Q1 2023 Letter
Thank you for your continued trust and support. I’m not happy with the fund’s performance over the first three quarters. Like we discussed last quarter, I’ve made too many mistakes. However, this quarter was truly a turning point in our investment process and I’ve never felt more excited for the future. I hesitate to dwell on short-term performance because we are truly focused on the long-term but I want you to know that it seriously weighs on me and I’m doing everything in my power to grow your investment.
The format of the last few letters has been a discussion of our philosophy and then an example of how we put it into practice. I’d like to continue that format for this letter. We’ve talked at great length about the three pillars of our strategy – investing in the fastest-growing, highest-quality companies at the best valuations we can find. I think it might be helpful to go through some of our criteria around quality and the checklist items we use. Refining this checklist and applying it to more than 600 companies in our database is one of the reasons I mentioned that this quarter was a turning point in our process.
Before jumping in, I’d like to point out that our checklists are directly related to our strategy pillars. We have one for the qualitative aspects of a company and one for the quantitative (growth/valuation). After all, the evidence needs to match the story! We create the portfolio by combining the two checklists and sorting the highest scorers. So let’s get right into it – here are the qualitative checklist items:
Large and growing market
Mission critical or consumer surplus?
Is it easily understandable?
Would I be proud?
Let’s go through these one at a time:
1. Founder/amazing management
At the end of the day, businesses are just groups of people providing value in exchange for dollars. We love founders or family-owned businesses because they usually have a lot of skin in the game; this business is their life’s work. Professional managers can share these characteristics but it’s not typically as common. The ideal manager for us is a founder that still has a large stake as that shows us they’ve been able to be prudent with the funds they raised or maybe they even bootstrapped the business. This could imply a strong product market fit or top-tier efficiency.
2. Competitive advantage
A good question to ask is: if an incredibly well-funded, focused competitor came in, could they replicate the core value prop of this company? Frameworks like switching costs, economies of scale, brand, culture, network effects, process power, etc. can be helpful but the essence of competitive advantage is power. The value proposition has to be so compelling that the other constituents are forced to interact with the company. It’s also helpful when advantages stack on top of each other, reinforcing the power the business has. A company like Apple might be a good example of this. It certainly has a strong, beloved brand. There are network effects with the developer ecosystem. More users mean that it is more attractive for an app developer to create something. There are also scale economies wherein Apple can push its weight around and get tight integration and bulk discounts with suppliers like TSMC. The switching costs are also quite high for an iPhone user – learning a new system, getting the eye-roll from friends when your green bubble pops up in group chats, and transferring your data and making sure it's compatible.
3. CAP trajectory
A company may not have a super strong current moat, but maybe they are getting stronger and stronger. This is where the competitive advantage period (CAP) trajectory comes into play. Are there signs that costs are coming down with scale? Are there hints of lower customer acquisition costs as the brand grows? Are retention rates actually improving as customers adopt more products, increasing switching costs and potentially, network effects? This is also very important for more mature companies. The direction of the CAP is key. I think we’ve seen this with Facebook/Meta over the past 5-ish years. The big blue app has been dwindling for a while and TikTok has taken quite a bit of share. The fact that a competitor could storm the scene in 5 years made investors a little more wary of the terminal assumptions implied in Facebook’s previous multiple. Maybe investors overshot to the downside, time will tell, but this drives home the importance of CAP trajectory.
4. Large and growing addressable market
High returns on capital coupled with a big reinvestment runway and a deep moat is the key to compounding. There are certainly riches in niches but if the company saturates its market, it can’t really grow besides increasing prices. The equation for revenue is price * quantity. If the business saturates the market, the only variable left is price. That’s the reason pricing power is crucial for a company with a big moat in a niche. The best companies constantly expand their market size as they venture into other areas. Amazon is the best example of this as it started as a book reseller but from early on, Bezos knew they would expand into other categories. And then, of course, AWS was completely unexpected. However, a large market alone is not a good enough reason to make an investment. The classic “if we only get 0.1% of the market, we’ll be a great company” pitch isn’t really convincing. Big markets also mean more competition. So there are upsides and downsides. However, a big market with tailwinds offsets some of the effects of competition. That’s why this criterion is a large and growing market.
5. Recurring revenue
Companies with recurring revenue have multiple advantages. For one, they can more easily predict demand. This enables them to hire efficiently, preparing for growth rather than overhiring when demand peaks. Two, customer acquisition costs are typically much lower in these businesses. Retaining a customer is so much cheaper than getting a new one and that plays right into companies with recurring revenue. Now, this doesn’t have to mean a software/subscription business. I would say that Starbucks has a certain degree of recurring revenue and maybe even Chipotle. Or a company like Pool Corp distributes chemicals and pool equipment to maintain pools, of which 80% is recurring.
