15 Investing Rules from Tech Investor Roger McNamee’s “The New Normal”
As far as famous investors go, Roger McNamee is not a household name nor is he one of today’s best known investors, nevertheless he is one of the most successful tech investors of the last few decades. He started his career covering software companies at T. Rowe Price Associates (mutual funds / public markets), and from there went on to found Integral Capital Partners (crossover fund), Silver Lake Partners (private equity fund) and Elevation Partners (private equity fund). He employs a “buy-and-hold” strategy that emphasizes research, patience, common sense, avoids momentum investing, and looks for investments with a solid core business and opportunities to grow. In his 2004 book, The New Normal, he discusses and contrasts trends in society driven by technology (the internet) and globalization (p. 1–202) and at the end of the book he outlines 15 rules for investing (p. 203–225) tried and tested over decades of successful technology investing. I wanted to review and summarize these rules into a format which I can easily review for my investing toolbox, so here they are.
Some of the rules, and the insight they reflect, appear to be common sense but Mr. McNamee does well to define them and combine them into considerations that can help build a more successful investing framework. Conceptually, the rules fall into three categories:
(1) Know yourself →(2) Have a strategy optimized for the investment landscape →(3) Principles to pick the best investments in the landscape.
The first section of the article lists the rules for the reader to get an overview of the entire list. The second section then repeats the rules with additional notes on each rule. Finally, the last section concludes with some of the other pieces of advice, maxims, principles, and insights which I highlighted while reading Mr. McNamee’s book.
(1) Rules:
Rule #1: Know Yourself
Rule #2: Determine an Allocation of Assets
Rule #3: Focus Pays
Rule #4: Some Businesses are Inherently Better Positioned than others, and the same is True for Stocks
Rule #5: Some Business Models are Inherently Superior
Rule #6: Insight is Precious
Rule #7: It All Comes Down to Products
Rule #8: For Growth Stocks, Product Cycles are the Cycles that Matter
Rule #9: Decimal Points Don’t Matter
Rule #10: In Making Investment Decisions, Do Not Rely on Management Guidance Alone
Rule #11: Balance Research Insights with Opportunism
Rule #12: A Perfectly Diversified Technology Portfolio is Bound to Underperform
Rule #13: Avoiding Losers is as Important as Picking Winners
Rule #14: There is only One Microsoft
Rule #15: Don’t Focus on the IPO Market
(2) Rules with Notes:
Rule #1: Know Yourself
· Define [honestly] your goals, time horizon, risk profile, interest level
Rule #2: Determine an Allocation of Assets
· Invest in what you know, it reduces the risk
Rule #3: Focus Pays
· Focus your attention on a type of investing and a sector [and do these well rather than worrying about the thousands of other companies and investing options and investing methods]
Rule #4: Some Businesses are Inherently Better Positioned than others, and the same is True for Stocks
· “Momentum investing” is risky for individuals and hard to stay ahead of positive news flow, rather use other methods of direct investing e.g. value investing
· If you try “growth investing” know that (1) timing has a huge impact on returns, and (2) know what you are buying (be able to tell the difference between average, above average, and outstanding companies.
· The best positioned companies often have the “most indispensable” products, so ask yourself “Whose products are the most indispensable”. Being well positioned isn’t the same thing as being a good stock, but it’s a good start. High gross margins relative to competitors and leaders in other sectors often signals that customers are willing to pay a premium and the products are indispensable.
· Assessing management is tricky
Rule #5: Some Business Models are Inherently Superior
· The best companies often have three things:
o Well positioned for the future
o Sell something for which customers are willing to pay a premium
o Ideally suited management
· Look for companies with “high [relative] margins, high market share, significant intellectual property protection, and low capital intensity”.
· Businesses that sell many units of low-priced products through indirect sales channels (e.g. Microsoft) are often preferable investments to businesses that sell a low-volume of high-priced products through a direct sales force (e.g. Oracle).
Rule #6: Insight is Precious
· When you lose money on a stock, analyze why and what you got wrong à did you have the key information but not give it the proper weight?
· Looking at where successful venture firms (e.g. Sequoia and Kleiner Perkins) are investing (by tracking their portfolio companies listed on their websites) will tell you where they are investing, where they are not investing, and where they “perceive public companies are unlikely to be successful”.
Rule #7: It All Comes Down to Products
· Wall Street estimates are very often wrong; too high or low → understand the product for yourself → rule of thumb: “If a product is hot, Wall Street’s earnings estimates will always be too low. If the product isn’t hot, the estimates will prove to be too high”.
· Spend your time analyzing the product itself, and then keep in mind the above rule of thumb.
Rule #8: For Growth Stocks, Product Cycles are the Cycles that Matter
· Product cycles matter most for growth stocks (not interest rate and economic cycles as for mature industries)
o Phase #1: Early adopters → success with early adopters allows economies of scale in manufacturing, which lowers prices and boosts sales volumes.
o Phase #2: Expansion → attractive combination of growth, volume, and profitability; where the money gets made by companies and investors.
o Phase #3: Maturity → “requires significantly lower prices to appeal to late adopters” which results in lower margins and growth.
