Once again, spot on Denny.
There are different ways to approach analysis. To me, the “latest ER” is not the driver of my investment thesis, important yes, trend of the last few ERs is even more revealing, but I tend to put my focus elsewhere.
My focus is primarily on products and business models. I think there’s a world of difference between companies that are predominantly B2B v B2C (setting aside hybrids like AMZN, GOOG, MSFT with the best of both worlds).
Consumers are fickle. They are fickle because they are free to be so. As an individual, it’s pretty easy to say I can live without NFLX any longer. Businesses, not so much. Take ZS for example. Let’s assume that dreaded recession is upon us as it will inevitably come. If you’re the CIO are you going to shed your information security blanket as a cost cutting measure? Really? How do you explain that to you stakeholders when your information assets are pirated? Or worse yet, your IT infrastructure corrupted or paralyzed. Might you swap it out for a cheaper alternative? What’s the alternative? What are the costs of transition? How long will it take to migrate (assuming you’ve found an alternative)? Why is ZS taking on new customers in droves? Why have they spurned the consumer market?
And are there any costs to be recovered? Let’s say you bought a three year subscription in order to take advantage of pricing. That’s a sunk cost whether or not you use the product. You can’t transfer the subscription. Get a reimbursement for the unused portion of the subscription period? Maybe, depends on the contract, but probably not, or dimes on the dollar. It’s bought and paid for.
Even if it’s only a one year subscription, where are you in the cycle? Back to the transition time - what do you do between the time you terminate your subscription and implement the cheaper alternative? These things don’t happen overnight. Swapping out an embedded, mission critical s/w package is not simple. Think about what a rigmarole you go through to simply change a personal email address. Now try to fathom what an enterprise must go through in order to swap out a deeply integrated s/w package (or suite of products - land and expand). This is not just a matter of terminating a contract. I know, I’ve been there. The bigger the organization, the more difficult and costly it is. You may read a lot about how companies want to avoid “lock-in”. It’s all hype and BS. Anyone who has experience in a big IT shop will tell you lock-in comes with the product, whatever it is. If it’s not locked-in, then it’s not mission critical and should be avoided as an investment in the first place. Lock-in does not mean permanent, it’s just means complicated and costly to transition.
Over the course of my career we went from punched cards and primarily serial batch (yes, mounting tapes and all) to editors and VSAM (still serial batch, but got rid of the tape drives), to hierarchical DBMS (IMS), to mainframe relational (DB2), to UNIX distributed relational (Oracle). With every transition, there always remained a bunch of legacy stuff that had to be maintained. When I retired after 30 years the company still had some serial batch on VSAM running in production. I have a friend who was a partner in a consultancy firm. He had a job at one point where a major bank was paying him $1,500 an hour to revise some assembler code in order to achieve SOx compliance. It was cheaper than recoding in COBOL (which would have been the choice at the time).
When the company I worker for transitioned to distributed (I was a manager on the transition team) we demanded POSIX compliant UNIX (in order to avoid lock-in). Guess what? Every vendor had a POSIX compliant UNIX - with extensions (read lock-ins). Instruct your IT folks to avoid use of extensions, yeah, right. Are you nuts? I should write 50 lines of arcane code when I can get the job done with 5 lines . . . ain’t gonna happen. Same goes for vanilla SQL, same goes for every significant IT s/w product. If there are standards, you can bet that every major vendor had people on the standards committee. Yeah, I’ve been there too. And I didn’t even work at an IT product company, just a big customer with a vested interest in standards.
I don’t look for “sticky” products. I look for products (or better yet, product suites such as AYX) that become embedded and mission critical. The pain and cost of moving to a better mousetrap, should one emerge is a major deterrent. And “better” is always open for debate. I’ve seen it time and time again, when it comes to product functionality, competitors leapfrog one another. Company X offers some brand new features, 6 months later company Y has those features and a bunch more (and every new version comes with a new suite of bugs as well). And so forth. OTOH, products like ZS, AYX, NEWR and MDB (maybe, it’s a little peculiar) are in a class that make them almost immune to replication, default near monopolies as it were.
These companies (and similar) offer products that fill a void and are mission critical. That’s what makes these companies disruptive. Can they be disrupted themselves? Of course, but as we’ve seen over and over again, disruption does not happen overnight. That brings us back to the quarterly ERs. Is customer acquisition slowing? Are margins shrinking? Is revenue growth diminishing? What’s going on with the promoter score? How about cohort sales? One quarter, maybe there’s an explanation (we’ve heard most of them, 3rd quarter sales accelerated into 2nd quarter, blah, blah, blah). Really? OK, what happened in the 4th quarter?
