My investing was never the same again after I discovered this. Realising the simple power of fundamental inflection points started me on a journey toward a new (and thus far, fairly successful) investment approach.
But first, let’s get clear on what we mean by a fundamental inflection point. The Investopedia definition will suit us fine:
An inflection point is an event that results in a significant change in the progress of a company, industry, sector, economy or geopolitical situation and can be considered a turning point after which a dramatic change, with either positive or negative results, is expected to result.
To be super clear, we are talking about changes in the fundamental cash flows of the business, not ‘charting’ share price changes.
There are many types of fundamental inflection points. Here are just a few of the types I like to look out for:
Turnarounds (with a major catalyst sparking the revival)
A new fast growing product/segment, ideally whose early growth has been hidden by a larger flat or declining segment
A major demand side break-through such as a new distribution agreement
Growth company tipping in to profitability (with strong operating leverage)
Hyper growth company that has has just ‘crossed the chasm’ (a topic for another update)
All of these have one thing in common, which is a very rapid rapid acceleration in the rate of improvement in fundamental performance.
Today I’ll talk through just the corporate turnaround example, as it is where I first got started as a value investor.
Imagine a company that has been generating steady revenue and profit when it suffers a setback and its performance takes a dive:
There can be a thousand causes. It could have been: a failed product launch; a botched acquisition; or a newly assertive competitor. Revenues slump, and profits plummet.
But whatever the cause, in this example, the declining business finally gets its act together and makes a rapid recovery. Note that this only occurs when there is a specific cause of the slump that can be quickly rectified.
The share price response to both the slump and the recovery is normally exaggerated. Here’s the typical share price moves we’d see in this situation:
This simple chart sums up a lot of ‘classic’ value investing.
Value investors look for businesses that have had some fundamental setbacks (the dip in revenue and profit). But more importantly, they are looking for situations where the market has over-reacted to the bad news (the share price plunge) and the shares are undervalued. They purchase shares during the troughs of the market’s despair and hope to sell later, when the market’s mood has improved.
For many years this was my investing modus operandi: buy something cheap, usually watch it continue to get cheaper, finally (hopefully) a rebound arrives, sell.
It can be painful. Value investors are cursed with being early. That means suffering through significant further price falls before the company’s performance improves. Classic value investing doesn’t really have an answer to this painful process, aside from developing the stomach to hold your nerve (always good advice).
And that is actually the best-case scenario.
“Turnarounds seldom turn” — Warren Buffett
In plenty of cases the turnaround never comes. The traditional value investor is left holding the bag on to a company that looks cheap, but where performance continues to decline. The ‘cheap’ often just keeps getting ‘cheaper’. This slow-motion train wreck is known in the industry as a value trap.
But what if we could cut out most of the pain of suffering through falling prices, and almost all of the value trap blow-ups?
A better approach
Instead of purchasing purely based on an estimated discount to intrinsic value, we can also wait for indications that a fundamental improvement is already well under way. We can wait for the fundamental inflection point:
By waiting until the inflection point has already started we avoid the worst of the losses that long-term holders have suffered. In turn we also miss out on some of the gains, since we are unlikely to be buying at the absolute bottom. But that also means we join in just when the fun is really getting started.
Most value investors arrive for the party two hours early and make awkward chit-chat with the hosts over a bowl of dip. We arrive a half-hour late, a couple of other guests have already arrived and the conversation is flowing. Soon the party will be in full-swing. Later on, when Mr Market has gotten drunk and starts making a scene, we’ll make a polite exit.
Here is a zoomed-in version:
My preferred spot is to wait until *after* there is already some compelling evidence that the company has hit an inflection point (the black line). This has the added benefit that we rely more on observation of the world as it currently is, than solely on forecasts of how it could be in future.
When executed well, this focus on inflection points can radically enhance our expected returns:
Reduce behavioural biases: less pain from holding falling shares means less temptation to sell at the worst possible time.
Shorten the average holding period. This is a key part of generating high annualised returns i.e. it is better to make 50% in six months than to wait two years.