· Growth investing: try find hot products as early in life cycle as possible → start-up phase is hard and big risk product won’t live up to expectations → Wait until product in expansion phase (reduces risk but also reduces potential upside); look for early in expansion phase. Maturity phase risk-reward is unfavorable (little upside, big potential downside).
· “Product-cycle investing works best with small and medium companies, as well as with large companies with limited product lines.”
Rule #9: Decimal Points Don’t Matter
· Never play for pennies
· Time horizon should be up to 5 years and initial price should compensate for risk of long holding period.
· Don’t sell a stock until the company’s position in its market begins to deteriorate. Rarely sell for valuation reasons (e.g. you think it’s a bubble).
Rule #10: In Making Investment Decisions, Do Not Rely on Management Guidance Alone
· “Management is often the last to know — and certainly the last to tell — when there is a problem in its business.”
Rule #11: Balance Research Insights with Opportunism
· “Research determines what should be done, but the market determines what can be done today.” → there is always volatility, even for the best-positioned tech stocks and minor results disappointments can result in huge swings in value. → Strategy: identify great companies, then wait for a shortfall to buy.
Rule #12: A Perfectly Diversified Technology Portfolio is Bound to Underperform
· New tech industries emerge every few years → investors interested and bid up valuations of every company in that industry → either new industry fails to materialize and companies disappear, or industry thrives and customers narrow to a few vendors. Many tech industries have a winner takes almost at all / are Darwinian (Google, Microsoft, Amazon etc.).
· In early industries can hold a wide basket of players, then reduce to fewer players as winner makes itself known.
Rule #13: Avoiding Losers is as Important as Picking Winners
· There are far more losers than winners
· Do your own work before buying a stock
· Identify early and eliminate before do too much damage
· Ask the questions:
o “How substantial is the business? Is it consistent from quarter to quarter?”
o “What is happening to profit margins?”
o “Has there been any balance sheet deterioration? If accounts receivable rise faster than sales, that’s an indication of a deterioration. What is happening to cash?”
o “How promotional is management?”
o Was bad news one-time event or signal of larger problem? If former, buy more in opportunity after price decline, if later sell quickly.
Rule #14: There is only One Microsoft
· Invest in best-positioned companies in the most attractive industries à the next Microsoft more likely to already be in portfolio, rather than spending time looking for next Microsoft.
Rule #15: Don’t Focus on the IPO Market
· Big money in investing: buy stocks of great companies and hold them for periods of years.
(3) Other Advice, Principles, and Insights Highlighted in the Book:
· Read Benjamin Graham’s The Intelligent Investor — need to understand fundamentals
· “Successful investors stay away from the crowd”
· Focus your attention
· “Working hard is important, but working smart is essential.”
· Return to traditional metrics: revenues, profits, and cash flow. (in sane times). → Cash flow and profitability matter in a major way, especially when mania ends.
· Most attractive investments have two ways to win: “solid core business that can provide a reasonable rate of return, but also a growth opportunity that can turbocharge your returns.” → depending on valuation: maybe can get reasonable return just from core business, and growth opportunity for free.
· Education never ends
· Focus on products, not concepts. (p. 84)
o Press over promotes new trends, early promoters have incentive to hype too → but most innovations fail to fulfill their promise = bad for investors.
o If products, then business model, then can judge attractiveness of business.
· New tech architecture comes: proponents forecast revolution and replace legacy systems → sometimes happens, but most often new tech applied to business processes not previously automated. I.e. new categories of applications.
· Major new tech industries typically have three distinct development phases (p. 91):
o (1) Infrastructure (physical hardware layer)
o (2) Enabling technology → together with infrastructure, form a platform.
o (3) Applications, content, and services (supported by platform).
o Phases happen sequentially and can take years.
o Enabling technology phase needs to stabilize for platform to form.
o Don’t jump the gun by investing in stage 3 before platform is stable.
o “Focus on stage appropriate investments”
o “The value of winners in each phase is very different” e.g. Infrastructure is capital intensive and competitive, but enabling tech can be natural monopoly (especially if ‘standards’ are necessary). Phase three co’s. are more competitive and less profitable than phase 2, but revenue levels can be huge.
· Favor the company with the “quick and dirty solution” over the company with the “technically elegant solution” (in industries where head-to-head competition is starting). → “The real world is not technically elegant, and the quick and dirty vendors are generally more willing to do what customers need.”
· “Being too early is the same as being wrong”
· Keep score on everything you do; analyze data, news, and own reaction to it → minimize emotional component.
· “The guy with the longest time horizon wins”
· “Always do your own research”
· Reduce time spent on low value activities
· Be aware of “paid in capital” of new businesses → how much capital (and time) did it take before company turned profitable.
· Look for owners / managers who really know their subject matter, and “genuinely understands the market he or she is going after…”
· Pay attention to competitors and threats → “new business models can offset advantages of scale. This is how upstarts displace market leaders.” → “Successful companies tend to fall in love with their business model and do not evolve with their market [become vulnerable to disruption].”
· On financial forecasts: Be skeptical. Use common sense.
