Finding the Next Tech Leaders

Even people who barely pay attention to the stock market know that technology has been a winning trade for years. The tech sector was up nearly 40% in 2017 and has gained 19% a year on average for the past five years versus the S&P 500, which gained 20% last year and 13% on average for the last five. The performance of a handful of companies tied to the growth of digital communications and commerce has been even more spectacular. These so-called FAANGs (an acronym drawn from the first letter of the names of some tech giants) dominate their respective industries—social media, e-commerce, mobile, search and video streaming—while also benefitting from powerful macro tailwinds that favor consumer-facing businesses.

So how do you find the next tech leaders?

We think the next FAANGs will be quite different from the current group. We expect them to benefit from some of the same trends as their forerunners, but we think their products and services will serve businesses, not consumers. Furthermore, the new leaders will likely be those companies that reduce the cost of production rather than the cost of consumption. They may do it through industrial automation, robotics, artificial intelligence or blockchain technology.

Identifying the right technology market is only half the battle. We think it is key for investors to focus on those companies that can take advantage of what are known as network effects—where each additional user of a service makes it more useful to others and ensures its dominance. Finding companies that can create industrial network effects can be the difference between a nice compounder and a transformational investment.

Consumer-facing network effects are easy to understand: A person joins a social network and then more people want to join because everyone they know is on that network. Likewise, a company sells its products through a popular website and then other companies want to sell through that site to reach that large customer base. Metcalfe’s Law, which comes from the telecom industry, posits that the value of a network increases more and more rapidly as the number of users grows. In other words, the value of a networked business is tied to its ability to grow its user base.  Interestingly, our research shows that FAANG stock values have grown for the past five years at the rate Metcalfe’s law suggests. 

Industrial network effects work a bit differently, but we expect the same growth paradigm to hold true. Below are three industries where new technology, plus an ability to take advantage of industrial network effects, could point the way to new tech leaders:

Corporate operating systems often require a steep learning curve – think how hard it can be to learn new applications when you change companies. This dynamic gives companies incentive to deploy the most widely used software in hopes that almost anyone they hire will already know how to use it. We believe an enterprise level artificial intelligence operating system could be developed that benefits from network effects—the more companies deploy it, the more will want to.

Companies are forming that collect, store and sell all kinds of data. A company with the richest data set  has a competitive advantage and thus should be able to pay more to acquire new data. For each industry, one company will likely become the vendor of choice for companies seeking to buy data.

Technology allowing for autonomous cars has already captured the imagination of investors. We see potential opportunity in fleets of self-driving trucks. They would, of course, be much less expensive to operate than trucks driven by humans. But we think network effects could also be a huge advantage as shippers gravitate to the fleet with the largest, safest trucking network. Today a small truck company can compete with a larger network for a particular job, but that will likely become more difficult.

It’s impossible to look into the future and some of the scenarios we’ve outlined don’t exist yet. But for investors, we see network effects in operating systems, data collection and transportation as being three fertile areas from which the next FAANGs could emerge.