How the S-curve explains why mega-techs still have enormous upside

Chris Demasi

Montaka Global Investments

Investors are eyeing the stratospheric valuations of mega-tech companies like Amazon (US$1.8 trillion), Alphabet/Google (US$1.7 trillion) and Facebook (US$980 billion) and assuming they must be overvalued. These companies have been delivering market-beating returns year after year. How on earth could that possibly continue?

The answer lies in the humble letter S.

This wire was written by Phill Namara, Research Analyst with Montaka Global Investments.

As American sociologist E.M Rogers’ Theory of Diffusion of Innovation noted, new technology typically displays S-curve growth. An S Curve tracks or refers to the growth of a company or industry over its lifecycle.

Every breakthrough technology in history - with the possible exceptions of the wheel and hot running water - has enjoyed a period of explosive growth before eventually being disrupted.

From good to great

Acknowledging the adoption S-curve is crucial to picking good investments. 

When a product is accepted by the early majority, a company can enter hypergrowth, delivering fantastic returns. Investors who look solely at financial statements to determine business trajectory can fail to acknowledge changes in consumer behaviour, missing a shifting paradigm as a business’ smaller, nascent products begin to inflect.

But at Montaka, we believe the factor that moves a company from "good" to "great" is its ability to successfully transition to new S-curves and embrace multiple acts. The best companies often ride multiple S-curves, which leads to enduring earnings growth. Rather than ‘one-hit wonders’, they become stars with real longevity.

It is critical to monitor and identify not only a company’s first S-curve opportunity but also any extra S-curves the firm could realistically address or ride.

What makes the structural winners like Facebook, Microsoft, Alphabet, Amazon and Tencent within the Montaka portfolio unique – and explains their spectacular returns and long-term potential, despite appearing seemingly expensive – is their ability to continually create new S-curves.

The data and digitally advantaged

In the current environment, two types of businesses have more opportunities to create additional S-curves: the data-advantaged, and those that deliver customer solutions digitally. They can create new S-curves by developing new business lines, product expansions, and by expanding geographically.

Data-advantaged companies can leverage their customer data, developing insights into consumer behaviour to inform product development.

Similarly, the zero marginal cost of innovation that digital businesses enjoy allows them to continually iterate on their products, receiving live feedback from customers, and improving their probability of success and viral growth in these new businesses or product lines.

Said another way, the opportunity cost arising from continual innovation and potential failure is lower for digital, data-advantaged businesses than traditional brick and mortar businesses.

This is a nuanced but key advantage that these businesses enjoy, enabling them to find and ride new S-curves.

Alphabet’s S’s

Alphabet is a prime example of a company that has successfully demonstrated an ability to ride multiple S-curves.

S-Curve 1 – Google Search

Readers will be familiar with Google Search, the dominant global search engine which is arguably responsible for shaping how the modern internet works today based on how it connects internet-goers and websites. Initially, founders Sergey Brin and Larry Page created the search engine to “organize the world’s information and make it universally accessible and useful”.

 The two recognised not only that the internet would likely become ubiquitous, but also that users would require some sort of organisation system before traversing it, and they were able to successfully capitalize on the new paradigm. Twenty-three years after its inception in 1998, people use it to search a repository of human knowledge, perform work and to source entertainment.

From its IPO in 2004 through to 2007, Alphabet’s market cap grew from US$35 billion to US$215 billion, largely on the back of their search engine.

S-Curve 2 — Android

But Google created another S. In 2005, as mobile phone penetration increased globally, Alphabet acquired a small start-up named Android. At this time, smartphone penetration was virtually non-existent, and the mobile phone market was dominated by Blackberry, Nokia, and Motorola.

After it bought Android, Alphabet formed an alliance with the smartphone manufacturers and cross-subsidised significant R&D investment in Android to ensure it became the dominant operating system for smartphones. Today, the Android penetration of the global smartphone market sits at 72%. Again, as the operating system for smartphones, much like Microsoft Windows for the PC, Alphabet positioned itself to capitalize on the next new paradigm of smartphones. This drove a fresh round of earnings growth that remains sustained today as smartphone penetration continues to improve within developing nations.

S-Curve 3 — Cloud

The latest major S-curve that Alphabet continues to ride today is that of cloud computing. Largely commercialised in 2006 at Amazon Web Services (AWS), cloud computing is today recognised as the next major IT platform, which will disrupt the old IT software and infrastructure vendors like IBM.

It took Google two years to begin offering cloud computing after Amazon, however back in 2008, cloud computing still was relatively nascent. 
Years later, in 2016, Netflix completed its migration to AWS, sparking a major sentiment shift towards cloud computing and enterprise adoption began to accelerate.

Today, this S-curve of enterprise adoption remains in the early majority phase. Gartner estimates in 2022 there will be an estimated $1.3 trillion in IT spend that will be affected by the shift to the cloud and this figure is expected to grow in the low double digits for years to come.

The combined cloud computing revenue generated by mega-vendors Microsoft, Alphabet, Amazon pales in comparison to this $1.3 trillion addressable opportunity and Montaka believes the long-term opportunity will be significantly larger than this.

Alphabet is well placed to offer higher value-add cloud services, leveraging the data inherent in their privileged assets Maps, Gmail, Search, Android and YouTube. This data trains their proprietary AI algorithms which over the coming decades will be offered to enterprises via the cloud, allowing them to take advantage of Alphabet’s capabilities without the need to create custom machine learning models themselves; a new S-curve.

The evolution of Alphabet’s business to date could not have been possible had it failed to ride the multiple S-curves of the internet, the smartphone and the company's many other important businesses such as YouTube. 

Similarly, the future of Alphabet will likely be dictated by the culmination of the data advantages accrued as it rode these prior S-curves.

Decades of compounding

The 21st  century is an age whereby the pace of disruption is accelerating, fuelled by improving technology and societal attitude towards entrepreneurship. There is no doubt that investors seeking to compound their capital at high rates of return must pay attention to this technological disruption.

One of the best ways to profit from this innovation is to view investments through an S-curve framework and particularly by owning businesses that exhibit characteristics of structural winners creating new S-curves to ride, like Alphabet.

Failing to appreciate a company’s new S-curves leads to underestimating not only the longevity or duration of earnings growth as the business successfully transitions to new S-curves but also the rate at which earnings can accelerate. Investors often also believe these companies are too expensive (valuation multiples for businesses with these characteristics screen expensive) and they miss the huge upside.

Our deep sector expertise enables us to recognise new S-curves and understand the quality and duration of earnings growth that these businesses are capable of. The companies that demonstrate an exciting ability to create new S-curves form a key component of our portfolio and will help us to compound investors’ capital for decades to come.

Montaka owns shares in Alphabet, Facebook and Amazon.  

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Chris Demasi
Co-founder & Portfolio Manager
Montaka Global Investments

Christopher is a co-founder and portfolio manager at Montaka Global Investments. Before establishing Montaka in 2015, Christopher has worked with LFG, the Lowy family's private investment firm, One East Partners and Goldman Sachs.

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