High growth & the path to profitability

Investment Analysis Clubs Saul’s Investing Discussions
1

Back towards the mid part of the year a lot of us were noticing that the search for growth was taking Saul and many of us towards investing in pre-profitable situations. At odds with the rules, guidelines and philosophies of the board’s growth investing in profitable situations driven by PEG type analysis and raising uncomfortable memories of the dotcom era.

This last set of quarterly results has helped ease my concerns and certainly re-assures me of the choices we are making.

If you consider the profit journey there are several critical milestones that certainly I look out for and track that provide useful progress markers on how companies are progressing.

Typically the journey might include the following generic stages (leaving aside pipeline industries like drug R&D and oil/gas/mining exploration):

  1. Hyper revenue growth with a lot of sclerotic at best or deteriorating metrics - (your classic dotcom era of burn rates where hope and fear are the investment strategies)

  2. High revenue growth rates with an improving set of metrics - (high risk investing based on belief that growth rates will continue to last out as metrics eventually turn positive)

  3. High revenue growth rates with improving metrics and trading in an operating cash flow or even better free cash flow positive position - (Lower risk of funding liquidity issues and a strong validation of sustainable business viability)

  4. High but potentially decelerating revenue growth rates reaching non-GAAP positive operating margin and positive non-GAAP net inc per share breakeven - (de-risking the stock but probably not yet growth at reasonable price)

  5. High but potentially decelerating revenue growth rates demonstrating operating leverage with outsized gains in non-GAAP net inc per share (low risk very high return wonder stocks that we are all looking for -

  6. High but potentially decelerating revenue growth rates reaching positive GAAP operating margin and GAAP net inc per share (Blue chip and accounting promised land type situations - CheckPoint, Microsoft, LGI Homes etc)

Let’s leave it there and not worry about low growth, high yield or decline situations which isn’t the focus of the board (IBM etc).

Ok what I’m pleased to see taking place in the Q3 and Q4 results is how so many of the higher risk, adventurous and pre-profitability Saul method stocks advancing through the stages - very encouraging for those of us worried about being left high and dry at the end of the bull run with a bunch of loss makers…

We have seen:

Moving from 1-2:
Talend

Moving from 2-3:
Box
Nutanix

Moving from 3-4:
Pure Storage
Shopify
Wix

Moving from 4-5:
Micron
Hubspot
Square

Moving from 5-6 and staying in 6 without growth deterioration:
LGI Homes
Arista Networks
Nvidia
The Trade Desk

There are probably others worth mentioning as well but these stand out to me.
Ant

56 Likes
2

There are probably others worth mentioning as well but these stand out to me.
Ant

Thanks Ant and interesting post.

The obvious question that derives from your 5 categories is “what, if any difference does it make as regards the investment return and risks”?

Let’s take a moment and look at each category and the stocks you listed. The YTD returns were:

Moving from 1-2:
Talend - 71%

Moving from 2-3:
Box - 33%
Nutanix - 30%

Moving from 3-4:
Pure Storage - 42%
Shopify - 115%
Wix - 13%

Moving from 4-5:
Micron - 95%
Hubspot - 57%
Square - 153%

Moving from 5-6 and staying in 6 without growth deterioration:
LGI Homes - 140%
Arista Networks - 121%
Nvidia - 77%
The Trade Desk - 67%

I suppose one could debate whether you placed them in the correct category and even whether these categories mean anything from an investment perspective.

At first glance though, at least for the year 2017, the data seems to favor buying stocks in later categories (move from 3 to 4 or later) as they have greater returns (and likely, although not revealed in the small dataset, would have a lower beta as well).

I mention this only because we have heard from a few posters on the NPI that one “Better get in early or you’ll miss the run”…and yet your categories don’t suggest that for this small dataset and single year’s return.

This does dovetail into the “Duma Rule” from 14 years ago and still true today IMO:

http://discussion.fool.com/the-duma-rule-20598973.aspx?sort=whol…

The technology Adoption LifeCycle (TALC) for any company rarely (if ever) tracks the Stock Adoption LifeCycle (SALC) particularly early in the adoption of any technology.

The high return investment may be made by:

  1. Being early in the SALC but before the reality of the TALC (Buckley Rule) in most companies.

  2. Being later in the SALC after the disillusionment of the slowness of the Buckley Rule becomes evident but for which there is compelling reason that the adoption will yet occur (post bubble burst).

  3. Being later in the TALC when it is much more clear that the technology is being truly adopted by the pragmatists

Understanding these three elements can assist in reducing risk and improving returns.

