PREVIOUS POSTS IN THIS SERIES
Part 6: The Path to Scaled and Profitable
Part 5: Numbers into the Google Sheet
Part 3: Journalist Lawyer Scientist
This is Part 7 of the series on analyzing growth stocks. Here I will discuss the main four characteristics I consider before selecting which high growth companies to add to my portfolio. There’s a ton of information available for any given company so it’s crucial to decide what’s important and what’s not. This post is about explaining what I look for and why.
In this post, I won’t cover how I assess these four main characteristics or which specific metrics I track; I will cover the how in upcoming posts of this series. In fact, there isn’t a common set of metrics to consider for all companies. The importance of specific metrics will vary to some extent depending on the company and the company’s business model. As investors, we need to determine how to evaluate and judge each of the four characteristics.
Ultimately, ascending shareholder value is what most matters to investors. The primary determinant of shareholder value of a company will be the future stream of cash flows generated by the business. However, since most hyper growth companies are not yet profitable, it’s difficult to quantitatively predict future cash flows, so instead we’ll assess the company’s business based on the following four characteristics. These will provide us with a basis for predicting a company’s future success (i.e. business success and likely increased shareholder value will follow):
- continued future growth,
- profitability,
- domination within its market(s), and
- durability of competitive advantage.
Let’s look at each of the four characteristics one at a time.
FUTURE GROWTH
An important selection criterion for a high growth stock is a history of strong revenue growth. I usually don’t invest in companies that haven’t demonstrated strong revenue growth for the past two years (eight most recent quarters). This is the ticket for admission for a company to be considered for the portfolio. If a company isn’t already growing its top line very fast then an investor would be relying on a company to change from less than high growth to high growth. It’s a lot harder to select a company that will move from less than high growth to high growth than to select a company that merely needs to continue to do what it’s already doing! The first question one might ask is “what is considered high growth?”. Not too long ago, there weren’t a lot of companies that were growing revenue more than 30%. Nowadays, we have more companies that are growing much faster, so I currently look for companies that are growing revenue more than 50%. There’s nothing magical about 50%; if there were a lot of companies growing more than 70%, I’d raise the bar. Conversely, if there weren’t companies growing 50% then I’d look for companies growing 40%. The point is that I’m always looking for the best available companies.
The next question one might ask is “why is revenue growth so important?”. Revenue is really the important metric, but revenue growth means that there will be increasing amounts of revenue going forward. Growing revenue is not only a prerequisite for profitability but also a signal that the business probably has satisfied customers, good product-market fit, a working channel strategy, effective sales and marketing, etc., etc.
While past growth is a good (maybe the best) indicator for future growth, there are other indications of more growth to come. In future posts of this series, I’ll go into more detail about picking up clues that could foretell future revenue growth. These clues include some key performance indicators (KPIs) and other qualitative information. Again, this will all be discussed in future posts of this series.
PROFITABILITY (OR PATH TOWARD IT)
While the primary long-term financial goal of any for-profit enterprise is to increase shareholder value, returning capital back to investors is often highly desired. Hyper growth companies don’t show profits overnight, but the best businesses will eventually become highly profitable and generate increasing amounts of free cash flow (FCF). Hyper growth companies that don’t show progress toward profitability may never become self-funding and could continually require outside capital to continue to grow. Outside capital comes at a cost: either share dilution (equity financing) or debt financing. I prefer to invest in businesses that are either profitable or showing very strong indications that they are moving toward profitability. While the former may be safer investments, the latter will usually deliver higher returns to investors assuming that they manage to become profitable. Part 6 in this series provides in-depth coverage of how to monitor a company’s path toward profitability so I won’t repeat it in this post.
DOMINATION WITHIN ITS MARKET(S)
I have a strong preference to invest in companies that are dominating their target market(s). Ideally, these companies are the clear market leader and are taking net market share in large, existing markets by offering a new way (often via technology) of providing customers one or more benefits over legacy competitors. Thus, the dominant companies in which we seek to invest are offering customers differentiated products/services (i.e. differentiated from their competitors). So long as our disruptor company continues to provide the customer benefit(s) and maintains its differentiation, it should be able to maintain its dominance. As investors, we want to monitor the company and target market(s) to ensure that dominance remains intact.
COMPETITIVE ADVANTAGE DURABILITY
Domination in the target market(s) is a current state, and it says little about what will happen in the future. We want our portfolio companies to continue in their dominance. This will require a durable competitive advantage. A competitive advantage enables a company to maintain one or more benefits as well as differentiation relative to the competition. Differentiation is important, particularly when the company first introduces its products and/or services into its target market(s). Differentiation also enables preservation of pricing power which is important for maintaining the business’ gross margin and net profit. As the company realizes success and gains market share, it can build on its initially disruptive advantages by also leveraging its size to exert additional competitive advantages over smaller competitors that are attracted to the target market(s) in part because of our company’s proven success in those markets. Such additional competitive advantages may include first mover advantage, distribution channel advantage, reputation advantage, financial resource advantage, R&D resource advantage, and other advantages. In short, the more a company builds and develops its operational capabilities, gains customers, locks up key partnerships, builds product breadth and depth, and increases its spending budgets, the more difficult it will be for a smaller, potentially disruptive competitor to gain traction. It will also make it more costly for a small competitive to enter the market. In essence, our company can raise a bigger and bigger barrier to entry while also sucking the air away from smaller prospective upstarts.
Smaller disruptive competitors are not the only threat. Our company may also be threatened by legacy market participants (i.e. those that our company is disrupting) or mega corporations with their sights set on entering our company’s attractive market. Fortunately, legacy competitors are often faced with the innovator’s dilemma: a tendency to avoid disruptive products/services because they will also disrupt and cannibalize their own huge legacy business lines. Mega corporations usually, but not always, lack the same focus and nimbleness to develop truly competitive products/services.
It’s important to continuously monitor both our portfolio companies’ competitive position in their target market(s) as well as vulnerabilities to future disruption. In future posts in this series, I will explain how I do this.
SUMMARY
In this post, I’ve introduced the four characteristics that I expect my prospective growth companies to display before I’ll invest in them. I’ve also explained why these particular characteristics are important. Although I make occasional exceptions to this rule, I rarely buy companies that don’t have all four characteristics. Knowing what you’re seeking and why is the first step to making investment selections. For me, following this first step in the process allows me not only to find my best investments, but it also illuminates why I’m selecting them. This first step is also important because it provides me with the clarity to then properly select, evaluate, and track the metrics and information that are important for determining whether a stock initially fits (and continues to fit) my investment criteria. The next step in the process is choosing the actual metrics and information needed to inform that the four characteristics are intact. As I’ve mentioned previously, the metrics and information that’s relevant will vary from company to company. I’ll get into selection of specific metrics in future posts of this series.
The opinions, thoughts, analyses, stock selections, portfolio allocations, and other content is freely shared by GauchoRico. This information should not be taken as recommendations or advice. GauchoRico does not make recommendations and does not offer financial advice. Each person/investor is responsible for making and owning their own decisions, financial and otherwise.