How I pick a company to invest in

This now 5-year old post of @SaulR80683’s rightly got over 200 rec’s. Some people feel Saul and others of us here have failed to adapt to the changing environment. I agree that in 2021 I didn’t know what to do. Everything was expensive…I still kind of think there was nowhere to turn…I mean we saw index funds drop 20% and 30% and more in 2022. Sure, you could have picked the perfect companies like Axon or Enphase that were actually up in 2022, but those were few and far between…I don’t think anyone made much money last year…we could have stemmed our losses better, but it was just a bad year for everyone. And in 2023 there are some companies performing phenomenally that I haven’t caught – but that’s nothing special. That will always be the case every year.

We all make many mistakes. That will happen every year too. Does that mean we should throw out the entire playbook? Come up with a style that’s brand new? Personally I believe a lot of Saul’s wisdom from 5 years ago still applies. Let’s examine:

No one talks about this, but I think it’s important. We don’t use screeners, or search penny stocks to find ideas. There are thousands of companies and then there’s crypto and etfs and bonds and all manner of things in which one can invest. We look for companies that are doing something special. Not “tickers.” More on the “special” below.

I mean, this will always be the north star. I know some look for value even in companies that aren’t growing. This is much, much harder in my experience. The price you pay is always an important part of any investment, but with a value investment, price is everything. With a company that’s growing and becoming more and more valuable, you have more margin for error.

This is another overlooked point. We’re not just looking for “SaaS” or software or tech or cloud. We’re looking for companies that are doing something special within these, and other areas. I still know little about the solar boom or the electric vehicle boom, but I can see that Enphase and Aehr have carved out niches. We’ll see going forward how they benefit from them.

Recurring revenue, as Saul says, is so important. But this is an interesting point on which we’re willing to be open minded – in other words, it’s not only subscription revenue, but anything that’s bought over and over. Example: I recently bought a look-see position (less than 1%) in Celsius, the energy drink. Is that recurring revenue? Well, kinda…it’s a consumable. They don’t have to find new customers to keep their sales at the same level as last quarter – they just need Celsius customers to continue to consume the same amount each month.

This is yet another underrated point. Sure, it’s been hard to find companies with improving metrics recently, but we can see the difference between the severe deterioration of SentinelOne’s numbers and something like Samsara. This can take some digging. Revenue growth isn’t exploding for many companies, but as one example, check out the last 5 quarters of net new $100k+ customers for Samsara:
91
92
124
124
138
…that’s a rapidly improving metric!

This we can be flexible on (it’s down at 6th for a reason), and in fact, I’m going to push back on this ever so slightly. Yes, I believe that the NRR is great if it’s 120-130 (at least in rapid growth times). Of course it’s nice when customers are spending more each year. However, I believe this can actually be a hazard if it’s in the 150+ range. That means sooooo much of the growth is coming from customers spending tons more each year, and there’s a limit to how long that can go on. In general, I’m down on consumption businesses…they’re great if they can drive revenue for customers, but if they’re a cost, I mean customers’ spend can only increase so much year after year. Once you get to a critical mass of customers (where the vast majority of your revenue is coming from already-ramped-up customers), consumption-based revenue can be a real headwind if customers find ways to spend less, or at least not spend more.

It’s so important to remember that asset-light companies in non-cyclical industries are free from at least some risks that other companies bear. Obviously we don’t limit ourselves to software companies only, but when we get into other areas, we need to be cognizant of the risk. This is one reason I’m not tempted by anything related to banking.

A lot of people believe (or try to sound like) they can pivot and predict every macro event and environment, or at least adapt to it seamlessly. It’s not true. This doesn’t mean we should stick our heads in the sand, but it does mean that we have to say maybe a lot. Maybe we can adapt to macro to our benefit (it’s also possible we could adapt wrongly and hurt ourselves). But “maybe” goes beyond macro…knowing what we don’t know is so important. Can we figure out which companies will benefit from AI? Maybe. Has it already been priced in? Maybe. Are we now in a bull market? Maybe. Does that mean our companies will do well? Maybe. I like how Saul doesn’t try to know the unknowable when it comes to external forces (macro). Focusing on companies makes sense, because their performance is measurable, and if they continue to do well long term, it usually works out for investors.

