customers over the long run.

The company that epitomizes a willingness to invest in innovation at the cost of achieving short term financial metrics demanded by certain investors is Amazon. Back in 2007, after competing against each other for nearly a decade, eBay was bigger than Amazon in terms of gross merchandise volume and number of customers, and it was the winning stock to own during the first decade of the Internet’s commercialization phase. Fast forward 16 years to today, Amazon’s market cap is now 52x the size of ebay’s. Why have Amazon shareholders been so much more rewarded than ebay shareholders? In his book, Nothing but Net author Mark Mahaney argues:

“The key takeaway from the Amazon versus eBay story is that the company that was more willing to aggressively innovate on behalf of consumers-even at the cost of dashing near-term investor expectations-ended up as the bigger long-term winner. There were lots of factors behind Amazon’s success, but this customer-centricity-rather than investor-centricity-was a key one”

A key example of this customer centricity was Amazon’s investment in its free shipping and video streaming subscription service, Prime. On the day when Amazon announced Prime in February 2005, shares dropped 15%. After the many billions spent and a big hit to Earning per Share (EPS), Prime now has 200 million plus subscriber and has been a key driver of Amazon’s growth.

4. Investing in Technology Stocks: Optionality

In the early 2000s, Jensen Huang - CEO of then niche graphics chip manufacturer Nvidia, received an unsolicited email from a Stanford researcher that would put Nvidia on a growth trajectory to becoming the world’s fifth largest company by market capitalization in the world (as of summer 2023).

As the apocryphal story is told by CEO Huang himself, the Stanford quantum chemistry researcher wanted to personally thank Huang for making his life’s work achievable in his lifetime. Despite having access to the super computers of the worlds number one computer science university, the researcher was struggling to find the computational power required to model the molecules he was researching. Seeing his dad’s frustration, the researcher’s son – a gamer, suggested the researcher go to the local electronics store to buy a bunch of off-the-shelf Nvidia GeForce graphics cards to try running the model on the graphics card for faster processing. The researcher ported his models onto the GeForce cards and was able to finish computing one model in a couple of hours, rather than the weeks it would have taken on Standford’s best super computers at the time. It turned out that Nvidia’s Graphic Processing Unit (GPU) parallel high intensity computing capability, which rendered stunning 3D graphics for the world’s most popular video games, was exactly what deep learning AI type models needed and weren’t getting from the more limited CPU sequential computing model.

Thus began Nvidia’s journey to go from being good at making commodity graphic cards to now owning the most in-demand computer chip that powers the world’s data centers, enables self-driving cars, and trains the most powerful AI models. It also led to Nvidia growing from a $20 billion valuation at the height of its graphics niche business to its current $1.2 trillion valuation.

While Nvidia may have stumbled into a new market on the back of its primary competency of making GPU’s, it tapped into the powerful concept of optionality that leads to multiples (e.g., P/S, P/E) expansion and subsequent stock price increases.

Optionality exists when a company has a second or third act that keeps the growth going beyond its original idea. You cannot expect wealth altering returns if the company is a one-trick pony. The best technology stocks are those that are optimized for optionality, meaning they have a high probability of generating new revenue streams based on their current success. Throughout a five- or ten-year period of holding an investment, the company you own is bound to encounter market shocks, disorder, and displacement. We want to own companies that can survive, or even thrive, these inevitable chaotic periods. In the world of investing, this adaptability comes from being what esteemed hedge fund manager and author Nassim Taleb terms as an “antifragile” company. Antifragile companies are not only resilient, but they become stronger during periods of stress or pressure. In his book Antifragile Taleb wrote: “An option is what makes you antifragile.”

I believe there are two types of optionality, both are strong indicators of future growth, but one is a bigger catalyst and quite rare:

• Use case optionality: This kind of optionality exists when a company has a core technology that can be applied to various use case scenarios. A good example of a company with “use case” optionality is Hubspot (NASDAQ: HUBS), the marketing cloud leader in the Small and Midsize Business (SMB) segment. HubSpot has a proven ability to execute and realize the inherent use case optionality of its business. At time of IPO, HubSpot had a marketing app that was targeting the small to midsize business segment (SMB). They have since evolved into full suite, adding products (they call them hubs) for the sales and service functions.

• Mission optionality: For a select group of tech companies, mission optionality exists. This sort of optionality only exists for special companies with awe inspiring missions. “Be earth’s most customer-centric company”, “organize the world’s information”, “make the world more open and connected”, “empower every person and every organization on the planet to achieve more”. Any of this sound familiar? These are obviously very inspiring missions, being big and audacious enough to present multiple ways for the company to achieve their mission. Take Meta and their mission of making the world more open and connected. Their acquisition of Instagram and WhatsApp, move into the metaverse, and recent move to make their large language model (LLM) Llama open source are all about making the world more open and connected.

Each type of optionality can offer some compelling investment ideas and I’m always searching for companies in both spaces. However, when I find that rare company that has mission optionality, and if I get in early enough, I am likely to hold onto the stock for decades.

The key to profiting from optionality is spotting it early enough. When you start to see multiples expanding, it’s a sure sign that other investors are beginning to realize the company has a lot of optionality. The investing edge is found when you can uncover companies with significant and attractive optionality with a high probability of being realized, that the market has not yet recognized.

Significant and attractive optionality

There is perhaps no other company in the world that has more greatly rewarded its shareholders thru the power of optionality than Amazon. We all know how Amazon got started. What started as an online bookstore quickly evolved to become the everything e-commerce store. Since then, we have seen the behemoth generate new growth off the back of significant optionality, including its very transformative cloud computing business AWS, advertising, devices, video and music services, and grocery retail. We are also seeing glimpses of what Amazon might have up his sleeve for its next act. Would anyone be surprised to see Amazon begin to offer shipping and logistic services that compete directly with Fedex or UPS? The company is also pushing into healthcare with its acquisition of online drugstore PillPack. It is no wonder Amazon has the astronomical valuation it does thru what amounts to an optionality premium.

