Mid-Month Portfolio Update

[CMF_BigECat]

Hi Wot,
I understood what you were trying to do and hopefully nobody was offended. And I am not trying to offend Tamhas or anyone else, but I don’t think you were trying to simplify at all. Although some detractors who have come to the board occasionally have. In fact, you were doing the same thing that I have been doing for about 3 years. Which is trying to really understand what Saul does. To understand the “secret sauce”.

I have read the knowledgebase a number of times and in my opinion Saul’s portfolio management is constantly evolving. What was in the knowledgebase 3 years ago would not have led you to the SAAS companies. My guess is that in 3 years it will have evolved again.

Saul, I hope you were not offended by Wot’s Questions, I believe they were sincere. When I read your midmonth update I was also struck by how much discussion there was on stock price. There has been other months when you have almost scoffed at the idea of worrying about fast growing companies being too expensive.

But let me be clear, I am not trying to catch you in inconsistencies. I know the reasons are always different. I know it is very clear to you and I believe the ruthless part was dead on right. Your ability to zig and zag quickly astounds me, but then on other stocks you ride then for a couple years with no thought of selling. My belief is that you definitely use stock price movement as a discriminator as to whether your understanding is correct. That doesn’t mean that you don’t buy on the way down. But it does mean that if it kept going down you would question your beliefs a little harder and most probably eventually decide you were wrong and get out.

Having said all that, I will say watching you work has been both an incredible learning experience for me and fascinating at the same time. I know that I am a better investor than I was a couple years ago because of you.

I thank you for that…

Randy

[bashuzi]

Thanks Saul for the portfolio update and the detailed explanation as always. It’s always a great learning opportunity.

Of the holdings in your current portfolio, I feel ZM may have the most vulnerability. Its still very high valuation and what o believe to be relatively shallow moat, may make its price recovery longer than the other stocks.

ZS may have the greatest uncertainty a couple months ago due to its sales model, but since its price has almost halved, its reward to risk ratio is probably attractive at present.

I’m eagerly waiting for the new earning season. Should be more interesting than usual given that it’s the first one after the big “rotation”.

Bashuzi

[XMFBreakerTinker]

I agree with Saul on the Zscaler issue. If your holding and just adding, more likely than not Zscaler will fix its chasm crossing issues and be materially more valuable than it is now. Heck, even its minimal guidance is only 11% below my 2020 expectations. Thus even the guidance was not nearly as bad as it seems.

But there are companies out there with products that are over the chasm and sell themselves as Saul indicates. Elastic is one such company, but each to their own in regard.

We are not rooting for the home team here. Obviously I think a lot of Zscaler and may just stick with all I have (which is still up more than 50% in the last 12 months or so) but there is less execution risk with many other companies to weigh against.

Yeah though, I do think Zscaler will at least equal what Palo Alto did since 2012, which is quadruple. Their shares fell 45% or so roughly during the same period after becoming a public company as Zscaler’s now has (but still at a nice profit from the IPO). Palo Alto was an easier sale though as it is a continuous innovation. Buy our appliances and not old fashion firewalls.

Zscaler is much more disruptive and its growth potential judg d by he Wall of Worry is greater. Look at all the resistance a blow back from those who work in the industry. “If you take our firewalls from us we will be naked and our network destroyed.” That is clearly not true however. As this resistance loosens that WoW will be climbed. But hey, AYX has no such resistance just struggling to increase rate of diffusion of its solution through the industries. One thing that is quite impressive is how Alteryx is just starting to penetrate Fortune 2000 companies internationally (someone correct me but 50% of Fortune 2000 sales this Q was to international companies - a large runway there to maintain growth).

Risk/reward. Albeit there is a ton to like w Zscaler. Particular as they sell a greater percentage of new customers to Fortune 2000 and a larger percentage of sales are the full transformation package. This easily increases revenues per new customers. And if existing customers start to move transformational package upsell as well, Zscaler will blow away current FUD issues.

“If” sucks. That is the only current issue between a Zscaler and an Alteryx, as an example. Much smaller ifs.

