Short Term, Long Term, and Circle of Competence

Investment Analysis Clubs Saul’s Investing Discussions
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When investing is easy and everything goes up (see May of this year and the following month or two), we sometimes forget how hard it can be. We’ve been reminded in August.

To me it’s a reminder how important it is to pick companies with a long term mindset. And I’m thinking specifically of durability/predictability…and which companies’ futures are least variable. I’m famously not a guy who thinks he can predict the future very well. But some companies surely have a higher likelihood of continuing to survive and thrive than others. Amazon probably isn’t going anywhere anytime soon, for instance. And I feel similarly about some SaaS companies, not necessarily because of the SaaS model, but because they are really pretty well tied to the cloud…example: I think Snowflake has an awful lot of sticking power.

But then there’s the short term. To me, this is equally important. Price is one factor that some of us consider, but even more important are growth trends, progress toward profits, customer growth, and a whole lot more.

Actually thinking back to Saul’s criteria for companies to invest in, some relate to the short term and others the long term: How I pick a company to invest in - #21 by PaulWBryant

When concentrating your portfolio (into large positions), I think it’s just critical to take a step back from every company, regardless of how exciting the short term seems, and consider the long term as well. This leads me to avoid companies outside my circle of competence. Some examples:

SMCI - hardware, small gross margin, cyclical? Just not in my wheelhouse.

UPST - There’s a TON outside their control that will decide their destiny. I have no idea what will happen with interest rates, lender sentiment, defaults, etc etc etc.

TMDX - I had a position but there is just so much outside their control, I think.

AEHR - Ok this one I’m not a hard “avoid” with. It’s my 4th largest position currently at just under 7%. But I feel I can’t make it a ton bigger even as the price falls, because I just don’t know what I don’t know here when it comes to semiconductors (specifically silicon carbide) and the market for testing them.

DUOL - Consumer tech has always been fraught. Their growth might currently look like that of some enterprise SaaS companies, but I worry it won’t last, and profitability will elude them. Look at Wix from 5+ years ago (and that actually had business users rather than straight up consumers). Maybe Duolingo will work, but it’s definitely outside my circle of competence.

Knowing what’s in your circle will probably help you predict the long term a little better. The point, to me, is that things outside the circle are REALLY a crap shoot, and that’s not what I want in investing. It’s important to know your limitations.

Hope some found this interesting. This is based on my experience over the last many years, seeing what works and where I’ve been bitten. I’d be interested to know if anyone else has had a different experience.

Bear

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Great post, Bear as always. Since my own Circle of Competence may be too small to cram a marble through, I only invest in companies where the CEO is a lifer in the industry. I look for three things 1) lifetime in the industry 2) obvious passion for industry 3) track record of excellence.

One stock I bungled was Stitch Fix. The founder/CEO said something in ball park of “I was in grad school looking for an industry to disrupt and I thought of a lot of different ones then landed on clothing.” Not good. Lots of others factors tanked the stock but I think a key factor was her lack of true passion for the industry.

TTD’s Jeff Green has been in the ad industry his entire career, talks with great passion about his vision for improving it, sold a previous ad-tech company to MSFT for good money and is widely admired thought leader.

ZS’s Jay Chaudry has long track record of success in security. And he worked with FSLY’s current CEO in the past to sell a security company to Motorola. Crowdstrike’s George Kurtz worked for McAfee for years and has spent his life in security. BILL’s CEO literally grew up in the back-office accounting industry, working as a kid with his dad in that space.

Small and maybe obvious thing but it helps at least widen my Circle of Competence in a way. FSLY was bungled early on by allowing basically a VC to be CEO. Sentinel One’s CEO did not come from security industry. Slootman may be exception to rule as elite hired gun but he gets pass for being ultra elite.

Bottom line to expand the circle, it helps to at least feel 100% certain CEO is an elite lifer in that space with enough competence for the two of us.

BD

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Nice post. I’ve had issues in the past where I purchased companies that I was not really interested in following (Upstart), too complex for me to easily follow (think lightspeed and all their acquisitions) or perhaps companies (StitchFix is an example) that were too cyclical or fragile in some way because I was pressing too hard for better returns.