Not all optionality is value accreditive, some new markets may have intense competitive dynamics and/or poor margins. During the pandemic Airbnb was forced to cut bait on its long-rumored plans to launch an airline. As a shareholder, I hope Airbnb does not decide to dust off its airline plans and go for it. The airline industry has terrible economics and Airbnb would be foolish to enter it.

The most compelling opportunities are where companies have a portfolio of optionality to pursue. Take Roblox, the global metaverse platform with 70M+ daily active users. Roblox revenue today is primarily made up of the sale of Robux, the currency sold to users who spend it on the experiences and virtual goods in Roblox. With the progress they’ve made building an entire economy on its platform, the opportunities for Roblox to purse are limitless. Over the long run, the potential total addressable market for Roblox is bringing all elements of our real economy into the metaverse. More immediately, Roblox has a robust optionality portfolio which includes an emerging advertising business, a potential real world commerce business that builds on its virtual marketplace, and an event platform for concerts (already happening), sporting events, or conferences.

The multiple expansion power of optionality was recently on display with Microsoft’s disclosure of its pricing for the new Chat-GPT like SKU available in its productivity franchise Microsoft 365. If just 10% of its existing Microsoft 365 users purchase the new $30/user AI add-on Microsoft would add an incremental $14 billion in annual revenue. The same day Microsoft made the pricing announcement, the already $2 trillion dollar+ market cap grew by 5%. The market knew at that moment that the AI opportunity added significant optionality for Microsoft investors.

Probability of realizing optionality

It’s very easy to get caught up in the enthusiasm of a CEO sharing their companies optionality prospects at the annual investor conference. They are doing their job laying out their vision for the future of the company. But this is where we must exercise skepticism as wise technology investors. Whether it was Google’s failure with the Facebook copycat social network Google+, Facebook’s inability to gain meaningful traction in hardware so far (e.g., Portal video-chatting hardware and the HTC First smartphone partnership both failed), or Uber’s departure from the massive China market; a strong brand and bold ambition does not guarantee the success of a technology companies second or third act.

There are a near equal number of attributes that enhance the likelihood of a company realizing its optionality as there are those that detract from the probability of a company fully realizing its optionality. Investors get rewarded when the companies they own can tap into the optionality enhancing factors and avoid or minimize the detracting factors.

Optionality enhancers

• Relevant assets: Successful technology companies have certain sets of assets that can be used to effectively convert optionality opportunities into growing new business segments. Assets such as brand, capital reserves, expansive distribution networks, a substantial, existing user base, and network effects tend to be the most useful in technology markets. For example, in their earlier days PayPal was able to use its trusted brand to venture into new product areas such as credit, loans, debit cards, digital wallets and brick and mortal retail payment solutions. Arguably, Microsoft Teams was able to beat out Slack because of its massive enterprise salesforce and its ability to attach Teams to its large Office 365 install base. The jury is still out on the long-term prospects of Meta’s Twitter copycat app Threads, but Meta was able to blow past the cold start problem inherent with new social apps by tapping into its two billion strong Instagram network to boost usage in Threads early days.

• Execution track record: Putting aside the Newton and Homepod product failures, Apple has a very long and successful track record of expanding into new product and market areas. This is why I get bullish about an emerging category or new paradigm when I see Apple enter like it did recently with the launch of its elegant AR/VR device, the Vision Pro. There is no greater boost to my confidence in a company’s ability to realize its optionality than actual proof it has done so previously. It turns out creativity, product design, technical prowess, go-to-market wizardry and good old “getting it done” muscles are transferrable capabilities.

• Innovation culture: We’ve all heard the stories of how 3M’s “15% rule” (3M employees are encouraged to spend 15% of their working on projects outside their regular job duties) and Google’s “20% rule” (Googlers are encouraged to use 20% of their time working on what they think will most benefit Google) led to the creation of Post-It notes and Google News, Gmail and its AdSense products respectively. Company’s must walk the talk and empower employees to invent and innovate, so they can continue delivering the premium growth tech investors demand.

• Necessity: In its early days of ecommerce retail Amazon encountered a major problem. Ecommerce was growing at an exponential rate, creating unimaginable amounts of customer and transaction data that needed to be stored affordably and securely to operate an at scale online store. This was a problem other organizations and governments around the world would encounter as they made the required move to digital. Because there was no solution to this problem, Amazon created what would go on to become it’s first Amazon Web Services (AWS) offering, a massively scalable and secure cloud storage service. As customer zero, Amazon gave birth to a massive new business out of necessity. AWS has grown to become a near $100 billion annual business for Amazon on the back of web services Amazon built for its first act - the world’s largest and most complex digital store. Necessity is really the mother of invention.

Optionality detractors

• Innovators dilemma: In 2017 Google researchers invented the basic algorithmic design underpinning today’s generative A.I. boom that OpenAI’s ChatGPT is getting much of the credit for. How is it that a not-for-profit upstart was able to beat the inventor of the breakthrough algorithm itself to market with the first consumer grade A.I. product that captured the world’s imagination and achieved mainstream adoption? Don’t forget, Alphabet is one of the largest software companies in the world with some of the most leading A.I. minds. Welcome to the innovator’s dilemma, a phenomenon that has caused some of the most innovative technology companies to miss out on a new technology paradigm. Because large incumbents like Alphabet have difficulty cannibalizing their cash cow businesses when threatened by new disruptive technologies, they can fail to realize their optionality. While Alphabet worried about releasing their generative A.I. product at the time (called LaMDA) due to fears of the technology’s shortcomings (e.g., hallucinations, bizarre and disturbing responses) causing reputational risk, the bigger concern was the potential cannibalization to their $160 billion a year search advertising business. Compared with Google’s Search product, the summarized answer generative A.I based chatbots provide seem to provide far less opportunity for advertising placement or sponsored links. Google only released their ChatGPT equivalent recently as an experiment when their hand was forced by the massive success of ChatGPT.

