What makes a company High Conviction.

I read Austin’s post on Herd Mentality (as many others did!) and it compelled me to do some self-introspection, because I think he was describing my mentality, at times. I certainly take notice when Saul does something, and pay attention to the “why”, and if it makes sense to me, I might follow his action. But this thought exercise also compelled me to review what makes a company High Conviction, for me, and if I might be missing out on some good investments because “my bar” is so high. Now this might be different for others, but it closely follows Saul’s criterion so other might benefit. I encourage other to consider what makes a High Conviction company for them,(in addition to “Saul owns it” :slight_smile: and share their findings.

The very first things I evaluate are: YoY revenue growth, the amount of recurring revenue as a % of the total, how much ARR is growing, and gross margin. If a prospective company’s revenue growth, ARR, and GM% aren’t greater than or in the ballpark of some of my High Conviction companies, I typically stop my evaluation. But this might be too restrictive and might result in me missing a great opportunity. Now I’m not suggesting that Saul’s criterion aren’t good: in fact, they are very good, and have been proven over time. I guess what I’m saying is that I need to look at the ranges at which I apply them.

For example, a friend suggested I take a closer look at Adobe (ADBE). First thing I looked at in the most recent quarterly was


YoY Revenue Growth:  22%  

this is somewhat below my other High Conviction companies, which have YoY Revenue Growth of >60% (CRWD, DDOG, NET, ZM)

ARR: around 75% of total rev ($9.6B/12.8B), growing at 24% YoY - this is good
GM%:  ~87%:  this is very good

So because their YoY growth wasn’t in the ball park of my other High Conviction companies, I stopped looking and told my friend why I wouldn’t be investing in Adobe because its YoY revenue growth didn’t excite me. Does this mean Adobe is a bad investment? Not at all, it’s just not a company I would invest in, as compared to my other High Conviction companies.

Same thing happened with Fiverr(FVRR)


YoY Rev growth:  82%:  

this is very good and not only in the ballpark but exceeds the YoY Revenue growth of my other High Conviction companies

ARR:  IMO, there is no recurring revenue in FVRR’s model. 

I know some may disagree but “repeat business” is not the same as the ARR that a company like CRWD enjoys, because FVRR needs to secure the business every time a user/customer places/accepts a job.

GM%:  83%:  this is very good

So I told my friends that while Fiverr has great YoY growth, their lack of ARR (by my definition), compels me to keep investing in my other High Conviction companies.

How about PTON?


YoY Rev Growth:  172% WOW!
Recurring Revenue %:  about 20%, lower than I typically like.
GM%:  about 48%, also lower than some of my other high conviction companies

So while PTON’s rev growth is amazing, I pass on PTON because of lower recurring revenue and lower GM% than I typically like, but it again got me wondering, “are my targets too limiting?”… Am I missing out on PTON because of this?

To help answer that, I looked at the stock prices for my high conviction companies and other companies that are not high conviction. I chose some relevant dates to compare (I won’t get into the dates I picked but most can figure it out by looking at the graphs of the companies). The summary of those results are below. Data is from the date listed as the starting point compared to today’s close (10/27/2020).


Top 5 Stock price growth since 3/16	Growth since 3/16
 LVGO 	                                      610%
 FVRR 	                                      577%
 FSLY 	                                      573%
 PTON 	                                      450%
 EXPI 	                                      433%

Now since very few of us would be able to time the dip on 3/16, I compared a few other “dips” and “highs”


Top 5 Stock price growth since 8/11	Growth since 8/11
 ZM 	                                      133%
 PTON 	                                       86%
 EXPI 	                                       60%
 NET 	                                       47%
 FVRR 	                                       42%

Top 5 Stock price growth since 9/8	Growth since 9/8
 NET 	                                       70%
 ZM 	                                       54%
 PTON 	                                       41%
 FVRR 	                                       39%
 TWLO 	                                       27%

Top 5 Stock price growth since 10/21	Growth since 10/21
 SHOP 	                                        6%
 BPRMF 	                                        5%
 ZM 	                                        5%
 LVGO 	                                        2%
 DDOG 	                                        2%

