Why my investing criteria have changed

Why my investing criteria have changed and evolved

A number of you have commented that my criteria for choosing stocks have changed and evolved over the years. This seems to have caused some perplexity and confusion. The questions you have especially asked are:

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 :grinning:)

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…. :grinning:…Well, I’m up 57.8% by the 13th of July this year.

I hope this helps.

Saul

PS - While many of us are up 40% to 70% so far this year,
the Dow is up 1.2%,
the S&P is up 4.4%,
the Russ is up 8.3%,
the IJS is up 8.7%,
the Nas is up 13.4%,

the five indexes average up 7.2% so far this year.
Compare that to my 58%, and to your own results. We are riding that revolution I was telling you about.

As I wrote in a previous post: There are still people who are anchored in the old world where suitable companies should be growing revenue at 5% or 10%… and 20% growth would be fantastic! They think we should be satisfied with an 8% total annual return from the S&P, and they are sure that our investing in companies growing at 56% with little if any current profit must be terribly risky! Then they are appalled and frustrated when our “terribly risky” portfolios don’t crash and burn, but keep rising instead, but as I said above, we are investing in a different world.

For Knowledgebase for this board,
please go to Post #17774, 17775 and 17776.
We had to post it in three parts this time.

A link to the Knowledgebase is also at the top of the Announcements column
that is on the right side of every page on this board

175 Likes

This time it’s different.

3 Likes

<<<PS - While many of us are up 40% to 70% so far this year,
the Dow is up 1.2%,
the S&P is up 4.4%,
the Russ is up 8.3%,
the IJS is up 8.7%,
the Nas is up 13.4%,>>>

“This time it is different”. I would suggest instead that you buy an index fund or some sort of general mutual fund, oh, since about 2011. Certainly, at some point again, “it will be different this time again.”

Am sorry, I hate cynics. The world is always changing, what is promising today will not be tomorrow.

Remember 3D printing? Wonder if you made any money in it? I did, and then I got out once I figured out there was no there, there, except for a few in two companies, one that GE bought out.

Suppose I should have just said, “this time it is different” when SHOP was selling for $3 billion marketcap and one of its biggest, yet mostly inferior rival was acquired for something like $2.7 billion by the idiotic and quite stupid Salesforce company that only has $10 billion in sales.

Quite the risk there given that I should ahve followed “this time is different”.

I am sorry, that is a pet peeve of mine. If you want to put out a platitude support it with facts. Not disdain and cynicism. That is worse than stupid campaign slogans like “change you can believe in,” or “I am for her,” or “make America great again.”

They say absolutely NOTHING and yet nobody cares to analyze what change? Why are you with her? What will you do to make America great again? One can put all their beliefs in each one, except for the one from H. Clinton that has to be the worst presidential campaign slogan in the history of this country, bar none, and I am serious.

Both Obama and Trump phrased their slogans to be about the voters, and what they wanted, Hillary phrased hers as to what she wanted, but I digress.

“This time it is different?” Different than what? How is it differnet? When will the difference be known? And what does it mean, “this time it is different” about all the great investing returns we have had? Should we go back in time and just say no, because “this time it is different?”

Perhaps it never happened, the build out of the Cloud Titans data centers that Arista created a new switching paradigm for? Perhaps it never happened, Nvidia’s evolution of the GPU to enable machine learning? Perhaps the move to the cloud is a silly form over function.

Do tell us, what the heck do you mean by “this time it is different?”

Apologies for my attitude, but yeah, I have an attitude about it. That phrase adds exactly ZERO to our discussion unless you can articulate what you mean and what it means to what investing steps we should take? Should we all go cash?

No, it is not all different. Investing is all about value creation. At this point in time there are two things that are foreseeable that can cause an economic ruckus (1) China having a real economic slow down, and (2) the international government debt numbers become unsustainable if interest rates rise too much.

Hey, that is actionable data, so please give us some to make your post useful.

With an attitude I admit, but too many of us work hard and contribute to this forum and I would like to know what that phrase means for what we should be doing now.

Thank you.

Tinker

21 Likes

Sorry, my curt post probably came off as snarky. I didn’t mean to be rude or disrespectful. Saul put a lot effort into his post with genuine consideration and reflection into why he’s changed course.

It just sounded like something ominous I’ve heard before. Can’t argue with the results at the moment though. Sincere good luck to us all!

3 Likes

My apologies for being a bit too harsh. It is understandable why we are a bit short on that topic. Told time and time again that we are lucky, or stupid, or whatever.

We do understand that there will be bull and bear markets. That we will need to adjust. That there is fake value and real value.