• Capital intensive core business: Capital intensive businesses often don’t have the capital available required to pursue new product or market options. These companies are often obligated to funnel all available free cash flow into funding the capital projects required to just stay competitive in their core business. A very telling example of this are the differences between two semiconductor giants, Taiwan Semiconductor Company (aka TSMC) and Nvidia. TSMC is the world’s largest dedicated contract chip manufacturer/foundry. They manufacture the most advanced semiconductor chips for some of the largest companies in the world, including Apple, Qualcomm, AMD and yes, Nvidia. Just to maintain their current market lead TSMC regularly invests $15 - $20 billion per new semiconductor manufacturing factory. This doesn’t leave TSMC any cash of significance to explore whole new businesses. They are the best semiconductor manufacturer in the world and the money they make goes back into staying the best. Like TSMC, Nvidia is also a semiconductor company, with one important difference, they are what’s called a fabless semiconductor company. Rather than invest billions in building their own chip factories so they can manufacture their semiconductor chip designs, Nvidia hires TSMC to carry the capital weight of manufacturing. The consequence is Nvidia can invest in new product areas such as software and digital twins, and new segments such as AI and automotive. Asset light businesses such as Nvidia, Airbnb and Uber fit the profile of technology companies with a higher probability of realizing their optionality.

• Regulatory and political considerations: Regulatory and political considerations can act as significant barriers for technology companies seeking to explore new business opportunities. The dynamic and rapidly evolving nature of the tech industry frequently clashes with existing regulations, such as those related to data privacy and sovereignty issues, antitrust regulations, intellectual property rights, and cybersecurity standards. Antitrust regulations have threatened to break up or curb the growth of many mega cap tech companies, including Amazon, Meta, Google, and Microsoft. Geopolitics and the repressive laws of the Chinese communist party have left Airbnb, Google, Facebook, Uber and other Western technology companies locked out of the massive Chinese market.

Optionality not recognized by wall street

There are certain stocks that Wall Street has a difficult time fully understanding. This can often lead to a discounted stock price caused by an underappreciation of the company’s optionality upside. Five years ago, this was the case with streaming platform company Roku. For a long time, Wall Street has believed Roku was in the hardware business. Roku built its brand on their digital media players and so this ignorance was understandable. Much of Wall Street was valuing them as a connected TV device manufacturer – a low margin business. At the time, Wall Street was missing the optionality Roku had in its business, that is an emerging platform that Roku could monetize through advertising. I pounced on the price arbitrage as I saw it. As more and more people caught onto the “true” Roku story the stock began to pop. There was an extended period where the market was mistakenly valuing them as a commodity hardware business while the signals were clear that they had built a successful advertising operation that was ready to explode.

In addition to looking for companies with significant and attractive optionality, that has a high probability of being realized, I favor stocks where Wall Street is not fully pricing in the optionality upside. As individual investors, Wall Street’s ignorance can be our biggest opportunity.

Some clues I look for to identify misunderstood stocks include companies that are either in the early stages of a new business (that I believe in) or have pivoted or started a new business that has not fully materialized in their income statement. It was not until 2018 that Roku’s advertising business pulled ahead of its hardware business, a few years after Roku began disclosing its ambition in this area.

5. Investing in Technology Stocks: Reasonable valuation and strong fundamentals

It’s time to have some math fun. Just like we would analyze stocks in any sector, with technology stocks we must dig into the numbers. Don’t fall prey to the “techonomic” theory of growth at all costs that has become a meme to justify investing in unprofitable technology stocks. Growth is still king for technology stocks, but there must be compelling unit economics that point to a profitable future. And, valuation matters, it always did. Let’s start with the first math lesson for technology investing, look for companies that have runway to grow.

Small enough to give runway for market capitalization growth

When looking for a technology stock with Multibagger potential I start with companies that are valued at less than $10 billion in market cap. At a $1 trillion+ valuation, today’s Amazon will not be turning into a ten bagger. Those days for Amazon investors are done. While Amazon could still be a great investment, if you are Multibagger hunting it doesn’t fit the profile. The law of big numbers disqualifies any likely probability that Amazon will grow to $10 trillion in the next decade. However, if you found a compelling company that met the previously discussed technology Multibagger criterion valued at let’s say $1 billion, growing to $10 billion is not as big a stretch. The e-commerce platform company Shopify (NYSE:SHOP), debuted on the TSX and NYSE in 2015 with a valuation of $1.27 billion, and as of September 1st 2023 its market cap sits at $85 billion. That makes Shopify almost an astonishing 67 bagger (67 times return on the IPO price) in less than ten years. Let me be clear. Picking a multi-bagger of that magnitude is very hard and not for the faint of heart. However, looking for companies small enough that provide enough runway for growth puts you in a better position to find 5-10X+ Multibagger.

Strong growth

Technology investors pay a premium for growth. The rule of thumb to justify the premium placed on technology stocks is consistent 20%+ revenue growth. The rewards come when investors can invest in companies that are early on in what turns out to be a consistent and sustained growth phase over a long period of time. This is an exclusive group of companies. As Mark Mahaney writes in his book Nothing but Net, “only about 2% of the S&P 500 have been able to consistently generate 20%+ revenue growth for 5 years, but these stocks have usually materially outperformed the market”.

Earnings still matter (sooner or later) for technology companies. It’s just that the domain of technology growth investing requires a different mindset from other styles of investing, one that prioritizes topline growth. A growth technology stock transitions to its next phase in its lifecycle when its growth rate drops below 20% and management starts to optimize for profits or returns cash to shareholders in the form of a dividend. This is when the technology growth investor can re-evaluate whether these companies warrant a continue position in their portfolio.

Technology investors must continually assess whether the growth premium placed on the technology stocks in their portfolio is justified. This means, looking for signs of deceleration and new growth initiatives that will sustain or, even better, accelerate growth.

