FORTUNE — Savvy technology investors seek potential, not performance. They identify companies leveraging technology to build and dominate new market sectors that show promise for significant growth. Because elite tech investors know two things that others don’t: First, there is no such thing as a legendary company in a dying sector. And second, the technology business is a winner-take-all game, where companies that dominate specific markets in tech, such as Google (GOOG), Facebook (FB) and Salesforce.com (CRM), often gain upwards of 50% market share over time.
Most financial news and analysis are a blizzard of historical numbers: Revenue, sales, backlog, margins, earnings, etc. This spreadsheet-based, historical analysis is often void of context.
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Legendary investors look to the future. They study the potential. Wrapping your brain around potential is a lot harder than analyzing an existing space. A mature sector like search advertising has a market that is relatively easy to measure. But, making a bet on an emerging space like “content marketing” requires non-traditional examination and a leap of faith.
“Smart investment choices require understanding the potential size and importance of the market category. We seek mission-driven founders who can build a great company and category at the same time,” Sequoia Capital partner Jim Goetz says. He should know. His early investment in WhatsApp turned into the $19 billion transaction heard around the world. Facebook didn’t just buy WhatsApp’s revenue, technology or its 450 million active users. Facebook wanted WhatsApp’s leading position in a strategic, massively growing new market called mobile messaging. The transaction was reported to be the largest acquisition in venture history.
All technology markets fall off over time. Understanding the growth prospects for mature companies starts with examining how much, if any, erosion they face.
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This is Dell’s problem. Server, desktop and laptop demand is stagnating. The companies leading new markets for cloud, smartphone and tablet are neutering their future. The same way the personal computer crushed the typewriter. That’s why Dell is pivoting to software and services. They are trying to access new potential because their current categories are eroding.
Traditionally, companies fight for market share within existing sectors. Think Coke vs. Pepsi or Eight Minute Abs vs. Seven Minute Abs. As new technologies create new markets, customers shift dollars from the old to the new.
Firms that currently dominate their sectors, such as SAP (SAP) and Oracle (ORCL), are staring at this demon now. Workday grew revenue over 71% last year, Salesforce.com (CRM) is now a $4 billion company, growing at over 30% with a market cap of $34 billion. Additionally, Dropbox, Box, ServiceNow, Netsuite and many more, continue to ascend. These new players are not competing with conventional weapons. They are driving customer spending away from on-premise apps to new cloud apps. As oxygen leaves the space, everyone suffocates.
This type of risk is the biggest threat technology companies face. As history shows, slow kills companies fast. The trick to understanding if the old leaders can grow again is examining how much erosion they face and how quickly they are pursuing new potential.
Big players always have outsized stock prices because potential plus execution equals a premium. This explains why Amazon’s (SAP) market cap is $155 billion with $75 billion in revenue, while Wal-Mart (WMT) is worth $245 billion on $476 billion in revenue. The tough question is what premium should high-growth companies that dominate their sectors have? Answering the question lies in what you believe about a given company’s strategy to make money off of their category potential.
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Tesla (TSLA) was founded 100 years after the Ford Motor Company (F). Today, Tesla has a market cap of $26 billion vs. Ford at $61 billion. How much potential do you think the electric car space has? According to Zachary Shahan, director of CleanTechnica, it’s growing at 300%.
“If the category is big enough and the category king is dominant enough, current valuation is almost irrelevant. The key to making investment decisions is understanding category potential and the ability of the category king to define, develop and dominate the space over time,” says Jason Maynard, managing director at Wells Fargo Securities.
As technology innovation accelerates so do new sectors. That opens new opportunities to make and lose money more quickly. Sector analysis should be as strategic as financial analysis if you want to make money in tech.
Christopher Lochhead, Dave Peterson, and Al Ramadan are co-founding partners at Play Bigger Advisors, a San Francisco-based firm that coaches technology executives to build market-leading companies. Follow us @playbiggeradv)
