Ever heard of Metcalfe’s Law?

Not gonna bore you with the technical definition but essentially it defines how a network becomes more valuable as more nodes are added:

Networks scale like viruses

As a network grows, it becomes exponentially more valuable. Businesses that capture this effect early will invariably lead to a winner-takes-all (or if not most) effect. We all know Facebook is terrible but keep using it anyway, because everyone is already there. It’s all about (social) liquidity.

And it’s the same reason why there aren’t 20 payment processors – just a few dominant ones – Mastercard, Visa, Amex.

Tech stocks tend to function the same way. Not only is the cost of adding a customer or closing an additional sale close to zero, more customers can actually add more value to the overall infrastructure/network.

Once companies pass the critical mass for adoption, they tend to achieve light speed growth, and that’s where you see their stocks really take off.

Warp speed ahead = Hockey Stick growth

Examples of tech companies which demonstrate this effect:

  • Payment processors (Stripe, Square, Paypal, Mastercard)
  • SaaS companies (Zoom)
  • Ecommerce ecosystems (Shopify, Amazon)
  • Data and networking (Google)
  • Electric Vehicles infrastructure (Tesla)
  • Social Media (Facebook, Linkedin, Twitter)

Consider Tesla. Tesla is not just an EV company – it’s actually an energy company, and there’s much untapped value in the infrastructure that they are still building. I converted to a Elon-believer the day that he made Tesla’s patents public and the stock didn’t even blink. Call it a publicity stunt, but it was definitely a unorthodox way of letting the world know that value didn’t just lie in the its books.

Source: Google Finance

Focusing on the number of cars they are selling in the next 2 quarters is a very short sighted way of looking at the company. Instead you need to look at the infrastructure that they are aiming to build. I think their game is to convert solar energy to hyper efficient batteries and own the grid (#youhearditherefirst).

The writing is already on the wall – synergistically acquiring SolarCity and complimenting SpaceX’s ecosystem are steps towards Elon’s grand plan, and we definitely need to be looking beyond the immediate quarter of Profit-Earnings analysis.

How then should we think about valuations? I prefer to focus on the qualitative factors, that can provide a clue about founder psyche as well as strategy.

Skin in the Game

If you’d cashed out $180,000,000 from your start up, would you risk all your proceeds and continue to grind 90 hour work weeks?

Ok so maybe you might.

But would you channel it towards a cause so bizarre like space exploration or take on the entire fossil fuel powered vehicle industry?

That’s when you know that a founder is either crazy or a genius. Short sellers had to find out the hard way that Musk is both. Coupled with insane work ethics, it’s no wonder why the company is where it is today.

Stick with founders who have the bulk of their net worth in their companies. These guys put their money where their mouths are, and if I had to go down guns blazing, I’d go down with these generals.

Respect for this dude is on a whole different level

Follow the Legends

Question: What does Buffet know that I don’t?

Answer: Alot.

He first took a stake in BYD, the Chinese EV darling in 2009. For someone as resistant to tech as he is, this stake would mean that he’s doubly bullish on the company.

Photo Credits: Fortune Cover 2009

If you have no idea wtf you are doing, it might not be a bad decision jump on his due diligence band wagon. You would have gotten yourself a 10 bagger since 2009. Not bad for a one-trick pony.

But don’t be silly and put 100% of your capital into a single investment. These ballers don’t do it. Neither should you.

Source: Google Finance

Following public filings is a good start. You can refer to other portfolio managers’ holdings like Einhorn’s Greenlight Capital or Icahn Enterprises if activist investing is more your thanggg.

In It to Win It

Another one of my favorite metric is specialized industry knowledge. After working in several (pretty different) banks over the course of almost 15 years, I’ve come to understand the short comings of the sector:

  • Margin compression due to increasingly savvy customers
  • Increasing grip of regulations on businesses
  • Inertia to replace legacy systems and platforms
  • Extremely top heavy corporate bureaucracy skewed towards short term results
  • And the list goes on.

All these hinder value creation. And that’s why I’m super psyched about DeFi and the current evolution of financial industry. Banks and financial institutions were pioneers for new technologies back in the 1950s. Since then, they have remained largely archaic.

And now they are ripe for disruption.

Because of my experience, I am able to spot (with relative confidence), financial sectors ripe for disruption. You would be able to do the same for yourself in your own niche – engineering, HR, legal, etc.

The idea is to identify current issues and trends, and disruptive businesses coming in to capture the value proposition from the stalwarts. Like what Amazon did to brick-and-mortar shops, and Uber to public transportation. You get the drift.

So How Now Brown Cow?

Unfortunately in the traditional finance world, analysts and portfolio managers live quarter to quarter and rarely have a chance for their long term investment thesis to play out.

P/E is a metric which is becoming increasingly obsolete in a fast growing tech world (it applies to other fast moving industries like biomed as well).

As these companies tend to scale exponentially, projecting an earning’s forecast based on a linear rate of return is like trying to pilot an aircraft after qualifying yourself with driver’s license.

Don’t get me wrong, of course a company still needs to be profitable in the long run, we just need a better way to value these organizations instead of GIGO.

P.S. Nothing in this post is to be considered legal or financial advice. All of the writing here is meant for information and entertainment purposes, so DYOR and make decisions based on your own beliefs.

P.P.S. If you enjoyed this piece, share it with someone using the links below!