Some degree of revenue growth deceleration can be expected. Rising interest rates or recessions will slow the growth of even the healthiest technology companies. What matters is the cause of the deceleration, and often the size of the growth drop and/or the rate of the deceleration. These are often early warning signs that something is amiss. If a growth tech stock sees a dramatic 50% drop following a period of sustained premium growth that are not related to macro economic factors, or if it experiences three to four successive quarters of sub-20% revenue growth, there should be alarm bells going off in your head. This type of deceleration could point to the company entering a growth winter due to market saturation, a lack of adapting to a new paradigm shift, share loss or poor execution.

Former Wall Street darling Fastly, an edge computing platform provider, saw their annual revenue growth rate decelerate by more than half from its peak of 60%+ in Q2 2020 to sub 20% levels (13%) a year later. This lackluster revenue growth persisted over the next two years to present day (CY2023 Q2), causing investors to re-rate the stock and driving its Price to Sales (P/S) ratio down from 31 to 2; resulting in a 92% beat down of its stock price. Throughout this exact same period, their primary competitor Cloudflare stayed above 50% YoY revenue growth. The numbers made it pretty clear to investors, Fastly was struggling with its execution. Their stock finally started to show signs of life once the CEO presiding over its slowing growth was replaced by a tech veteran. This cycle played out just like it has many times before with many other stocks, investors aren’t going to pay a premium for a non-premium growth stock.

One of the most satisfying moments as an investor for me is when a company I own reaccelerates their revenue growth. When growth accelerates, the stock price will likely increase off two powerful catalysts – revenue growth and multiple expansion (P/S, P/E). The fuel for acceleration, and sustained growth for that matter, are new growth initiatives successfully implemented by the company. Growth initiatives can include prices increases, geographic expansion, new product launches or new customer segments penetrated.

Adobe and its successful transition from a traditional, perpetual software license to a Software-as-a-Service (SaaS) subscription model in 2012 is a striking example of this growth acceleration and stock re-rating dynamic. Facing sub 10% revenue growth in 2011 and an emerging new paradigm for software delivery, Adobe was facing the classic innovators dilemma. Pivot to SaaS and cannibalize its traditional licensing business significantly in the short term or stick with the status quo and face a likely long, drawn-out death.

In November 2011 the company made the decision to pivot its business to a SaaS model public by announcing its intentions to Wall Street and by the next year their new SaaS subscription service Creative Cloud was live. There was some pain in the short term. 30,000 customers signed a petition on Change.org asking Adobe to abandon the SaaS transition, and revenue decreased through 2013 and early 2014. However, the transformation began having the expected effects. Revenues were stabilized by the shift from one-time purchases to recurring revenue, lifetime value of customers increased, the customer base expanded to include more casual customers who could justify a monthly subscription, and piracy was reduced. Revenue surged, going from quarterly declines to 20%+ quarterly growth in under two years. Adobe’s premium revenue growth (20%+) would sustain over the next six years. Investors took note, re-rating the stock from a Price to Sales ratio of 3 to 21 by the end of its cloud fueled premium growth phase. Investors along for the ride saw a near 20X increase in their bet on this transformation over its ten-year lifespan.

But growth on its own is not enough. Without good unit economics and a reasonable valuation, you are playing with fire. It’s time for our last two math lessons.

Unit economics

"Unit economics ultimately determines the long-term success of a business. No amount of funding can save a company with fundamentally flawed unit economics."

- Marc Andreessen, Co-founder of Andreessen Horowitz

The era of cheap money came to an end officially post Covid when central bankers started to raise interest rates in early 2022 to curb inflationary pressure. Technology company valuations cratered, and investors began demanding tech CEOs walk and chew gum at the same time (grow and be profitable). Historically, growth investors were willing to accept a lack of profitability in their technology growth stock investments when profitability wasn’t a pipe dream but a conscious trade-off in favor of growth. I do believe the pendulum will eventually swing back to its historical trade-off of growth over profits for earlier stage companies that are battling for market share and have good unit economics.

Unit economics help investors evaluate the profitability and sustainability of a business. This is particularly important for high growth companies that are in the growth stage, where scaling and winning share is the modus operandi. More practically, unit economics tell us how profitable (or unprofitable) the company is on its basic unit of value. The basic unit of value can be measured in different ways, depending on the type of company. It can be measured as a customer, a product or a service offering. If a company isn't generating attractive profits based on its unit of measure, and there's no reason to think its unit economics will change, it's not worth investing in.

There are two main ways to measure unit economics, either on a product/service basis or on a customer basis. We will focus on scenarios where the unit of measure is a customer as it’s the best way to gain insight into the health of a SaaS business and its long-term profitability potential once scale is achieved. The mostly widely used formula for calculating unit economics for this scenario is by dividing the Lifetime Value (LTV) of the company’s average customer by the costs to acquire the average customer, aka Customer Acquisition Cost (CAC). LTV is defined as the amount of revenue earned from the average customer over its lifetime minus the directs costs of providing the service or product. This unit economics formula calculates the cumulative gross profit the average customer generates over their lifetime relative to the upfront acquisition costs.

Unit economics = LTV/CAC

A simple equation in theory that is easily obfuscated or often not disclosed in the real world of a public company’s financial reports. It can be quite difficult to calculate for public companies. Rather than go into the details of how to calculate LTV and CAC, you can do so here if you are so inclined, let’s focus on the input measures and proxy’s that you should be able to baseline on so you can do relative comparisons:

• Gross margin

• Sales and marketing efficiency

• Net dollar retention

Gross margin

Gross margin is a key metric for any modern software company. Gross margin can be a telltale sign of true SaaS company vs. a "fake" SaaS that requires a lot of professional services support to implement. It measures the difference between the revenue generated from a software product and the cost of delivering that product, expressed as a percentage of the total revenue.

Gross margin = [(Total revenue – Cost of goods sold)/Total revenue] *100%

The costs of delivering a software product, aka the cost of goods sold (COGS), includes expenses such as hosting, customer support, maintenance, customer success and professional services. The lower the COGS, the higher the gross margin and the more cash available for operating expenses and funding new growth initiatives.

