- Ryan Reeves
The 3 Legs of Good Investing
I won’t beat around the bush – the three legs of good investing are growth, quality, and valuation. Growth without any value capture/real cash flow is harmful. A huge moat with no growth won’t lead to supernormal returns (buying back tons of shares can only take you so far). And having a super low valuation doesn’t mean squat if you can’t survive. The true huge winners have all three of these elements. If you had to choose one leg for getting big returns, it’s growth. This is because companies that grow quickly typically have strong tailwinds or an interesting product or some tidal wave of demand. That usually doesn’t happen by accident. However, that doesn’t mean you have a real business. Real businesses make money because they provide so much value that customers don’t mind paying for it. That’s the “quality” piece. If you can make something that people want, that’s the growth piece. But quality is more like why it’s difficult for other companies to replicate what you’re doing. You might call it a moat. Quality is much more, for lack of a better word, qualitative. Things like company culture, underlying predictability of sales, fixed vs. variable cost structures, industry trends, competitive dynamics, talent retention, etc. The reason investing is hard is that the three legs interplay with each other because reality isn’t compartmentalized. Without understanding the growth runway and the competitive advantage, it’s difficult to get an accurate valuation. Sure, maybe you just extrapolate out the recent growth but if you didn’t know that a competitor has an infinitely superior product, that valuation estimate will be wildly incorrect. The way I see it is that growth tells you what has happened in the past, which is a somewhat reliable indicator of the future. Quality gives you the probability of sustainable future earnings. And then valuation marries both of those together to get an estimated value of the company. Another abstraction is that growth tells you about the demand for the product and quality informs you about the supply. If there is strong demand for the product or service, the company will grow. But if there are tons of alternatives (supply glut) for that product, the business won’t produce much cash. Moreover, quality is about the inputs that go into the product – the things that make the business special. In this sense, it’s really about the supply of the product and why it is difficult to reproduce. And then valuation extrapolates the combination of the demand and the supply out into the future. What I’m trying to get at is that these three elements interact and they can’t really be separated. Sure, it’s fine to invest and sell at the first hint of a slowdown without examining the quality of the company or the valuation but your risk increases quite a bit. If you don’t understand why things are happening, you run the risk of making uninformed decisions. One example that sticks out is when Datadog slowed down during COVID. In Q2 ‘20, sequential growth dropped from 15% to 7%. What a disaster, right? Wrong! At the time, management was clear they had some customers limit their expansion at first but they had already resumed normal spending. The next two quarters of sequential growth were: 11% and 15%. Datadog wasn’t a broken business and it has been one of the biggest winners in the portfolio since the bottom of COVID, up more than 300%, even after this big pullback. The “why” is very important! Moreover, not all growth is created equal. It’s not just about top-line revenue growth. You could create a business that gives away dollar bills for 90 cents and I’m sure you would grow pretty darn fast! Growth with clear evidence that the business is getting more profitable is what we’re looking for. Operating leverage shows that the company is executing well. But that doesn’t mean the company has to be profitable right now. Oftentimes, early-stage companies are unprofitable because they are vigorously reinvesting their profits to gain more market share, make the customer experience better, and lay a stronger foundation for future growth. It’s not about being GAAP profitable or not, you can have an amazing business either way. It’s about how much value a business is providing and how much of that value the business is capturing. Understanding these two dynamics is much more difficult than if there is a negative in front of the operating income line but it’s much more important. Value creation is all about the value prop of the product or service. How much time or money does it save customers? What are the alternatives? How much better does it make a customer’s life? Etc. And then value capture is more about the hard numbers like the cost to acquire a customer and how valuable that customer is in the future. All businesses can essentially be reduced down to a price per unit and units sold. The underlying margins of each unit are called unit economics. For a business like Chipotle, at a granular level, that would be how much it costs to feed one person a burrito. But when you aggregate all the customers at one location, then you can get the profit and loss on a per-store basis. And when you add all the locations up, you get the unit economics of the entire business. Lastly, to get overall profitability, you also need to add in marketing that is distributed across all of the units and executive salaries, etc. If a company isn’t profitable on a per-unit basis, then it definitely won’t be profitable at a business level. And when I say “quality” I’m talking about the why behind these unit economics. Why can’t Chipotle be replicated? How difficult would it be to make a superior burrito at a lower cost? How much capital would it take to get the same mindshare as Chipotle? What are the special ingredients (pun-intended) of the company culture that would make it a tough competitor? What does the logistics system look like to get fresh ingredients at the locations every day? All of these questions would go into understanding the quality of the growth and whether it will result in big-time cash flow. Now, it’s usually not crucial to understand every little aspect – oftentimes there are only a few important things to focus on. To continue the Chipotle example, it might be the store-level payback period and how many stores they are opening. If you can understand those two things, then you probably have the majority of what you need. Sometimes it can be a distraction to feel like you need every piece of information but there are diminishing returns. At some point, the need for more information can be a crutch. If you really feel like you absolutely need every last piece of information, it actually might be a sign that the opportunity is too difficult. Lastly, after all of this, if investors are paying infinitely too much for the combination of growth and quality, it leaves no upside. This is why investing is hard! The game is always changing and so are the probabilities. But if you have thought through the growth, quality, and valuation, you’re likely far ahead of most investors. One other framing that might be helpful is that growth is sort of how big the company could get, quality is the likelihood it will get there, and then valuation is the starting odds of that bet. If the valuation is low, your payoff will be much higher if things turn out very well. Ok, that’s enough abstractions for one post! I hope you have an amazing weekend!
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