Higher ‘hit-rate’ which allows greater concentration i.e. the number of profitable trades as a percentage of all trades increases.
So why isn’t everybody already doing it?
Why it works (a.k.a. why it’s hard)
Thankfully, there are several challenges to successful inflection point investing.
First: anchoring. “I’ve missed it” are three of the most dangerous words in investing.
By the time the inflection point is already underway, the share price has likely rebounded off its lows. Investors that have been watching the stock often anchor to the lows, instead of reassessing the current value. They avoid buying, thinking that they have missed the gains.
Second: cognitive biases. The changes that happen at inflection points tend to be extremely rapid. We humans are not great at exponential thinking.
Our brains evolved to be very good at linear forecasting. That lion is running towards me. I predict that if this continues I will be his lunch. I better do something. That is very helpful linear forecasting. But it is less helpful in the modern world of finance.
When it comes to forecasting rapid change, our brains are slow to adapt. The market tends to forecast based on a linear extrapolation of recent results:
The market repeatedly under-estimates how quickly the company will improve. Then finally, the market actually overshoots to the upside. The stock then becomes overvalued. Smart investors sell, and the whole glorious cycle of expectations can start again.
Third: the search is hard work. No one rings a bell to tell you an inflection point is underway.
Small-cap and micro-cap companies are often a good place to look for these opportunities. Often nobody else is watching closely. Or more precisely, nobody else that is managing enough funds to move the price.
In these ‘under-followed’ cases it is often possible to identify the inflection point simply by following the company’s latest financial reports. But it is not always that easy. Often by the time the inflection point is readily apparent in the published financials, it is already too late. Smart investors need to be doing the hard work of equity research to identify a fundamental inflection point before it is obvious in the reported results. That means digging through every piece of information about the company, it’s competitors, suppliers, customers etc. Investors also need to ensure they aren’t being fooled with a false positive. Or as Buffett calls it, a ‘turnaround that keeps on turning’. It can be an incredibly rewarding process, but it’s hard work.
Fourth: patience. Or rather, being extremely selective. It is hard enough to find a company that is undervalued. Inflection point investing means holding off, and only investing when you have found undervaluation and a positive fundamental inflection point.
Thankfully none of that is easy, or everybody would be doing it, and the magic would disappear.
Understanding the power of inflection points can significantly enhance a ‘classic’ value investing approach.
We’ve only scratched the surface of inflection point investing. We talked through just one example, the corporate turnaround. But there are dozens of others. In fact, we didn’t get a chance to talk about about my favourite type of inflection point (a hyper-growth company that has has just ‘crossed the chasm’). That will have to be the topic of another update!
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This is the story of how a little company from New Zealand grew to become a 14 billion dollar giant, the signs that indicated a big future ahead, and the tale of one of the greatest blunders in Australian business history. It is also the story of how we can apply the principles of what I call monster hunting to our own investing, and use the lessons on our quest to find the next potential winner while it is still small and undiscovered.
The Monster next door
I first purchased my shares in a2 Milk (ASX:A2M) in late 2015. It’s been a fun ride. In just four and a half years the shares have delivered a 2,200% return for shareholders. In annualised terms that is an incredible 99% per year. Past performance is no guarantee of future returns, both for our stock selection, and the business itself. Also, as we’ll talk about later it’s been a wild ride too. Holding on required enduring multiple occasions where the share price slumped, up to 30% or more, sometimes for more than a year.
It’s no secret that A2 Milk has generated strong returns for long-term shareholders. Bloomberg even named it as the best performing stock in the world:
It may have been the decade of smartphones, on-demand everything, and Instagram memes, but the prize for the world’s best-performing stock in the MSCI World Index goes to a dairy company in New Zealand.
But what a lot of this coverage misses is an understanding of how the company did it. A2 Milk is my favourite applied example of monster hunting. It’s not because of the returns (although sure, those are nice too). It’s because of how the business delivered those returns.
This was a company that could be purchased at multiple times throughout its growth journey for a very reasonable price. Its business is simple and its customer value proposition is easy to understand. Most of all, the returns were not driven by price swings, they were primarily driven by astounding organic earnings growth.
