How to pick tech stocks that deliver wealthy returns

How many have you caught yourself saying “If only I had invested in Google…or…Microsoft…or….Apple, or any industry titan today, before the stock took off”. Scoring multibaggers (Wall street parlance for a stock which gives a return of more than 100%+) – whether it’s five baggers (500% return), ten baggers (1,000% return) or beyond can seem quite elusive. But, with the right investment hypothesis, research and buying what you know; allocating a small portion of your total investment portfolio to taking measured risk can be worth it for the potential of hitting the odd home run that super charges your returns. In my case, I’ve set 5% of my portfolio aside for these sort of “swing for the fences” multibagger potential stock picks.

During the dot.com bubble I struck out way too much with some of my investment swings, and it took me going down to the minors to rebuild my mechanics to find my stroke. But, with a much more patient approach at the plate I am able to wait for my pitch and take a more thoughtful swing. I have had the odd strike out, but by limiting my exposure and only pulling the trigger when I have a sound hypothesis, the odds are more in your favour of getting it right and reaping the rewards. Plus, the grand slams you hit over the course of your career should more than make up for your swing and misses, if you limit how often you “swing for the fences”.

One recent home run for me was The Trade Desk (NASDAQ: TTD), an industry leading ad tech company that enables agencies to buy and manage programmatic advertising campaigns. Programmatic ad buying refers to buying digital advertising via an online auction, rather than the traditional process of buying advertising via RFPs and human negotiations. It is a far more efficient process to buy digital advertising and TTD has established itself as the market leader. Up 500%+ since my purchase of TTD almost two years ago, there are several tailwinds that have contributed to TTD’s astonishing growth. These include the fast growing programmatic advertising market and the cord-cutting movement that is seeing more and more television advertising dollars shift to the emerging connected TV market. TTD provides agencies with a cloud based platform to purchase inventory across a variety of channels (web, social, mobile, video, connected tv and audio) with tech that enables far superior targeting relative to alternatives and better measurement of the advertisements effectiveness. The other aspect of TTD’s story I really like is its ability to pull multiple levers to deliver long-term growth. It’s not just web or mobile advertising growth, but emerging sectors like connected TV and audio, as well as its investments to penetrate the China market.

My inclination to buy TTD was based on a set of patterns I observed that were consistent with other multibagger stock picks I’d made previously, whether it was Facebook (600%+), Mastercard (375%+), or Shopify (300%+). Riding a mega-trend, having multiple ways of driving long-term growth (referred to as optionality), and offering a better mousetrap than existing alternatives were the dynamics I saw TTD benefiting from, and are among a set of characteristics that can be used as a framework to improve your batting average in selecting stocks with multibagger potential.

In this article I will share what I see as important characteristics to look for when trying to select the next multibagger stock, different types of multibagger stocks, important metrics for assessing potential for multibagger status and disciplines required to realize multibagger returns. My focus in this article will be selecting multibaggers in the tech sector specifically. I will walk your through how I approach the plate to hit a home run, including how I leverage my knowledge of the technology industry, gained from a 15-year tech career, to spot mega-trends and the emerging companies best positioned to experience hyper- growth.

Characteristics of a Multibagger Tech Stock

1. Riding a mega trend

“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

The most important characteristic of a potential multibagger stock in the tech sector is whether the stock is competing in a market that is impacting or undergoing itself a transformational change that will create significant value over an extended period of time. This level of structural change is often referred to as a mega trend that changes the economy, business and/or society. 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.

How do you know if the timing is right to invest in a mega trend?

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 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 eventually tend to exceed those early expectations, but not on the timeframe it was first promised. 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 for 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 launched and crushed a billion dreams?

• 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 the successful commercialization of the Internet. The promise of the Internet was “information at your fingertips”. Well, this was hard to realize when most people spent the majority 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 broadband technology was just not there for an acceptable end user experience. Now, players such as YouTube, Netflix, and Roku have all rewarded their investors significantly as a result of broadband technology advancing.

• Mega trend investing success is not just about technology innovation. Business model innovation is an important catalyst to value creation and thus 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.

Before pouncing on the latest technology fad, be skeptical and make sure all the elements of an investment ready mega trend are present. You don’t want to be too early to the party, left holding the loot bag with no loot.

2. 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. We aren't talking marginal improvements or marginal cost savings, that will only get you early adopters who are passionate about the space. If marginal improvements were enough, the Segway (a personal mobility device invented in the early 2000s) would have a market beyond mall cops and tour groups. The well proven method of walking around is just fine, thank you very much.

The key to finding high growth companies is to look for a big enough market of buyers who can be reached in a scalable manner.

I 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 just gives you a much longer runway of growth.

3. 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

Can a 19th century quotation 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 then 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 that simply blew them away.