SaaS companies typically have high gross margins compared to other types of businesses because they have low variable costs and benefit from economies of scale. According to a study by KeyBanc, the median gross margin for public SaaS companies was around 73%. The Capchase SaaS Benchmark report showed that the top SaaS companies consistently achieve gross margins of 80%+. There are several factors that can constrain a software company’s gross margins, including its lifecycle stage, size and business model, so a good rule of thumb for evaluating software company gross margins can be:

• 85%+ ->Exceptional

• 80% - 84% -> Very good

• 70% -79% -> Good enough

• Less than 70% -> Make sure valuation multiples reflect sub-par gross margins

Typical drags on software gross margin performance can include a large portion of the revenue mix being professional services revenue (poor margin business), extensive training and customer success costs, and expensive compute required from the large cloud infrastructure providers (AWS, Azure, etc.). Some of these costs may be reducible through greater modularization and simplifying the implementation effort, improved usability or the more dramatic step of “repatriating” workloads from the expensive public cloud providers to run on lower cost, custom-built infrastructure the SaaS company itself runs in co-location facilities. In 2016 Dropbox shifted most of their workloads from AWS to infrastructure they leased and operated directly. The company was able to increase their gross margins from 33% to 67% as a result, making them a much more attractive company leading up to their IPO (Source: a16z).

Sales and marketing efficiency

Perhaps the metric that best demonstrates the trade-off technology companies must make between growth and profitability is the company’s sales and marketing efficiency. The OG SaaS company Salesforce has always attracted a certain type of investor who was willing to put profitability on the back burner in favor of growth. The company spent lavishly on sales and marketing to grow its revenue, with an incredible 55% of its revenue going towards Selling, General & Administrative (SG&A) related expenses. One of the most public examples of this insane spending is its annual customer conference Dreamforce, which attracts 170,000+ people and basically takes over San Francisco for three days of learning, networking and partying. U2, Stevie Wonder, Metallica, Foo Fighters, President Barack Obama, Buddhist monks and many millions of people from more than 83 countries all over the world have attended or streamed Dreamforce over its 20 years of existence. Sure, the conference has gotten bums in seats, built almost a cult-like loyalty from its customers and helped it gain share; but it came at the cost of healthy gross margins. Even Salesforce has had to adjust to rising interest rates the last couple of years with a thesis changing focus on profitable growth.

The best companies keep their Customer Acquisition Costs (CAC) low through efficient sales and marketing spending. While there is no perfect metric for measuring the efficiency of a company’s sales and marketing expenditures, I prefer the SaaS Magic Number developed by Scale Venture Partners (SVP) to allow for practical comparisons amongst public SaaS companies. The SaaS Magic Number is ideal for subscription-based companies because it accounts for the unique revenue treatment subscription revenue is afforded, the recognition of revenue over time as the service is delivered. The more traditional ratio of sales and marketing expense expressed as a percentage of revenue (S&M%), is adequate (the lower the ratio the better) for non-subscription revenue but not SaaS companies. The SaaS Magic Number rationalizes the delay between revenue recognized in the current quarter and the attributable sales and marketing spend that occurred in the months and years prior to the current quarter’s revenue. The SaaS Magic Number formula does this by comparing the sales and marketing expense (in a quarter) to the change in revenue for the following quarter.

SaaS Magic Number = [(Revenue Current Quarter − Revenue Previous Quarter) × 4] / (Sales & Marketing Spend Previous Quarter)

Upon analyzing thousands of SaaS companies over ten years, Scale Venture Partners has settled on the following interpretation of the SaaS Magic Number

• <0.5 → Inefficient

• 0.5 to 1 → Moderately Efficient

• >1.0 → Very Efficient

Net dollar retention

One of my favorite metrics for measuring the retention performance and health of a subscription business is net dollar retention. Net dollar retention measures the percentage change in recurring revenue from one period to the next, accounting for revenue lost from customers who cancel or downgrade their subscriptions, as well as the revenue gained from customers who upgrade, expand, or renew their subscription.

Net dollar retention = [(Starting MRR + expansion MRR – contraction MRR – Churn MRR)/Starting MRR] * 100

Where MRR = Monthly recurring revenue

Revenue growth from existing customers is a much cheaper form of growth than acquiring new logos (both are important). If the company is good at customer acquisition but none of their customer’s are remaining customers at time of subscription renewal (and expanding their use of the company’s services), then you have an unsustainable business. Net dollar retention became so critical to the health of a SaaS business that a whole new profession, Customer Success, was pioneered in the 2000s by Salesforce.

When evaluating the net dollar retention of a public company, consider the following benchmarks:

• 130%+ -> Best in class

• 120%+ -> Good for enterprise serving SaaS company

• 110%+ -> Good for SMB serving SaaS company

• 106.5% -> Median of SaaS companies at time of IPO

• Less than 100% -> Uninvestable

High net dollar retention rates point to a product that is loved by customers, very sticky and has lots of room to grow in accounts once new customers are landed.

Once a company achieves strong unit economics, magic can happen if the company is able to win large markets, scale its volume and cover its fixed costs. The result for a fully scaled business is a stable, forecastable and reoccurring revenue business that prints fantastic profits for its investors. The flip side for a company with poor unit economics is a death spiral, a company that chases market share without making money and perpetually dependent on capital raises.

Valuation

Valuing technology stocks is both an art and a science. Tech investors must be part futurist and part financial analyst. How do you quantify the potential of a ground-breaking AI Startup that's yet to turn a profit, but may hold the key to revolutionizing entire industries? Traditional valuation metrics don’t account for disruptive technology, network effects, winner take all markets, and the potential of exponential growth.

The best any tech investor can hope for when trying to assess valuation is to be in the ballpark. Throw out any notion of trying to calculate the intrinsic value of a high growth tech stock to the closest decimal point. That sort of precision analysis will cause you to waste a lot of time and overlook the more important technology investing principles we’ve been discussing so far. Put your Discount Cash Flow (DCF) Excel spreadsheets to the side, turn on the analytical side of your brain and embrace the uncertainty of the future amidst the hype and potential of today’s breakthrough technologies.

