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Which Tech Companies Should You Invest In?
BY MATT BARRIE - 31/10/2014 | VIEW MORE ARTICLES BY MATT BARRIE

The incredible scalability of the business models of some technology companies can lead to phenomenal returns for investors. Even though eBay's share price went up a spectacular 163% on its opening day after listing, if you bought $10,000 of shares on market after this rise and held on until today you'd have made over $350,000. If you bought $10,000 of Amazon shares the day after it listed, you'd be up over $2.7 million, and if you'd bought $10,000 of Microsoft shares at IPO in 1986, you'd be up over $6.7 million.

If you are an investor in the US stock markets looking to invest in the next big thing in technology, unfortunately you're out of luck. As I wrote in my previous article, the spectacular gains witnessed in technology companies are now, for the most part, being kept by venture capitalists all to themselves.

However, if you are an investor in the Australian Securities Exchange, you're in for a ton of luck. Due to the lack of a robust and sophisticated venture capital industry, and dwindling government grants, technology companies are increasingly looking at the ASX as a source of funding- and they are doing it at a size and stage of company reminiscent of the US markets of yesteryear. 

2013 saw the start of a stream of technology IPOs on the ASX. In that year OzForex, iSelect, iBuy Group, Smartpay, 99 Wuxian, and my company, Freelancer Limited went public- in total raising over $726 million via primary issuances. This opened the floodgates in 2014; this year to date, eight software companies went public on the ASX with $796 million in primary issuances (including iSentia, 3P Learning, Vista Group, Gentrack, Urbanise.com, BPS Technology, Rewardle, 8common), another five technology companies went public with over $1b in primary issuance, and a further 238 technology companies either used a back door listing or raised via secondary issuance over $234m.

Compare this to the Australian venture capital industry which in the whole of 2013 only raised $155m via three funds, and invested a total of $111m in 69 technology companies according to the 2013 AVCAL Yearbook.

So with the large number of technology companies coming to market on the ASX increasing the opportunities for ordinary investors, how do you identify the good from the bad? The answer is exactly the same answer I give entrepreneurs when they ask me what sort of business they should be starting.

First, the only businesses I’m interested in are those where the market potential is the size of Texas. I am not interested in businesses where the opportunity is to be a niche player in a small market. I’m only interested in businesses than can potentially grow to hundreds of millions of dollars, billions, or tens of billions of revenue.

Even more importantly, I am only interested in businesses that are scalable. What do I mean by scalable? A scalable business is one where there is unbounded capacity to grow revenue without a corresponding increase in costs or complexity. Put simply, these are businesses which have the potential to grow profits much faster than costs.

An example of a business that’s not scalable are human “services” businesses- think yoga instructors, piano teachers or IT consultants. In these sorts of businesses you usually have to charge out each yoga instructor, piano teacher or IT consultant you employ at about 3-5x their salary in order to cover costs and make a small profit.

Let's consider the case of running a yoga studio. For a start, each yoga instructor can only work a certain number of hours per week (say 40), and each class can only have a maximum number of students until you run out of room. From day one, there is a maximum amount of revenue that can be generated with one instructor per annum before you have a large step up in variable costs; hiring another yoga instructor, renting another studio, and so on. Staff and rent are particularly expensive. The problem is also worse than that- once you start hiring a large number of instructors, you'll start needing a whole bunch of support staff to manage and coordinate them. You’re thus (doubly) constrained on capacity, you have high variable costs (staff), and you have a complexity (HR) problem in managing lots of staff if you get big. In the technology industry these sorts of businesses are typically IT staffing or consulting businesses.

On the other hand, a company that produces yoga software is highly scalable. The marginal cost to produce a second piece of software is zero. In the olden days when software was distributed shrink wrapped in a box, you might have had a small cost to produce the CDROM or disk, print the manual and packaging and transport through the supply chain. Today software is distributed over the Internet- so once you have sold the first copy of software, the cost to produce the second piece of software is effectively free- it's just another download. Sure, there might be a minuscule cost for hosting (electricity), but these are tiny compared to the price of the product. This is what makes software businesses incredibly scalable.

