Internet Stock Picking

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In "Nothing But Net" (2021), Mark Mahaney, one of Wall Street's top tech analysts with 25+ years of experience, shares 10 lessons on how to pick winning internet stocks.

Mahaney focuses exclusively on high-growth tech stocks, the sector that produced 23 ten-baggers from the late 1990s through 2020.

This post covers the key drivers of tech stock success, from revenue growth and product innovation to management quality, and how to approach valuation and volatility in a sector where conventional investing rules don't always apply.

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You will lose money in the market. It's not a question of if, but when and how much.

Being a good stock-picker means being both a good fundamentalist (forecasting revenues and profits) and a good psychologist (guessing what multiples the market will assign).

Getting both right consistently is nearly impossible.

Let’s say you buy a stock at $15 with $1.00 in earnings (15x P/E multiple). You correctly predict earnings grow 10% annually to $1.33 over three years.

But a new competitor enters the market and a pandemic hits. The market now assigns only a 10x multiple to those $1.33 earnings.

Therefore, the stock is worth $13.31, not $19.97 ($1.33 × 15x)—you lost 11% despite nailing the earnings. In other words, you were a great fundamentalist but a bad psychologist.

The point is that you will lose money in the market even if fundamentals/valuations are sound, simply due to major market movements. As Mahaney shares:

Mahaney then transitions into discussing three failed investments:

Even with decades of experience, you'll make bad calls. Mahaney had 15-20 years analyzing stocks and still got Zulily and Blue Apron wrong—and even "sure thing" stocks can crash 70%, 80%, or 90%.

Even best-in-class companies face massive selloffs. Every major tech winner has experienced at least one 30%+ correction.

The key is distinguishing temporary dislocations from permanent impairments. Patience gets rewarded, but you'll endure painful pullbacks first.

Netflix: The Subscriber Miss Correction

In 2018, Netflix crashed 44% from $417 to $234 after missing subscriber guidance by almost 50% in its June quarter. The company added 674,000 US subscribers versus 1.2M expected.

Multiple factors hit at once: World Cup in Europe, no major new shows, and summer seasonality.

Then, in 2019, Netflix crashed again, 32% from $385 to $263, after reporting its first US subscriber decline in almost a decade (down 130,000). Investors panicked about aggressive price increases and Disney+ launching.

But Netflix recovered both times. The company ended up adding more subscribers in 2018 than 2017, and Disney+ didn't permanently damage growth. The stock hit new highs by 2020.

Even the best stocks face massive corrections. Netflix returned 375% over five years despite these 44% and 32% crashes.

Short-term thinking destroys long-term returns. Companies obsessed with beating quarterly estimates sacrifice innovation for predictability.

Investors who trade around earnings usually underperform those who focus on multi-year trends.

Here's why playing quarters is a losing game:

The reality is volatility around earnings almost always exceeds the fundamental change. A stock may drop 10% on a miss, but long-term estimates rarely decline 10%. This exaggerated reaction creates opportunities for long-term investors.

As Mahaney notes, one quarter rarely confirms or refutes an investment thesis. Expect three out of four quarters to confirm your thesis. When a miss occurs, assess if it's temporary (e.g., product launch delayed) or structural. Stay focused on the long term.

Two examples worth highlighting:

Overall, short-term investors who sold during quarterly misses and volatility missed massive gains across these stocks.

Revenue growth is the single most important metric for tech stocks. Companies can manipulate earnings through accounting, but revenue is harder to fake.

Mahaney's 20% rule states that companies demonstrating consistent 20%+ revenue growth can provide good stock returns almost regardless of near-term profitability.

Only 2% of S&P 500 companies achieve this growth rate for five straight years. But these rare companies significantly outperform:

Here’s why revenue matters more than earnings in tech:

Public market investors consistently pay higher multiples for revenue growth versus cost cuts or buybacks because revenue growth is the hardest thing to achieve in tech.

Profits eventually matter for tech, as profitless growth creates no value in the long run. The point Mahaney is making is that excellent revenue growth is a good indicator of outperformance and future profitability.

Growth Curve Initiatives (GCIs)

Growth curve initiatives (GCIs) are strategic moves that can reignite/accelerate a company's growth trajectory, which often leads to multiple expansion.

In 2018, Netflix implemented three GCIs simultaneously: price increases (10-17% on different tiers), new original content launches, and Asian market expansion.

Revenue growth accelerated from 33% to 40%, operating margin hit a record 12%, and the stock soared 98% in six months. The valuation multiple expanded from 7x to 13x sales.

Look for GCIs like new product launches, geographic expansion, or price increases. When successful, they drive revenue acceleration, margin expansion, and stock re-ratings.

Product innovation is one of the biggest drivers of fundamentals, especially revenue growth, and that's what drives tech stocks.

Companies must constantly reinvent themselves or face obsolescence. The best companies launch products that seem "crazy" at first but become essential later.

Successful product innovation can generate entirely new revenue streams (Amazon with cloud computing), replace existing revenue streams (Netflix with streaming), or improve existing revenue streams (Spotify with podcasting).

How to Spot Innovation

Product innovation is spottable. The cost of testing Netflix's streaming was $7.99 per month. Testing Uber, DoorDash, or Airbnb takes a few taps on your phone. You're a consumer—you can try many services yourself.

A good sign of innovation is when competitors copy. Facebook copied Snap's Stories, geofilters, and selfie masks. As Mahaney notes, "Imitation may well be the sincerest form of successful product innovation."

Spotify spent 3x more on R&D than Pandora ($1.1B versus $350M from 2016-2018). The result was Spotify reaching a $50B market cap while Pandora sold for just $3.5B.