Top 5 Stock price growth since ATH	"Growth" since ATH
 LVGO 	                                       -3%
 MELI 	                                       -4%
 SHOP 	                                       -4%
 ZM 	                                       -8%
 BPRMF 	                                       -9%

What does this tell me? It tells me that while holding just my highest conviction companies has yielded excellent results, other companies that satisfy Saul’s criterion, but maybe not the “highest” (e.g. highest rev growth, highest ARR, largest GM%, etc.) in the list of companies also do well, and in some cases, do better than my highest criterion companies. Don’t get me wrong, this isn’t about beating the market or any mutual fund, because that’s almost a given. I’m talking about ringing out a few more % of return in your portfolio.

I think the lesson learned for me is to continue using Saul’s criterion to evaluate companies but maybe lower my range, say to include companies with revenue growth =40% (instead of 60%), GM% =50% (instead of +75%), and so on. It reminds me that winning the investment game is probably 2/3 objective evaluation (like using Saul’s criterion) and 1/3 intuition, which Saul has, but I do not.

For those interested, below is the data in its entirety. Stock prices rounded to the nearest dollar (sorry for the crappy formatting)


Comp 3/16 8/11 9/8 10/21 ATH(close) 10/27 Growth since 3/16 Growth8/11 Growth9/8 Growth10/21 Growth ATH
ZM  $108 $231 $351 $513   $583      $539 	399%	         133%	  54%	      5%	-8%
CRWD $33  $97 $126 $135   $153 	    $133 	303%	          37%	   6%	     -1%	-13%
DDOG $29  $76  $80  $99   $117 	    $101 	248%	          33%	  26%	      2%	-14%
NET  $16  $38  $33  $55    $62 	     $56 	250%	          47%	  70%	      2%	-10%
DOCU $72 $192 $206 $218   $269 	    $222 	208%	          16%	   8%	      2%	-17%
LVGO $20 $115 $123 $139   $147 	    $142 	610%	          23%	  15%	      2%	-3%
ADBE$286 $435 $462 $496   $534 	    $479 	67%	          10%	   4%	     -3%	-10%
BPRMF$15  $18  $19  $19    $22 	     $20 	33%	          11%	   5%	      5%	-9%
EXPI  $9  $30  $40  $48    $61 	     $48 	433%	          60%	  20%	      0%	-21%
FSLY  $11 $75  $81  $79   $129 	     $74 	573%	          -1%	  -9%	     -6%	-43%
FVRR  $22 $105 $107$161   $179 	    $149 	577%	          42%	  39%	     -7%	-17%
MDB   $99 $192 $211$249   $270 	    $244 	146%	          27%	  16%	     -2%	-10%
MELI $467$1101$1022$1,299 $1334   $1,282 	175%	          16%	  25%	     -1%	-4%
OKTA $96  $196 $197 $221  $247 	    $221 	130%	          13%	  12%	      0%	-11%
PTON $22  $65  $86  $121  $136 	    $121 	450%	          86%	  41%	      0%	-11%
SHOP 322  972  917  1022  1134	    1083	236%	          11%	  18%	      6%	-4%
TWLO $72  $244 $226 $299  $338 	    $286 	297%	          17%	  27%	     -4%	-15%
116 Likes

This is awesome Gary. Exactly the type of response I was hoping for with my post. I truly didn’t mean to insult anyone, only to encourage that we think for ourselves and evaluate our own behaviors/process.

Thanks for posting this.

8 Likes

I am really impressed by this reasoning, that’s exactly the framework I am trying to developing , I feel so grateful that I found this board and Saul has been so inspiring and generous about his time and knowledge, Believing it or not . I have read KB almost 7 /8 times now since I have found this board a month ago . The knowledge I learned from this board are so solid and rigid in terms of evaluating a business, it takes a lot of guessing and emotions out of this process. Now I have found myself exactly following those steps from this posts .
Just one small add to PTON , I did a preliminary assessment that their ARR would only grow in terms of percentage of total revenue. It’s like the bike is the trap , once a person has it, he would just subscribe the service year after year.