Tinker

[XMFBreakerTinker]

Btw/ this said, my only real mistakes over the past 5 years were either (1) playing earnings or (2) selling companies (like SHOP - which I decided to sell w Arista and Nvidia (who had real reasons I sell) w out a real reason but simply boredom).

There is no fundamental reason to sell Zscaler. It is simply a presence issue based upon the size of the current “ifs”. So I understand Saul’s perspective. Doesn’t mean I will follow it (or maybe I will - but have not yet as I bought more) but it is excellent reasoning depending on your portfolio methodology and time frame.

Tinker

[XMFBreakerTinker]

I’m just in a compulsive mood. Whether reviewing televisions (don’t ask) or talking Zscaler.

One thing Zscaler has is a lot of people with no pecuniary interest in Zscaler talking about Zscaler. Whether GE, Microsoft, or even Palo Alto.

Cisco’s VP in charge of their cloud security offerings is on record stating that Zscaler is the leader and that both Zscaler and Cisco would be billion(s) dollar a year companies in this industry. He also mentioned that Bluecoat (now Symantec) might be as well (as a third wheel).

For whatever it is worth and whatever you take it for. For the most part - for me - doing “nothing” {as I define it} is the best thing I can do and doing something {again as I have defined it - has almost always cost me}.

So good discussion.

I would like to know if anyone has heard of or knows of a security job that NGFWs can do that will make the enterprise network (1) more secure, or (2) less expensive, or (3) less difficult to manage, or (4) provide better user experience than what Zscaler provides.

I’d be really interested to know of such a use case.

Tinker

[stocknovice]

BigECat: My belief is that you definitely use stock price movement as a discriminator as to whether your understanding is correct.

I can’t speak for Saul, but I do think that is a pretty good way to describe what a lot of folks seem to do around here. Most of us have seen the quote “In the short run the market is a voting machine, but in the long run it is a weighing machine.” I believe most on this board select stocks through the weighing lens (I know I try to at least). Purchases are made with the intent of investing rather than trading. When the underlying thesis is matched by increasing price – i.e. the voting matches the weighing – full steam ahead! However, when the price action falters or lags for a reasonable period, I tend to view that as the market telling me it’s time to double check my work. Especially when everything I own is moving one way, but something else is not (as Saul has recently encountered with ZM). I don’t always sell on that signal but will sometimes adjust an allocation or conviction level. For example, a lengthy price lag led me to exit PD but only trim TWLO.

I like it when what I believe is a market-beating company responds with a market-beating price. Otherwise, I’m simply gambling that I’m right and the entire rest of the market is wrong. One, I’m not good enough to make that bet very often. And two, there are enough good companies out there that I don’t really need to.

[BrianKnittel]

Great thread on both Saul’s methodology.

I watch what Saul does because he is successful and there is something to learn. I wouldn’t want to duplicate what he does, because I have my own ways of investing that I’ve honed over 2 and a half decades so I can only modify what I’m doing based upon what I am learning from what he is doing. IMO, the best thing Saul has done is to bring together a group of investors with a great deal of skill and to moderate the conversation to keep it productive.

And I expect to continue to see Saul make successful investment decisions that I don’t see a complete pattern for. Some of what he is doing appears intuitive based on the full knowledge base in his head from his experiences, a knowledge base that could never be completely written down, and that I will never fully understand. I’m OK with that.

Enjoy,
Brian

[tamhas]

Wot, please understand that my remark was intended to point to a general pattern, not specifically to you.

[SaulR80683]

Great discussion. I want to thank you all for it. It inspired me to look back at what I actually did with Zscaler and why, and when.

I’m busy today but I’ll have more for you tomorrow.

Best,

Saul

[SaulR80683]

However, when the price action falters or lags for a reasonable period, I tend to view that as the market telling me it’s time to double check my work. Especially when everything I own is moving one way, but something else is not (as Saul has recently encountered with Zoom).

I don’t buy explanation of negative price action blamed on lock-ups expiring two or three months from now. But the lock-up expiration ending this Tuesday, the day after tomorrow, explains last week’s divergence of Zoom from the rest of the SaaS companies totally, completely, and to my full satisfaction.

Of the holdings in your current portfolio, I feel Zoom may have the most vulnerability. Its still very high valuation and what I believe to be relatively shallow moat, may make its price recovery longer than the other stocks.