I’ve tried to work on that. There’s a great book called “Hell Yeah or No” by Derek Sivers. If you feel anything less than “hell yeah!” about something, say no . We say yes too often. By saying no to almost everything, you leave space and time in your life to throw yourself completely into the few things that matter most.

If you are trying to own your best 8 or 10 ideas, I think this philosophy is good food for thought.

This year I started positions in Celsius (CELH) and Tesla (actually re-started) over some other companies, not just because I believe they are good companies but also because they are just plain fun to follow and I’m excited about what they are doing.

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@BroadwayDan
Good post, I fully agree. I freely admit, to a great extent I am a dilettante. I have many interests so I tend to know something about several different topics. I have a greater depth of knowledge about some topics as opposed to others, but I have always been a generalist rather than a specialist. Quite simply, I am hard pressed to identify my “wheelhouse.”

I think your criteria, “1) lifetime in the industry 2) obvious passion for industry 3) track record of excellence” provides a good strategy for someone like myself. I also think that it’s beneficial to consider the thoughts and actions of those who have exhibited a successful track record in their endeavours. I would hold up Saul as an example. While he repeatedly cautions that it’s not a good idea to mimic his portfolio positions, I think it’s similarly not a good idea to ignore them. Especially because he is so generous in explaining his rationale for most of his buy/sell actions.

I would add Gayne Erickson, CEO of Aehr to your list of CEOs, he is an “elite lifer in that space with enough competence for the two of us.” His entire career has been devoted to semiconductor test equipment. I am confident that Gayne’s competence far exceeds the two of us along with several others.

I would also posit that another thing to look for is the people that provide support and advice to the C-suite.

Bear mentioned it’s best to avoid companies that are exposed to external forces that have a significant influence which are also beyond the sphere of control of the C-suite. He provided Upstart as an example of a company in this situation.

I agree, the three founders of Upstart have tech backgrounds, none of them have much depth when it comes to the financial industry. If you compare Upstart with Pagaya you will quickly see that the two companies have a great deal in common. The two founders of Pagaya are techies with a background in the Israeli army (not to be scoffed at, the Israeli army strongly embraces information technology). Both companies offer AI decision making for commercial institutions that provide loans to the public.

But they differ significantly when you look at the business models that underpin their businesses. In addition, the board members of PGY constitute a who’s who of the finance industry. A former CEO of Amex has a seat on the board. Other members have a strong background in finance. I am confident that the reason PGY has a superior business model is due to the board.

Lending might be the second oldest business. Successful lenders understand how to deal with the external forces that influence their ability to make money. I recently had a profitable position in Upstart. I had the good fortune to close that position just a day before their stock price went south. I have taken a position in PGY. This decision was not based on my knowledge of banking. It was based largely on the opportunity provided by the lending business based on AI assisted decision making and the depth of knowledge (not to mention the one-on-one connections) of the people the founders had the good sense to employ in support and advise roles.

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Great post, Dan. And to clarify, by “circle of competence” I don’t mean that I really know anything about how to program software to run in the cloud. All I mean is, what businesses am I competent at evaluating? Airlines? NOPE. Insurance? NOPE. Biotech? NOPE. Banks? NOPE.

But asset-light, recurring revenue, high gross margin, high NRR, subscription businesses that have been able to grow at 30%+ even through a very difficult last couple years (and much faster before that)? Yeah, I think I have as good a handle on those as I can on anything.

I just thought that was an important clarification, because if we had to have mastery over any business we invest in, that would severely limit our choices!

Bear

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Bear, for a lot of us in the community asset light, recurring revenue, high GM/NRR, subscription businesses have been the standard because of how well we’ve done with them, prior to 2022. Yet SAAS really is a new class of businesses that didn’t exist prior to ~2015, and we’ve not been able to see if there are cycles in the industry.

