Alex Sacerdote of Whale Rock Capital
Alex Sacerdote is the founder and portfolio manager of Whale Rock Capital Management, a $1 billion global long/short equity manager focused on the technology, media and telecom (TMT) sectors. Prior to founding Whale Rock, Mr. Sacerdote was an analyst and sector portfolio manager at Fidelity Investments. He began his career in Smith Barney’s TMT investment banking group, and also served as VP of Finance at Interactive Imaginations, an internet advertising start up. Alex received his MBA from Harvard and earned his BA from Hamilton College. Alex currently serves on the Board of Trustees of Hamilton College and Shady Hill School, and is active on their investment committees.
Graham & Doddsville (G&D): Can you discuss your background and your path to investing?
Alex Sacerdote (AS): I’ve been interested in the stock market from an early age. In the early ’80s, my father bought each of me and my two siblings a share of Apple and I watched it incessantly and was delighted when it split three for one. Although I was too young to understand that I had not tripled my money. In the second grade I distinctly remember doing a report on the stock market with crude stock charts. Out of college, I started out as an investment banker in the Tech, Media, and Telecom Group at Smith Barney. It was a boot camp-like experience in which I really learned the mechanics of finance. We were active with M&A deals, IPOs, and high yield offerings across a range of subsectors from media, software, and wireless to semis, so it was great exposure. But my initial interactions with buyside investors led me to believe that was the place for me. During our roadshows for IPOs and high yield offerings, we brought our management teams to a number of buyside institutions. The buyside analysts across the table at the big firms like Fidelity were roughly my age, but they were much more knowledgeable about the industry, even though I had been working on the deal for three months. In some cases they knew as much or more than even the management teams. If you are really intellectually curious and you want to spend 90% of your time critically thinking, the buyside is where you want to be. At the same time, the internet revolution was just beginning. I decided to work for an internet advertising start up in New York City in 1997 before going to business school. The company, Interactive Imaginations, actually pioneered the concept of the ad network. It gave me a deeper understanding of internet based businesses, and there were a handful of other publicly traded internet companies like AOL and Yahoo that I carefully followed and invested in on my own. So at business school I targeted buyside opportunities and secured a summer internship at Fidelity. I was very fortunate because Fidelity provides their interns with a tremendous amount of responsibility. They said to me, “There is this new thing called the Internet. You know something about this. Why don’t you cover e-commerce for the summer?” I was in heaven. I travelled the country visiting the roughly ten internet companies that were public at the time and met the CEOs and founders. I was able to attend Amazon’s first investor day and had lunch with Jeff Bezos. He had the same laugh back then too! By meeting with the companies and studying them carefully, I came to the conclusion that Amazon was going to run the tables and win in e-commerce in a big way, and it was only a matter of time before they expanded beyond books. At the time Amazon was very out of favor, and I made a 25 page presentation to the entire equity department advocating that Fidelity buy shares in Amazon. I think half the investment team thought I was crazy because of the high valuation and losses, but some people must have liked the analysis because I got the job at Fidelity, and that’s how I got into the business. I spent the next six years there as an analyst and sector portfolio manager primarily focused on technology. It could not have been a better training ground. First, there were so many great investors to engage with and observe: Danoff, Wymer, Tillinghast with his unique brand of value, and Myers, who actually started in my intern class back in 1999. It was a very individualistic place with so many different styles and processes. I also got some nice time with Peter Lynch who loved to mentor younger analysts. His temperament, curiosity, and love of the craft were amazing. I’ve read his book several times. You also get great exposure to management teams and a chance to really master your industry and the confidence that comes with that. Finally, you get the chance to run money pretty early on to hone your skills and investment style. Ultimately, I decided to go out on my own. Fidelity was really about running large pools of capital diversified across industries, and I viewed myself as a tech specialist. In the technology sector, it’s important to be a specialist. The long/short format is great for TMT because there are always winners and losers, and the ability to short can dampen inherent volatility.