Sorry, but companies with “shallow moats”, “lots of competition”, “easy to commoditize”, etc SIMPLY DON’T:

Grow revenue at 96% last quarter

Especially with an annual revenue run rate at present of close to $600 million

Have gross margins of 82%

Have positive earnings while growing said revenue at 96% !!!

Have positive operating cash flow of $51 million last fiscal year, and $31 million just last quarter alone

Have positive free cash flow of $30 million last fiscal year, and $17 million just last quarter alone

Have customers growing at 78% last quarter and 466 customers over $100,000 ARR, which number grew at over 100% from a year ago

And have a net retention rate over 130% every quarter.

Sorry but those things just don’t happen with a shallow moat. Too many competitors would already be there.

Saul

[XMFBreakerTinker]

“Too many competitors would already be there.”

The competitors are already there - raised many times as to why Zoom does not have a moat - and yet here we are…

I think the CAP question is answered for Zoom.

Tinker

[SaulR80683]

The competitors are already there - raised many times as to why Zoom does not have a moat - and yet here we are… I think the CAP question is answered for Zoom.

Hi Tinker, Obviously the competitors can’t compete or Zoom wouldn’t be growing at 100%, and it would have to cut prices and have much lower gross and net margins, but could you explain what you mean by “the CAP question is answered for Zoom.” I couldn’t figure out what you meant to say.
Thanks
Saul

PS Just think about Zoom’s “Rule of 40” score. It must be well over 100 !!!

[XMFBreakerTinker]

Saul, I use the acronym CAP as short for competitive advantage period.

This is comprised of two elements: (1) magnitude of competitive moat, and (2) duration of competitive moat.

A very small degree of competitive advantage that lasts forever (as was Warren Buffett’s investing style) can be superior to a huge competitive advantage that will decline rapidly. The best of course is both magnitude and duration being large.

The stock market assumes competitive advantage falls to the mean as new competitors or alternative technologies enter the market. Companies with high CAP do not fall to the mean but tend to the extreme and thus is a rare company that violates this market assumption.

Therefore “overvalued” comments are based on the return to the mean assumption by the market without realizing this company is not normal. We do however and thus our advantage over the market who calls such “overvalued” companies market darlings as if it is simply a fluke.

The most descriptive example comes from Gary Alexander with his numerous GARVs (growth at reasonable value). Amongst these companies (and Gary has a huge and continuous track record in regard) is Nutanix, Talend, Cloudera, and Pure.

All can be used as textbook examples with Pure perhaps the GARV that may break out some day.

In any event each of those GARV stocks had smaller than usual multiples. This drew “value” investors who did not realize the smaller multiples related to smaller CAP. Thus, they really were not great values.

Whereas say an AYX or Mongo or ZS - even after market crashes remain “overvalued to extremely overvalued” as recent Seeking Alpha articles have referenced. They may be down but the market has not given up on their CAP.

Or to the gist a company with higher CAP will produce superior economic returns for longer periods of time than will the common company that reverts to the mean. Graphically the magnitude of the increase in returns can be massive as we are talking compounded superior returns over many years.

Hope that explains it ;). I get a little convoluted sometime as these things are dynamic concepts and not rigid orthodoxy and thus understanding the why is very important to understand why the concept is so important.

Needless to say a company line ZOOM is building a huge moat that is based on its platform and networking of people factors and not based on magic technology. Magic technology can usually be reproduced or commoditized, brilliant platforms that gain networking power much more valuable and lasting.

Mongo, OKTA, SHOP, AYX, MSFT and Cisco of yore are four present and two past examples of platform + network effect producing enormous CAP and thus enormous long term returns that no magic technology could touch as the power is in the platform and people network.

Tinker

[SaulR80683]

I use the acronym CAP as short for competitive advantage period…

Thanks Tinker, that description of how you use it was incredibly helpful.

And, since you mentioned Alteryx, two evenings ago my wife and I were at a New York Film Festival film and lo and behold, in the bathroom I ran into a young guy (to me, young means maybe 30 years old) wearing an Alteryx tee shirt from their recent conference. I asked him if he worked for Alteryx and he said “No, but I use it all the time.”… I asked if it was really as easy to use as they say, and he said “Oh Yes!” His company/group analyzes the data on Alteryx and uses Tableau for visualization. Interesting and reassuring getting a first hand anecdote about one of our companies.

