I would venture that if it hadn’t been for the incredible forward pull of demand due to COVID, none of these companies would have seen 50%+ sustained growth for the time they did. They would have probably grown closer to 30% all along. Now if that IS true, looking for companies that grow 60% durably(!) is throwing the wrong anchor in my mind - a mirage. I am not saying we shouldn’t invest in 60% revenue growers, in fact, I am investing in some that do currently grow at this clip or even higher; what I am saying is that we shouldn’t have the expectation that they’ll continue to grow durably at this pace (as Bear rightly pointed out).
This brings me back to the second part of this discussion and whether our investing criteria have, or should change. I have two thoughts here:
First, what is the goal? Triple our portfolios in the next 12 months? Or outperform the S&P500 by 10% per year? Or outperform the S&P500 by 2% per year? Note, a consistent 2% annual outperformance over 20 years will roughly double your money compared to an underperforming investment. The spectrum of goals can be continuous where you try to outperform the S&P500 at the maximum rate that’s possible for a given amount of risk (and a given amount of time you have to tend to investing). Anyways, I think one’s individual goal will strongly affect the types and mix of companies to invest in AND the style/methodology of investing in those companies.
Second, and coming back to the growth rate question and what companies to invest in, and whether our investing criteria should change, let’s start with what I think is an universal truth:
The reason we invest in revenue growth is because we believe that this will eventually turn into profits and not only that, but that it will maximize the profits from now until “then”, compared to slower growing companies. Again, the spectrum of potential growth trajectories can be large. What is better, a company that grows 1000% YoY for a few months and then falls of a cliff or a company that grows at 30% for many years, or a company that grows at 15-20% for decades? Maybe one that starts higher at some point and very slowly decelerates? (and I am not talking about timing here; instead I am talking about the long term, meaning many many years and to decades, where I assume that taking our portfolio as a whole, we can be constantly investing in an “average” company that grows in such a way, even though individual companies can come and go in an out of the portfolio).
I don’t think there is a generally true answer as to which revenue growth rate trajectory of the scenarios layed out above will make more profits from now until “then”. It depends on each individual case (i.e. individual company) and our goal should be to pick the most successful ones. Or stack those 70-30 bets in our favor, as @Stocknovice likes to say.
Maybe there is a bit of universal truth in the idea that, at a constant valuation (P/S), a company growing revenues durably at x% YoY should give you a return of x% per year. And if the S&P500 returns 25% in a year, you should aim for x=30%. If the S&P500 returns 10% or 15%, maybe x=15% or x=20% is enough. And if revenue growth is not durable, but eventually decelerating (even if accelerating for a few quarters initially) maybe YoY revenue growth needs to be initially much much higher than 30% to continuously outperform the S&P. I just think predicting outperformance gets much harder if revenue growth isn’t somewhat durable or unpredictable.
So where does that leave us? I am not saying we shouldn’t look for new companies to invest in. In fact, I echo what @wpr101 said on the other thread,
I also think keeping an open mind goes both ways. How do we know that the top durably growing software companies are not (on average and whether they are new or not) going to outperform the S&P500 by a mile from now on? What I am saying in response to the question if our investing criteria should change, is that, at the most basic level, Saul’s investing style of looking for, and investing in companies (old or new), that will maximize future profits, shouldn’t change. And I think the 20-25% revenue growth, that @PaulWBryant thinks is not enough, is probably at the lower end of the range where, especially at 20%, durability over decades is needed to outperform the S&P500. Maybe those are all just opinions which can’t be proven one way or another, or only in hindsight, and everyone should make up their own mind… By the way, we had a similar discussion about what growth rates to look for, a little less than two years ago, here.
There is an additional nuance I want to bring for consideration. High revenue growth cannot be the only criterion, because it doesn’t guarantee those maximum future profits. And this is where software shines over (especially Capex heavy) hardware, because we have established tools and evaluation strategies that I think still work in the age of AI and will continue to do so. Looking for high gross margins and a clear trend towards improving profitability, we can make sure that those future profits will come. Can we even assess this with companies like Coreweave, Iren or Nebius? Or are all those mega deals they make with the Hyperscalers too obscure (financially) to properly evaluate with the information we have? How do we know that the Coreweave’s of the world don’t screw themselves long term with some deals that might look great on paper now, but are really unfavorable in the future? At which point are we just gambling when we invest in those companies (or stories)?
Lastly, @PaulWBryant brought up “the right price”:
I think this is a really really tough one. I am not saying that price doesn’t matter. But I think it is much harder to actually know what the right price for any company is. Yes, there are established valuation techniques, but how good are they really - especially in growth investment - where little changes of the input conditions to a discounted cash flow analysis can create enormous changes in the projected future cash flows? Take Cloudflare as an example of a company that has constantly been one of the top of the most expensive companies on Jamin Ball’s tracker. Clearly, two years ago, after revenue growth rates had dropped from previously 50% to 30% there was an argument that Cloudflare is totally overpriced and that argument even continued until a year ago when YoY revenue growth had continued to drop to 27%. And yet, Cloudflare stock has roughly doubled in the last two years (a ~40% CAGR) and at some points in the last two years it has even tripled (a ~70% CAGR). This just goes to show that I’d be at least very skeptical if someone tells me they think a growth company is overpriced at any given point. Even if that might be and definitely will be true in hindsight for some companies, how am I going to know this is true for sure right now?
-Ben