But throughout all these experiences and from an early age, my father was clearly the biggest influence on me. He was a great role model both as an investor and a human being. He had a wonderful career in finance at Goldman Sachs as head of Corporate Finance and then Chairman of the Private Equity group. He represented the old guard. He was a true gentlemen and was known for his keen intellect, leadership, and mentoring. Not many bankers are known as great investors, but he certainly was. He chaired the credit and investment committees there for more than two decades and kept them out of a lot of trouble. He was an electrical engineer from Cornell and was smart as a whip and could instantly get to the heart of any issue, but he always exhibited humility and graciousness. The best thing about my father was that he was such a great mentor to so many and when he passed away in 2011, I received countless letters and stories about this.
G&D: Identifying S-curves is an important part of your process. Can you talk about that?
AS: It can be tricky to invest in the tech sector. There is constant change, brutal competition, price deflation and often high and “bubble” like valuations. At the same time, it’s clear that there has been massive, large scale wealth creation in the internet sector over the past 20 years. By some measures, it is $2 trillion in wealth. As technology goes deeper and deeper into society and spreads around the globe, there is a chance this wealth creation accelerates. I had the opportunity to watch some of this play out over the past few decades. I started to realize that there are three common characteristics of great winning technology stocks that produced this wealth. The first characteristic relates to the S-curve of technology adoption. All technology adoption starts very slowly. It can be held back for a variety of reasons: high price, complex products, lack of an ecosystem. At some point, these barriers are removed, and the technology moves on the S- curve from the early adopter phase into the majority phase. At that point a massive wave of demand kicks in, and you can see three to four years of incredible unit growth. Everybody says tech is so unpredictable, but if you understand the way S-curves work, it actually can be quite predictable during certain time periods. You are able to understand how fast units might grow over a three to five year period. In analyzing the S-curve, it’s important to assess both the slope of the curve as well as the height of the curve. One example of an S-curve was flat panel TVs. Flat panel TVs came out in 2000, but the products were very expensive and there was no HD content. However, by 2005, the price of a 40 inch flat panel TV fell to $1,500. Monday Night Football and other high quality HD programming was available on TVs and the demand just exploded. We went from 2 million units to 50 million units in a four year period. It was clear that once flat panel TVs hit the mainstream, you were going to get this incredible unit growth that you just don’t get in any other part of the economy. The most famous recent S- curve is the smartphone adoption cycle. Smartphones were actually out in the 1990s, but they were clunky, internet access was unreliable and there were no real apps or any features we commonly associate with smartphones today. Apple changed that and you went from one percent penetration to 50% in a five year period. This became a billion unit market and this is well known now but at that time you’d be shocked at how few people truly grasped this.
Understanding where a technology sits along the S- curve and if you are nearing that inflection point is powerful. The inflection point not only creates incredible unit growth, but it also reduces risk because one of the biggest drivers of tech company failures is faltering demand or demand well below expectations. It’s very hard for that to happen in the middle of an inflection point on the S- curve. Sometimes understanding the S-curve can help you time your exit as well. When adoption gets close to 50%, growth can rapidly decelerate.
G&D: You have important parts of your process beyond the S-curve. Do you want to expand on those?
AS: When we find an attractive S-curve, the next thing we do is search for companies benefiting from the S-curve that have strong competitive advantages. Tech can be brutally competitive, but, occasionally, a company can emerge with a near monopoly. There are many subtle factors within technology ecosystems that create powerful competitive advantages. On the internet it’s about network effects, in software it’s about coalescing around standards like PC operating systems. So we spend time assessing companies within S-curves that might exhibit really strong competitive advantages.
G&D: Is it hard to assess competitive advantage during rapid growth? The rapid growth may obscure what will eventually be fierce competition.
AS: Growth investors will occasionally find an attractive S-curve, but the important piece really is competitive advantage and operational abilities. Finding that competitive advantage, understanding it, appreciating it before other people, and developing a more in-depth understanding of its strength are really important to us. Just about every e- commerce company I evaluated in the Fidelity report in the late 1990s is gone, except for Amazon. In smartphones, Apple created half a trillion dollars in wealth but HTC, RIM, Nokia, Motorola, and LG destroyed value. Several went bankrupt and didn’t make a dime out of the smartphone S-curve. Investors have occasionally grown skeptical of Google’s competitive advantage. During our research of Google roughly five years ago, we met with Microsoft’s head of search. Despite Microsoft making a huge push, it was clear that even Microsoft’s search team realized the tremendous uphill battle they were fighting. We developed a new appreciation for Google given that Microsoft, one of the most valuable companies in the world, could not successfully enter the market. We’re constantly looking for similar stories to illustrate competitive strengths. Microsoft invested several billion dollars for multiple years to take share in search, and they have 15–20% of the US desktop search market. Google has 60–70% in the US and 80–90% share in most other geographies around the world. We think they can sustain this advantage because of their massive scale, significant R&D budget, and so many other pieces throughout the sales channel. Their ability to add adjacent markets on top of search with Android gives them a further advantage.