Saul

[XMFALieberman]

Saul,

I was just doing whatever it took to get you to stop talking to me in the bathroom…

; )

That is EXACTLY how so many companies use Alteryx and Tableau together. It’s a great combo and the world is continuously generating more data.

Alteryx helps companies get the most value out of that data.

[brittlerock]

“If you take our firewalls from us we will be naked and our network destroyed.” That is clearly not true …

I find as my years into retirement advance, my long years of IT experience wane in value. The rapid change in technology is not just hard to keep up with, but my interest level in doing the same thing in retirement that I did for about 30 years just doesn’t hold my interest. BTW, Tinker, I assume your doing well as an attorney, but you would have made a fine IT guy as well. Your apparent grasp of the technology and implications is on a par with some of the best enterprise architects I’ve known.

But while the technology changes rapidly, other things have a tendency to stay the same. There is a hidden story in the little bit of your post that I think most people have missed. Let me rephrase it slightly: “If you take our firewalls from us we will be naked and our organization destroyed.” That is clearly true.

Therein is precisely the reason that Zscaler must be sold at the C-Suite. Management gains value and status based on the size of the organization under management. Budgets are in large part determined by the number of people under a given manager. Despite all the advances in technology, this bit of organizational reality has not changed. No manager willingly takes a fire ax to their organization. Take away all those appliances and network doodads required to “secure” the environment and reduce the threat level at the same time by so doing will not be done by the middle manager who is in charge of all that stuff and the people required in order to maintain it. I guarantee it. I was once a member of a very small team of managers that was charged with coordinating a major RIF (reduction in force) during a severe business downturn where I worked. In all my years of employment, in and out of management this was among the most stressful and truly irrational episodes I experienced.

BTW, I’m long ZS. I’ve not sold a share. But I pay a lot of attention to Saul’s portfolio and his rational for making changes. Just maybe being a non-techie has its advantages.

[SaulR80683]

Great discussion on a great thread. I want to thank you all for it. I said yesterday that it inspired me to look back at what I actually did with Zscaler and why, and when, and that I’d have it for you today. Here it is folks:

Zscaler hit its peak at about $89 in July. During that time it was about tied for my largest position with Alteryx at about 18%. As an aside, near the end of July, Wedbush raised its target for Zscaler, with the analyst citing the "massive tailwinds" in the cloud security products with growing momentum heading into the next 12 to 18 months, and saying that ZS has a “long runway ahead” and “a competitive moat that we view as very defensible.”

Over the next few weeks it drifted down with the market to about $82, but then, near the end of August, Zscaler suffered a large decline attributed to a negative article by a boutique analyst company, and I increased my number of shares at $72.50 even though it was one of my largest positions. I thought that that was a ridiculous response to an analyst article.

However, over the next two weeks, leading into earnings it continued to fall, with panic feeding into itself, so that five weeks ago it closed at $64 dollars. (This was down from a high of $89 remember.) Even excellent earnings didn’t help as the sell off in SaaS stocks in general hit, and Zscaler dropped in the next week to $47.50!!! It was down almost 47% from its high on no clear bad news at all.

I had not added since that purchase at $72.50 because I didn’t understand what was going on.
I knew that they had guided conservatively but all these companies do that so that they can beat.
I knew that they were encountering longer sales times with larger enterprises, but I knew that they had hired a superstar to take over sales and marketing motion.
I added a considerable amount at an average price of about $49 or so.

But then I reconsidered, and over the past four weeks I sold back more than twice the considerable amount that I had added at $49 dollars. Well why?

First of all, I do feel, as almost all unbiased commentators do, that the old firewall paradigm, as represented by Palo Alto, is obsolete.

The CEO of Palo Alto, the number one in security, making a huge point of crowing about how his company beat out Zscaler, a little company one-tenth the size of Palo Alto, in a few sales, shows how scared they are. Think about it! Why would a really dominant company even mention, or care about, beating out a little company a tenth their size, ordinarily? Unless they fear that the world thinks that that little company has a better product!

