Geez, MusiCali, this is no mystery. I placed the answer to your questions in the side-bar ages ago, but since you didn’t bother to read them, here they are again:
Why have I “abandoned” PE as my most important indicator of desirability for a stock, and
Why am I willing to invest in companies that are losing money.
Those are good and valid questions and they deserve a response. Please take into account in reading my response that I’m not a techie and some of my details may not be accurate. And above all, remember that this is just my opinion, the opinion of a non-techie.
After some reflection, I think I’d say that it isn’t so much that I have changed, but that the world has changed, and that the business models of the companies I invest in have changed. Companies like the ones I am currently investing in simply didn’t exist before. They have only emerged in the past few years.
There has been a revolution in the world of business, and especially in the world of software. As recently as four or five years ago, with the exception of perhaps one or two companies, a company selling software would sell a customer a perpetual license to use it. Then they’d charge for updates that the customer might have to install, and they’d charge for service, and they’d try to sell the customer a new updated version of the software in two or three or four years. The customer might decide to skip the next version and just wait for the one after if he’s happy with the current one. Think Microsoft and all those Microsoft Office and Word versions you had to buy. It was the same for big companies with their software.
This procedure was bad for both of them. It was terribly inconvenient for the software customer, and there was no visibility into the future for the company selling the software.
There was little if any recurring revenue. For an investor, encountering a growth company that had even a small percentage of its revenue recurring was a major find. The only companies that had most of their revenue recurring were slow or no-growth utility type companies. Think: the electric company!
There was little or no recurring revenue because the customer who bought a perpetual license for a version of the software this year might not buy an updated version for 4 or 5 years. All you had that was recurring revenue were service contracts, and not every customer took a service contract.
It was the same with dollar-based net retention rate. There was simply no such thing. You were essentially making a one-time sale with the hope of making another sale in a few years.
As an investor, PE and profit was all you had to go on (besides hope).
Finding a company that was growing revenue at 20% per year was great. NO companies had revenue growth of 40% to 60% on a regular basis. It was unheard of. It was something you couldn’t even imagine, except perhaps for a tiny company growing off a very small base, or as a one-time occurrence.
But then an incredible new world came along in which data, and Internet usage, and Cloud usage, and software usage, have all hit an inflection point and taken off, literally exploded in their usage. What these software companies are selling is actually needed by every company currently, in every field, whether it’s a bank, a grocery chain, an insurance company or an auto manufacturer. It’s not going to go away. Every company needs software now, needs the internet, needs a website, needs ecommerce of some sort, needs security against hacking, needs to be able to analyze and visualize data, to analyze customer patterns, needs… well you get the idea.
And something amazing called SaaS was developed. It stands for Software as a Service: Instead of selling the software on a perpetual license, you, the software company, lease the customer your software, and the customer makes monthly payments “forever.” You have visibility for the first time in your company’s life, and your customer doesn’t have the large upfront outlay of cash. These monthly payments you are getting are recurring revenue.
You can update your software monthly, weekly, or even daily using the Internet, which keeps your customer very happy and very hooked, and keeps him renewing his lease contract every three or so years. Your software becomes an integral and essential part of your customer’s business. You can sell the customer additional programs, with new bells and whistles that your R&D department just perfected, or sell to additional departments in the same customer company, and your revenue from this customer will be higher next year than it was this year (dollar-based net expansion rate). This is referred to as land and expand.
Because of increasing spend by existing customers, and because of increasingly high demand for what you are selling from new customers, you may see revenue grow by 40%, 50%, or 60% each year. This means that your revenue will quadruple or even quintuple in four years, or five at most.
Your margins rise with time because your monthly S&M charges for the recurring part of your revenue are miniscule compared to what you paid for the initial sale. You could make all your updates in the Cloud and it would be even cheaper, and cheaper for the customer too, as the customer doesn’t need to buy all that computer hardware.
This is still early innings. All companies out there need what you are selling but most of them don’t have what you are selling yet. You want to go all out and sign up as many of these companies as possible before credible competitors emerge on the scene. This means increasing S&M expense now. You know that while a dollar of S&M expense spent today is mostly expensed against your current earnings, it will bring in (expanding) revenue almost forever in the future. This incredible opportunity also means spending on R&D so you continue to have the best products to sell. But this is all new and greenfield, and the imperative is to sign up as many customers as you can, as rapidly as you reasonably can while still providing good service, and not worry about current profits.
Just think about this revolution for a minute. Every good-sized company now uses more and more software every year. They all want to be part of the cloud, they all need what our companies are selling, and most of them don’t have it yet. The opportunities are enormous, and once the software is incorporated in the customers business it becomes harder and harder to change providers… really a pain for the customer and a risk of all kinds of disruptions to their business if they tear it out, so they will need a really, really, good reason to change.
So our software companies have mostly recurring revenue, and not only recurring, but expanding recurring revenue as the old customers increase their spend (dollar-based net retention rate), and new customers sign on. This means that each year our software companies add lots of new recurring revenue. And they are growing at rates that will quadruple their revenue in four years. (Actually 50% compounded for four years will quintuple their revenue in four years, but I’m being conservative 
)
And that’s why I buy SaaS companies, that are growing revenue at rates I couldn’t have imagined a few years ago, and it’s why I don’t worry about them not making a profit now. My other criteria are still there: rapid revenue growth, recurring revenue, lack of debt, insider ownership, a moat, not capital intensive, not hardware, doing something really special, etc, etc, but I’m taking advantage of this new world.
People who are looking for conventional companies with PE’s of 15 or 20, and with 10% or 20% growth, are investing in the S&P and growing their portfolios at perhaps 12% per year, while we are growing at…. …Well, I’m up 57.8% by the 13th of July this year.
I hope this helps.
Saul
We are investing in a new model of enterprise: year after year very high growth, very high gross margin companies, whose revenue is almost all recurring, and largely locked in, and whose dollar-based net retention rates are greater than one, meaning that last years customers buy more this year than last year instead of having an attrition rate. I’ve never seen companies like this before. Have you?
Of course a company like this is worth higher EV/S and higher PE than the old model of fairly low revenue growth, with little or no visibility into what revenue that you could absolutely count on for next year!
Of course companies without security of revenue had to show a profit (PE) before we’d invest in them. Of course we pay more for a company where revenue is recurring. Of course rapidly growing revenue which has very high gross margins is worth more per dollar of present revenue (EV/S) than slower growing, non-countable on, and lower gross margin, revenue.
And don’t bother telling me they are not making any profit. Any company with 75%, 85% or 95% gross margins can make a profit whenever they decide to! All they need to do is slow down spending on grabbing every new customer they can grab while the grabbing is good. Personally, I’d rather they keep grabbing all those customers now, from whom revenue will keep growing for the indefinite future.
