Identifying S-Curve Companies With Underappreciated Earnings Power
TL;DR
- Investing in companies ascending an "S-curve" of adoption, characterized by rapid unit growth and predictable expansion, enables exponential earnings growth that is often underappreciated by the market.
- Identifying companies with powerful competitive advantages, such as network effects or critical intellectual property, is crucial for capturing value within an S-curve trend.
- Underappreciated earnings power arises when S-curve adoption and competitive advantages lead to exponential earnings growth that outpaces linear market expectations, allowing for investment at attractive multiples.
- The AI S-curve is a multi-decade trend impacting infrastructure, foundational models, and applications, with infrastructure being a safe and analyzable investment due to its foundational necessity.
- Companies that successfully navigate multiple S-curves, like Amazon and Tencent, demonstrate the power of visionary leadership and an innovation culture that can pivot to new technological waves.
- Volatility is inherent in technology investing, with significant sell-offs often preceding major innovation cycles, necessitating a disciplined adherence to process and a long-term perspective.
- The "Mag Seven" companies are well-positioned to benefit from AI due to their massive data advantages, existing cloud infrastructure, and ability to integrate AI for revenue growth and cost savings.
Deep Dive
Alex Sacerdote's investment philosophy centers on identifying companies poised to ascend "S-curves" of adoption, leveraging a framework of competitive advantage and underappreciated earnings power. This approach allows for the identification of exponential growth potential in technology sectors, particularly in AI infrastructure, cloud computing, and electric vehicles. The implications of this strategy are profound: it enables investors to capitalize on multi-decade trends by pinpointing companies with sustainable moats and future earnings that the market currently undervalues, while also offering a robust method for identifying and shorting companies destined for disruption.
Sacerdote's core framework, developed at Whale Rock Capital, involves three key components. First, understanding the S-curve of adoption, which maps the trajectory of a new technology from slow initial uptake through rapid mainstream takeoff to eventual saturation. This provides a roadmap for market size and growth duration, offering predictability often absent in tech investing. Second, identifying powerful competitive advantages, which in the digital age can include network effects (e.g., LinkedIn), platform dominance, critical intellectual property (e.g., Qualcomm, ASML), or strong brand and scale (e.g., Amazon). These advantages create moats that protect and amplify growth. Third, recognizing underappreciated earnings power, which arises when the combination of an S-curve and a competitive advantage leads to exponential, rather than linear, earnings growth. This dynamic is often missed by investors who struggle to forecast beyond a few years, allowing for the acquisition of high-quality companies at seemingly high multiples that are in fact very cheap on a forward-looking basis. This framework has been applied to identify winners in significant trends like cloud computing, where AWS captured a vast market, and more recently, in AI infrastructure, where the demand for compute power is expected to drive substantial growth regardless of which foundational models ultimately prevail.
The second-order implications of this rigorous, research-intensive approach are significant for both long-term investment strategy and risk management. By focusing on S-curves, Sacerdote's firm can identify not only potential long-term winners but also companies on the declining side of technological shifts, making the framework equally effective for shorting opportunities. For instance, traditional hardware companies being disrupted by GPUs or established EV players unable to compete with Tesla's advancements represent clear short candidates. The emphasis on deep primary research, involving thousands of meetings annually and a "learning machine" to gather intelligence, builds conviction that can weather short-term market volatility. This allows for sustained investment in companies like Nvidia and Tesla during their respective S-curve ascensions, even when facing market skepticism. Furthermore, the framework's adaptability extends to private markets, recognizing that companies are staying private longer, necessitating an understanding of private market dynamics to inform public market investments, as exemplified by their investments in Stripe and Databricks. The consistent application of these principles, even through market downturns like 2022, underscores the resilience and long-term efficacy of Whale Rock's investment philosophy.
Action Items
- Audit AI infrastructure: Quantify compute capacity needs and GPU supply constraints for the next 3-5 years.
- Analyze competitive advantages: Identify 3-5 companies with strong network effects or critical IP in emerging tech sectors.
- Measure S-curve penetration: Track adoption rates for AI and driverless technology across 5-10 key markets.
- Evaluate management teams: Assess 3-5 leaders for vision, innovation culture, and commercial orientation in disruptive industries.
- Track earnings power disconnect: For 3-5 high-growth companies, calculate the difference between current multiples and projected earnings power 3-5 years out.
Key Quotes
"Alex is a passionate TMT investor who describes how he finds companies ascending their S-curve of adoption."