Technology companies that operate online marketplaces or provide Software as a Service (SaaS) platforms can be even better, because there's only one copy of the software! These businesses also tend to be very agile, as they can ship improvements to the code 20 or 30 times a day without having to contact customers and deal with legacy versions of the software. They can move faster and as a result tend to grow revenue quicker. On top of this, their cost structure is lower again.

Most important of all, however, is the team. I always tell entrepreneurs to hire the best people they can afford. "A" players will hire other "A" players, but "Bs" will hire "Cs". Always invest in A grade teams with B grade ideas, but not B grade teams with A grade ideas. If you had to choose between compromising on one of the team, the market and the product, I would always pick the product. An all-star team in a big market will continue to iterate on the product until they get it right. If you compromise on the market, no matter how good your team is, you'll never be able to build a big company.

So far we're looking to invest in scalable businesses which operate in big markets with all-star teams. What else should we consider when looking to invest in a technology company?

Every successful company solves a problem. Look for businesses producing products or services that are pain killers, not vitamins. The problem with vitamins is that they are nice to have, but not essential. These are offerings that solve real pain points that a customer has. We’d all like to take vitamins on a daily basis, but we often forget. However if we have toothache- we need a pain killer and we need it now! Customers are also prepared to pay big money for pain killers. Is the product or service that the company sells a pain killer or a vitamin?

Even better than a painkiller is a narcotic- a product that gets the customer hooked, that makes the pain go away but that's so good the customer can never go back. From the minute I started using Uber to catch a cab, there was no going back. In the past calling a taxi was painful- it was unpredictable whether it would arrive or not, they were dirty and the drivers never knew how to get around town. With Uber I simply pull out my phone and hit a button, and a few minutes later a modern, clean car arrives.  On top of this I can track it on a map so I always know how far away it is. I'm hooked, and I'm never going back to the old way of doing things.

Another thing to consider when investing in a business are the trends. When Wayne Gretzky, arguably the greatest ice hockey player ever, was asked what made him so great he replied, "I skate to where the puck is headed, not where it's been". This pearl of wisdom is just as prudent for an investor considering a long term position in a stock. What happens to the business when you extrapolate key macro, social, political and technological trends?

Technological trends are extremely important to consider, as many of the trends are exponential in nature. We live in an age where everything is changing, where the amount of change that is happening is so immensely rapid, we couldn’t even imagine it ten years ago. “Every aspect of information and information technology is growing at an exponential pace”, said Ray Kurzweil, the famous American inventor and futurist wrote in The Singularity is Near. This growth is not slowing down, it’s accelerating at a tremendous pace.

To give you a feeling for exponential growth, imagine folding a paper in half, so that its thickness doubles each time. A piece of paper is about 0.01cm high. When I fold the paper once, it will be 2 pages thick. But when I fold it twice on itself, it’s four pages thick. Three times and it’s eight pages thick. Fold it forty-two times and its thickness would span the distance from the Earth to the Moon! As a result, businesses that might not seem viable today might be incredibly lucrative in the near future if they are built on underlying technologies which are trending exponentially.

Moore's law is well known in computing; effectively the number of transistors in an integrated circuit doubles approximately every two years. As a result, we have seen an exponential trend in the power of computing from 1971 to today. Kurzweil has shown that this trend in the power of computing has existed long before the invention of integrated circuits, and that it extends all the way back through vacuum tubes, relays and electromechanical circuits. Thus it might be reasonable to expect Moore’s Law might continue for a number of years to come. How does this affect the business if this trend continues and more and more computing power is available? If you project out Moore's Law, a single computer is expected to surpass the brainpower of a mouse by 2015, the power of a human brain by 2023 and all human brains by 2045. How, for example, would this affect a business like Google?