G&D: The last characteristic you evaluate is valuation?
AS: Right, we don’t just invest blindly when we think we have found a winner. We need to see long term under- appreciated earnings power. When you have an S-curve in combination with a really strong competitive advantage, the earnings can grow exponentially. This happens more frequently than you might think. Apple’s earnings per share went from $0.50 to $9, Priceline’s went from $2 to $40, and Tencent’s went from $0.12 to $2.58. If a company is experiencing strong unit growth and a competitive advantage prevents price compression, the company will grow revenue rapidly and will be able to leverage their expense structure. That’s what produces exponential earnings growth. If we have a lot of confidence in both the S-curve and the competitive position, we are able to model out the business with a high degree of confidence and ensure we are buying at reasonable long term multiples. A great example was LinkedIn (LNKD). They came public in 2011. We really liked their S- curve. They have 3 businesses, and the most important one is their talent management business. LinkedIn has a fully updated database of almost every single white collar worker in the United States and beyond. We realized this was a huge game changer. Before recruiters were relying on two solutions: Monster, a resume database of unemployed people, and head hunters, a really expensive option. It was so superior to the existing solutions that we knew it would see widespread adoption. We attended a number of human resources trade shows and spoke to 50 or 60 recruiting companies and found out that LinkedIn had 100% penetration among recruiters at early adopters like Microsoft and Google. And yet most Fortune 500 companies were just beginning to adopt it. Our research also suggested that they would have pricing power. We also spent time assessing LinkedIn’s market penetration, which can be a challenging statistic to calculate. We asked questions like what is annual employee turnover, how many businesses are there of various headcount sizes, what industries have a lot of turnover that are more white collar oriented. We came to realize that LinkedIn was maybe 3% to 4% penetrated, but it was definitely hitting the mainstream. We determined that there was probably $8 per share in earnings power. At the time many people said, “I like LinkedIn, but it’s so expensive.” For us, it was a bargain. Our price target was almost 2.5x what the stock was trading for based on a 30x multiple of our $8 estimate of earnings power. There are a lot of reasons we thought it would still trade at 30x even three or four years out because if you look at other subscription or information database businesses like Factset or CoStar, they still have very high multiples, even with low single digit revenue growth rates.
G&D: Can you discuss your decision making process to exit?
AS: Sometimes share prices reflect the potential future scenarios we are envisioning for a company. The rest of the world catches onto the story and it is no longer under- appreciated based on long term earnings power. This happened with LNKD and within a year and a half it hit our target. Also, the company launched a few new products that didn’t receive significant adoption. That, combined with the rapid share price appreciation caused us to be more cautious on our outlook. Another good example is Apple (AAPL). We have been big Apple bulls for a long period of time. In 2012, US smartphone penetration hit 50%. The 50% level starts to make us nervous. Adoption will begin slowing down. Apple also had started to lose share in 2012. We were hoping Android would fragment which would hurt the Android ecosystem, but by 2012, it was clear that Android was here to stay. The idea that Apple could potentially fully run the table in smartphone software was no longer a possibility. And lastly, we were previously well ahead of Wall Street on our EPS expectations, even 100% in some cases, but the world had caught up to us. So the S-curve was not a green light anymore. The competitive advantage was very good, but not getting better and maybe getting slightly worse. And third, the under-appreciated earnings power had become appreciated. We exited the position at that point.
G&D: What is your current positioning with regard to Apple?