This quote introduces Alex Sacerdote and his core investment thesis: identifying companies that are on an "S-curve of adoption." This concept, central to his strategy, suggests that successful companies experience rapid growth as their products or services move from early adoption to widespread market penetration. Sacerdote's focus on this dynamic indicates a strategy geared towards capturing significant growth during these inflection points.
"I devised this three part framework which we're known for at Wall Rock which is S curve competitive advantage underappreciated earnings power and the first one is all technologies start slowly they have a lot of barriers to adoption it might be too expensive or complicated there might not be the right ecosystem there might be a lot of inertia."
Sacerdote outlines his firm's foundational investment framework, which consists of three key pillars: S-curve, competitive advantage, and underappreciated earnings power. He elaborates on the S-curve by explaining that technologies initially face significant hurdles such as cost, complexity, or lack of ecosystem support, which must be overcome for widespread adoption to occur. This highlights his methodical approach to understanding the lifecycle of technological adoption.
"Find a powerful S curve and then second look at all the companies in that ecosystem trying to find the one or two that have an incredibly powerful competitive advantage and the thing about the digital world is some of these competitive advantages can be much stronger than in the offline world and accrue faster in software you can be the operating system on the internet you can have a really powerful network effect if you're linkedin more people on linkedin the more valuable it is the faster it grows it makes it impossible for the competition."
This quote details the second and third components of Sacerdote's framework: competitive advantage and its amplification in the digital realm. He emphasizes identifying companies with strong moats, such as network effects exemplified by LinkedIn, which create a virtuous cycle of growth and deter competitors. Sacerdote suggests that digital businesses can often build more potent and rapidly accumulating competitive advantages than traditional offline businesses.
"The biggest reason people blow up in tech is they miss on revenue and when you're rocketing up that curve you very often overdeliver on the sales and if you do have an airtight competitive advantage there's few things people can do against you but sometimes you get excited one s curve that we got wrong but were able to get out was the ev s curve and that's another dynamic s curve the idea was that 50 60 of cars were going to be electric and that's happened in china but when we hit about 10 in the us it hit a wall."
Sacerdote addresses a common pitfall in tech investing: misjudging revenue growth, and highlights how a strong competitive advantage can mitigate this risk. He then provides a concrete example of an investment thesis that did not pan out as expected, specifically the electric vehicle (EV) S-curve in the U.S. This illustrates that even with a seemingly strong trend, market adoption can plateau unexpectedly, demonstrating the dynamic nature of S-curves and the importance of continuous re-evaluation.
"The Mag 7 has moved up because of the earnings have been so strong in addition most of these companies have major scale and they have cost savings so they're able to grow without adding costs if they want to be more aggressive they can dial back costs I think these Mag 7 have the most to gain from AI on so many different dimensions number one revenue growth a lot of the Mag 7 is driven by advertising and AI plus advertising is amazing."
Sacerdote explains the strong performance of the "Mag 7" companies, attributing it to robust earnings growth, significant scale, and cost-saving efficiencies. He posits that these companies are particularly well-positioned to benefit from Artificial Intelligence (AI), especially in areas like advertising, where AI can dramatically enhance targeting capabilities and drive revenue. This suggests that AI is not just a new trend but a significant accelerant for established digital giants.
"We spent a lot of time looking at it trying to learn as much as we could we met with dozens of these companies it was always a technology looking for a problem the use cases were few and far between also there was an element of it where there were all these meme coins and it wasn't solving any true productivity gains we thought that was somewhat of a false s curve."
This quote reflects Sacerdote's assessment of the cryptocurrency and blockchain space, where he found a lack of clear use cases and a focus on speculative "meme coins" rather than genuine productivity gains. He categorizes this as a "false S-curve," indicating that the perceived adoption and growth were not based on fundamental value or problem-solving. This highlights his disciplined approach to identifying genuine technological trends versus speculative fads.
Resources
External Resources
Books
- Barron's - Mentioned as a publication the guest's father read, and the guest read in college.
Articles & Papers
- "The Egg Timer" - Mentioned as a concept used by Peter Lynch for concise stock pitches.
People
- Alex Sacerdote - Founder of Whale Rock Capital Management, guest on the podcast.
- Ted Sids - Host of the Capital Allocators podcast.
- Jeff Bezos - Mentioned as CEO of Amazon during the guest's early career.
- Will Danoff - Mentioned as a mentor and portfolio manager at Fidelity.
- Peter Lynch - Mentioned for his approach to concise stock pitches using an "egg timer."
- Steve Jobs - Mentioned for his role in the development of the iPhone and Apple's success.
- Elon Musk - Mentioned for his role in Tesla's success and the EV s-curve.
