What should you look for in tech stocks?
Should you look at revenue growth? Profitability? Maybe looking at the addressable market is a good idea?
The problem is there’s no formula. No graph you can look at that will tell you to buy or sell.
Every business is different.
It’s why it’s so important, especially when it comes to technology, that you understand each business.
You need to know how they make money, the reason why customers keep coming back and any factors that could affect their longevity.
It’s not enough to buy just because sales are growing.
How to judge the success of a tech stock
You need to know the businesses strategy. Netflix, Inc [NASDAQ:NFLX] for example has a very different strategy compared to Alphabet Inc Class A [NASDAQ:GOOGL], Google’s parent company.
To emphasise the point, let’s take a look at both now.
Netflix is a subscription service and Google dominates search.
For Netflix, it’s all about growing active accounts.
The more active accounts they have, the more cash they have.
The more cash they have, the stronger their content buying power is.
The more content they have the more likely you or I will sign up to Netflix rather than Stan or Hulu.
Over time, Netflix’s number of accounts becomes extremely valuable.
Today, Netflix has about 130 million subscriptions. Let’s roughly assume that each subscription is paying about $10 per month. So that’s about $15.6 billion in subscription sales each year.
Now imagine Netflix increased their monthly subscription to $20 a month. Even if they don’t grow subscribers, that’s still $31.2 billion in sales.
Put a profit margin of 10% on that and Netflix would earn $3.12 billion, which would give them a price-to-earnings (PE) ratio of 48 rather than their current 153 PE.
Google on the hand doesn’t need active accounts. They care far more about their search algorithm. It is key to their overall business and the billions in ad revenues they collect each year.
So rather than subscription numbers, investors like to see market share, usage and engagement on Google’s search platform.
Keeping their dominance on PC and mobile allows Google to grow sales year on year.
For an ecommerce business, like Amazon.com, Inc [NASDAQ:AMZN], the important factors again change. The range of goods, prices and delivery are all important.
But there’s one ecommerce business in the east taking advantage of arguably the most important quality: trust.
Trust is the best competitive advantage
No matter where you go. No matter what culture.
Trust is extremely important.
If I’m going to do business with you I want to know you’re going to act honestly. If you’re going to buy something from me, you don’t want the wool pulled over your eyes.
This doesn’t just apply to just business. Our legal and political system, along with all relationships, are built on trust. Without it society breaks down.
Developing trust will differ depending upon where you are in the world.
In Australia for example, we generally assume people are trustworthy until they prove otherwise.
It doesn’t work like this in China. Trust is not the default. It’s something you need to earn.
You could argue we’re all becoming more like China as we start purchasing things online. We want to know that our credit card information is safe.
We don’t want to buy fakes, broken goods or never get what we ordered.
Amazon saw this early on. They knew trust was far more important online than it is in-store. It’s why Amazon is willing to forgo profits to create trust with customers by allowing goods to be sent back at no cost to the consumer if they’re not happy with the product.
You might be curious to know why China is less trusting.
Well, it may have something to do with their legal system.
China had to adopt rules and regulations fast, most of which it took from the West. But there are still pockets that need patching up.
‘The number one rule to doing business in China is not to completely rely upon contracts,’ the China Law Blog (CLB) wrote.
It goes without saying that a lot of contracts are broken regularly in Australia too. However, you need ‘more than a contract’ in China, CLB said.
Chinese politics don’t exactly inspire trust, in our view.
Rather than putting a vote to the people, China’s officials are elected by superiors within each region.
So rather than a party for the people by the people, China’s officials work primarily in the interest of superiors.
Just take a look at what a high level official in Jiangsu province wrote to his son after hearing he wanted to get into politics:
‘Rule #1: Your objective is not to find the truth but what’s right for you. Your superior is always right. Rule #2: You should not only learn how to tell a lie but be really good at it. The career of a hooker and an official are very similar. The difference is an official is betrayed by his mouth.’
Then of course there’s the fake food, fake brands and fake everything sold to Chinese consumers. According to OECD figures, 63.2% of all fake products in the world between 2011 and 2013 were from China.
Footwear was a popular fake, followed by clothing, leather goods and gadgets. Rolex, Nike, Ray Ban and Louis Vuitton were the most counterfeited brands.
It’s not hard to see the obvious opportunity here for some lucky company: become the most trusted site in China.
That way hundreds of millions of Chinese consumers won’t want to shop anywhere else.
How to become number 1 in China
One of the fastest growing ecommerce sites in the Middle Kingdom is Pinduoduo.
They just recently went public on the NASDAQ. The company already has a market value of US$22 billion.
But in my view, they won’t become China’s biggest ecommerce site. Not until they get rid of the fakes. Reported by Quartz:
‘…something is wrong on Pinduoduo. A careful look at the platform reveals scores of shoddy counterfeit products pretending to be from well-known brands — and increasingly, those brands are speaking up.’
Instead, China’s top ecommerce stop is likely to remain Alibaba Group Holding Ltd [NYSE:BABA]. In 2018, Alibaba saw sales climb 60%, adding US$13 billion to their top line.
And even at US$460 billion, Alibaba likely has far more room for growth.
I say that because they are the most trusted ecommerce site in China.
To gain that title, Alibaba spent millions. They even created their own payment system. South China Morning Post writes:
‘In a low-trust society like China, online transactions were difficult to complete because buyers did not know if sellers would actually send out the product once they received payment, nor were sellers willing to send out items until they received payment confirmation.
‘To solve that problem, Alipay was introduced in 2004 as an escrow service that would hold on to payments until the buyer had received their purchase before releasing the money to the seller.
‘…Alipay, which eventually became more sophisticated and automated, was a game changer for the Taobao platform, allowing its users to have the trust that they would not be cheated when using the platform.’
Ultimately, you must understand the businesses you invest in and think about what makes them great.
If you do that, you’ll make better investment decisions in the years ahead.
Editor, Money Morning
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