As a rule, technology stocks are more expensive than other sectors. The technology stock dominated Nasdaq has traded at a forward Price to Earnings (P/E) ratio of 20x from 2000-2020. During the same time, the S&P500 traded at a forward multiple of 15x .

If technology investing were only as simple as benchmarking your current technology stock watchlist companies based on their current P/E multiple, you’d just need to use a simple conditional formatting formula in your tracking spreadsheet to find undervalued technology stocks. It’s not that easy.

The best perspective I’ve found on both the art and science of technology stock valuation is found in Mark Mahaney’s book, Nothing but Net. In his book Mahaney stresses the importance of assessing whether a stock is trading at a premium or discount relative to its growth rate. High growth rates can turn seemingly expensive stocks based on their P/E multiples, into reasonably priced stocks. Mahaney argues that we should pay more for a high-growth company because “the earnings stream of a high-growth company is worth more than the earnings stream of a low-growth company”. The free cash flow of the former will grow to much higher levels over time than the latter. Mahaney offers a helpful rule of thumb for spotting “ballpark reasonably valued” high growth companies, “a P/E multiple in line with or at a modest premium to a company’s forward EPS growth is ballpark reasonable”. More specifically, a company with a 20% EPS growth outlook can be reasonably priced at a 20x P/E multiple to as high as 40x P/E in some rare cases. What’s most important when using this shorthand is to be curious. Is the earnings growth sustainable? Does the company possess the other multi-bagger attributes (e.g., riding a mega-trend, large TAM, better mousetrap, strong leadership) to deliver on the expected growth?

Look for the rare cases where quality technology stocks are trading at a discount to their premium growth rates (i.e., 20% EPS grower trading below a 20x P/E multiple) but settle for a fair value price when the more important characteristics of a potential Multibagger are present.

Technology stocks don’t always fit into this neat and tidy earnings composite. There are plenty of examples of world class technology stocks that are either generating minimal earnings, or none altogether. Amazon and Netflix were amazing investments during long stretches where they had zero profits. We need a method for valuing companies that fit these scenarios, so we don’t miss out on the next FANG members. Mahaney delivers here again.

a) Company with minimal earnings and sky-high P/E multiples

While both Amazon and Netflix defied investing traditionalists with their negligible earnings and gravity defying P/E multiples for close to a decade, the management team for each company were steadfast in their view that investing in growth would reward their shareholder’s long term. And they were right.

In its earlier years, Netflix needed to invest heavily in marketing to support their geographic expansion. But that high marketing spend would not persist indefinitely. Once Netflix gained a strong foothold in each new market they no longer needed to invest as aggressively in customer acquisition. The even larger spend on developing its own content would go on to make the Netflix value proposition so compelling that subscribers would not churn. Content development investment would also shrink over time as a percentage of revenue. Their library of content become so large that Netflix could taper their investment in this area without worry of diluting the customer value proposition. Plus, Netflix’s content investment developed a nice flywheel effect. A growing content library attracted more subscribers, which generated more revenue and more funds for developing more content, and so the flywheel spun.

Long-term Amazon investors were rewarded for their patience and foresight. Amazon’s business model went through a major transformation throughout the 2010s that led to it catching up to its lofty valuation. While the company started the decade earning most of their gross income from their low margin ecommerce business, they ended it with 59% of Amazon’s operating profit being generated from its cloud business AWS. Smart investors read the tea leaves and bet early in the decade Amazon’s fastest growing, and wonderfully profitable emergent business segments (AWS and advertising) would overtake the ecommerce business and transform the customer obsessed company from a low margin business to a profit printing behemoth.

There are three key questions Mahaney gives us to help separate the future profit machines from the bad businesses:

1. Can the company sustain premium revenue for a long period of time?

2. Are the company’s current earnings being depressed by major investments that will subside or be subsumed when it achieves scale?

3. Is there reason to believe the company’s long-term operating margins can be healthier than current levels?

b) Company with no earnings

In the rarer cases, there could be companies that despite having zero profits are still investable. In these cases, P/E multiples are useless, but if used more creatively the Price to Sales (P/S) ratio can be helpful. The key is to find the right comparable to assess whether the company has a fair valuation. The best comparable are of a similar revenue size, growth outlook, gross margins and long-term operating margin potential.

To go beyond simple multiple comparisons for assessing valuations in these cases, Mahaney encourages us to think more deeply with thought provoking questions:

1. Are there public companies with the same business model that are already profitable?

2. Are there segments within the business that are currently profitable?

3. Is it likely that scale will drive the business to profitability?

4. Are there tangible steps that management can take to achieve profitability?

6. Investing in Technology Stocks: Strong and visionary leadership

In the summer of 2022, The Verge obtained a recording of a June 30th all hands call where Meta CEO Mark Zuckerberg had a come to Jesus moment with employees. Zuckerberg told employees:

“Realistically, there are probably a bunch of people at the company who shouldn’t be here. And part of my hope by raising expectations and having more aggressive goals, and just kind of turning up the heat a little bit, is that I think some of you might just say that this place isn’t for you. And that self-selection is okay with me.”

With Facebook, now Meta, we had been here before. This time Meta was facing existential threats from TikTok, privacy setting changes to Apple’s iOS that were constraining Meta’s ad business and costing it billions in revenue and Zuckerberg himself was getting beat up for his previously announced metaverse plans. The stock was languishing at 3 year low of $160 and pundits were eulogizing the end of social media.

While the stock price would continue to crater, hitting a new low of $93 by the end of October, Zuckerberg had already activated his “wartime” CEO mode on that fateful call and things were destined to improve as had been done many times in the past. Popularized by Andreessen Horowitz Cofounder Ben Horowitz in his popular blog post about war and business, faced with an existential threat the “wartime” CEO acts very decisively and demands strict adherence and alignment to his marching orders.

