📚 Nothing But Net by Mark Mahaney 📚

10 timeless stock-picking lessons from one of Wall Street’s top tech analysts

About Mark Mahaney
Legendary analyst Mark Mahaney has been covering internet stocks on Wall Street since 1998, with Morgan Stanley, American Technology Research, Citibank, RBC Capital Markets, and Evercore ISI. Institutional Investor magazine has ranked him as a top Internet analyst every year for the past 15 years, including five years as number one, and he has been ranked by the Financial Times and StarMine as the number-one earnings estimator and stock picker. In addition, TipRanks has placed Mahaney in the top one percent of all Wall Street analysts in terms of single-year stock-picking performance.

Lesson 1: There will be blood… when you pick bad stocks.

“There will be blood” is a simple way of saying that you definitely, absolutely, positively will lose money in the market if you invest in and trade stocks. Being a good stock-picker involves being both a good fundamentalist – correctly forecasting revenues and profits – and a good psychologist – correctly guessing what multiples the market will place on those revenues and profits. It’s very, very hard to get both of those right most of the time. Then there is always market shock events (Covid-19) that are impossible to forecast and can undermine the best-laid stock-picking plans. Investing requires grit.

You will also lose money from time to time because you will almost certainly make some bad stock calls.

Lesson 2: There will be blood … even when you pick the best stocks.

Even best-in-class stocks aren’t immune from company-specific sell-offs. They can suck at times.

Even best-in-class stocks aren’t immune from broad market sell-offs. In wake of a broad market correction tied to global GDP growth, trade war concerns and rising interest rates, these best-in-class stocks can lose a significant percentage of their value, despite little / no change in their estimates or growth outlook.

Lesson 3: Don’t play quarters

Successfully trading around quarters requires both an accurate read of fundamentals and a correct assessment of near-term expectations, a tricky task for individual (and most professional) investors to pull off. Trades around quarters can also be misleading and can cause investors to miss long-term fundamental and stock trends. Staying invested in a strong fundamentals name and ignoring short-term fluctuations can be highly profitable.

Near term, fundamentals and stocks can be highly dislocated even when it comes to fundamentally key events like earnings — sometimes because of expectations, and sometimes because of events like lockup expirations that have nothing to do with fundamentals.

Fundamentals may be clearly improving (revenue growth acceleration and operating margin expansion), but stocks can still trade down on these results if “whisper” expectations aren’t met.

Stocks follow fundamentals over the medium-to-long term.

Lesson 4: Revenue matters more than anything.

Over the long term, fundamentals move stocks, and for high-growth tech stocks, the fundamentals that matter most are revenue and key operating metrics which will vary from company to company (such as gross merchandise value for eCommerce companies, number of paid subscribers for Netflix).

The 20% revenue growth “rule”: Only about 2% of the S&P 500 have been able to consistently generate 20% top-line growth for five years, but these stocks have usually materially outperformed the market. It can often reflect large market opportunities, relentless and successful product innovation, compelling value propositions and top-quality management teams. As a start, look for companies that have generated 20%+ revenue growth for at least five or six quarters in a row. Past performance can sometimes be an indicator of future performance.

What drives accelerating revenue growth is Growth Curve Initiatives (GCI). These are steps that companies take to drive new top-line growth such as price increases, geographic market expansion and new product introductions.

Subscription businesses are wonderful because (1) they provide an enormous amount of revenue visibility and (2) with a successful subscription business is that market expenses can show leverage.

Revenue growth acceleration can lead to operating margin expansion because revenue will scale against fixed costs. Successful price increases are especially sweet because the revenue unit generates more revenue but the costs of delivering that unit are unchanged — price increases can be considered “pure margin”.

Watch out for companies with sharply decelerating revenue growth — revenue growth rates that get cut in half over three or four quarters are a major concern especially if that deceleration is caused by market share losses, market saturation or management mis-execution. Just because growth rates taper off below 20% doesn’t mean you will face a “tech wreck” or a major stock correction.

Successful tech investing doesn’t mean being oblivious to profits. Profitless growth creates no value in the long run. But the history of many of the leading tech companies over the last two decades demonstrates that revenue growth, especially premium revenue growth, is a good indicator of future profitability. Either the company will start getting leverage against largely fixed costs or its growing scale will allow its unit economics to improve, as the company gains leverage against its suppliers and through increased experience and scale becomes more efficient at managing its costs.

Lesson 5: It don’t mean a thing if it ain’t got that product swing.

Successful product innovation is one of the biggest drivers of fundamentals, especially revenue growth and that is what drives stocks.

Lesson 6: TAMs – The bigger the better

The bigger the total addressable market, the greater the opportunity for premium revenue growth, which is a major driver of tech and growth stocks.

TAMs can be expanded by removing friction and by adding new use cases.

Sometimes, TAMs are hard to ascertain, especially when a traditional industry is being disrupted.

Large TAMs can help drive growth that can lead to scale, which has intrinsic benefits in the form of experience curves, unit economics advantages, competitive moats, and network effects. Scale wins. Large TAMs increase the opportunities for companies to tap into these scale benefits.

Lesson 7: Follow the value prop, not the money.

Follow the consumer value proposition. Some of the best-performing stocks of the past decade belong to companies that prioritised customer satisfaction way over near-term investor concerns.

Amazon may well be the poster child. It consistently demonstrated a willingness to invest aggressively to offer a more compelling value proposition, even at the sacrifice of near-term profits. Its launch of Prime in early 2005 is a classic example. Margins came down and capex more than doubled. What came out of that was arguably the single best customer loyalty program in internet history. And maybe the “best bargain in the history of shopping”.