6. Leader/limited competition
This is similar to the moat but a little different. A company like Datadog can still have quite a bit of competition but it’s the leader in the space which attracts some of the best employees and lowers its cost of capital. In short, there are benefits to being the leader. We love it when a company is in a growing space but has limited competition. A company like Airbnb might fit this description. Sure, VRBO exists but Airbnb is the behemoth that leads to more unique supply which leads to greater demand. Ideally, the company is a leader by default because it has no competition but more often, there are always competitors. I see this dynamic more in medical devices where a company is the sole provider of a particular type of device through FDA approval. Inspire Medical Systems is a good example of that.
7. Net cash position and free cash flow positive
These next two are pretty straightforward. First, I like to see a positive net cash position. Quite honestly, I’m not really looking for management to optimize the balance sheet. That’s more appropriate for companies with a super deep moat and few reinvestment opportunities. Ample cash is like slack in a system. Sometimes it’s healthy because it provides a cushion when unexpected things happen. For example, I’d much rather a company hold a bunch of extra cash on the balance sheet and then buy a big slug of stock in a huge sell-off rather than just systematically offset dilution. Likewise, it’s awfully hard to go out of business if you’re making cash and you don’t have any debt. In fact, it’s astoundingly hard to do! If we can chop off the left tail just like that, I’m all for it.
8. Diversified customer base and supply chain
Some companies, especially smaller companies, have very concentrated customer bases. For example, there is a small skin cancer company where 75% of revenue comes from one customer. It’s not the end of the world to have a big customer but it certainly increases the risk. What if the customer leaves? That’s a huge short-term risk! The stock could be down 50-70% in one day. Some companies have a few big customers but they are very ingrained in their business. Something like Taiwan Semi might be a decent example because Apple makes up a decent chunk of revenue but it’s a little far-fetched that Apple would in-source the manufacturing or use anyone else. So there is a bit of nuance here but watching out for concentration on both the customer and supplier side is very important.
Companies that make too many large acquisitions are riskier, in my opinion. Now, that isn’t always the case. Constellation Software or roll-up players like Transdigm have been some of the best-performing compounders of the last few decades. I do think there is a difference between a company that does big acquisitions and a company that is formed with the explicit intent to roll-up an industry through small acquisitions. I think the differentiator is decentralization. It’s tough to do a bunch of acquisitions and stay centralized. Salesforce might be a solid example of doing it well but there are many more companies that have fallen by the wayside because of empire-building (too many big acquisitions). If a company has done a lot of acquisitions, it makes me more nervous. Lightspeed or Teladoc could be examples of that. It’s not a hard and fast rule, but we pay attention to it in our risk score. One quick and dirty rule we look at is goodwill compared to the enterprise value. If it’s over 5%, we think we have the right to question management’s capital allocation a little bit. Just because management does a lot of acquisitions doesn’t mean they have wasted dollars. Constellation Software does hundreds of acquisitions per year but goodwill only makes up ~2% of its enterprise value.
10. Mission critical or consumer surplus
This is a very important dynamic but it’s an either/or question, though ideally the company has both characteristics. Both of these characteristics are pretty subjective but the idea is to think about them more deeply, not necessarily get the “perfect” scoring. Starting with mission critical, Salesforce would probably be a good example of getting deeply embedded into a company’s processes. Or an Oracle database would be an even better example. Migrating an entire database is not a simple task and it can be risky if things go wrong. Mission critical means that, once the product is being used, it’s not easily replaced since it serves such an important function. The next criteria is that the business provides a lot of consumer surplus. Costco is a perfect example here. They are intentionally not maximizing margins because they know that will maximize long-term profit dollars. The key phrase here is long-term. Management teams with short-term mindsets may try to maximize margins to juice earnings. But always providing more value than the alternatives increases customer loyalty and the odds that the business will perform well compared to competitors. Now, ideally, the company won’t have any competition but one sure way of keeping competitors at bay is providing so much value that customers can’t help but use the product or service.
As noted earlier, ideally the company can be both mission critical and provide consumer surplus. However, it’s something we look at together because it’s harder for consumer facing companies to be truly mission critical. A company like Uber is incredibly important but Lyft still exists (though it is currently being dominated) and taxis have improved quite a bit. There could be an argument that Uber is mission critical but I just use this example to say that it’s a little more difficult for consumer facing products because there tend to be lots of alternatives and low switching costs.
11. Is it understandable?
This has to do with both my own circle of competence and the business itself. Some businesses may very well be simple but I lack the sense to fully understand it. Others are just plain complicated. Either way, if I don’t deeply understand the crucial factors, I won’t know when I should change my mind.