Salesforce.com, at 10 billion a year in revenue, has seldom had any profit, and yet it has and continues to create great economic value.

Despite my rather large profits in SHOP I did sell out materially before the top (in the $90 and low $100s) and moved on because I got to see more beneath he business model and the reliance on merchant numbers. I ran the numbers and to get where I want to go front he valuation old quality merchants in numbers at least 5x need to come on the platform and thrive.

That is why SHOP needs to become the Shopify Plus company. There is disagreeent on the merchant quality point here, which is great and investors who continued to hold made another 20-40% or so.

Point being, it is not like we do not intelligently examine our investments based upon real economic parameters. Value creation.

Ever see the books for Ted Turner in the early days of TBS? I did back at MBA school, appalling! Yet he was a first mover in an industry ready for disruption and like Elon Musk, with all the cynicism he made something huge out of it. I use to own Tesla stock. I do not now.

That was my only point. I have a similar discussion that has gotten a little more personal than it should, on possible future disruptive technologies to replace GPUs in AI. There is absolutely NOTHING commercially deployed that makes a difference (including the Google TPU) and the best the contributor comes up with is 3 to 5 years out. If we all were concerned about some vapor ware 3 to 5 years out we would never buy a Nvidia as an example. My point was I will worry when something starts to gain some commercial success, but before then, it is all talk.

So I apologize if it came off as too personal. I can get that way. It is my job in my other life and people love me for it. I should learn a bit more sensitivity.

I welcome alternative views (trust me, Duma has saved me at least 3x over the years from such things, and Mauser caused me (inadvertently on his part) to rethink 3D printing as I thought in more detail as to the specifics of the technology and thereby how its narrative could not be met. But ignorance can be very profitable until that point in time.

As such, I just find platitudes to be destructive to wealth creation, which is what this board is about.

With this apology I will stop the thread, I know it has gone on too far. Have to deal with panicked pups as we are having a bit of a thunderstorm here. Even as kids turn on you, women are indecipherable, the hound always needs you and gives back “until they pee in your hallway out of storm panic” - sigh.

Tinker

7 Likes

JLodie,

You said: “can’t argue with the results at the moment”.

I think you meant.

“Can’t argue with the results over the last 20 years”.

Saul has had legendary returns for far more than “a moment”. He and others have built a community teaching others to do the same.

Start reading and truly understanding the method and companies discussed here and it will be tough not to want to adjust your investing process. I changed mine.

8 Likes

You said: “can’t argue with the results at the moment”.

I think you meant.

“Can’t argue with the results over the last 20 years”.

That is quite an understatement. Average returns of 34% for 26 years. Multiply 1.34 times 1.34 and hit equals 24 more times. Then multiply that number by $10,000. That gives you the current value of every $10K invested 26 years ago. I don’t think anyone can name an investor with that kind of record because there probably isn’t one.

13 Likes

To what should we reasonably compare our results? As a quick 'n dirty solution, I use Salesforce (CRM). This big company is in the same field, is very well run and is much less risky. It might well buy some of the smallcap companies we invest in and pay a premium for them. They say elephants don’t gallop. So we should expect to do much better with our adventurous holdings and high turnover and hard work and maybe capital gains tax than CRM. CRM is up about 44% YTD.

You could add ADBE and MSFT to the behemoth mix and take an average. So ADBE is up about 46% YDT; not too shabby. MSFT is only up 22% YTD and drags the average of CRM, ADBE and MSFT down to 37% YTD.

So Saul’s results YTD (58%) continue to be outstanding and his effort worthwhile. Possibly not so much those who have trailed my comparators’ average badly. But here’s the thing: ADBE and MSFT, which I have bought and held for an unmodified long time, have hardly had a glance from me YTD. Both not so many months ago long ago came through my quality GARP screens - again.

When the bear roars, it is those I will hold.

7 Likes

To what should we reasonably compare our results?

I think about this too, Strelna, but I’m not sure there’s a good answer. Any “behemoth basket” you came up with would probably contain GOOG too, and it’s only up 14% YTD. I think all these efforts are a bit of Monday morning quarterbacking, though.

Seems pretty clear that we’re not going to have any trouble beating the S&P 500. But if you were “indexing,” that’s exactly the return you would get! So I don’t think it’s unfair to compare to that. We simply have to acknowledge that we’re taking on a lot more sector volatility and some company-specific risk. But you’d be doing that even if you bought a basket of behemoths. Heck, even buying the Nasdaq composite would assume more sector volatility than the market. Seriously, the bold phrase seems enough to qualify what we’re doing. To me, describing it as any more precarious than that just seems overblown and paranoid.