But now that the conventional security companies are aware of the threat to their very existence, they will fight tooth and nail, with lies, and false and distorted claims, and whatever they can, to hold on to the bulk of their business for as long as they can. Zscaler may take over a large part of the security world, but it definitely won’t do it overnight. It will be a long struggle.

Second, Zscaler was clearly worried about their lengthening sales cycles as the early adopters have been worked through and they have to sell to the C-level executives of larger enterprises, who may know nothing about security but will worry about changing everything they have, and may have IT departments worried about losing all their beloved hardware (and maybe their jobs, some of which will become unnecessary). Clearly Zscaler made the right move in hiring someone really competent in order to deal with this situation, but you don’t overhaul a sales process overnight. There may be a couple of disappointing quarterly reports before things pick up (or don’t pick up).

So here I am, with Zscaler, with a tailwind of inevitability, sure, but a company that is asking huge enterprises to revamp their entire security systems, and that has a lot of temporary obstacles in its path which may cause growth rates to diminish in the near term, like desperate large competitors, customer IT departments that don’t want to lose their jobs, and enterprise CEO’s who don’t really understand security… while I have other companies, growing like mad, and without these execution problems, so it made sense for me to reduce the size of my Zscaler position from huge to just large (and it is still a large position), and to use the cash to buy into companies like Coupa and Datadog. There isn’t any relationship at all to “momentum,” but rather it’s evaluating what is going on and acting on it.

I hope that this clarifies a bit,

Saul

[Diablito]

Saul,

thank you for sharing your thoughts, this is very helpful!

Inspired by your write-ups I initiated small starter positions in DataDog and Zoom, although I still have concerns mainly due to valuation. Here are some quick thoughts about these companies:

DataDog: Bought a small starter position at $34.96 today.
Reasons: Great growth, great profitability potential, and very efficient business model;
Bert wrote it up nicely, he thinks it’s a buy in the middle to high $20 (bought it a bit higher than that but who knows if it will ever pull back to the 20s); Saul likes it A LOT – he initiated a +7% position almost immediately (similar to Alteryx); even Gary Alexander likes it despite high valuation; Alex Clayton (IPO S-1 guy) wrote it up enthusiastically;
My concerns: high valuation (almost 40x TTM sales) and it looks like it’s competing in many highly competitive fields at the time; the competitive moat from a strategy view (7 Powers) is not quite clear to me yet; it’s a great software that customers love obviously (considering growth rates) and it’s easy to install and use instantly – but doesn’t that also mean that switching costs are not as high as usual with enterprise software? What if another competitor adopts the same „single pane of glass“ approach? What are the other sources of moat? Can their platform approach be described as disruptive? How are incumbents defending this? Is there an innovators dilemma, i.e. incumbents like New Relic, Splunk, etc. have something to lose if they adopt this platform approach?

Zoom: Bought a small starter position at $70,21 today.
Reasons: EVERYONE seems to love Zoom; financials are AMAZING; the market had some time to digest the valuation and it’s keeping its premium pretty nicely; maybe it sold off a bit also because of lock-up expiration; BIGGEST REASON: potential NETWORK EFFECT!!! This is huge I think; combined with growth + profitability potential + visionary founder leader makes this really exciting.
Concerns: Valuation and already high market cap of $19.5 bil; that’s really the only thing; not to belittle the importance of valuation – it is vital – but after thinking about it for quite some time I can’t really find any fault in the business and if valuation is the only concern it might be a rule breaking (and great) investment. If growth keeps up the valuation should look cheap in the rearview mirror in 2-3 years

My position sizes are still quite small (below 2% of my portfolio) because I still have to put the numbers into my numbers sheets and dive a bit deeper into the financials. Opening these positions should help motivate me to do so.

Thanks again Saul and all the other contributors!