Further, I’ve just noticed that if a company is making money in a very complicated way, there is typically some financial or lending component. For example, I just can’t quite figure out SunRun’s business. Maybe I’m not smart enough but I’d much rather focus on companies that are easily understandable. It helps me sleep at night and enables me to know when I should change my mind.
12. Would I be proud to be a shareholder?
Last but certainly not least, would I be proud to be a shareholder? I love this question because it gets at the heart of something very important – negative externalities. That’s just a fancy way of saying that something isn’t win-win. A company like Altria has plenty of negative externalities as smoking kills people. Plain and simple. Therefore, they face multiple headwinds. At the same time, Altria has been a great performer because it is highly addictive and they can just raise prices and buy back stock. However, I do think there are tailwinds to doing the right thing. Now, this is a very subjective question and some people invest using the inverse of this question. Companies like Warrior Met Coal and Altria are really cheap because people don’t want to own them and there is likely embedded alpha in those “unownable” companies. That’s fine but from a long-term perspective, I think we’re chopping off the right tail for things to go really right. Sure, these types of companies can continue to outperform, but we’re trying to zone-in on risk and I think negative externalities increase risk.
So those are the 12 main questions we reflect on to assess the quality of the business. This list certainly isn’t exhaustive but it helps us quickly sort companies so we can spend our time well.
There is quite a bit of nuance in these scores because the moat of Apple might be much deeper than the advantage that Crowdstrike has in endpoint security. So there is a magnitude in each of these questions – Bezos wouldn’t be put on the same level as an unproven founder (it’s not my place to name names!). Or Google’s financial strength is much different than a company that just put in its first quarter of free cash flow.
Lastly, very few companies can pass this checklist test with flying colors. Apple actually has one of the highest scores of any company I’ve looked at but even it doesn’t have a high degree of recurring revenue. Sure, you could make the argument that people upgrade their phones pretty often but that could also be delayed several years based on personal circumstances. The point is that there are always trade-offs with investing. This checklist is a start to understanding which trade-offs we’re going to make in the portfolio.
Now let’s look at a company in the portfolio that scores very well on the quality checklist.
Axon is most famous for popularizing the Taser. In fact, the company’s old ticker symbol was TASR, until it started expanding into new product categories and updated the ticker to AXON.
The founding story is quite unique. Rick Smith was at Harvard when two of his friends from high school were shot dead. While grieving, he wondered if there was a non-lethal weapon that could solve the problem of gun violence. He kept thinking about the idea and eventually found the inventor of the Taser, Jack Cover, to team up with. Mr. Cover was a NASA engineer and had been working on his idea for nearly 20 years by the time Rick Smith reached out. But the story goes back even further. Some of Jack Cover’s inspiration was a 1911 children’s book called Tom Swift’s Electric Rifle (TSER – Mr. Cover later added an “A” to the name). Rick Smith and his brother, Tom, set out, with the help of Jack Cover, to improve the Taser in 1993. The original Taser actually used gunpowder so it was officially labeled a firearm which really depressed sales. So the Smiths decided to use compressed nitrogen and sales eventually took off. One early marketing stunt the company did was to pay cops to teach citizens how to use Tasers and thereby sell more devices. Now, Tasers account for just under 50% of the company’s $1.2 billion in revenue and the new Taser 10 should be released here pretty soon. As mentioned, for 24 years the company was named Taser International, but it rebranded in 2017 to Axon. Over the past decade, Axon has diversified its business and now the overarching mission is to protect life. In fact, Rick Smith set out a moonshot goal to decrease the number of police related deaths by 50% over the next decade.
One of the main products that Axon offers is body-worn cameras for law enforcement officers. These cameras are designed to record video and audio of interactions between officers and the public, which can be used for evidence in criminal cases and to improve officer training and accountability. A key feature of Axon's body-worn camera system is its cloud-based storage and management platform, Evidence.com. This platform allows agencies to securely store and manage their video and audio evidence, as well as other types of digital evidence such as documents and photos. Evidence.com also includes a range of tools and features for analyzing and organizing evidence, including redaction tools and automatic tagging of important events. Apparently, the library of footage in Evidence.com is 22x the size of Netflix’s entire catalog
In addition to body-worn cameras, Axon also offers a range of other products and services for public safety agencies, including in-car video systems, a portal for citizens to upload police-related videos, evidence management software, and training and consulting services.
Now that we have a sense of the business, let’s run Axon through the checklist:
Rick Smith has been at the helm since the beginning. I believe he is a fantastic leader and a real visionary. His brother is no longer involved with the company but actually started a somewhat competing company in the non-lethal weapon space, called Wrap. The idea was to use a silky substance to tangle intruders or criminals. So basically, Spiderman. Recently, Tom left Wrap and now works for a jet-sharing company called Set Jet.