A mega trend like the Internet and the problem of finding information on such a vast network like the Internet is going to attract a lot of entrepreneurs and venture capital funding. How do you pick the winners? You can’t go wrong picking the company with the best solution to the problem. 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 competitors above would make it super obvious which had the best search engine.

• Taking the product for a test drive is not always an available option. This is especially true with enterprise businesses. 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 that can provide a thorough perspective on which provider has the best solution. Also, 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.

• Look to investing analysts and publications that provide thorough and unbiased recommendations. For example, I’ve come to rely on the Motley Fool for identifying market leaders in various sectors of the technology industry.

4. Optionality

The more options a company has to grow over the long run, the greater the likelihood they will become a multibagger stock pick. Optionality exists when a company has a second and third act, potential for a new business or market that keeps the growth going beyond its original idea. You can’t expect runaway returns if the company is a one-trick pony.

A great example of a company with a lot of optionality is Amazon. We all know how Amazon got started, what started as an online book store quickly evolved to become the everything store. Since then we have seen the behemoth generate new growth beyond their e-commerce core business, including cloud computing, advertising, devices, video and music services, and more recently the grocery industry. We are also seeing glimpses of what Jeff Bezos might have up his sleeve for his 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 thru its partnership with Berkshire Hathaway and JP Morgan Chase on a pilot primary care service for their employees. The next logical step is to offer this health service to the general public. It’s no wonder Amazon has the astronomical valuation it does thru what amounts to an optionality premium.

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

1. 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 Splunk (NASDAQ: SPLK), a provider of software for making sense of machine-generated big data. It’s specialty is the real-time capture and analysis of big data generated by machines, not people. There are several use cases of it’s technology – for IT operations, improving security and to manage industrial operational data. Its technology is differentiated from competitors, it does what it promises really well and there are multiple use cases of its technology that will generate growth for a long time. I’m certain, just as they expanded beyond their original beachhead of IT operations, that they will find new use cases.

2. 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 these sound familiar? These are obviously very inspiring mission’s, being big and audacious enough they present multiple ways for the company to achieve their mission. Take Facebook and their mission of making the world more open and connected. Their acquisition of Instagram and What’s App, move into virtual reality and even their recent efforts with Project Libra are all about making the world more open and connected.

Both types of optionality can offer some really 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.

5. Small size

Look for smaller companies with a lot of runway to grow in market cap. When looking for a multibagger I start with companies that are currently valued less than $10 billion in market cap. At a $1 trillion valuation, Amazon is not going to be turning into a ten bagger, or even a five bagger. The law of big numbers disqualifies any probability that Amazon will grow to $5 or $10 trillion in the next few decades. However, if you found a compelling company valued at $1 billion, growing to $10 billion is not as big a stretch. For example, the e-commerce platform company Shopify (TSX:SHOP), debuted on the TSX and Nasdaq in 2015 with a valuation of $1.27 billion, and as of November 20th 2019 its market cap sits at $36 billion. That makes Shopify almost an astonishing 30 bagger (30 times return on the IPO price) in less than five years. Now, 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 sufficient runway for growth puts you in a better position to find 5-10X+ multibaggers.

6. Strong leadership

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. 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.

Types of Tech Multibaggers

Over the years I have come to recognize patterns of what I believe to be four different types of multibagger stocks.

1. Tollbooth collectors

I use tollbooths along major highways that collect small sums of money for each car using the highway as an investing analogy for companies that have a similar model. In traditional markets this can include companies that own major oil pipelines or railroads connecting point A to B, charging a fee for access to this infrastructure. I’m a big fan of modern tollbooth collector business like the credit card processing companies MasterCard and Visa. These two companies run the world’s most dominant payment processing systems. They make money every time one of the many credit cards with their logo is swiped. In essence they are collecting a fee, similar to the ones paid on a highway, for use of their payments infrastructure. There are emerging players that have similar characteristics, such as Square and PayPal.

2. Democratizers

Major technology breakthroughs – think the printing press, the Internet, Artificial Intelligence – typically start out available only to an elite few or specialized community. While the Internet was first invented in 1969, its initial use was limited to scientists, those in academia and the government. It took 25 years for the Internet to become accessible to the masses. And boy, has it ever helped level the playing field for the masses. That is the societal benefits of new technologies that become more accessible to more people. This process is referred to as the democratization of technology and is defined by Wikipedia as: Democratization of technology refers to the process by which access to technology rapidly continues to become more accessible to more people.

The power of this democratization of technology is profound in the area of entrepreneurship. It is now cheaper than ever to build a startup. What used to take millions of dollars in capital expenditures and lots of time – procuring servers, buying expensive database licenses, building custom applications and hosting extensive server farms to keep their business running - now, thanks to companies like Amazon, Microsoft and Google, within weeks or months this can all be spun up and all for an affordable monthly subscription that increases only when your business grows.