When I first purchased shares in late 2015, the total market capitalisation of the entire company was approximately $560 million NZ dollars (note: for simplicity I will refer to NZ dollars throughout this article unless otherwise noted). In 2015, a2 Milk had recently tipped past break-even and was generating $1.2m of EBIT from $155m of revenue.
Fast forward to today and the business is forecast to generate $560m of EBIT this year. Approximately the same as the company’s entire market cap in 2015. Revenue is now forecast to be $1.725 billion at the midpoint of guidance. Not only that but the company now holds $618m of cold hard cash and has another $260m worth of listed investments in its supplier Synlait Milk (ASX:SM1) representing a 19.84% stake.
In five years a2 Milk increased its revenue by 1,000%, its operating profits (EBIT) by 46,000%, and now holds significantly more cash than its starting market cap.
A2 Milk exemplifies what we should be trying to achieve as investors. Finding the large dominant businesses of tomorrow while they are still small. Luck plays a role in every business success, but this wasn’t a speculative lotto ticket like a mining explorer or biotech. This was a hyper-growth consumer brand that delivered eye-watering returns from consistent and steady improvements in fundamental performance.
What’s more, these stellar returns were primarily driven by fundamental growth, not by a big increase in the multiple that investors are willing to pay. This is best illustrated by this chart of the forward p/e multiple that a2 Milk has traded at over the past five years:
Despite many commentators saying that a2 Milk was overvalued along the way, it has typically traded at a fairly reasonable valuation given the incredible growth that it is experiencing. This is not a story of a huge multiple expansion, it is a story of compounding high returns on invested capital.
How to Catch a Monster
As I wrote in How to Catch A Monster, while most of the market is mired in mediocrity, there is a small group of companies that generate insane returns for shareholders. I call these companies monsters for the way they dominate their industries and transform portfolios. A few years ago I set out to study these huge monster winners, reading books like ‘100 to 1 in the Stock Market‘ and trawling through Standard & Poors data to see if I could identify any common traits. Most importantly, I wanted to see if it was possible to identify these winners early, before they started their huge run, and the rest of the market caught on.
As I see it, there are four steps to catching a monster:
Choose your hunting ground – avoid pretenders to the monster throne.
Catch your monster – identify key traits.
Watch closely – continuously monitor and sell quickly if your thesis is broken.
Hold on – be able to stomach the volatility without selling too early.
We’ll step through each in turn, in the context of a2 Milk.
The Hunting Ground
Investing is an art of negative space. What you don’t buy is at least as important as what you do. The best investors say no to potential ideas early and often. As I wrote in The Bizarre, Weird and Beautifully Inefficient World of Aussie Small Caps it means saying no to a lot of companies. Thousands of companies in fact. But that process of elimination leads us to a precious few companies with very attractive underlying economics.
What made a2 Milk so special – and what most of the market missed – is the power of its business model.
At first glance in 2015, a2 Milk looked like just another commodity food producer. At that time the significant majority of its revenues were from fresh milk sales at supermarkets in Australia. Its now famous infant formula had only just started to take off.
What really set a2 Milk apart is that it isn’t really a food producer at all: A2 Milk is a marketing business. All of a2 Milk’s products are produced by external suppliers that the company holds a close relationship with, in particular the New Zealand dairy company Synlait Milk. A2 Milk’s job is to create demand, maintain customer relationships, and manage the supply chain. Their partners do the hard work of building out factories and converting cow herds to be able to supply a2-protein-only milk.
As a result, A2 Milk is incredibly capital light with high returns on incremental invested capital. The company expanded from selling $136 million worth of products in 2015 to over $1.7 billion today. How much did a2 Milk spend on capital expenditures over the past five years, while it added over $1.5 billion in revenue? A paltry $9 million dollars. How is that possible? Their partner Synlait Milk did the heavy lifting for them, investing over $560 million on capital expenditures over the same period. Synlait has other customers than just a2 Milk of course, but it gives some sense of the scale of capital-intensive investment that a2 Milk avoided.