6 Likes

What makes a company High Conviction.

A defensible business with the highest economic impact on the world.

Zoom is a verb…
Healthcare is one fifth of US GDP
About one and a half billion cars in the world

A.K.A. TAM

Denny Schlesinger

6 Likes

This analysis suffers from lookback bias.

The stocks discussed on this board pass a hurdle to give you increased odds of future success. They also give you the conviction to hold during pullbacks.

On the other hand, you cannot explain why those stocks should have picked in March or on any other date.

On top of that, you haven’t looked at other stocks with similar metrics that tanked.

If you like, you should just list the stocks by momentum and follow the top 5 each month. You’ll get good (not Saul like) returns and you’ll have an explanation as to why your choosing them (because they are going up)… but you won’t be able to say why they are great companies.

4 Likes

Correction: meant look-ahead bias.

I think the lesson learned for me is to continue using Saul’s criterion to evaluate companies but maybe lower my range, say to include companies with revenue growth =40% (instead of 60%), GM% =50% (instead of +75%), and so on. It reminds me that winning the investment game is probably 2/3 objective evaluation (like using Saul’s criterion) and 1/3 intuition, which Saul has, but I do not.

A wonderful analysis and a valuable post. Thank you.

I came to similar conclusions via a different route which led me to starter positions in PTON,Fvrr, SE and U. I think that one should not dismiss out of hand good performance based on repeat business just because it is not recurring revenue. For example today’s report on FVRR shows continued strong revenue growth based in part on repeat business and new customers. eg rev +88% Y/Y driven by compounded growth increases in active buyers, spend per buyer and take rate. Y/Y rev growth for Q4 2020 has also been raised to 80%. Other reported numbers are also positive.

My intuition which counts for 1/3 more or less of a decision tells me we will see continued growth for PTON also for similar reasons.

Parenthetically I see the same dynamic in regard to SE which is posting pretty good numbers.

cheers

arnie.

2 Likes

Awesome post. It illustrates the majority of what I go through as well.

One key point I’d like to add is the balance between “keep it simple” and adding context to the numbers. Revenue is straight-forward, which is why it makes for such a great first glance. However, Gross margin needs context. What I mean is, you can’t always compare a few numbers in isolation between different kinds of companies. For example, NET can still have a healthy gross margin while being lower than DDOG because NET has some overhead DDOG doesn’t due to the type of business rather than doing something that hurts their business. …

  • On one hand the margin can just be a point to investigate to be sure it is reasonable, or to check a trend within the company itself, and that is good enough when other numbers are great.
  • On the other hand, one could dismiss this as a complexity that should warrant a pass because why should we have to know there is some extra overhead when other companies that are growing nicely don’t have the consideration at all?

I think both of these ways of approaching the numbers can be valid.

Peleton is an interesting one because it does represent a departure from the normal kinds of businesses I see invested in here.

  • It contains a large segment of non-subscription revenue.
  • There is a hardware-sales component
  • It is in fitness which gets a high fad-risk label.
    Peleton needed a bit of complexity in the context to win a spot in my portfolio. They are showing impressive revenue growth (or it wouldn’t have warranted a deeper look) while accelerating some other metrics using scale. The more people there are viewing content, the cheaper the content gets per-user and the retention rate means more users buying once and subscribing. As a percentage of revenue:
  • The cost of content goes down
  • The ratio of subscriptions goes up
    There is a network effect as well which is not a common point we list but is certainly front-of-mind (there was a good amount of time spent discussion this for Zoom, for example). Peleton may be the first serious Exercise-as-a-Service cloud company. A single class can have thousands of subscribers attending. There is no physical size limit, making the network effect a powerful growth factor.

With all of this needed to justify Peleton as an investment however, I could see why one might skip it entirely.

As Saul always says, you can’t own them all. How we get to the best ideas is a personal path we each must discover.