Just as he had in 2018 on the heels of the Cambridge Analytica privacy scandal, and in 2012 when he bought Instagram for a then staggering $1B to neutralize the threat of the native mobile photo sharing platform’s emergence, and again later in 2012 when Facebook made the epic pivot from desktop to mobile against the backdrop of a major tech platform shift; Zuckerberg took decisive and unilateral action.

This time Zuckerberg anointed 2023 as the “Year of Efficiency”, laying off thousands of workers, reducing employee benefits and perks, making performance mandates more severe, removing layers of management to speed up decision making, and issuing a return-to-office mandate. The results speak for themselves. Major ground achieved in their battle against TikTok. A return to double digit growth in Q2 2023. Increasing operating margins. Open sourcing of capable LLMs. Even a new app, Threads, to take on Twitter (now X). Wall streets confidence in Zuck has even been restored with the stock up 80% (as of September 1, 2023) from last year’s low.

Zuckerberg’s ability to act with urgency and deliver results in the face of turmoil are exactly why I’ve been a shareholder since the company IPO’d in 2012. My bet on Facebook was a bet on Zuckerberg, as it continues to be. And that bet on Zuck has paid off in spades with the stock up 7x over the 11 years of its existence as a public company.

Zuckerberg exhibits many (maybe not all) of the attributes investors should look for in the senior management teams that lead the technology stocks they are invested in:

• Founder-led

• Technical leadership at the top

• Long term perspective

• Willingness to make the tough decision

• Deep bench

Let’s first review each of these attributes and then discuss how you as an outsider far removed from the company can assess the quality of leadership at the company.

Founder-led

The most iconic (and largest) technology companies in the world are synonymous with their founders. Whether it was Jobs at Apple, or Gates at Microsoft, there is a reason these companies got to where they did – the unique advantage that founders-led companies have over their competition. Founder-led companies are given more leeway/benefit of the doubt from investors, shareholders and employees that their non-founder contemporaries could ever hope for. This allows the founder CEO to more easily take a long-term view and muster the fortitude to make a sharp and quick pivot and stay the course when facing controversy or criticism. The payoff for investors in founder-led companies is consistently good, outperforming non-founder led companies by a factor of 4 according to the Harvard Business Review.

As founder, Zuckerberg has been able to build Meta the way he wanted to and make major pivots when he felt he needed to. These pivots have mostly paid off in spades for shareholders. Zuckerberg is right more than he is wrong. But even when he gets it wrong, he gets a pass. In 2019, Zuckerberg made the most dramatic change by announcing the name change to Meta and soon after his plans to spend $10B on creating the metaverse. Unfortunately, three years later and billions later he is no closer to achieving his vision than when he first shared it publicly. The embarrassment of this pivot is forever memorialized in memes spread throughout the Internet. Even Meta employees working on their primary metaverse platform called Horizon Worlds were not using it, which was rife with bugs and underwhelming experiences. Let’s be honest, no other non-founder CEO would have been given the latitude Zuckerberg was given to first invest such crazy amounts in such a nebulous technology and then survive after having nothing to show for it after pouring billions into it. Luckily for Zuck, and Meta shareholders, at the same time he was spending billions on the failing metaverse project he was spending more on AI, putting Meta in a great position to capitalize on this new era of AI kicked off by the release of ChatGPT.

Technical leadership at the top

If history is a guide, strong technical leadership at the top is usually a positive sign for the future success of a technology company. The world’s best technology stocks were led during their formative years by strong technical CEO’s. Microsoft (Bill Gates), Amazon (Jeff Bezos), Google (Larry Page, Eric Schmidt), Facebook (Mark Zuckerberg), Nvidia (Jensen Huang), and Netflix (Reed Hastings) were all led by incredibly technical CEOs. It’s very hard to have a good read on where a technology-based market is headed without a deep understanding of the technology itself. Recruiting top technical talent can be hard without a good BS detector grounded by a technology background.

While there are always exceptions to the rule (Tim Cook at Apple), non-technical CEOs often lead previously innovative technology companies in the wrong direction. Intel lost a lot of technical ground, and the stock has since suffered, when it was run by a non-technical CEO. Under the leadership of marketing and sales-oriented CEO Steve Ballmer for 14 years, Microsoft’s shares fell by more than 30% (only to increase 600% under his successor and technologist first, Satya Nadella’s tenure). During his tenure as CEO at Electronic Arts, John Riccitiello (who began his career in marketing) oversaw a stock decline of 60% over his six years.

Technical acumen alone is not sufficient for the highest paid executive position at public technology companies, but bonus points for strong CEOs that are deeply technical.

Long term perspective

Picking Multibagger’s requires investors hold their shares for a long time to allow growth to compound. The same is true for technology companies, who need time for their multi-billion-dollar investments in new technologies and platforms to pay-off. When CEOs inevitably face macro economic headwinds, shareholder activists or political uncertainty it can be difficult for them to take a long-term perspective in their decision making. Yet, the best CEOs maintain their long-term focus in the face of uncertainty and pressure to deliver in the short term.

Throughout his two-decade tenure as CEO of Amazon, Jeff Bezos constantly shrugged off pressure from short-term shareholders and analysts to boost profits at the expense of long-term growth. In building Amazon, his decisions were never guided by delivering current-period results. From day one, he was upfront with shareholders to expect a bumpy ride. Taken from Amazon’s first letter to shareholders in the company’s 1997 annual report:

We believe that a fundamental measure of our success will be the shareholder value we create over the long term. Because of our emphasis on the long term, we may make decisions and weigh trade-offs differently than some companies. At this stage, we choose to prioritize growth (over profitability) because we believe that scale is central to achieving the potential of our business model.

This prioritization on growth lasted much longer than many shareholders wanted. Major capital expenditures over decades were made, whether building out its delivery network, fulfillment centers, robotics, cloud computing infrastructure, all coming at the expense of short-term profits. Without these investments, while it wouldn’t have taken the 15 years it took for Amazon to be consistently profitable, they wouldn’t be the behemoth they are today. Nor, would long term investors have made the 137,563% return they did (assumes an investment in Amazon from the day of their IPO in 1997 to present day).