2. Competitive advantage
Axon has several competitive advantages. One of these is its strong brand and reputation, which has been built up over the years through its commitment to providing high-quality products and services to public safety agencies. The company has a stronghold with police stations, as roughly 85% of all stations are active buyers of Axon products.
You can think of these stations like an installed base where Axon can continue to sell new models of Taser, more storage for Evidence.com and more sensors and cameras for officers. It’s not a perfect example, but Axon’s business model is similar to Apple’s with hardware upgrades and an incredibly captive audience because of sticky software.
3. CAP trajectory
The company continues to innovate and roll out new products. The Taser 10 is highly anticipated and to further the Apple analogy, a whole lot of customers will be reflexively upgrading because it’s an Axon product. But the company is certainly not resting on its laurels. It’s currently building VR training systems and drones for de-escalation, crime scene reconstruction, and search-and-rescue.
4. Large and growing market
The company pegs its own market at $50 billion, $10 billion of which is from evidence management. The thesis here is that Axon will just penetrate the wallet share of police stations even more deeply. This isn’t necessarily a land-and-expand type of business because Axon is already such a cognitive referent in the industry. However, as the company upgrades its products and stations need more and more storage for evidence back-ups, Axon has plenty of runway left.
5. Recurring revenue
About 45% of the company’s revenue is from Taser, which is non-recurring. But another 40% is recurring revenue made up from three sources: Evidence.com, Axon Records, and Axon Respond. Evidence.com is the cloud storage solution. Axon Records is a dynamic reporting system that enables officers to streamline their workflows for citations or managing evidence. And Axon Respond is a physical asset management software that shows police stations where all of their officers are for efficient routing. What’s amazing is that annual recurring revenue has grown at a 51% CAGR over the last 6 years and now makes up nearly $500 million in revenue.
6. Limited competition
Some of Axon's main competitors include Motorola Solutions, Digital Ally, and WatchGuard Video. These companies offer similar products and services to Axon, including body-worn cameras, in-car video systems, and evidence management software. But Axon is certainly the dominant player. In reality, it’s incredibly rare that a company has zero competition. But I love looking for singular companies, where they are so dominant that they might as well have no competition. I believe Axon fits this bill.
7. Financial strength
The company has $550 million in net cash and it did $180 million in free cash flow last year. While stock-based comp is pretty high at $100 million, a majority of that is from Rick Smith’s long-term equity incentive package.
8. Diversified ecosystem
The company doesn’t have any 10% customers for revenue or receivables. It also doesn’t rely too heavily on any specific supplier.
9. Organic growth
The company is extremely selective about its acquisitions. It only has $45 million in goodwill and will do small tuck-ins acquisitions for technology like buying a photo-sharing service called Familiar in 2013 to help build out Evidence.com.
10. Mission critical or consumer surplus
Police stations wouldn’t be in compliance with federal laws without their Axon products. The constant video streams and storage is a prime example. Sure, there are alternative products but they won’t work seamlessly with everything else. I keep coming back to the Apple example but I think the hardware/software integrations are very underappreciated.
11. Is it understandable?
The business is fairly straight-forward. About 40% is from physical Tasers and cartridges, 35% comes from Evidence.com, and the remainder is from sensors like Axon body and dashboard cams. Axon has a virtual salesforce to sell these products and also uses distributors that receive a small mark-up.
12. Would I be proud?
While there have been roughly 1,000 Taser related deaths since 2000, the company’s goal of cutting police related deaths in half is certainly worthy. In context, just last year, there were nearly 1,100 police related deaths. I believe Axon is headed in the right direction and even the mere presence of body cams creates more accountability.
Axon is a perfect example of a company with the qualitative characteristics that I look for . A dominant position in a large market, incredible economics, a founder at the helm, a good chunk of recurring revenue, a strong and growing competitive advantage, and a strong preference to internally innovate.
Now, this is just the qualitative checklist portion of our process. When combined with the quantitative measures, that’s how the portfolio is created. A company with all of the right intangibles could be a terrible investment if the price is far too high. Balancing the three pillars of our strategy – quality, growth and valuation – is tricky but I believe it lays the foundation for a very robust portfolio.
I’m honored to have you as a partner. Thank you for your trust and support. It enables me to think long-term and will be our own competitive advantage.
The stock market, like life, will have its ups and downs. All we can do is focus on what we can control and work hard to continually raise our standards. Our strategy is simple – hitch a ride to the world’s best entrepreneurs that are running the fastest-growing, highest-quality companies at the most attractive valuations we can find. Here’s to many more years of focusing on the inputs and letting the outputs take care of themselves.
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