For my own personal growth, I’m focusing on leaning towards keeping things more simple without also over-simplifying and ignoring important factors - simple, but with eyes wide open. A focused portfolio is something I’ve always liked but that used to mean 15-25 investments and letting some organically take a larger spot over time. Now it means 7 or 8 with most concentrated in the top half, so I’m learning to use everything discussed in this thread to take more active action than I ever have before. For a long time I’ve had a mantra: Make the best decisions with the incomplete information available and remind myself this is what I did in the future when something looks like a mistake in hindsight. I think this just gets more important with a more focused portfolio.

17 Likes

Rafe: For example, NET can still have a healthy gross margin while being lower than DDOG because NET has some overhead DDOG doesn’t due to the type of business rather than doing something that hurts their business. …
- On one hand the margin can just be a point to investigate to be sure it is reasonable, or to check a trend within the company itself, and that is good enough when other numbers are great.
- On the other hand, one could dismiss this as a complexity that should warrant a pass because why should we have to know there is some extra overhead when other companies that are growing nicely don’t have the consideration at all?

Great thread guys. On this point if I can just add some flavour to what I might look out for, in this example, with NET’s margin trend. And why, for me, context is important.

First thing to note, is Cloudfare’s Gross Margin: 78%, 77%, 76% over the past 3 quarters. Very healthy already (for comparison with two of my other holdings the GM% in Q2 of Datadog was 79% and Zoom 71%). Let’s now compare it to a company in the same market, Fastly’s Gross Margin % (GM%) in the last three quarters: 57%, 57% and 60%. Cloudfare is now looking even more attractive.

Gross margin is a good indicator of future profitability. But let’s look at their operating margins too:


As a % of revenue                  Cloudfare            Fastly
**Sales and Marketing                   52%**              33%
**Research and Development              28%**            22%
General and Admin                     21%                 24%

What jumps out at you is Cloudfare’s significantly higher S&M expense and higher R&D. So you might ask why that is? And a story begins to form:

  • Cloudfare has a higher S&M expense because of its business model targeted at driving revenue through customer growth. Does it work? Cloudfare’s S&M expense as a % of revenue in the last 3 quarters: 56%, 51%, 52%, and its sequential revenue growth in the same period: +14%, +9%, +9%, and number of Enterprise customers’ YoY growth: +79%, 65%, +65%. A high level glance would suggest a clear correlation between S&M%, Enterprise customer and revenue growth. I like this, as it suggests to me an effective sales org. The story is beginning to make sense.

  • For comparison Fastly’s S&M% is increasing over the same period that Cloudfare’s is decreasing, as it tries to drive its Enterprise customer growth (which has been decelerating quarterly). There is less correlation between Fastly’s S&M expense and Enterpise customer growth than Cloudfare, suggesting either a less effective sales org or perhaps a slower sales cycle due to the size of their customers (an Amazon or Shopify would not be signed overnight).

  • So what about the higher R&D expense for Cloudfare? Well, we know they recently launched a slew of new products, which must have incurred significant R&D in prior quarters. Importantly they are doing something with their R&D. See Stocknovice’s breakdown of their new products here (https://discussion.fool.com/cloudflare39s-crushing-it-34646557.a…)

Adding it all up, what is the importance of this? Well to me, it suggests that Cloudfare has healthy gross margins and its operating margins are being used effectively - through both its sales org to drive revenue growth and through its R&D by releasing new products.

The bottom line (copying from one of my previous posts) - while Fastly’s losses as a % of revenue in Q2 of 19% appears at first glance appears better than Cloudfare’s 25%, Cloudfare has improved its losses as % of revenue from 40% in Q1 - while Fastly’s has stayed at 19% each quarter. This suggests that Cloudfare’s margin is more rapidly improving, evincing a clearer path to profitability perhaps.

Margin is just one element of a financial report but, in my opinion, it can help provide some context. And when you look at a trend, a story begins to form, which you can begin to look out for at the next earnings report.

36 Likes

nice post Gary. But if you demand very high gross margins you are probably limiting yourself to software companies. Which may or may not be good depending on sector rotations.

1 Like