Best,
Niki

[mauser96]

thanks Saul. You are so good at knowing when to sell

Crossing the chasm , switching from early adapters (who tend to be pre sold) to mainstream users is a particularly difficult task. These potential new customers tend to be like mainstream car or clothing buyers, they are not adventuresome, they will look around and see what their peers are doing. Many of them will have an attention span not extending much the next quarter or two, or to their impending retirement. Most are employees not founders Almost all will be under pressure from their own IT department , people they know and trust.
I look for “broken processes” , something in the company so screwed up that it demands attention, something known throughout the company ,up to the top levels. Present cyber security is bent but may not be completely broken. This is a key question for determining speed of the spread of ZS solutions
Furthermore finding and training sales people to deal with C level executives will take time. So I am prepared for the possibility of a few rough quarters. I won’t be increasing my ZS holdings, but I will hold on to what I have. Because I can see few things more inevitable than the switch from hardware to software in cyber security. It is the time span that is under question, and I have fewer insights into that.
On the bright side is the likelihood that longer sales cycles to bigger customers will also bring in larger deals. And if ZS works as well as I think, and is as easy to implement as I think, deployment inside the company will expand quickly.

[brittlerock]

Saul,
Just a little (possibly stale) insight on how big companies perform IT spend. Again, this goes back to my time in the business. I assume this is still true, but I don’t know for sure. It is also true for large companies, I don’t know if it also applies to mid-size and smaller firms.

There are two distinct approaches to spending money on IT products:

1. Routine maintenance: This is the spend required to keep the ship afloat on a daily basis. If the company is growing, new employees means new IT spend. For desktop products it is pretty much the same as office supplies. For network and data center it’s a step function. Networks, compute and storage are always designed with excess capacity or “headroom.” The headroom is intended to absorb sudden peak utilization and growth in utilization as a normal function of business. As utilization encroaches on the headroom, nominal capacity will be incrementally increased.

2. IT refresh: This occurs on a multi-year periodic basis. The cycle varies from company to company, but in general it’s every 3 to 5 years. In times of retraction a refresh may be delayed, but that’s unusual. In my 30 years in IT only once did I see a refresh delayed. And then it was only delayed for one annual budget cycle. A refresh is exactly what it sounds like it is. The entire IT environment is examined from top to bottom in light of new technologies. Entire segments of the hardware/software infrastructure may be replaced with newer, better and in the long-run (meaning 3 - 5 years) usually cheaper solutions.

The refresh cycle is most likely where Zscaler has the best opportunity to pick up new clients. Due to the size of the spend during a refresh, top executives, possibly including the CEO (but not usually) may need to be convinced that the decisions are the right ones.

Your point that these executives are usually not all that tech savvy is often true, but for the most part they aren’t stupid either (I’ve known a few notable exceptions). They may not get the arguments that prevail at the nittygritty level, but they certainly can understand the main points when presented in a succinct manner. They also understand the financials, the ROI and hockey stick (payback period). Of course, with security products, these factors can be very difficult to present. What’s the ROI of an averted breach? Mostly, with security products we’re talking about risk reduction. That’s difficult to quantify.

Enter the new Zscaler CRO (Chief Revenue Officer, if I have his title correct). So what does this guy bring to the table? I’ll start by saying I don’t know of him from my personal experience, I don’t know his background. But I think I can pretty well tell you his attributes despite the fact that I don’t know who he is.

First, he’s been in the business for a long time. He has a reputation of being a straight shooter. He does not trade in hyperbole. Second, he already has a number of personal contacts at the C level in quite a few companies who trust him and would be willing to introduce him to other C level executives. Third, he plays golf (and he’s good at it, good enough to know when to lose by a stroke or two). Fourth, he already knows the refresh cycle for a large number of big companies. He keeps track of these things.

So yes, it is safe to assume that the low hanging fruit has largely been harvested. Zscaler most likely would not have felt the need to recruit this guy if that weren’t true. How quickly can we expect him to have a positive effect on revenue. My guess is that he won’t have a long adjustment period.

He will do a quick assessment of the existing sales staff. Some guys (including managers) will be given notice pretty quickly. He will recruit people he already knows to be reliable and able to close sales at the executive level. This will include sales staff from Palo Alto and other Zscaler competitors. Sales people are not particularly loyal in my experience. They go where the money is to be made. Some of the best sales people are the ones that used to work for the competition. He’s not going to scour Linkdin for talent. He was hired not just because of who he is. He was equally hired because of who he knows. My guess is he will bring in some big, new clients within 6 months.