I like to revisit old posts like this sometimes, and I’m always thinking about what we do right and how we can improve. I’ve learned a lot from Saul and this board over the years, and I don’t want to forget these lessons.

Bear

161 Likes

Thank you, Bear for sharing your unique thoughts in such a great post.

Especially your thoughts on NRR are thought-provoking.

It feels so natural to think that more is always better with NRR, and in many cases, it is (like, customers either really love or need the product, use cases (demand) are growing, and the pressure to win new logos is smaller).

What is often over-looked, and tbh, I never really thought about it the way you did, is the high dependency of revenue growth on existing customers spending more and hence, having a company that’s more prone to cost optimization than many others. Additionally, the Sales (expansion) effort for NRR is probably also underestimated. We all know it’s an effort to win new customers, but esp. in tough times it’s equally hard to get existing customers to expand.

Personally, I think it’s fine to own consumption-based businesses with such a high NRR, if:

  • They have a very large TAM + runway to grow, and

  • New customer pipeline is healthy and contributes to growth and runway, and

  • The investor doesn’t mind sticking through optimization times owning such a stock (not blindly, ofc), and

  • The said investor is aware of the trade-offs of such a high NRR that you just pointed out - thanks again for bringing this thought up!

Cheers!

25 Likes

Thank you to Bear and Lisa for sharing your insights on this, dare I say relatively timeless post that encapsulates what Saul has so selflessly shared with us all.
The foundation of the post provides excellent metrics for those interested in creating their own personal investing checklist on Excel, etc.

Specifically, regarding Samsara (IOT), for which I am a shareholder, I have a bit of a concern about IOT’s revenue mix being comprised of 2/3 hardware and 1/3 software. I cannot help but compare IOT to another company that many of us on Saul’s board were invested a few years back, Alteryx (AYX). AYX had a revenue mix also comprised of hardware and software that the company worked to get off their financial statements, and yet IOT has a far larger mix of hardware than AYX did.
Although to the best of my knowledge, IOT does not have a consumption-based revenue model, it is not user based, rather it is priced based on the number of individual assets that are monitored daily, monthly and on an ongoing basis all year long. I would assume there is no or very limited “optimizing” of the assets that are monitored. To plagiarize Lisa’s point regarding investing in not being concerned about investing in user-based businesses with NRR, IOT has a
-Very large tam + runway to grow (which IOT has) and

  • New customer pipeline is healthy and contributes to growth and runway (which IOT has) and
    -The investor (me) doesn’t mind sticking through optimization times owning such a stock (which has not happened to IOT due to their ROI and payback period of months value proposition)
    -The said investor is aware of the trade-offs of such a high NRR as Bear pointed out
    Guessing others may share this concern re hardware revenue concentration. How do you and others feel about the revenue concentration of IOT’s hardware?
    sjo
14 Likes

sjo,

Where did you see this? Samsara’s TTM revenue is $714m and their ARR is $856m. Seems like pretty much all their revenue is recurring. It’s possible they could lease the hardware, but otherwise I don’t see any way their revenue could be 2/3 hardware and 1/3 software.

Bear

10 Likes

Bear,
My bad. I apologize for the confusion.

It was Aehr Testing (AEHR) that I confused with Samsara (IOT). I received this information from the William Blair Growth Stock Conference on 6/7/23 when I posted about the interview/presentation given by AEHR’s CEO Gayn Erickson.

In fact 2/3 of AEHR’s revenue comes from the equipment (testers and aligners) and 1/3 of the revenue comes from the consumable (die/cartridge) as stated by AEHR’s CEO.

That said, please substitute AEHR in lieu of IOT for the question referenced in my post earlier this afternoon. Again, I apologize for the confusion.

sjo

11 Likes

And wasn’t it Nutanix not Alteryx that was shifting hardware out of the revenue model.

Alteryx is software all the way.

Absolutely AEHR is an equipment company all the way and there is no escaping that.

Ant

6 Likes

1/3 of revenue recurring? That is actually more than I thought. Although yes, 2/3 is not.

I guess you have to realize this will not have a SaaS-type floor. If growth is just gonna be 30% or 40% YoY then I would say AEHR is overvalued. But I think the growth might be exploding to much higher rates.

And it’s already profitable, so that helps.

As you know, it’s a ~7% position for me. That’s about the most I can go, until we see the next report. There is some risk, as always, but I think the upside could be worth it.

Bear

16 Likes