A brief update on my positions and thoughts

A brief update on my positions and thoughts

I thought I’d write a brief update as I made some changes in my portfolio since my end of January summary.

First, in January I had sold out of my Mongo position. Here’s a synopsis of what I wrote:

MongoDB, had a very uncomfortable month, with Amazon entering the field as a competitor, and then Red Hat, representing the pure open-source point of view, attacking Mongo too, for trying to protect their open source model from being used for free as Amazon was doing, a veering away from pure open-source. I read all the positive opinions on Mongo which seemed very convincing, and all the negative opinions on Mongo, which also seemed very convincing, and decided, since I have zero technical knowledge to help me decide which is right, or if the truth is somewhere in-between, that Mongo was just too much of a battleground stock for me, and I sold out of part of my position, and then all of it…. I am in no way sure that I was correct in doing so. I may have been completely wrong. In fact the preponderance of evidence seemed to be that this could be even a positive for Mongo, and I know that they will have great results for their Jan quarter, but it made me worry about the long term viability of their open source business model… As I said, I simply have other companies without that kind of issue and existential worry. Again, I may be completely wrong but that’s what I did.

Well I decided I was wrong and bought back into Mongo these past two weeks, and I currently am up to a 3% position.

Second, Square. I wrote last month that it had been 2.6% of my portfolio at the end of December and was now (end of January) up to 4.7%. It’s now up to 5.3%, although the price has dropped from $78 to $72, as I have added significant amounts as my confidence has returned as they keep coming out with amazing new products, and the CEO has regained seriousness.

To get money for this I reduced Alteryx from 20% plus to 17% plus. (Having 0% in Mongo and 20% in Alteryx just didn’t make sense to me). I have no current plans to reduce Alteryx further. I also eliminated my speculative position in Guardant Health, feeling that I would rather speculate in little SaaS companies.

I added trivial amounts to my huge Twilio position and to my smaller Elastic and Nutanix positions. They are now 21.1%, 6.7% and 9.0% positions.

And as far as the EV/S question that worries so many people, I have to say I don’t have the answer to what is overvalued. I just know that:

Of course a company with 90% gross margins is worth a much higher EV/S ratio than a company with 30% or 40% gross margins because each million dollar of sales is worth so much more to the company.

Of course for a company with a subscription model and recurring revenue, and with a 125% net retention rate, each million dollar of sales is worth much more to the company, pretty much forever.

Of course a company consistently growing revenue at 50% to 70% is going to have EV/S ratios higher than were seen previously, because those growth rates weren’t seen before either.

And of course, of course, of course, companies with 80-90% gross margins AND a subscription model with recurring revenue AND 125% net retention rates AND growing revenue at 50% to 70% …are going to have very high EV/S rates (…duh), and I don’t know what is high, and I will never sell out just because the price has gone up. I don’t know where these guys will ultimately end up.

(Example: I bought Shopify originally at about $26 or something, and in a few months it was up over 70% !!! at $47. That’s clearly over-hyped and a SELL, right? No, I added, and eventually sold up over 400%, in two years.)

Just my thoughts.

Saul

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Of course for a company with a subscription model and recurring revenue, and with a 125% net retention rate, each million dollar of sales is worth much more to the company, pretty much forever.

The more I think about that point, the more it sings to me:

A company that makes a million dollar of software subscription revenue hasn’t just made it for this year. It’s made it for next year too, and the year after, and the year after that, etc, with probably as much certainty as you can ever have about anything in the business and investing world. And with a net retention rate well over 100%, you can only expect that million dollars to gradually increase each year. How do you put a EV/S value on that??? And how do you call it over-valued???

Saul

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How do you put a EV/S value on that??? And how do you call it over-valued???

Hey Saul, I generally agree that recurring revenue makes it easier to invest in, but maybe the criterion that gives a highly valued company a high EV/S is not that it has a subscription model, but how important it is the user?

I’ll use Abiomed as an example. No exactly “recurring revenue”, as they still have to re-sell product after each use, but its so important to hospitals that it becomes recurring, as you stated a few months ago. I know this argument is one of semantics, but I’d like to think that companies with a high EV/S are justified because they are mission critical to their users, not exactly because they have a subscription model or recurring revenue. That thinking helps me find companies like Abiomed and The Trade Desk that have different models, but are still great investments!

CloudAtlas

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How do you put a EV/S value on that??? And how do you call it over-valued???

Would 200 be too high?

Bear

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Would 200 be too high?

if they were growing at 300% per year with the potential to do that for a couple more years with 90% margins and recurring revenue…maybe not?

all depends on the circumstances

-mekong

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if they were growing at 300% per year with the potential to do that for a couple more years with 90% margins and recurring revenue…maybe not?

all depends on the circumstances

Exactly my point. All we can do is compare companies who are somewhat close on revenue growth rates, margins, etc. If you have two companies with 60% growth rates and 80% gross margins, and one has a EV/S of 15 and the other has an EV/S of 35…you should try to figure out why!