Most importantly, companies that demonstrate repeated innovation have built the processes, culture, and management teams to keep innovating. When you find these serial innovators, you've likely found exceptional long-term investments.

Total addressable market (TAM) determines a company's ceiling. The bigger the TAM, the greater the opportunity for premium revenue growth.

Companies attacking trillion-dollar markets can sustain 20%+ growth even from massive scale. Those targeting billions eventually hit growth walls.

TAMs can be expanded by removing friction and adding new use cases. Large TAMs enable scale benefits that create competitive moats.

Pulling a Google

Only three companies in history sustained 20%+ revenue growth for a decade after reaching $25B in revenue. Mahaney calls this "pulling a Google:"

The law of large numbers says growth rates slow as companies get bigger. But Company A generating $10B in a $50B market (20% share) has less runway than Company B generating $100B in a $1T market (10% share).

Google expanded its TAM by removing friction. Self-service tools let any business run marketing campaigns. Smartphones didn't threaten Google - they removed friction and enabled searches anytime, anywhere. More searches meant more advertiser demand.

Uber and Lyft expanded TAMs by lowering prices, increasing drivers, reducing wait times, and making payments seamless. They went from replacing taxis to becoming alternatives for all transportation.

Why Scale Wins

Large TAMs enable four specific scale benefits:

Companies with compelling customer value propositions beat companies with great business models. Customer-centric companies beat investor-centric ones.

The best performing stocks of the past decade belong to companies that prioritized customer satisfaction way over near-term investor concerns.

The reality is that building “expensive” value propositions can eventually generate positive business model effects through pricing power.

Pricing Power Flywheel

Netflix increased its standard streaming service from $7.99 to $8.99 in May 2014 - the first increase since launching streaming in 2007. Netflix took it slow, allowing existing users to maintain $7.99 for up to two years.

Despite the price increase, Netflix accelerated subscriber adds - 11M in 2013 to 13M in 2014.

By 2020, Netflix had reached 37M annual subscriber additions and 200M total subscribers despite raising its standard plan to $13.99 - a 75% increase over six years that generated $14B in annual all-margin revenue.

Management quality determines outcomes more than any other factor. Look for founder-led companies with long-term vision, customer obsession, and willingness to admit mistakes.

Also look for deep technology backgrounds and strong operating benches. Avoid hired CEOs optimizing for quarterly earnings.

Unlike investment funds, for management teams, past performance IS an indicator of future performance.

To elaborate, Mahaney looks for:

Finding most of these characteristics signals a management team worth betting on.

Founder Advantage

Founders think in decades. Hired CEOs think in quarters. The average tenure of successful tech founders is 24 years - more than twice Malcolm Gladwell's 10,000 hours rule for excellence.

The key advantage of founder-led companies is their ability and willingness to stick to a vision in the face of controversy, criticism, and contempt. They're more willing to be misunderstood.

As Bezos said: "If you're going to do anything new or innovative, you have to be willing to be misunderstood."

Regardless, not all founder-led companies succeed. Grubhub and Pandora were founder-led but acquired at fractions of competitors' valuations. And Priceline was a monster stock for a decade under operator CEO Jeff Boyd who wasn't a founder.

But the track records heavily favor founder-led companies.

Traditional valuation metrics fail for tech companies. P/E ratios mean nothing when companies deliberately suppress earnings to invest in growth. Valuation shouldn't be the most important factor - just ask if it's "ballpark reasonable."

Focus instead on revenue multiples, growth rates, and market opportunity. High-growth tech stocks can look expensive but that doesn't make them poor investments.

Companies With Minimal Earnings

For companies with minimal earnings, ask three questions:

Netflix's earnings were depressed by content investments and the switch from licensed content (cash paid over years) to original content (cash paid upfront).

But the company maintained consistent GAAP profitability while growing revenue 35% and expanding operating margin from 7-10% - that 3 point increase on a 7% base meant almost 50% EPS growth.

Companies With No Earnings

About a third of NASDAQ companies aren't profitable. Almost all internet IPOs over the last decade were unprofitable at IPO.

For these companies, run four profitability logic tests:

Mahaney tracked market caps of unprofitable companies from 2011-2020. Combined value grew from $100B to $1.3T.

Markets are willing to bet profitless models can become profitable - that's why they generate returns before proving profitability.

The best opportunities come when great companies face temporary setbacks. These "dislocated high-quality" (DHQ) situations create massive returns for patient investors who distinguish temporary problems from permanent impairments.

Every single high-quality company gets dislocated at some point. Facebook, Amazon, Netflix, and Google were each dislocated multiple times over five years.

What Makes Stocks Dislocated

Stocks become dislocated when they're down 20-30% from recent highs or trading at discount to growth rates (P/E lower than expected EPS growth rate).

Every dislocation lasts 3-6 months on average. None of the high-quality stocks Mahaney tracked had dislocations lasting over six months. Facebook's lasted five months. Netflix's lasted six months (187 days).

Don't try to catch the exact bottom. Even buying Facebook after it fell "only" 20% to $175 returned 14% in 12 months versus market's 7%. Buying after 30% decline to $151 returned 19% versus market's 5%.

When to Sell

The key sell indicator is material deterioration in fundamentals. Specifically when revenue growth decelerates 50% within a year (not from macro shocks) or dips below 20%.

Companies that went from outperforming to lengthy underperformance after sharp deceleration include: Booking, Criteo, eBay, Snap, Shutterstock, Tripadvisor, Twitter, Yahoo, and Yelp.

Don't sell on temporary regulatory issues, sentiment shifts, or quarterly misses at companies with strong positioning. You must distinguish permanent impairments from temporary dislocations.

As Mahaney concludes: "Growth thrills. Substantial deceleration kills."