- Lou Gerstner - Mentioned for his concept of the "new stack" in client-server computing.
- Todd Arno - Mentioned as a Nantucket icon who promoted the guest.
Organizations & Institutions
- Whale Rock Capital Management - The guest's investment firm.
- Goldman Sachs - The guest's father's former employer.
- Fidelity - The guest's former employer where he worked as a portfolio manager.
- Smith Barney - The guest's former employer, which became Citigroup.
- Citigroup - Formed from the merger of Smith Barney and Citicorp.
- Harvard Business School (HBS) - Where the guest and host were classmates.
- Apple - Mentioned as an early stock investment and for its product innovations.
- Boeing - Mentioned as an early stock investment by the guest.
- Interactive Imaginations - An internet advertising startup where the guest worked.
- DoubleClick - A competitor to Interactive Imaginations.
- Amazon - Mentioned as an early investment and for its e-commerce and cloud services.
- Egghead.com - An e-commerce company mentioned in the context of early internet retail.
- PreviewTravel.com - An e-commerce company mentioned in the context of early internet retail.
- OnSale.com - An e-commerce company mentioned in the context of early internet retail.
- 2000CDNow.com - An e-commerce company mentioned in the context of early internet retail.
- Qualcomm - Mentioned for its critical intellectual property in mobile technology.
- ASML - Mentioned for its critical intellectual property in lithography.
- Tesla - Mentioned as an example of a company on an s-curve with strong competitive advantages.
- Nvidia - Mentioned in relation to the AI s-curve and ChatGPT.
- OpenAI - Mentioned as a pioneer in AI and LLMs.
- Google - Mentioned in relation to AI and its Gemini LLM.
- Meta - Mentioned in relation to AI and its LLMs.
- Microsoft - Mentioned in relation to AI and its cloud services.
- AWS (Amazon Web Services) - Mentioned as a leader in cloud computing.
- Azure - Mentioned as a cloud delivery layer.
- XAI - Mentioned as an LLM company.
- Netscape - Mentioned as a historical moment in the internet's development.
- RIM (BlackBerry) - Mentioned as a smartphone company that did not adapt.
- Palm - Mentioned as a smartphone company that did not adapt.
- Nokia - Mentioned as a smartphone company that did not adapt.
- HTC - Mentioned as a smartphone company that did not adapt.
- Motorola - Mentioned as a smartphone company that did not adapt.
- Lenovo - Mentioned as a smartphone company that did not adapt.
- BYD - Mentioned as an electric vehicle company.
- MIT - Mentioned as the origin of an EV battery company.
- 10cent - Mentioned as an example of a company that successfully navigated multiple s-curves.
- Netflix - Mentioned as a disruptor of traditional media.
- Uber - Mentioned in the context of potential disruption by driverless technology.
- Stripe - Mentioned as a leading digital cloud-based payments company.
- Adion - Mentioned as a next-generation cloud-based payments company.
- Canva - Mentioned as a next-generation cloud-based Adobe.
- Data bricks - Mentioned as a leading software AI heavy analytics big data platform.
- Revolut - Mentioned as a leading digital bank in Europe.
- Walmart - Mentioned in comparison to Mag 7 valuations.
- Costco - Mentioned in comparison to Mag 7 valuations.
- Goldman Sachs - Mentioned in the context of AI adoption by traditional industries.
- The Podcast Consultant - Provided editing and post-production for the episode.
Tools & Software
- YouTube - Mentioned as a growing channel for podcast listening.
- Twitter - Mentioned for following Ted Sids.
- LinkedIn - Mentioned for following Ted Sids.
Websites & Online Resources
- capitalallocators.com - Website for the podcast's mailing list, premium content, and transcript access.
Other Resources
- S-curve - A framework for understanding technology adoption and growth.
- TMT (Technology, Media, and Telecom) - An investment sector.
- AI (Artificial Intelligence) - A major technological trend.
- Mag 7 - A group of seven large technology companies.
- Cloud computing - A major technological trend.
- Electronic vehicles (EVs) - A major technological trend.
- Blockchain - A technology discussed in the context of potential applications.
- LLM (Large Language Model) - A type of AI model.
- GPU (Graphics Processing Unit) - Hardware essential for AI computation.
- EV s-curve - The adoption curve for electric vehicles.
- Digital platform economy - An economic model characterized by large, dominant companies.
- Driverless technology - A developing technology for autonomous vehicles.
- Robotics - A field of technology involving robots.
- Crypto - Cryptocurrencies, discussed in relation to their use cases.
- Stablecoin - A type of cryptocurrency designed to be stable in value.