AS: There have been a lot of developments since our exit. But last year we came back in. The idea that Apple’s value is in their platform not their hardware was strengthened with the launch of the Apple Watch, the App Store growth, their innovations in payments, and the TV product. None of those on their own are big enough to double the earnings of the company, but if iPhone can still grow 5% to 10%, the addition of those four things might get to 20% growth. And even if iPhones are flat, these other segments might have a potential to drive 10% growth. We remain pretty excited about the App Store. Gaming revenue and app revenue are starting to become meaningful for Apple. It might be just under 10% of profits, but it’s growing significantly faster. That stream of earnings should command a premium multiple as well. When Tim Cook made the announcement that their sales in China were progressing well even in the face of the stock market crash, he cited the App Store as having record revenues there. Lastly, many people laugh at the idea of an Apple car. They think it is way out of Apple’s realm, but the fact is, there is a lot of change in the car. It is becoming a supercomputer on four wheels with millions and millions of lines of code, hundreds of semiconductor chips, visual graphical user interfaces, high quality audio and video output, wireless entry with your phone, and there is even the driverless possibility in the near future. There’s no doubt that an Apple car is a long way away and analyzing the potential value of such a business is difficult. However, Apple is investing heavily in the car business and given their track record and some simple assumptions, it can actually be additive to the share price today. If you assume Apple achieves 3% market share of the car industry, sells units at an average price of $75k, and achieves gross margins in line with Porsche, this could actually move the EPS needle in a big way even for a company of this size. We think Apple has the track record and scale to be successful. Tesla has already demonstrated that the barriers to entry are not insurmountable. Apple can afford to invest billions in R&D without endangering the company, which only a few companies can say. It’s not an important part of our thesis and we’re not counting on this but if it kicks in, that could double the P/E of the stock from an absurdly low level, roughly 10x. It wouldn’t be crazy to see it at a P/E of 15x or even 18x. The other aspect is capital allocation, which generally is not a large driver in our typical investments because we typically focus on companies in their growth phase, but with Apple as a somewhat mature company, it can be a really great way to improve stock performance. They’re doing the right things there.
G&D: Benedict Evans of venture capital firm Andreessen Horowitz agrees that barriers to entry are coming down and that the car market is really the only market that can rival phones in terms of total value. However, he points out that autonomous driving is a negative trend for Apple. It means we likely do not own cars and only use them in an on demand fashion. That likely reduces the role of design and likely favors Google over Apple. How do you think about that?
AS: There are still a lot of unknowns in cars. I think our vision for Apple’s car is a four to five year vision while Benedict’s may be even longer- term. I think we still have a long time before autonomous driving is mainstream, so people will be buying cars like they normally have for some time and even when they are autonomous people likely will want their own. I don’t want to give the impression that I’m super bullish on Apple being a home run success in the car market. But over the coming years, I think other investors will begin to appreciate that there may be more potential for an Apple car than they previously expected.
G&D: You have mentioned a handful of frameworks you are looking for with regard to competitive advantage. Are there any other common situations you gravitate toward?
AS: We like it when companies become industry standards. We already mentioned Microsoft, but Oracle is another obvious one. Oracle’s position within the relational database has translated to an excellent competitive position. Everybody has been trained on it, a number of other software programs were integrated with it, and the companies that had adopted it were reluctant to change given the mission critical nature of certain databases. Another good example is Ellie Mae (ELLI), which we feel is in the process of becoming an industry standard. They provide a Software as a Service offering for the mortgage industry. The process of filing a mortgage in the US is incredibly paper and time intensive. There are all kinds of different players in this ecosystem and layers upon layers of regulation. Mortgage lenders basically do not have the technical competencies to design a technology solution that keeps up with the regulations and the paper and time intensive steps in the industry. The value proposition is obvious. There are fewer mistakes, lower costs, and streamlined processes saving time and money. You protect yourself against regulatory and compliance risks. We think Ellie Mae will become the common cloud for the mortgage ecosystem almost like Bloomberg is for financial professionals. There are 600,000 mortgage professionals in the US. The industry’s S-curve has recently started accelerating for secular and cyclical reasons. Underinvestment in technology by mortgage lenders during the housing downturn means lenders are being forced to adopt Ellie Mae. They are growing subscribers at 30% per year, and revenue per subscriber is also growing as subscribers adopt more features and modules. This is a recurring revenue business and we think Ellie Mae will be hard to displace. Their customers today are generally smaller mortgage companies, but the Big 6 mortgage players like Wells Fargo have not yet adopted it. These companies represent 200k of the 600k in industry headcount. To date, they have used their own systems, but they are client-server based, so we think there is a good chance that Ellie Mae could get one of them to sign up as a customer. This would be a huge accelerator to the growth rate. Their current margins are around 20%. We think they can double or triple sales and have 40% operating margins. This is a company we are still excited about even though it has been a successful stock for us so far.