Anyway, thanks for posting this Ant…its a nice framework to ponder and perhaps you could cross post over at the NPI as well.

Best:
Duma

13 Likes
3

What you say is certainly true Anthonyms but in view of the monetary situation going into reverse in 2018, including the Fed. and the ECB withdrawing $1T of liquidity from the market while the Fed. also raises rates, I am continuing my strategy of a permanent cash reserve insurance policy of 25-30% (premium irritating, but ain’t that just always the way with insurance?) and more-than-usually heavy portfolio weightings in fewer high-quality companies.

I think your worry about ‘being left high and dry at the end of the bull run with a bunch of loss makers’ is a valid one as the market begins to alter its valuation multiples downwards just as comprehensively as it has done upwards in the last 8 years, while earnings also probably fall as a result too. Ah, the double whammy, so wonderful on the way up and so grievous on the way down. I will be badly affected too but with cash to average down while I fear the market will be ruthless to very-high-multiple companies without histories of fundamentals.

I have my bets on the horses too, SHOP, SQ, HUBS and one or two others but they are fun on the side.

2 Likes
4

Hi Stelna,
Would you care to qualify this statement a little more, “including the Fed. and the ECB withdrawing $1T of liquidity from the market”?

I am very interested in your opinion and would like to understand how you came up with the $1T value.

Thanks!

Noserider.

5

Regret I cannot remember where I saw it cited over the w/e, likely UK’s Telegraph Business section Sat. or Sun. or FT on Sat. incl. their Money supplement. However, no further detail was supplied I don’t think and I took it on trust.

6

Very late to this thread, which a put to the side to read later. Turns out to be much later…

Where would AMZN fit on this scale, a notable outlier for earnings?

7

Guys

I wanted to return to this in terms of framework to protect us from the eventual next down turn. Whilst this results season has continue to bring some terrific results and momentum along the path to profitability for our focus stocks - Alteryx being the ultimate standout in the crossover stakes, I wanted to keep an eye on potential concerns to watch out for.

For me there are probably 3 that stand out but I would love to hear how others are looking at this…

  1. The obvious one is failure to make progress on the bottom line despite high double digit revenue growth:-

Whilst there were a few companies that had very specific issues to deal with that could be forgiven for one off circumstances (Twilio and Uber or Mercadolibre and Venezuela), there were a couple that made me worry somewhat more either in the announced results or in terms of guidance:- Appian was one, Talend was another.

For me the one acceptable excuse would be when the bottom line fails to make progress but in reality, companies are lining up massive amounts of deferred revenue as well growing reported revenues and probably building a cushion of positive cashflow.

  1. The next is debt. This article today made me sit up and think that I have not being paying attention to the corporate debt situation… http://money.cnn.com/2018/02/26/investing/corporate-debt-ris….

I feel I need to get a better handle on high growth companies I am invested in and their debt levels. If we hit any acceleration in interest rate hikes and or a downturn happens faster than anticipated compromising any debt renegotiation/repricing etc then again I don’t want to be caught blind sided to it.

  1. Lastly is SBC. I don’t want to get into GAAP vs Non-GAAP and how to account for it but I do want to know how much dilution is taking place and where the worst offenders are. If companies are progressing or struggling along the path to profitability and are not getting their SBC under control, it can completely destroy stock holders’ value in the company. Think CREE think Twitter etc.

Whilst high growth tech companies do tend to use this more than most, some stand out to me to be particularly high.

I’m not in a funk right now or a glass half empty place however after last month’s volatility seeing how some companies have performed vs others I’m interested in eliminating unnecessary risks or at least being able to identify them. Anyone else keeping an eye on any other sources of investment risk in Saul method stock investing?

Ant

ps Very late to this thread, which a put to the side to read later. Turns out to be much later…
Where would AMZN fit on this scale, a notable outlier for earnings?
Sorry Kiplin - only just seen your post. I think Amazon is a complete rule breaker in so many ways but in one respect I would say that it is a combination of 2 companies… AWS which is probably at stage 6 and core ecommerce which is still at stage 1 or 2 being cross subsidised by AWS as it invests ahead of the curve to capture the future of everything online.
A

11 Likes
8

2) The next is debt. This article today made me sit up and think that I have not being paying attention to the corporate debt situation… http://money.cnn.com/2018/02/26/investing/corporate-debt-ris…

I feel I need to get a better handle on high growth companies I am invested in and their debt levels. If we hit any acceleration in interest rate hikes and or a downturn happens faster than anticipated compromising any debt renegotiation/repricing etc then again I don’t want to be caught blind sided to it.

Here’s another instance where looking at EV compared to market cap would provide a very quick insight.