There are plenty of other trends in technology that have held true for some time; Kryder's Law says that data storage capacity doubles every 12 months and Nielsen's law that bandwidth doubles every 21 months. There are plenty of other technology trends and effects; advances in realtime machine translation will reduce the importance of native language (perhaps making it easier for two people on other sides of the planet to work together). Advances in 3D printing will reduce the patent and political restrictions on physical goods as anyone will soon be able to print at home projects in plastics, nylons, ceramics and metals. Trends in education have led to the boom in Massively Open Online Courses (MOOCs); free online courses through sites like Coursera, Udacity, edX and Khan Academy which are leading to hyperdeflation in education costs. Trends in crowdfunding are reducing the importance of Silicon Valley venture capitalists and banks (note that the ASX is crowdfunding at its finest!).

There are plenty of other macro trends to consider; the reach of the Internet (60% of the world's population are yet to use the Internet) and global demographics such as imbalances between the aging population in the western world, the booming workforce population and rising middle class in the developing world.

There is another very important thing to look for in companies that will be enduring; for businesses to survive long term: they need to have a sustainable competitive advantage. This is the secret sauce that enables a company to continue to win long term. Don't invest in one hit wonders that produce a gadget or a gizmo which is a one off and does not lend itself to a long term business with a series of offerings over time. One hit wonders are the sorts of companies hawking products you might see on the New Inventors TV show- a better mouse trap, a better garden hose. Look instead for businesses that have something special about them that will lead to a long term series of products or services that competitors can't match.

Sustainable competitive advantage is also known as an unfair advantage. There are many forms that this might take- the company might have a team with specialised skill sets or deep customer relationships that others can't easily replicate. They may have a unique channel for acquiring talent that other companies can't tap into. There might be deep intellectual property, such as Google's search algorithm, that others can't replicate; perhaps the team that produced it is unique, the IP is a trade secret, or maybe it is protected by patents. The business might uniquely benefit from network effects (which mean customers inherently gain more value from using their service over another) and use this to lock competitors out. It might have an entrenched distribution channel for getting the product or service to market that others can't replicate (consider Amazon.com as an example). Alternately, the business might lock-in the customers in a way they can't leave easily (think of how eBay's rating system locks in sellers, or how Facebook locks in its users because while they make bulk upload of your photos easy, they make downloading them all to another site such a pain). You need to look for businesses that have a sustainable competitive advantage over the rest- the nature of this will be unique to the business model and industry segment.

Peter Thiel, the famous Silicon Valley entrepreneur and venture capitalist, said that the greatest opportunities exist where there are big secrets. Big, uncomfortable secrets- the important truths that few people agree with. He said, “What kinds of things are we allowed to talk about? Are there areas that people can’t look into? What is explicitly forbidden? What is implicitly off-limits or taboo? What can people who are running companies not say?”. Great opportunities to invest exist where the market has not yet realised how valuable the secret is that the company has discovered.

In Freelancer's case, the big uncomfortable secret when we started the company in  2009 was that 80% of the world's population had not used the Internet yet, and an even bigger and more uncomfortable secret was the other five billion people live on $10 a day or less, in some circumstances substantially less.

Even today, providing jobs to the developing world is a topic that many people are very uncomfortable talking about. People in developed economies often feel ashamed or embarrassed in discussing the disparity of global wage rates. Our long term mission at Freelancer is to work towards positively affecting 1+ billion people’s lives in some small way, by giving them a (small) job, in a more skilled area and at a much higher rate of pay than is otherwise available to them. It's a very ambitious goal- so far we have had only 6.6 million jobs posted in our marketplace- but it's also a big opportunity.

So look for scalable businesses to invest in with A grade management teams, that sell pain killers (not vitamins) in big markets- better yet, a narcotic. Look for businesses with a sustainable or unfair competitive advantage that will benefit in the coming years from global macro, technological and social trends. Look for businesses that solve real problems facing customers that have also discovered big secrets- big, uncomfortable secrets.



View More Articles By Matt Barrie

Matt Barrie is an award winning entrepreneur and the CEO and Chairman of four-time Webby award winning Freelancer.com, the world's largest freelancing marketplace. Prior to founding Freelancer.com, Matt was founder and CEO of Sensory Networks Inc., a vendor of high performance network security processors, which was acquired by Intel Corporation (NASDAQ: INTC) in 2013.



 

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