Heller Letter

Some investment firms are starting to wake up to the advantages that software companies have. Heller House put out a letter to investors that talks about how they are finally realizing that cigar butt investing is not the way to go and they should focus on companies that benefit from the new economy where software companies have incredible opportunities. See link with some of the letter pasted in below:


Software is infinitely replicable and, through the internet, can be delivered at zero marginal cost. When a major input to business— distribution cost—goes to zero, entire industries get disrupted. When one can build a business model from the ground up with entirely new assumptions, one can attack incumbents in a way that is very difficult to defend.

We have good reasons for our shift in focus. First, I believe that the traditional “value investor” mentality of buying cheap securities, waiting for them to bounce back to “intrinsic value,” selling and moving onto the next opportunity, is flawed.

In today’s world of instant information and fast-paced innovation, cheap securities increasingly appear to be value traps; often they are companies ailing from technological disruption and long-term decline. This rapid recycling of capital also creates an enormous drag on our after-tax returns. In addition, by focusing on these opportunities, we incur enormous opportunity costs by not focusing instead on the tremendous opportunities created by the exceptional innovation S-curves we are currently witnessing.
There is another reason “cheap” is a poor proxy for value: the new business models I described above—SaaS in particular—are not well suited to traditional GAAP accounting. Here’s why: if distribution costs are zero, the optimal strategy is to gain as many customers or your software product, as quickly as possible. In digital businesses, there are increasing advantages to scale, and many of these companies operate in winner-take-all or winner-take- most markets. The name of the game is thus to build, grow, then monetize. Frequently, this means spending a lot of money in sales and marketing, which depresses reported earnings.
Thus, SaaS companies spend to acquire customers upfront, and recognize revenue from those customers over many years. This mismatch burdens the income statement. Some of the most successful—and highest performing stocks—in the SaaS world have spent many years growing despite producing no meaningful accounting profits. They are very profitable in terms of unit economics (as we’ll explain below), and once they stop reinvesting every dollar generated into further growth. The traditional method of screening for low P/E stocks doesn’t work in this scenario.

In the latest, sixth edition of the book Valuation, Measuring and Managing the Value of Companies by McKinsey & Company, the authors wrote, “We’ve found, empirically, that long-term revenue growth—particularly organic revenue growth—is the most important driver of shareholder returns for companies with high returns on capital. We’ve also found that investments in research and development (R&D) correlate powerfully with positive long-term shareholder returns.”

Growth works for companies with high returns on capital. (In lousy, low-return businesses, growth actually destroys value.) The internet has enabled two very interesting dynamics: huge growth (with zero distribution costs, companies can scale globally), and the use of very little capital (no expensive factories and stores to build). Internet-first businesses therefore score very highly in the high growth, high return on capital metric. And as the authors point out, this metric is highly correlated with attractive shareholder returns.

They also mention investments in R&D. Innovation and investment in the business is key. What’s the point of attracting the world’s best, brightest employees, showering them with stock options, only to deprive them of growth opportunities? Not only that, but competition—capitalism—will ensure that a stagnant company that isn’t constantly learning, growing and improving will no longer have a business in the future.

Yet most corporations are incapable of innovating because of misaligned incentives. I saw this first hand at this year’s Consumer Analyst’s Group of New York (CAGNY) conference, which hosts presentations by most of the world’s leading packaged goods companies, like Unilever, General Mills and Johnson & Johnson. The entire conference had a funereal atmosphere, with all executives complaining about “disruption” to their businesses, guiding to tepid revenue growth, and promising more cost cuts (anything to juice earnings).

While some of these companies pay lip service to innovation, overall they are run by management teams focused on keeping margins consistent and earnings per share growing or at least stable. True innovation requires pain; the reason is that innovation requires attacking new markets, and by definition, new markets cannot be analyzed (because they don’t yet exist). Most companies cannot stomach the short-term hit to earnings required for innovation because management incentives are not aligned. These managers are mercenaries; they’re in it for the money. Most management teams’ goals are to grow earnings per share over a certain number of years, collect their yearly bonuses (which are predicated on these metrics), and then retire with a golden parachute. As Charlie Munger said, show me the incentives, and I’ll show you the outcome. Incentives really matter, and when it comes to the majority of corporations, the incentives are at odds with those of long-term shareholders. The McKinsey book cited above notes that “in a survey of 400 chief financial officers, two Duke University professors found that fully 80 percent of the CFOs said they would reduce discretionary spending on potentially value-creating activities such as marketing and R&D in order to meet their short-term earnings targets.”

What advantages do truly innovative companies have? They tend to be run by missionaries, not mercenaries. Missionaries will do whatever it takes to reach their mission and are willing to experiment, disrupt their core businesses, invest for growth, and seek out new markets for expansion. Alphabet’s mission is to organize the world’s information and make it universally accessible and useful.

They also talk about how Benjamin Graham made most of his money on Geico, which was a growth company at the time with recurring revenue. Unfortunately he also focused on cigar butts, which ended up being the laggers of his portfolio.