G&D: Can we discuss shorting? Do you also use your S-curve framework in evaluating shorts?
AS: Short ideas can fall at any point along the S-curve. The classic is the maturing industry, but you don’t want to just short companies at the top of the S-curve. We would also like the company to be losing their competitive advantage and have over-estimated earnings power, which is essentially the opposite of what we look for on the long side. Newspapers were an interesting example where the industry had been mature for a long period of time, but then the internet came along and significantly eroded their competitive advantage. That’s a classic short we would look for. We like looking for companies without competitive advantages as well. We mentioned all the losers in the smartphone game as well as in e-commerce. Another area is technology in the early phase of the S-curve. These technologies can get really overhyped. Electric cars a few years ago were a good example. There was a company called A123 that was perceived to have an excellent position. They claimed they had proprietary battery technology and some high percentage of cars would eventually be electric, so their earnings power would be significant. The company ultimately went bankrupt because the barriers to adoption were still significant and they had no competitive advantage in a commoditized battery market. There were no good OEMs using their technology, and there were still concerns about electric car range. It was just too early in the S-curve ramp.
G&D: Have there been situations where you were bullish on a company in the beginning of a growth phase, but transitioned to a short when the thesis played out and other investors continued to extrapolate the great results?
AS: Sure. Certain companies have incredibly powerful and durable competitive advantages, while other companies might have a competitive advantage that only lasts two or three years. This is often the case in semiconductors. One of the few ways we found to play the flat panel TV S-curve was a chip company that made an image processor for the TV. They had 15% share going to 30% share in a period when units were growing from 2 million to 50 million. The problem is the Chinese or Taiwanese end up reverse engineering the chip. In those cases, you have to be really on
top of it to know how long the advantage can persist.
G&D: It’s clear that Whale Rock travels pretty extensively and that management meetings are a key part of your process. Can you talk about this?
AS: Yes, we do 1,000 face to face meetings a year despite being only a team of five. I think we travelled something like 250k miles last year. We go to Asia three or four times a year. We recently travelled to India to meet with 30 private and public Indian internet companies. Within our framework, we do not specifically include management quality, but it does tend to play out that these great companies often have incredible management teams, so it makes sense for us to spend time with them.
G&D: Have you come across any management teams that you think are especially underrated?
AS: He is not exactly underrated, but I think Mark Zuckerberg is underappreciated as a businessman. He saw earlier than anyone else how valuable Instagram and WhatsApp would be. Both assets have tremendous value. He also moved quickly on virtual reality. There are indications today that VR could be a mainstream medium. He found a management structure enabling him to focus on the long term future of technology while Sheryl Sandberg and other incredibly talented professional management can focus on the business. He seems quite skilled at delegating and hiring, acting on strategic M&A, executing and building the culture of the company, and he also has that broader vision of connecting the world. If you compare Facebook to Twitter, so much of the difference is execution. I think Facebook is a better asset because frequency of use is higher and it’s more broadly adopted, but if you talk to advertisers, even Facebook’s ad systems are more robust than Twitter’s. Facebook has an impressive ad platform and distribution and sales process. I think he’s done a tremendous job there. Another CEO is Jeff Bezos of Amazon (AMZN). He is not underrated either but he deserves even more praise than he gets. Most CEOs might accomplish one great thing, which would’ve been the retail operation for him. He now has helped create a second massive opportunity with AWS. I think Amazon’s e-commerce business is pretty well understood. I think the main misunderstanding with regard to Amazon is AWS. I think Amazon shareholders know it is an interesting opportunity, but I don’t think they fully understand what they are sitting on.
G&D: Can you explain the AWS opportunity to us?