Customer-centric companies beat investor-centric ones. Both eBay (versus Amazon) and Grubhub (versus DoorDash) as examples that did not focus enough on innovating to meet consumer needs, in part, out of a strong desire to preserve highly profitable business models.

The company with the ugly business model (low margins, lots of capital requirements) but the more compelling consumer value proposition beats the company with the attractive business model (high margins, minimal capital requirements) but the less compelling value prop.

Case study: Amazon beating eBay

  • Amazon was better at product innovation than eBay such as AWS, Kindles, Alexa devices, the Prime shipping program, state-of-the-art logistics, and cashier-less store.
  • Amazon consistently maintained a longer-term investment horizon than eBay. The latter also thought long term but it did;t do it as successfully or as consistently as Amazon.
  • Amazon has a more consistent management team. Per a February 2020 Seattle Times article, the average Amazon tenure of the Amazon S Team (its 20 or so senior executives) was 16 years. Amazon has had only one CEO from its IPO in 1997 until 2021, while eBay has had four.
  • Amazon had the larger TAM.
  • Amazon has from the beginning had a more consumer-centric orientation. The line most often use by its management: “We start with what the customer needs and work backwards.”. For eBay, the customer was oftentimes the seller; not the end customer.

Lesson 8: M is for management.

The quality of the management team is possibly the single most important factor in tech investing. In the long term, stocks are driven by fundamentals and fundamentals are largely driven by management teams. Get the management team right, and you will likely get the stock right.

The quick hit list of characteristics includes:

  1. Founder-led companies
  2. Long-term orientation (and largely ignore short-term pressures)
  3. Great industry vision
  4. A maniacal focus on customer satisfaction
  5. Deep technology backgrounds and benches
  6. A deep focus on product innovation
  7. the ability to recruit top talent
  8. The confidence to be forthright with employees and investors about mistakes and challenges.

If you’re going to do anything new or innovative, you have to be willing to be misunderstood.

Jeff Bezos

With management teams, past performance is an indicator of future performance.

A successful track record doesn’t mean consistently beating Street quarterly earnings estimates — that’s expectations management, not fundamental generation. A successful track record doesn’t mean having a fab-looking stock chart — lots of factors go into near-term stock movements. A successful track does mean generating consistent premium revenue growth, successfully introducing new products and feature improvements and winning greater customer satisfaction and loyalty. These fundamentals and their core drivers will likely deliver good-looking long-term stock charts. The management team is most responsible for those fundamental and those core drivers.

Lesson 9: Valuation is the eye of the tech stockholder.

Valuation should not be the most important factor in the stock-picking decision process. Valuation frameworks can be useful in picking tech stocks, but valuation is not a science and it carries precision traps — precise answers where precision isn’t realistic, possible or justified. Action questions will vary based on whether the company is generating robust earnings, minimal earnings, or no earnings. But the overriding action question should always be Does the current valuation look ballpark reasonable?

Tech stocks can at times look expensive but that does not make them bad stocks. P/E multiples in a vacuum are not useful; it is always important to look at them on a growth-adjusted basis. Higher growth stocks warrant higher P/E multiples because the earnings stream of a high-growth company is worth more than the earnings stream of a low-growth company (assuming similar capital intensity and cash flow dynamics). High-quality earnings — earnings that are driven first by revenue growth and second by operating margin expansion and earnings that convert strongly into free cash flow– will also warrant higher P/E multiples.

For companies with robust earnings, a P/E multiple in line with or at a modest premium to a company’s forward EPS growth is ballpark reasonable. For example, a company with a 20% EPS growth outlook can reasonably trade at a 20x P/E multiple to as high as a 30x or even 40x P/E multiple and still be considered to be ballpark reasonably valued. The key action question: How sustainable is that earnings growth? How much confidence do you have in that 20% growth, which is rare, premium growth. Does the company’s TAM, management team, level of product innovation, and customer value proposition support that level of growth?

For companies with minimal earnings, you can respect to see super high (>4-x) P/E multiples, but these can still be good investments. The key action questions: Are current earnings being materially depressed by major investments? Is there a reason to believe that long-term operating margins for a company can be dramatically higher than current levels? And can the company sustain premium revenue growth for a substantial premium revenue growth for a substantial period of time? If the answers to these questions are positive, then those super high P/E multiples may well be justified.

The case of companies with no earnings provides the toughest valuation challenges, but four logic test questions and valuation comparisons based on factors like revenue (price to sales) can help determine whether a valuation is ballpark reasonable. The four logic test questions for companies that are currently unprofitable:

  1. Are there any public companies with similar business models that are already profitable?
  2. If the company as a whole isn’t p[profitable, are there segments within the business that are?
  3. Is there a reason why scale cannot drive a business to profitability?
  4. Are there concrete steps that management can take to drive the company to profitability?

Lesson 10: Hunt for DHQs — Dislocated high-quality stocks

One of the best ways to make money as an investor in high-growth tech stocks is to identify the highest-quality companies and then buy them or add to positions when they are dislocated.

Investing in high-quality companies — marked by premium revenue growth and driven by large TAMs, relentless product innovation, compelling customer value propositions. and great management — reduces fundamentals risk. Buying companies when they are dislocated — 20% to 30% corrections and/or when stocks are trading at a discount to their growth rates — reduces valuation/multiple risk.

When to sell a stock.

The key Sell indicator is a material deterioration in the fundamentals of a company. To be specific, when revenue growth decelerates materially (50% deceleration within a year or less that is not driven by a macro shock like the Covid-19) or when revenue growth materially dips below 20%, adjusting for comps and macro shocks.

Companies that have gone from outperforming to underperforming for a lengthy period when they have experienced material revenue growth deceleration: Booking, Criteo, eBay, Shutterstock, Tripadvisor, TrueCar, Yahoo! Yelp, etc.