Here’s the best way to spot stock-market winners, according to this 25-year tech analyst – MarketWatch

High-growth tech stocks seem particularly volatile these days, driven high and low by rising and receding fears related to interest-rate rises and COVID waves. It’s enough to make the average investor forswear the tech sector.

But please don’t fall into this trap. High-growth tech-stock volatility is nothing new. I would know. For the past 25 years, I’ve covered the Internet sector, which has created some amazing stock market returns – Netflix NFLX, -1.09% up 45,000% since its IPO and Amazon.com AMZN, -0.28% up 166,000% since its IPO – as well as some downright duds – Blue Apron APRN, -5.22% and Groupon GRPN, +0.05%, both down 90% since their IPOs. And along the way I’ve learned some valuable lessons that you can use when making your own stock picks. 

At a high level, when we invest in high-growth tech stocks, we’re trying to manage two types of risk: fundamentals risks and valuation risk. By fundamentals risk, I mean the risk of revenue and profit shortfalls – not just missing Wall Street estimates on any given quarter, but of revenue growth dramatically slowing and margins collapsing, perhaps due to market saturation or competitive pressures or management mistakes or some other factor. 

Valuation risk is the risk of a material de-rating or decline in a company’s valuation multiple, either due to a fundamentals correction or a broad market de-risking, such as when there’s a significant change in interest rate expectations.

My best advice for mitigating these two risks is to hunt for DHQs, or Dislocated High-Quality stocks. By dislocated, I mean stocks that have declined 20%, 30% or more from recent highs. Now there’s a fair amount of judgment required here. A 20%-30% correction off of a rapid 100% appreciation spike isn’t that dislocated.

Another source of ideas is stocks that are trading at a discount to their growth rates – stocks whose forward-looking P/E multiple is less than its forecasted growth rate for earnings per share.

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One thing I have found through my 25 years of looking at tech stocks is that even the highest-quality stocks – Amazon, Apple AAPL, -0.80%, Google parent Alphabet GOOG, -1.18% GOOGL, -1.32%, Microsoft MSFT, -3.26% and others — get dislocated from time to time. It happens a lot more than most investors realize.

A checklist for finding high-quality companies

So you want to hunt for dislocated stocks. But which ones? My experience has taught me that the highest-quality companies have almost always been the best-performing stocks over a long-enough period – say, one to two years.

My experience has also taught me that at least four factors make up a high-quality company – large TAMs or Total Addressable Markets, effective product innovation, compelling value propositions, and excellent management teams.

TAMs are the end markets that companies are addressing. Google’s revenue model has been predominantly driven by advertising revenue since its inception. That means its TAM is global marketing spend, especially given the broad range of advertising solutions the company offers and its global ubiquity (with the notable exception of China).

So almost from the beginning, Google has been facing a T-TAM or a trillion-dollar TAM. This is one reason why the company generated premium (20%+) revenue growth for a decade after reaching a $25 billion revenue run rate. That is extremely rare. Only two other companies in history have been able to do this: Apple and Amazon. 

This consistent premium revenue growth has surely been one of the major drivers of its dramatic stock outperformance over the past two, five and 10 years. So look for companies that are addressing large TAMs and have the ability to “pull a Google.” They may well be high-quality companies.

Next is effective product innovation. This drives revenue growth, creates new market opportunities, can be spotted by outsiders, and is repeatable. 

There is a very useful expression in investing that goes along the lines of past performance is no indicator of future success. Well, I don’t think that’s true when it comes to product innovation and management teams. Management teams that successfully generate product innovation usually have something in their corporate culture, organizational structure or personnel that allows them to continue to innovate successfully. 

I think about this with Amazon. Although the stock has been a phenomenal performer since its IPO, even longstanding bulls like me have to acknowledge that it was a highly speculative stock for at least the first 10 years of its public market existence. But by 2007 or 2008, after Amazon had demonstrated the ability to successfully expand across retail from just books and had not only extended into cloud computing and e-reader devices but established leading positions in both markets, it had proven to investors that it was a sustainably effective product innovator and should be a core holding in growth portfolios. 

So look for companies with effective product innovation.

The third factor is a compelling value proposition. My high-level lesson from 25 years of tech tracking is that customer-centric companies generally beat investor-centric companies, both in terms of market share and in terms of stock-market value. I believe this is the right conclusion from how Amazon came to utterly dominate the initial King of Online Retail, eBay EBAY, -1.26% : through better price, selection and convenience, even though these generated an inferior (lower margin, more capital-intensive) business model.

This story also played out in the rise of DoorDash DASH, +0.76% and the fall of Grubhub – at least as public stocks. The David with the broader restaurant selection and the more reliable delivery services (DoorDash) beat the Goliath with the better business model (higher margins, profitable) and eventually went on to carry a market cap 10 times greater than the price at which Grubhub was acquired in 2020.

Read: This surprising investing strategy crushes the stock market without examining a single financial metric

The final and arguably most important factor is management excellence. You get the management team right, and you’ll often get the stock right. Yes, this is a hard factor to assess, but here are a few signs. The biggest market-cap names in the world are almost all tech companies, from Apple to Tesla TSLA, -0.82%. And they almost all have featured founder involvement for very substantial periods of their corporate lives, with the founders of the biggest tech companies usually actively involved for 20 years or more. So looking for founder-led companies can be one screen. 

McGraw Hill

Looking for management teams with industry vision is another screen. There’s the wonderful example of Netflix, which was co-founded by Reed Hastings in 1997, 10 years before streaming was even functionally possible for the most of U.S. households. Yet, Hastings and team could see – and did correctly see – where home entertainment would evolve. That’s impressive vision. 

A third screen can be deep technology backgrounds. If you’re going to win in the consumer tech sector, it will certainly help to have a management team with deep industry experience. This may well be the right lesson to draw from the missed opportunities and lack of long-term success of companies like Yahoo!

So that’s the framework as you hunt for Dislocated High-Quality companies. It can help give you confidence to invest in – and to remain invested in – some of the best investment vehicles of the past five and 10 years: Facebook (now Meta Platforms), Amazon, Netflix and Google, which I believe can still outperform the market as a group for the foreseeable future. And it can also help you identify what could be emerging new high-quality names such as Airbnb ABNB, -1.80%, Uber Technologies UBER, +4.28% and Spotify Technology SPOT, -1.30%, which I currently recommend.

Mark S.F. Mahaney is the head of internet research at Evercore ISI and author of “Nothing But Net: 10 Timeless Stock-Picking Lessons from One of Wall Street’s Top Tech Analysts”. 

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