AS: We think they are a leader in a market that represents $500 billion in annual spending. They are focused on the public cloud, which we think is the biggest opportunity in all of IT. It will encompass spending on servers, storage, networking, systems management, related services, and several other areas that aren’t even fully developed yet. The FAA recently completed a large transformational deal with Amazon. They will be spending $100 million per year with Amazon, and that will not even be their entire IT budget. That’s about 50 basis points of their budget. That gives some indication of the scale of the opportunity. It’s not hard to envision a majority of global companies spending 50 bps of sales on AWS. Even with all the discussion of cloud activity and the movement to the cloud over the last six or seven years, the amount of compute that’s done on AWS is 2% to 3% of the world’s compute. It’s really just getting to the mainstream now. We think the S-curve has the potential to last 20 years. These big shifts in enterprise IT happen once every two decades with mainframes in the ’60s and ’70s, client server in the ’90s up until now, and the public cloud will be the next one. On competitive advantage, most investors think that the public cloud is a commodity business. The reality is that AWS is pretty sticky due to the whole software layer on top, 10 different flavors of storage, systems management containers, all kinds of software that increases switching costs. They’re the biggest player and they are out-investing the competition. We have spoken to a couple hundred users of AWS and they say that this is similar to Coke and Pepsi except there is no Pepsi. A recent study we reviewed suggested that 50% of customers use Amazon, 10% use Azure, and Google is not particularly relevant. Another interesting insight was that the customers using Amazon have much higher volumes than the average customer. The usage differential can be 10 to 1, or more. The software lock-in is not on the same level as a Microsoft operating system, but it’s enough to where you don’t want to switch providers. Your team is trained on it and they become familiar and efficient with the tools of AWS. Even if it were a commodity, AWS would be 10 times the size of the next biggest competitor anyway. The scale of AWS gives it a big advantage in unit costs, but it also allows AWS to invest significantly more in R&D. We are hearing that AWS has some of the best computer scientists in the world working as part of their team. They added 350 features this year. Last year it was 100 and what we’re hearing is they’re pulling away from the competition in terms of features and additions.
G&D: What about overall returns on capital? Bezos has cited the capital intensity of AWS as one of his worries.
AS: That is a big question that we have spent time thinking about. We have analyzed server costs, required data center capex, and AWS unit pricing by service. One part that is challenging to predict is pricing. Within the last 2 years, Google cut price by 50% or more in an attempt to improve the competitiveness of Google Compute. Amazon
immediately responded with a similar cut. And they have cut price essentially every year.
But we haven’t seen a big dramatic move recently, so AWS is growing revenue in line with usage and achieving high teens margins, but pricing could see another significant cut in the future.
Given how impressive the moat is, that switching costs will only increase in the future, and the fact that they are already making 20% margin, I think ROIC will likely be very good. Moore’s Law should also help them lower the capital intensity per unit of server capacity.
We think half of all compute will be in the public cloud versus 3% today. Bezos draws the analogy to the old days when corporations had their own power plants before we eventually developed centralized utilities. We think AWS could wind up as the equivalent of a centralized utility with 50% to 70% market share around the entire world. We are convinced this is going to be an extremely valuable business. The stock is getting credit for it now but we still think people are missing how big the opportunity is and how thoroughly Amazon will dominate it. It’s a large position for us now and it continues to amaze me how one company has been able to position itself so well for two of the largest business opportunities of our generation in e-commerce and the public cloud.
G&D: You have an interesting thesis on gaming. Would you like to discuss that?
AS: We own companies related to traditional console video games as well as companies benefiting from the mobile S-curve. On one of our trips to China two years ago, I noticed a teenager on the subway who had a really big phone and was playing a really intense game. It started to become clear to me that mobile gaming would eventually be huge. It has been very hard for companies to effectively monetize mobile games. The screen sizes were much smaller and the graphics power in mobile CPUs were much weaker so the only games that succeeded in any way were very casual games. The casual games tended to have relatively short lives, posing additional difficulties to effective monetization. What we are now seeing is very positive for mobile gaming monetization. With bigger screen sizes and better graphics, you can have games with richer stories that require a much larger development team. These developments favor scale players. On top of that, these PC games have millions of players to the point that it is similar to a social network. Virtual goods can be purchased for low price points but the user base is so large it can be meaningful revenue. A Japanese gaming company, GungHo, launched a game that generates over $1 billion in revenue. It’s been going for two or three years now, and there are no signs of it going away. We have followed NetEase (NTES), a Chinese video game company, for years. It has a very high quality management team. The CEO,William Ding, owns 50% of the company. He does not spend time talking with sell-side analysts, he is very focused, and he has essentially built the Activision of China. The company has grown their net income from $50 million to $700 million in PC gaming. Their PC gaming revenue is an attractive base of recurring revenue supported by long duration franchise games. The value proposition to the customer is very compelling. It works out to roughly 2 cents per hour of game play. NetEase was early to appreciate the potential of mobile gaming. Two years ago, they started developing mobile games and thinking of ways to take their great IP from PCs to mobile. They recently launched a mobile game, Fantasy Westward Journey Mobile. We have been tracking it actively. Our interns on the ground in China have been visiting Internet cafes and we have different ways to track app store activity. Our research suggests it is the number one game in China. We think it will generate about $1 billion in revenue. To put that revenue figure in context, the company generated around $2.6 billion in revenue last year, so it is a very meaningful contributor. They have several other mobile games in the pipeline that could deliver additional upside. NetEase has appreciated in the last six months, but we still think this is the best opportunity for playing the mobile gaming S-curve.