Another great example of democratizing technology for entrepreneurs is the Canadian e-commerce provider Shopify. Their mission says it all:

We help people achieve independence by making it easier to start, run, and grow a business. We believe the future of commerce has more voices, not fewer, so we’re reducing the barriers to business ownership to make commerce better for everyone.

By removing the barriers to commerce with its easy to use and affordable e-commerce platform, Shopify is changing capitalism where anyone with ambition, from anywhere, can be an independent business owner.

3. Platforms

A platform company enables others to make things, or in the case of technology build applications. The quintessential platform companies are Microsoft and Apple. They are the Coke and Pepsi of computing platform choices. Platform companies make money by selling licenses and subscription fees to use their technology.

4. Aggregators

Aggregators bring together vast amounts of information to attract and provide direct value to end users. They typically don’t make money by selling their products, rather they sell ads to monetize what are typically free consumer products. The dominant aggregators in tech are Google and Facebook.

Disciplines Required for Realizing Multibagger Returns

Picking winning stocks is not the only element to generating multi-bagger return levels. There are some important disciplines necessary for riding an attractive looking stock all the way to it realizing its full potential. Timing, spreading your bets and letting winners ride all play their part in going from good to legendary returns.

Timing

Let me be clear, I am not suggesting you try to time the stock market. I’m no fan of this fool’s errand. I’m a big believer of buying and holding. The timing I am referring to in this context is attributable to famed investor Peter Lynch who between 1977 and 1990 outperformed the S&P index by more than two times. The legendary investor was also a baseball fan:

“Enter early — but not too early. I often think of investing in growth companies in terms of baseball. Try to join the game in the third inning, because a company has proved itself by then. If you buy before the lineup is announced, you’re taking an unnecessary risk. There’s plenty of time (10 to 15 years in some cases) between the third and the seventh innings, which is where the 10- to 50-baggers are made. If you buy in the late innings, you may be too late.”

- Peter Lynch

How do you know when it’s too early or too late? You want to see that the company has a successful formula and room to grow. In the case of Starbucks it might have been waiting until they hit 100 stores, if you were so lucky to spot them at such an early stage of their growth. For technology based companies it might be waiting until they have conquered one segment of the market or industry, with a clear path to crossing over into new ones. Or, maybe it’s waiting for success in a geography. Shopify is a good example, they have achieved success in English speaking markets but are now expanding internationally, localizing their platform, offering regionally specific payment methods and letting merchants list products in multiple currencies. Looking for these clues is more of an art than a science.

Diversify your bets

Finding companies that will provide 10X returns is no easy feat. You’ll increase your probability of realizing 10-bagger returns on a stock if you spread your bets across multiple mega return potential stocks. Remember I’m advocating for only 5% of your portfolio to be devoted to finding 5-10 baggers, so your opportunity to diversify your bets is limited. This should not stop you however from increasing your probability and minimize your risk by diversifying in this special category of “swing for the fences” capital allocation in your overall stock portfolio.

Let winners run

Multibaggers, especially the higher return types such as 10-baggers, do not happen overnight. It quite likely will take more than five years. If you want wealth altering stocks in your portfolio you have to prepared for hold for a long time and sometimes resist the urge to “lock in” profits when warranted. As an extreme example, imagine you bought Amazon after its fall during the dotcom bust period of the early 2000s. If you started your 2001 new year off by purchasing Amazon at its then rock bottom price of approximately $18 and only sold when it reached 10-bagger status of $180+ in late 2010, you would have missed out on an additional 10X growth between 2010 and current day November 2019. That means not realizing an additional $162,000 on an original $1,800 investment.

There can be good reasons to sell though and take profit. For example, if the stock becomes to big a proportion of your overall portfolio, or you foresee the winning streak to come to a end, or you just need the money. It’s ok to trim or sell your position outright. Just be strategic about why you are selling or why you are letting the winner run. For example, I recently sold a position in a stock I had purchased only four month early after a 39% gain. The stock was a Japanese company named Tokyo Electron (OTC:TOELY) My rationale was straightforward, my hypothesis had been realized.

Important Metrics for Finding Multibagger Tech Stocks

Analyzing company fundamentals is a cornerstone for successful stock picking. I’ve written in the past about the traditional metrics (see “The Informed Investors Checklist for Selecting Winning Stocks”). Finding multi-bagger stocks in the technology requires a different set of metrics and in some cases ignoring certain, more traditional fundamentals. For example, while profitability is a very important metrics for assessing more mature businesses, using this as a filter for finding potential multi-bagger stocks who are in the early stages of their growth is actually counter intuitive. If an early stage high growth technology company is focusing on profitability they are likely NOT making important investments to enter new markets, or investment in R&D to find the next big innovation. I’m not suggesting profitability is not important, it’s just that context matters. For early stage growth companies I want them going full throttle on entering new markets, growing their sales organization to scale, or making other prudent investment decisions to accelerate their market share gains and capitalizing on the headwinds driving the industry. I’d rather see this then them eking out some profits to satisfy traditionalist. If you are picking sound businesses with strong leadership, they will make the pivot to profitability at the right time.