Willingness to make the tough decision

The most difficult decisions in a company always travel to the top. CEOs and senior leaders face gut wrenching and difficult decisions, such as layoffs, budget cuts, killing products, cannibalizing cash cow businesses in favor of adopting disruptive technologies and hard personnel decisions. Weak leaders procrastinate and delay, despite the obvious. Strong leaders act quickly.

Satya Nadella, CEO of Microsoft, faced a slew of difficult decisions when he took over from Steve Ballmer. The company was stagnant and there were too many sacred cows that were preventing the company from repositioning itself for the reality of the mobile platform shift that was well underway and challenged the company to adapt or die. The biggest sacred cow at Microsoft was its founding bedrock, the linchpin for all of Microsoft’s legacy products and the most profitable business in its 40+ year existence, Windows.

“Nothing is More Important at Microsoft than Windows” – Steve Ballmer, CEO of Microsoft, 2012, five years after the first iPhone was launched

This maniacal focus on propping up Windows was getting in the way of the company growing. Windows was being disrupted. The emergence of the Internet and web browser reduced application lock-in to Windows. Smartphones untethered the masses from their computers to become the most dominant device in people’s lives. Microsoft had lost the devices war, but under Ballmer it was still clinging to the past. In just a month after taking over as CEO, Nadella introduced Office for iPad. Something Ballmer refused to do until there was a touch version for Windows 8 so that Microsoft could prop up Windows as the best experience for Office. Over the ensuing year, Nadella continued to deprioritize Windows so the company could pursue its destiny as a productivity and platform company, regardless of the device end users were adopting. This included reorganizing the company to untether it from Windows as the single strategy and ultimately killing Windows as a standalone division in the company. Considering Windows was still printing significant profits for the company, Nadella’s shift to a post-Windows Microsoft was a very difficult, yet necessary decision.

Deep bench

To deliver mammoth returns for shareholders, CEOs must have massive ambition. Consequently, the CEOs of these companies can’t do it alone. They need to be able to hire the best people and empower them to execute the vision. The best companies in the world have deep benches that bring diverse perspectives, align all facets of the organization to the company’s strategy and stand ready to fill key executive roles as they may open.

I look for leadership teams that offer a mix of homegrown talent and outside hires. It shows the company can develop its own talent and attract the best and the brightest from outside. The pedigree of companies where outside hires come from matters. Executives with successful track records at the likes of Google, Apple, Meta, Microsoft, or Amazon can be very validating. Top talent can go virtually anywhere, the fact that they are leaving the best companies in the world speaks to the prospects of the company they are joining. Not to mention the impact these top professionals will bring.

Be wary of executive teams where there is a lot of churn. Are executives leaving because they have discovered problems that outside investors are not yet privy to? Does the exodus speak to a lack of cohesion amongst the leadership team? Sometimes it’s better not to wait to find out.

How to assess

It goes without saying high growth tech stocks need strong and visionary leadership. The question becomes, how do you as an outsider far removed from the company assess the quality of leadership at the company. Watching their speaking engagements where they lay out their vision can be helpful, but let's face it dynamic speakers can easily be mistaken for good leaders. How can we go beyond anecdotes and third-party reporting to assess the quality of leadership at the company’s we want to invest in.

There are two quantitative measures I consider as imperfect, but useful considerations for assessing the leadership of a public, high growth technology company:

• Rule of 40

• Employee ratings of leadership

Rule of 40

Without oversimplifying, leadership’s mandate is to create value. That’s how shareholders benefit from leadership decisions and actions. Leaders raise the value of an enterprise, which eventually accrues to shareholders in the form of the stock price rising.

In the technology sector, especially still fast-growing subsectors like Software-as-a-Service (SaaS), profits can be unrealistic for businesses that are still in the early stages of their S-curve growth. Balancing the need to invest for market share capture in fast growing sectors like SaaS, while spending responsibly and inline with revenue forecast is the sweet spot for outstanding leaders of high growth technology companies.

How effective leaders are at finding the right balance between growth and profitability can be measured by the “Rule of 40”. The Rule of 40 demands that a company’s growth rate when added to its free cash flow rate should equal 40% or higher.

YoY Annual Recurring Revenue% + EBITDA (earnings before interest, taxes, deprecation, and amortization) as a percentage of revenue = 40% or more.

The “Rule of 40” is not an easy bar for companies to clear. McKinsey research found that barely one-third of software companies achieve the Rule of 40. Fewer still manage to sustain it. However, if you can find companies that sustain this level of performance, the price of the stock will be given a premium. According to McKinsey research, top-quartile SaaS companies generate nearly three times the multiples of those in the bottom (exhibit).

Achieving the “Rule of 40” is hard because it forces leadership to achieve a level of operational rigor that most cannot. Great leaders set achievable growth targets with the existing product portfolio and manage the business within that range.

Employee ratings of leadership

The best way I know to get some insight on the quality of leadership at a company is to go to the source. What are the employees saying about the leader. Glassdoor is a public site where employees write reviews of the company and rank the CEO. When I was assessing The Trade Desk (NASDAQ: TTD) as a potential buy, knowing that 94% of employees at the company approved of the job the CEO was doing was reassuring.

Take these Glassdoor ratings with a grain of salt. Sample sizes may not be sufficient to offer a statistically credibly rating. The company may be recovering from layoffs. Disgruntled former employees can be non-objective.

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Pursuing Multibagger technology stocks, when done successfully, can deliver wealth altering returns. I’ve shared what I have found to be a successful approach to finding and adding Multibaggers to my portfolio. Success in this domain is not about luck, but make no mistake, success is hard to find. That’s because selecting and waiting for Multibagger success requires a level of foresight and discipline that is difficult to achieve. Technology evolves too quickly, and human beings are not wired to weather the market storms or let their winner’s ride. But it is worth the effort.