Again, as Saul said, he’s not changing the game, he just found something valuable – and the market is still catching up to that fact. I can boil the why down to a sentence: software is high-margin, and subscription business are steady. The confluence of those two factors (in SaaS) is creating a massive opportunity. In the future, there may be another. This one is good today.

Bear

20 Likes

Saul writes: 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.

Paul writes: I can boil the why down to a sentence: software is high-margin, and subscription business are steady. The confluence of those two factors (in SaaS) is creating a massive opportunity.

It’s not just any SaaS company, it’s specific SaaS companies.

It’s worth pointing out that “old” software companies like Adobe switched to a SaaS model about a decade ago. You can’t buy a copy of Photoshop for one price transaction and then use it forever anymore. And while some say that “saved” their business, Adobe hasn’t seen the kind of stock price growth that many on this board are seeing. Adobe is not growing its customer base nor its revenue at the rates that some of the companies discussed on this board are, so its stock price, while it has appreciated, hasn’t appreciated as much.

So, part of the equation is finding companies offering new products/services in new & growing markets. And competition for these new markets is pretty intense, so one must be nimble and recognize when a company isn’t

When Paul says:
…the market is still catching up…

I’d just insert a reminder that while many of these stocks are not profitable, that the stocks’ prices have risen is likely the market catching up with this board’s recommendations - and doing so within a few weeks to months in some cases. Since these are growing markets and technology innovation in this space is pretty intense, we must remain vigilant and nimble to recognize shifts early enough.

12 Likes

Adobe is not growing its customer base nor its revenue at the rates that some of the companies discussed on this board are, so its stock price, while it has appreciated, hasn’t appreciated as much.

?

52 week low was $144, today $256
last Q, sales up 24%, operating income up 39%
trailing cash flow is 15x trailing CapEx
unlike a lot of companies mentioned, ADBE is growing fast
and growing cash flow fast - exceptionally fast
and margins are expanding, not contracting
sure, they are facing the law of large numbers
but I’m not sure I get your point here

I mean, i get the land grab argument, but unless you are Amazon
and can have spiraling growth rates into other segments
there has to be a transition where growth rates are achieved with profitability
course, the deferred revenue argument and RSUs are what makes this all so challenging (from a traditional stodgy investor) cause it rightfully pumps up cash flow in the first case and does it more controversial in the 2nd (though watching SHOP do secondary offerings has to make you re-evaluate even this view)

Course, you can spend a lot of time and heartache wondering if
recurring revenue is recurring revenue, and wondering if the technology
is replaceable and can’t be circumvented, but what I’m learning from
Saul (among other things) is that if you just trust the numbers are the numbers
you can profit extremely well

8 Likes

Adobe is not growing its customer base nor its revenue at the rates that some of the companies discussed on this board are, so its stock price, while it has appreciated, hasn’t appreciated as much.

It seems to me that the difference is a combination of the product and the state of the market. With Photoshop, the market penetration was already very mature. With the companies that excite us here, there tends to be a huge potential TAM in relationship to the existing customer base. People who wanted photo editing software mostly already had Photoshop or one of its competitors. The SaaS model didn’t present any fundamental new capability except for continuous feature updates. The SaaS model was more or less revenue neutral for the customers who bought every new version when it came out, but was actually a disincentive for people like me who would only upgrade every three versions or so. For the companies that excite us here, the SaaS model is attractive to the customer because it sizes dynamically in response to usage, much as the cloud does for the underlying hardware. So, the customer is happy to be increasing spending because it means they are deriving increasing value. Moreover, since penetration is small relative to the TAM, it is possible for there to be tornadic growth for an extended period.

3 Likes

You bring up adobe, im curious, have all the one time purchases switched ver to suscription model by now? Or is growth still hidden???

Bear, that is exactly why the broad index is an inappropriate comparator. We are (now) investing in smallcap Saas. No index or ETF yet exists. So I use CRM. That is more revealing than the index, for example showing that we emphatically did not beat a valid benchmark by the wide margin indicated by an invalid one.

Adobe is not growing its customer base nor its revenue at the rates that some of the companies discussed on this board are, so its stock price, while it has appreciated, hasn’t appreciated as much.

I thought the same, except I also had a good position in it (~5%-6% of portfolio). Wasn’t sure the growth rate of the company was sufficient to justify the share price of around $150, so I sold. Bad decision in retrospect but with the run-up in price I haven’t been able justify it given “analyst” expectations for earnings in 2019 and my concerns as to how big their market might be.