If certain traditional metrics are not appropriate for assessing high growth technology stocks, what are? I’ll share a few I keep a watchful eye on, particularly in the cloud and Software-as-a-Service (SaaS) space.

Active usage

There is a reason Wall Street anticipates the monthly or daily active usage numbers from subscription or social media based tech companies when they report their quarterly earnings. They matter a lot. In this new world of cloud computing where companies are no longer making large upfront capital expenditures for enterprise software, instead opting for the operating expense friendly method of monthly software subscriptions, consumption matters. It’s a lot easier for companies to cancel a monthly software subscription if they are not using the software. One of the best predictors of not just revenue growth but recurring revenue growth is what’s happening with companies active usage numbers. In the case of social media companies, active usage growth is another critical health metric and predictor of revenue growth. If Facebook’s usage growth is decelerating or declining you will see this same pattern materialize downstream with their revenue numbers over the long run.

Retention rate

The rate at which cloud based businesses are retaining their customers is another metric that has a majorly consequential impact on the company’s overall growth prospects. If the company is good at customer acquisition but none of their customer’s are actually remaining customers at time of subscription renewal, then you have an unsustainable business. The company “Salesforce” was an early pioneer in understanding this dynamic and practically invented the new Customer Success Manager role, who have usage and renewal responsibilities inside an enterprise SaaS company. This is so important in ensuring the retention rate is healthy.

I use the retention rate as a health metric of a Software-as-a-Service (SaaS) tech stock. For example, The Trade Desk has held steady a customer retention rate that has exceed 95% for 23 straight quarters. If there starts to be some consistent erosion for this important metric it will be a major alarm bell for me and cause me to revisit my investment hypothesis that has me viewing TTD as a long term hold.

Net expansion rate

The Net Expansion Rate (NER) is defined as the expansion revenue, from cross-sell, upsell and consumption expansion, generated from existing customers as a percentage of total revenue. To spot high growth companies you want to see their next expansion rate exceed 100%, this tells you the company has incredibly satisfied customers that are spending increasing amounts of money with the company. A 100%+ NRR is also an indicator the company has growth from their existing customer base that more than offsets any losses from that same customer base.

You typically won’t find these emerging metrics on Morningstar.com. You’ll have to search the company’s quarterly or annual reports, mostly under the “Management’s Discussion” section of these reports. While a little more work, it is well worth the investigation.

A Word of Caution

“Swinging for the fences” brings a heightened level of risk as compared to some alternative investing approaches. This is the part of the article that I provide some sobering thoughts after getting you excited about the potential rewards of chasing multibaggers. Here are some considerations before getting into the batters box and swinging for the fences:

• Avoid hardware and cybersecurity stock plays. I have not had any luck with hardware and cybersecurity companies. I’ve purchased companies in these sectors of the tech industry with pretty poor results. There have been the odd singles or even doubles but these were pretty unique circumstances, but mostly I’ve struck out in these two sectors. My takeaways are hardware is ultimately a commodity that ends up being a race to the bottom and the emerging and ever evolving threat space in cybersecurity make it very difficult to pick winners. There are exceptions to the rule, Nvidia is one example that comes to mind, but I’ve decided to avoid hardware plays. If you are an expert in cybersecurity than you will probably have much better insight to have some success. But most of us aren’t cybersecurity experts.

• Always do your own research. Only make these sort of investments based on your own extensive research. You don’t know what level of analysis your friend of a friend may have done with the latest stock, or what the source recommenders motivation is.

• Start small. When just beginning with this strategy, only allocate a very small portion of your portfolio. In fact, I recommend capping your bets on potential multibaggers to 5% or less of your total portfolio.

• Avoid if you are not prepared to lose your investment. I hope this gives real pause to folks reading this article. If you can’t lose the money or even stomach the idea of losing the money then this strategy is probably not a good fit for your investor profile.

• Avoid if close to retiring. Given the risk and the likely long timeframes required to achieve 5-10 multibagger status, if you are close to retiring then it should go without saying that high risk investing like this should be avoided. As you get closer to retirement your focus as an investor should shift to capital preservation and income.

While a riskier form of investing I do believe “swinging for the fences” stock picking does have a place in my portfolio and perhaps yours. Already discussed are the caveats I’d attach to the aforementioned statement – small well researched bets, spreading your bets, 5% or less of your total investment portfolio, etc. Chasing multibaggers, when done successfully, offers up wealth altering returns. I’ve shared what I have found to be a successful approach to realizing multibaggers in 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 level 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 winners ride. But, it is worth the effort.