If you can’t figure out a pretty flagrant reason, then you can conclude that one is certainly valued more dearly than the other.

It doesn’t seem that debatable to me.

Bear

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The higher the valuation at the time of investment; the lower the subsequent investment return.

Example:

Company is growing revenue at 60% per annum and TTM revenue is $100

Company A’s revenue will compound at 35% over the next 5 years (growth rate has to slow with size)

After 5 years, Company A’s revenue will be $448.40

Today, Company A is trading at 20 times revenue (current market cap of $2,000) and in 5 years time, when growth slows down to just 30-35%, its valuation will also contract from 20 times revenue to say, 10 times revenue (future market cap of $4,480).

Under the above scenario, HALF of the future growth of Company A will be lost due to multiple compression. So, despite the fact that this business will grow like crazy over the next 5 years (35% CAGR), its shareholders’ capital will only grow by 17.5% CAGR.

Shareholders’ returns come from two sources - earnings/sales growth AND valuation expansion.

The best investment is one whereby business growth is strong and valuation expands over time.

When the current valuation is sky-high and the multiple contracts in the future, it acts as a headwind and reduces shareholders’ returns.

When valuations get extremely rich, then a stock can trade sideways for years/even drift lower whilst the business’ operating results catch up with the stock (company’s market cap).

This is exactly what transpired in the US between 1968-1982 and more recently from 2000-2013. During these periods, companies’ earnings continued to rise but their stock prices went nowhere.

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All,

A company that makes a million dollar of software subscription revenue hasn’t just made it for this year. It’s made it for next year too, and the year after, and the year after that, etc, with probably as much certainty as you can ever have about anything in the business and investing world.

Although SaaS has worked beyond great for most of us (myself included) in the past couple of years, I respectfully disagree. I never take future revenues for granted (and neither the continued growth), also not for SaaS companies. In times of crises, companies cut back on their licences and subscriptions, review how many employees really need to have access to specific software and which software is really needed at all, opt for lower priced or even free alternatives instead, put pressure on the prices they pay for the subscriptions, fire people which reduces the number of subscriptions etc. It has happened before and it is bound to happen again.

SaaS may be a great business model, but it’s not bullet proof. Just a thought for those who also want to keep an eye on the potential risks of their investments.

LNS

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Glad to have a lot healthy skepticism. Means we’re not at a top, and there are still plenty holding out.

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Saul,

I know from reading your Knowledgebase that you liked to use PEG ratios a lot in the past. I was always wondering what you think of the idea of calculating “hypothetical” PEG ratios? These have been brought up on the board in the past. Just to clarify what I mean:

Let’s assume a company has a forward PS ratio of 20. Despite being unprofitable today you could assume that this company will achieve 30% net margins in the future (because of gross margins in the high 80s, high retention rates, and a recurring revenue model). If you divide the PS of 20 by 0.3 (30% net margin) you get a hypothetical PE ratio of 66.67. If we also assume that the revenue growth rate will approximate income growth in the long-term we could now divide the hypothetical PE by the expected revenue growth rate for the next year and get our hypothetical PEG ratio. Now, if I remember correctly, according to Peter Lynch, a company with a PEG ratio below 1 is cheap, between 1 and 2 is somewhat “fairly priced” and above 2 is overvalued. So in my example, the company with high gross margins, high retention rates, that will potentially achieve 30% net margins in the future would be “fairly priced” between 33% and 67% revenue growth according to this slightly tweaked Lynchian frame-work. This would mean that many of our companies are not overvalued at all. But there are a lot of if’s involved as well.

Do you think it is helpful to make these assumptions/calculations or is it too far fetched? I know you don’t like to look at valuations nowadays and you are very confident in your stock holdings. However, since you used PEG ratios quite a lot and very successfully in the past, doesn’t this PEG-frame-work sometimes cross your mind when looking at these high-growth, still unprofitable companies?

Best
Niki

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In times of crises, companies cut back on their licences and subscriptions, review how many employees really need to have access to specific software and which software is really needed at all, opt for lower priced or even free alternatives instead

I 100% agree, which is why I place an emphasis on services that are absolutely critical to a business. I’d also place emphasis on services that actually save companies money or improve ROI, such as Zscaler and The Trade Desk, as they are less likely to be cut during bad times (though services like Zscaler could still reduced if the number of seats decrease).

All this is to say that there should be MANY factors that go into whether an investment is worth its valuation. Gross margins, growth rate, business model, insularity from macro events have all been mentioned so far as affecting business performance, and I’m sure other members would add to that list.

CloudAtlas

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This board doesn’t discuss valuations but the below study done on 17 MSCI Indices from 1979-2015 is quite telling -

https://www.starcapital.de/fileadmin/user_upload/files/publi…

This study’s conclusion -

“All indicators have in common that low valuations were followed by higher returns than high valuations”.