I should re-assess with the upcoming earnings info and conference call.

Obviously, there is little value in worrying about owning “all” the great opportunities, but I definitely don’t like it when I miss one like this (selling before a big earnings jump). Shame on me.

Rob
Rule Breaker / Market Pass Home Fool & STMP/MTH Maintenance Coverage Fool
He is no fool who gives what he cannot keep to gain what he cannot lose.

You bring up adobe, im curious, have all the one time purchases switched ver to suscription
model by now? Or is growth still hidden???

Definitely not. I refuse to abandon the CS5 suite because it does 98% of what I need very well, and I am a cheap bas^#4rd that loves to see recurring revenue in the companies I invest in – as long as it isn’t coming from me.

That, and Lightroom still has an inferior workflow for photo processing, but it works awesome for the lay person that just needs to tag, resize and maybe do a one-click white balance correction.

That said, I’m sure I’m the exception, and I imagine that the majority have given up on such principled talk by now, especially those who need it for more professional reasons.

That said, I’m sure I’m the exception

You are not entirely alone. I am hanging on to my older version, even though I know there are some definitely cool features in newer versions because I simply can’t justify the subscription price by my current usage level. 5 years ago I was the photo editor for a small historical journal and did a lot of work on restoration of old photos … but with no budget. Today, the usage level just isn’t there. If I could still upgrade for a one-time cost, I might do that, but no way I am going to go to a subscription model.

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…

“The four most dangerous words in investing are: ‘this time it’s different.’”
—Sir John Templeton

🆁🅶🅱

3 Likes

Saul writes: 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…

RoyGeeBiv responds: “The four most dangerous words in investing are: ‘this time it’s different.’”
—Sir John Templeton

RGB’s response is a mis-application of Templeton’s words. Saul’s not saying The Market is different, he’s saying that there are new business models. And Saul’s right.

Here’s one element of proof:

I present to you a company whose stock price has tripled in a bit over 4 years - that’s a 30% CAGR. This is not a startup, it’s been around since the 1980s. Many, including myself, had written this company off as a potential investment a long time ago and didn’t bother to check back. They were a huge leader, both in market and stock appreciation, but as technology changed they didn’t keep up. They missed disruptions in the late 1990’s and early 21st century: in the web, mobile, tablets, etc. Trying to stay competitive, they bought companies, including one for Billions that they wrote off just a year later - major disasters.

Then in 2014 they appointed a new CEO, who changed the company’s emphasis to The Cloud, and has centered its business around subscription products with regularly recurring revenue. (link further down). Today, two-thirds of this company’s revenue is recurring, coming from subscriptions, which as Saul points out, are very sticky. As a side-effect, cash flow is way up, too.

So, this company has re-invented itself. As Saul says, the world changed, and this company was able to completely change its business model to reflect that new reality. Saul does concentrate on companies that didn’t exist before, but I bring up this company to show that even old dogs can learn to be competitive in this new environment - and shareholders of those companies have been rewarded.

The company?

Microsoft.

Read more here: https://www.cnbc.com/2018/07/17/how-microsoft-has-evolved-un…

Note that I’m not recommending an investment in MFST today. I don’t know if its streak will continue or not. I do know that Saul has discarded another old dog that is in the Cloud space, AMZN, as a potential investment today, but its AWS business is another example of how a company getting into this new business model is rewarding its sharehnolders (AMZN is hitting new all time highs just this past week, btw). Of course, Amazon arguably literally invented the Cloud model with AWS, and Microsoft jumped quickly on it with Azure.

Saul, given what you’ve said about not focusing on valuation or profits, can you tell us (again) why you don’t think AMZN was/is a good investment? I’m up 58% this year on AMZN alone. So, clearly, it ain’t just new/small companies that are benefitting from recurring revenue models.

6 Likes

Saul, given what you’ve said about not focusing on valuation or profits, can you tell us (again) why you don’t think AMZN was/is a good investment? I’m up 58% this year on AMZN alone. So, clearly, it ain’t just new/small companies that are benefitting from recurring revenue models.

Hi smorgasbord, I went back and looked and here’s what I wrote in my own notes at the time. I was canine:

“It’s not one that I can see tripling in price in the next few years, because of size… I’m also a little concerned about possible anti-trust action when they are publically feuding with the President, and when I see figures thrown around like 45% of all online commerce going through them. AWS, their cash producer, was totally dominant at first but now it’s having more and more competition from Microsoft and others…and they seem to have gone off and forgotten again about being profitable.”

I don’t see any of that which has really changed, but I wish you well with the investment. I buy everything I can from them.

Saul

4 Likes