And I’ve not really delved into the difference between selling widgets at a one-off price versus selling subscriptions to an intangible product. “Intangible?” You might ask. Let me relate a story from the early days of the space program. Weight is an important consideration for everything that flies. If it’s big, expensive and important there’s a group called Weights Engineering. Their job is to estimate everything that goes into the craft and where it goes. Their goal is to minimize weight and insure appropriate distribution of weight. So, a weights engineer was conversing with a software engineer (this is a true story). He was trying to get an estimate of how much the s/w weighs and where it would be on the spacecraft. The s/w engineer told him that s/w was weightless. The weights engineer was incredulous. We’re paying you guys to create something, it’s a thing, therefore it must have mass. A seemingly logical argument. They went round and round on this for a bit and finally the s/w engineer got an inspiration. He brought out a deck of punched cards that had the code for some program and showed it to the weights engineer. The weights engineer observed that the cards had mass, tell me how many cards you estimate will be required and where they go. The s/w engineer told him to look closely at a card, do you see the holes? That’s the s/w, not the card.
Saul has written extensively about this vital difference. If you make and sell widgets it doesn’t make any difference what they are. If you want to grow revenues, you must make and sell more widgets than you did previously, or sell them for an ever increasing price which is possible (NVDA) but difficult to achieve. Software, once developed is almost without cost with respect to replication (the downside being piracy). You can sell more and more of it with only the additional cost of packaging, training materials, etc., and even those costs are approaching zero as almost all of it is delivered in digital format over the internet. And then if sold on a subscription basis, the revenue becomes recurring rather than a one off (this harkens back to what I mentioned about the importance of the business model).
One more comment and I’ll bring this lengthy essay to a close. When folks show up on this board with dire warnings about the coming bear market and ensuing recession as they are prone to do upon occasion it always comes down to the same story. First, they pick the truly excruciating macro examples like 2000 and 2008. Then they always talk about extreme conditions, like if had bought XYZ at its peak and what kind of loss you would suffer at its nadir and how long it took to recover if you had held through the entire episode. Followed by “beware ye novice” (which is really meant to encompass everyone who follows a Saul like strategy of investing in growth companies), “this is your inevitable fate.”
I try to consider these warning objectively. I do worry about the impact of a bear market and recession. I’m not young anymore and unfortunately, time marches in only one direction. Have I reserved enough cash? How long, how deep might that recession be? I’ve paid off my mortgage, I own my cars, I carry no CC debt, but I did cosign my daughter’s school loans, MFA from Columbia, those are big loans - in deferment, I’m paying interest on them so that it won’t be capitalized (reverse compounding).
But it always comes down to this: I’m not invested in “the market.” I’m invested in a small number of companies. These companies have products that are likely to be in even greater demand during a general economic downturn as they provide measurable efficiencies and/or irreplaceable mission critical functionality to their customers. Yes, IT budgets get attacked during belt tightening exercises. Been there. But not mindlessly so, not these days anyway. Most hardware spend is easy to defer another 12 - 18 months, not so with mission critical s/w. It might be sign us up for another year (as opposed to 3 years), but abandonment is not too likely so long as the customer is viable.
What’s the alternative? Sit on cash and wait for the bottom to arrive? When will that happen? What’s the opportunity cost? Invest in a stalwart like Colgate? I use their toothpaste, could I get by with a cheaper generic brand if I had to - yup, easily. OTOH, what’s the cheaper, generic alternative to ZS? Incur the one-time capital outlay of buying a gaggle of appliances - what company is going to do that when cash conservation is critical? How about Pfizer? People literally can’t live without some of their products. OK, good point. But while politics is out of bounds on this board as a prudent investor you can’t ignore political ramifications irrespective of your affiliations. Pharmaceutical pricing is under attack. It’s not unlikely that a recession will bring some strict pricing regulation (we might get that even without a recession).
I’m certainly not as good as a lot of folks here when it comes to looking at sectors and even individual company analysis and all the rest. But I’m always hard pressed to think of where my investments would be safer and productive. These growth companies are volatile, I’ll grant you that. But I would argue volatility and risk, while related, are not equivalent. I don’t see any better strategy. I don’t see any better alternatives. I’m open to it, I just don’t see it.