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Although SaaS has worked beyond great for most of us (myself included) in the past couple of years, I respectfully disagree. I never take future revenues for granted (and neither the continued growth), also not for SaaS companies. In times of crises, companies cut back on their licences and subscriptions, review how many employees really need to have access to specific software and which software is really needed at all, opt for lower priced or even free alternatives instead, put pressure on the prices they pay for the subscriptions, fire people which reduces the number of subscriptions etc. It has happened before and it is bound to happen again.

The future is uncertain but one has to make projections knowing full well that it won’t apply to every case every time – but it’s the way to bet.

Complex systems like the economy and the stock market don’t follow strict laws like physics but that does not mean they are lawless. Growth, for example, follows the “S” pattern. Wealth follows a Pareto Distribution. SaaS businesses have their own rules for growth (if not laws) based on CaC and LTV the latter which depends on churn rate. Sorting your SaaS positions by these metrics will tell you which to hold and which to sell.

Denny Schlesinger

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In times of crises, companies cut back on their licences and subscriptions […]

I spent 15 years working in tech, and saw this firsthand during the Great Recession.

The top-down directive was to comb through all licenses and subscriptions, and to re-negotiate or not renew contracts. And so mission critical software and services went without upgrades and support.

Granted, the world is changing to SaaS, and so it’s become harder to remove a SHOP or SQ when they’re an embedded lifeblood of your company.

So, during a recession, is the cup half full or half empty? It’s both.

Companies will take a hard look at their SaaS obligations, in order to cut costs.

But demand for SaaS will also go up, because that’s another way for companies to cut costs.

Chris

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A company that makes a million dollar of software subscription revenue hasn’t just made it for this year. It’s made it for next year too, and the year after, and the year after that, etc, with probably as much certainty as you can ever have about anything in the business and investing world. And with a net retention rate well over 100%, you can only expect that million dollars to gradually increase each year. How do you put a EV/S value on that??? And how do you call it over-valued???

Agree, though the present value of a future stream of payments is readily calculable.

🆁🅶🅱
wordlessly watching, he waits by the window and wonders…

“Granted, the world is changing to SaaS, and so it’s become harder to remove a SHOP or SQ when they’re an embedded lifeblood of your company.”

Important statement.

I own restaurants. In a down economy I’m not going to stop a needed service that saves us money like our credit card services. What’s the alternative? There is none.

If a better, less expensive service comes along, that’s the only reason we would change vendors and it has nothing to do with economic conditions.

That said, I’ve had a damn limit order in on SQ at 50 for seemingly weeks. Missed it by .30 this morning. So instead I just bought a third of a position right now.

The stocks we all follow on this board seemingly have been discovered after amazing returns in 2018, which always concerns me a bit. Once the heard starts jumping in are the best returns behind them.

Chris

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That said, I’ve had a damn limit order in on SQ at 50 for seemingly weeks. Missed it by .30 this morning.

Is that a typo at 50? This morning?

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“Is that a typo at 50? This morning?”

Yep, too many prices in my head. 70. Meant 70. :wink:

Chris

In times of crises, companies cut back on their licences and subscriptions, review how many employees really need to have access to specific software and which software is really needed at all, opt for lower priced or even free alternatives instead, put pressure on the prices they pay for the subscriptions, fire people which reduces the number of subscriptions etc. It has happened before and it is bound to happen again.

Agree on the comment re: people, and travel, etc., That stuff is easy to reduce cost on. But I’ll tell you this ---- cutting back on SaaS in a number of cases isn’t even an option. Our company has Workday and Salesforce.com. It doesn’t matter if we’re getting kicked in the teeth on sales ---- we still need to pay Workday and Salesforce.com. Thank you may I have another. They require that in their contracts. You can true down on # of licenses at end of contract (yes), but then your per seat costs goes up (not surprising).

Keep that in mind.

Yes your purchasing/sourcing teams can dial for dollars ---- yet good luck w that!

That said, I’m not sure how companies like ZS contracts look. Are they locked/loaded regardless of customer revenue/recession? Not sure. Maybe someone can answer that. That said, companies like ZS also reduce costs w things like high expense WAN ---- needless to say, big benefit in recessionary times.

TTD? Well, no true deferred revenue/contract requirement. Yet do you think that high ROI advertising is going to be used less when revenue is needed? No, not if it’s high ROI…

TWLO? Well, no true deferred revenue/contract requirement. Yet, are people going to communicate less w their customers and partners? Perhaps slightly, but that’s pushing it… I think an argument can be made for more communications during recessionary times (even w less employees).

Again, I’d value the other side of the coin to my thoughts, but i think SaaS is locked/loaded per contracts (regardless of customer revenue going down) and due to the core need/problems that our companies solve…

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Well I decided I was wrong
Probably that ability is one of the big keys to your success as an investor. Changing one’s mind is very hard to do for most of us, and the problem is compounded if you have made public statements about previous opinions.

You were also one on the earliest investors on MF to recognize there was something special about SaaS and the subscription model, pure genius.

One doesn’t need more than a couple of insights like this to develop a comfortable retirement fund.

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