‘Exponential’ Investing Explained

Technology is back.

With the U.S. Nasdaq hitting the 5,000 level on March 10 for the first time since the bubble peaked just over 15 years ago, investors are slowly climbing back onto the technology investing bandwagon.

While the financial media is dominated by the doom-and-gloom crowd, obsessed with the dysfunctionality of politics in Washington, D.C.,  a whole new generation of (usually Silicon Valley-based) hyper-optimists are focused on developing the next generation of companies set to change the world.

“Disruptive” has become the new buzzword, in a world where asset-light companies like Airbnb and Uber are valued more highly than long-established brand names like Intercontinental Hotels Group plc (IHG) and Fiat Chrysler Automobiles N.V. (FCAU) within a few years of their founding.

Silicon Valley’s super-optimists are tackling problems ranging from self-driving cars to abolishing human mortality. The mantra of Astro Teller — the director of the Google X laboratories responsible for Google Glass and the Google Driverless Car — is that if you aren’t providing a solution to a problem that is at least 10X better than the current one, it’s not worth his attention.

The Relentless Mathematics of Exponential Change

Of course, all of the “this time it’s different” talk carries with it more than a whiff of financial mania.

That said, the intellectual justification behind Silicon Valley’s super aspirations just may be more substantive than the sock puppet of the Internet boom.

The core idea of the hyper-optimists is that the technology — or, more broadly, solutions to all of humanity’s natty problems — is driven by a universal but hard to get “law of exponential growth.”

Futurist Ray Kurzweil, himself striving for immortality, has argued for decades that the pace of change in technology is not just linear. It is exponential — and accelerating.

The graph below illustrates the remarkable — and counterintuitive — implications of this difference.

Here are two oft-cited examples of exponential change.

If you could fold a piece of paper in half indefinitely (essentially doubling its height every fold), it would only take you 42 folds to reach the moon.

Or, if you started with one dollar and doubled your money every day, by the end of the first week you’d have $64. But by the end of the first month, you’d have $268,435,456!

As Kurzweil put it:

“Today, we anticipate continuous technological progress and the social repercussions that follow. But the future will be far more surprising than most people realize, because few observers have truly internalized the implications of the fact that the rate of change itself is accelerating.”

The Challenges of Exponential Growth for Investors

So what does exponential growth mean for investors?

On the one hand, in terms of cash today, you’ll make money by investing in today’s stalwarts like 50-year-old Berkshire Hathaway (BRK-B) rather than in tomorrow’s exponential growers.

On the other, over the longer term, an exponential investment, if it is successful, crushes the slow-and-steady returns of proven business models such as Coca-Cola (KO) and American Express (AXP).

That’s why investing with an exponential mindset requires an even longer-term time commitment that requires companies to maintain focus on their grand mission and not get sidetracked by the short-term lack of results. It is this type of focus that drives Jeff Bezos at Amazon (AMZN) to continue to expand the company’s operations even at the cost of generating next-to-no earnings.

It also is the kind of commitment that can screw with Wall Street’s mind. Of course, investors love the exponential equation once it reaches a tipping point and massive profits kick in.

But they are less patient over the short term when it seems the company won’t generate more short-term results.

Challenging the Value-Investing Paradigm

Investing in exponential growth upends traditional approaches to investment valuation. That’s because these investors don’t ask: “what is the price today?”

Instead, they ask “what are the chances of success, and how much should we pay for that success?”

Take the example of gene-sequencing firm Illumina Inc. (ILMN) — about as pure a play on exponential growth as you’ll find in publicly traded markets. Between 1990 and 2001, more than 200 scientists joined forces in a $3-billion effort to sequence human DNA.

Since then, the price of sequencing a human genome has fallen exponentially from $3 billion to less than $10,000.

That rate of price drop was faster than what is predicted by “Moore’s Law.”

Today, Illumina trades at a price-earnings (P/E) ratio of 79 — a level value investors cannot stomach.

But looking at Illumina through the eyes of an exponential investor, you get a different picture.

With the price of gene sequencing expected to fall below $1,000 in the coming years, and approximately 90% of all the human genes sequenced on Illumina equipment, the company’s prospects have risen, well, exponentially.

As Steve Jobs observed, it is “when data hits biological sciences” that things will get really interesting.

Within a decade, all babies will be sequenced at birth. And if you have serious illnesses, your DNA will be sequenced in detail many times.

That kind of exponential change is exactly what Illumina is benefiting from today.

A comparison of Illumina’s stock price growth with that of Berkshire Hathaway over the past decade is revealing.

With this kind of growth, positive cash flow today or a high multiple of current earnings become irrelevant.

The driving force of exponential growth lies behind the best opportunities in technology, healthcare and biotech investing over the next decade.

The one big caveat?

Just make sure you bet on the winners.

In case you missed it, I encourage you to read my e-letter column from last week about the legacy of Lee Kuan Yew, former prime minister of Singapore. I also invite you to comment in the space provided below my Eagle Daily Investor commentary.