Negative Space and Innovation
Lately, I've been thinking a lot about innovation because it's at the core of our investment philosophy. There are a lot of stocks out there. About 4,000 actually. The point of having an investment philosophy is to narrow down this universe so that you can create a circle of competence and gain an edge on the competition. Our edge is innovation. But we also think the best way to outperform is concentration. So how do we create a concentrated portfolio with companies that have high odds of failure and are part of highly competitive industries? To answer this question, let's start by inverting it. So here are the types of companies we prefer NOT to invest in. 1) Companies that are cheap on a trailing basis. We are always looking forward. The past already happened and if a company is truly cheap on a trailing basis, that likely means something is wrong. That also means that it has stopped growing. We prefer companies that are growing the topline quickly because the math makes sense. If a company has stopped growing, the way to outperformance is betting that the multiple has been beaten down too much. If a company is growing quickly, the way to make money is by betting that the growth will outrun the shrinking multiple. That's why companies with accelerating revenue do really well. They get the perk of the extra growth, coupled with a boost in the multiple. But to make it very simple, if a company grows the topline at 50% for a year, if the multiple holds (assuming no dilution), then you're left with a 50% return. Not too shabby! If the starting multiple is 10x, then let's figure out what the multiple can shrink to in order for you to get a 20% return. $100 sales $150 sales year 1 $1,000 valuation $1,200 valuation year 2 multiple 10 multiple year 2?? So all we have to do is divide $1,200 / 150 and we get 8. That means that you can get a 20% annual return if the multiple shrinks by 20%. This math is one of the reasons why we look for companies that are growing the topline quickly. 2) Companies that are not leaders. With big tailwinds, usually comes big competition. Rarely does a high growth industry have no competition. That’s the holy grail. However, in order to cope with competition, we look for companies that are emerging as leaders. In the digital age, economies of scale take the form of increasing returns. This means that a company who emerges as a leader, entrenches itself further. Take search engine optimization as an example. For a company who is driving a lot of traffic to its website, Google will give it a higher domain authority. This, in turn, will give it a higher position in search rankings which will further cement the domain authority, and the cycle continues. This takes place because of the economics that the internet provides. Since there are zero marginal costs, it doesn’t cost more for this scenario to take place. It works similarly with software. Since software has an interface and oftentimes it takes some training, companies that have mindshare with developers and IT professionals have increasing returns. When you buy an office chair, sure, you might stick with the brand you like, but it’s not like you need to be trained on how to use it. Ideally, the sub-industry contains very little competition, but in most cases, that’s not reality. Therefore, we prefer to invest in leaders because winners usually keep on winning. 3) Companies with “inserted” management “Inserted” means brought in from the outside to lead the company. While this is not an immediate disqualifier, we prefer to invest in founder led companies. This is because of incentives and passion. A founder of a company lives and breathes it. It takes up a good portion of their brain space. The company is their baby. On the other hand, when someone is brought into a company, though they may be passionate about the mission of the company, there likely isn’t the same level of attachment and care. There are obviously a few exceptions like if the inserted CEO has an amazing history of success. But, again, we prefer to latch ourselves onto CEOs that dream about their companies. Now we can get back to the topic of innovation and our final inversion point. 4) Companies that have only sustaining innovations Sustaining innovation is when the same product is made better. A good example of sustaining innovation is when Apple releases a new iPhone and it has a higher definition screen and more battery life. We prefer discontinuous innovations. These are innovations that completely change how something is done, typically driven by a platform shift (on-premise to cloud, desktop to mobile, etc.). The shift in platform enables a better customer value proposition on at least one vector. This doesn’t necessarily have to be price but it is probably the easiest example. For instance, Amazon and Netflix didn’t have the sunk costs of dealing with brick and mortar buildings. This allowed them to create a better customer experience as technology progressed. For some of our own examples, MongoDB’s NoSQL databases allow for more unstructured data to be stored. ZScaler gets rid of the need for hardware appliances. The Trade Desk’s platform changes the way ads are bought and sold. Our core positions in the portfolio are not sustaining innovations. Sure, you could make the argument that Alteryx is a sustaining innovation from Excel but you’d be missing the power of its software. It allows everyday people without a data science background to do complex analysis. Seems discontinuous to me. In an ideal situation, the discontinuous innovation would also be disruptive. The difference is that disruptive innovato get a foothold at the low end of the market and then move upmarket. Alteryx may be disrupting a $300k/year data scientist hire, but it is not a cheap product. This usually draws more competition because other companies see how enviable the economics are. So far, Alteryx’s 90% gross margins have not been scathed. The reason that we look for discontinuous first and then disruptive second is because disruption is difficult to foresee. It usually only becomes clear in hindsight and there are many counterexamples today. For instance, the iPhone wasn’t disruptive. It was a premium priced product. However, it was disruptive to the PC. What I’m getting at is that it can be difficult to know what a product is actually disrupting. Uber disrupted car ownership, not taxis. It was essentially a sustaining innovation for a taxi service. ZScaler is not disrupting firewalls, it is discontinuing them. It may seem like a trivial distinction, but it’s not. Disruptive technologies buy time for innovation. Netflix was disruptive and look how long they had before they had a serious competitor. It simply didn’t make sense for the competition to come down-market. It’s not like incumbent companies are stupid, they are actually too rational. MongoDB is disruptive and discontinuous. It is much cheaper than Oracle’s databases and it offers a new way to store data. Tesla is discontinuous but not disruptive because it started at the high end of the market. But the thing is, it is nearly impossible to be disruptive and not discontinuous if the business model remains roughly the same. This requires a huge amount of cheap funding. An example is WeWork. It’s disruptive because it started at the low end of the market but the concept is not discontinuous. The only reason that WeWork could happen is because of the gobs of money that were thrown at it from SoftBank and look how that’s turning out. The point is, you can’t really just lower the price and expect to outperform incumbent companies. You can if you have a vastly different way of running your business or you have a structural way to be the low cost operator. Otherwise, you won’t be profitable enough to survive. It’s no wonder why enterprise software companies migrate up-market. That’s where the real money is. Those are the most profitable targets. So that’s why we focus on discontinuous and not disruptive. Because disruptive can be difficult to predict and if it isn’t preceded by discontinuous, it can be a problem. Conclusion These four principles are crucial to how we break down the investable universe. But just like the companies in outbreaks portfolio, we will continue to iterate on and improve our own product, which is the research and investment philosophy.
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