Just playing devil’s advocate here, are you confident that it won’t turn out to be a cyclical industry as well, just one that we happened to jump into early and thus enjoyed quite a few years on the S curve? After all, none of us in the community would have thought that the SAAS companies we made so much money off of would suffer such severe declines in growth rates, to the point where +30% a year is now considered great. And it’s not just revenue growth, customer adds are down across the board. What’s going to allow these companies to continue to grow now that customers and spend per customer are both saturated or getting close to being saturated? Some members have posited they will benefit from AI, but it seems most AI efforts from these companies appear to be more talk and PR than converting AI related products into actual revenue. As you’ve pointed out that for several of the cohort, customer spending/NRR can only increase so much before they’ve had enough. What are your expectations for the long term with these companies? Do you think better macro will result in a reacceleration of growth and a revaluation of these companies?

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SaaS is a business model, not an industry.

I don’t know many enterprise SaaS companies where customers are completely “saturated.” Even the “old guard” companies like Salesforce and ServiceNow are still adding customers. And for my expectations, I also don’t know exactly what companies you mean, but I’ll answer for the ones I own (and SNOW, which I mentioned).

DDOG and SNOW - I believe these will reaccelerate a little. What’s more important is I believe they will grow for many years to come. Whether that’s 20% growth or 30%+ growth or possibly even more, the point is that there’s a price to buy them (especially since profits and FCF are already flowing). Considering I have a sub-1% position in DDOG and no position in SNOW, I don’t think the price is right on these currently.

ZS/CRWD - I lump these together because I think they have a slightly higher disruption risk than the first two, and so their multiples are both usually a smidge lower. At present I also expect 30% growth for these (with increasing profits), eventually decelerating some…but there’s a little doubt that growth will last as many years as SNOW’s or DDOG’s.

BILL / IOT - Maybe slightly more growth for these in the near term. For a while I expect ~40% revenue growth for IOT and 30-something for BILL. I think BILL still has zillions of potential customers. And I think Samsara has a lot of optionality, so I won’t try to guess a limit for their customer count either.

HCP - Similar possible acceleration to SNOW/DDOG with similar drivers. But they’re smaller so potentially still more room to grow and add customers.

PCOR / MNDY - I expect 30%+ growth or better for a while, but the future is murkier and I don’t know how many customers they can get, thus my positions in these will stay smallish.

OKTA - growth will be lower (15-20% maybe) but the price is right.

I hope this helps.

Bear

[edit] PS - I forgot Axon! Ha. It would have elements of higher levels of growth near term (like IOT and BILL), but maybe a more PCOR/MNDY level of “I’m not sure how big the TAM is” although I don’t see that being a problem for quite a while. But the best part is rapidly expanding profits while PE (and esp fwd PE) remains lower than most of the others above.

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So with the exception of IOT you’re expecting 20-30% growth, but with a long tail - that makes sense. Hopefully the market will re-rate these back upwards, for now as long as interest rates stay elevated (or maybe this is the new normal? who can say), profits and FCF seem to be much more of a focus from the market for the 20-30% growers.

To me the biggest issue in this environment for SaaS companies is that they need to find a way to cut their sales/marketing and R&D costs (believe much of this across the industry/business model is SBC related, and thus does not affect FCF tho does really hurt GAAP EPS), without it crushing their already tepid growth numbers. Having 60-90% GM doesn’t matter if you’re plowing the money into an ineffectual sales force/research department that’s not producing new products/revenue lines.

Should rates turn back, then we might see growth at all costs be back in vogue.

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I don’t think that’s an “issue” but rather, an opportunity. And it’s already happening. Yes growth is slowing some (it was always going to anyway), but look at BILL and MNDY for example – they went from negative net margins to 20%+ net margins in a few quarters’ time.

I 100% agree with you there.

Bear

PS – Thanks for the questions. I enjoyed the exercise of summing up my thoughts on each company earlier. It made me realize that I have more confidence in BILL than I thought. I had already taken advantage of the price yesterday to bump it back up to #1 in my portfolio (at about 16% or so right now). Not sure if I’ll go higher before earnings tomorrow afternoon, but I’ll sleep well tonight. :slight_smile:

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