G&D: And the console gaming opportunities?
AS: Everybody thought mobile would kill the console. That is not happening at all. The console has remained strong due to the connection to the internet and the ability to generate recurring revenue through downloadable content. The popularity of certain console games has continued to increase massively. The margins have generally increased as downloadable content has high incremental margins without any margin shared with retailers. We see it as a big renaissance for the gaming industry. The console market is now more lucrative and mobile is opening up a potential new market for them. We are looking for companies with great IP that can now use that IP in other ways that might not be appreciated. We think Electronic Arts (EA) has done a fantastic job with FIFA and NFL Ultimate Team.
G&D: Do you have any advice for Columbia students looking to enter the investment management industry?
AS: I think you have to be in the business for the right reasons. It’s really important to be very curious and have a passion for investing because there are so many people out there competing with you. It’s really important to love what you are doing. In this business, it’s not about sheer brain power, SAT scores, or an MBA from a leading business school. Those factors help and of course are nice to have, but they do not guarantee success by any stretch. I’ve worked closely with scores of investors across roles and across strategies in my career, and really a small percentage are truly gifted and able to generate alpha over long periods of time. I’ve thought a lot about what characteristics these people have in common which I think may be important for your younger readers to consider if buyside public markets are the right path for them. Some stock picking can be trained or learned but there may be an innate aspect to it— an inherent savviness, contrarianism, and creativity in thinking. I view it as a willingness, if not a passion, to challenge the status quo or vehemently argue other viewpoints, coupled with a flexibility and openness to adjust to new facts and information. You have to love learning and really get excited when you gain conviction in a theory. You have to be a sponge for information and ready to learn from anyone or anything. Munger talks about how Warren Buffett is a learning machine with his constant reading. At Whale Rock we talk about this concept of the learning machine and how we can become better learners individually and as a team. It’s not how many brain cells you have, it’s how the synapses fire together and this is why we focus a lot on effective communication within the team. We spend a lot of time collecting data, but much more important is developing insights from it and building it into our collective thinking. Also, for those interested in investing, there are a lot of really helpful books that you can read. My favorite for growth investing is Common Stocks and Uncommon Profits by Philip Fisher. It is essentially the Bible of growth Investing. Philip Fisher was doing this in the 1950s and almost everything he says in that book is true today. In the book, he outlines 15 elements of a great growth stock. When I read the book, I was amazed at how similar it was to our process for conducting research. The Gorilla Game by Geoffrey Moore is the best book on tech investing. A lot of what we do at Whale Rock can be found in this book. And finally, I can’t leave out The Tao Jones Averages: a Guide To Whole- Brained Investing by Bennet Goodspeed. The thesis of the book is that Wall Street and academia favor and attract left brain thinkers who are good at linear thinking and can crank through problem sets quickly. But to really spot big inflections and change (where the real money is made), especially in technology, it’s often the domain of the right brain which is more spatial and intuitive. Right brainers can connect dots from seemingly disparate sources to put the whole picture together. I also encourage students to invest on their own. It doesn’t have to be a lot of money, but if you do it on your own account, you will learn a great deal.
Lastly, if you are trying to enter the business, make sure you have two or three reports on companies you really like with supporting models and a well-articulated thesis. It’s important to demonstrate that you can really do the research.
G&D: Thanks so much for your time, Alex.