The real cream (sorry) in a2 Milk’s business model is the combination of being capital light with the premium margins that it generates as a trusted consumer brand. Once a customer has selected a2 Milk’s products, particularly its infant formula, they are reluctant to switch. As anyone who has tried moving their infant away from a formula that they are happy with knows, there is a big downside risk (tears, sleepless nights) for very little payoff. This loyalty gives a2 Milk the ability to earn an incredibly healthy operating profit (EBIT) margin of 32%. When we roll together limited capital costs, sticky customer relationships, and strong pricing power, a2 Milk generates a mouth-watering return on equity of 42% – and that’s while sitting on over $600m of cash.
As I wrote in How to Catch a Monster:
Monsters are businesses that deliver huge shareholder returns by compounding high returns on invested capital. These businesses generate strong free cash flows, and most importantly, the business is able to reinvest those cash flows at high rates, and for a very long time. That reinvestment has a compounding effect over time, with the company’s value building up faster than a snowball rolling downhill.
Running down the list of everything else that I look for, a2 Milk has extremely high-quality earnings, a rock-solid balance sheet, strong demand and supply side competitive advantages, incredibly attractive unit economics, unknown or misunderstood by the market, and is well led. Meanwhile the business was also tipping past some fundamental inflection points that I’ll touch on in a moment as well.
Safe to say that a2 Milk was, and is, very much the type of business model that we are hunting for. Now, on to Step 2.
Catch your Monster
Every monster is different, but I have found there are four key traits that monsters tend to have at the start of their journeys:
#1: They start out small
This might be an obvious one, but it’s important. It is much easier for a company to increase in value by many multiples, if it is starting from a low base.
A2 Milk started this epic run from a market cap of around $560m, much smaller than the big blue chips that get most of the market’s attention.
#2: Unique edge
A lot of people got this wrong about a2 Milk. They thought that the company’s unique edge was that it was selling a particular type of dairy protein. This confuses the raw materials with the product. The value add for any brand isn’t its raw ingredients, it’s the associations that are formed in the minds of its customers. Red Bull doesn’t just give its customers caffeine – there are much cheaper caffeine pills that do that – it gives them wings. Consumer wellness products are the same: brands first, and health products second.
By 2015 a2 Milk had a strong and steady market share of around 10% of the entire Australian fresh milk market. But most importantly it had positioned itself as the premium branded alternative to home-brand milk. For a lot of Australian consumers it was trusted as a healthier alternative. That set the scene for what would become a2 Milk’s home run product: infant formula.
In 2008 hundreds of thousands of Chinese infants were fed infant formula that had been poisoned by the industrial product melamine – the stuff that we make those shiny white table tops out of. It was a devastating scandal, with over 50,000 infants hospitalized and at least six killed. Chinese food safety standards were not up to par, so wealthier Chinese mums sought out trusted overseas brands.
Over the following years, demand for high-quality internationally-sourced infant formula soared in China. Australian supermarket shelves were often stripped bare as Chinese personal shoppers – daigou – bought all that they could and then on-sold the products in China at much higher prices.
It was against this backdrop that a2 Milk launched its infant formula product and leveraged the success in the fresh milk category. The Aussie mums that were used to buying a2 Milk’s premium fresh milk now started buying the infant formula. The product was priced significantly above competitors, and supply was tightly managed. This provided a powerful signalling effect to Chinese mums that only wanted the best for their children: the health-conscious and more affluent Australian mums were buying a2 Milk so they should too. The strategy worked and a2 Milk infant formula rapidly became the market leader in Australia.
A2 Milk is also, in its own way, a disruptive innovation. The large dairy incumbents struggle to launch an a2 protein only product and market it aggressively because by doing so they would risk hurting the image of their much larger existing traditional dairy business. It poses a fun twist on the classic innovator’s dilemma and it meant that once established a2 Milk was largely left to own the a2 protein category.
Whatever your personal take on a2 Milk’s wellness benefits, millions of people love the product — and that is what counts. A2 Milk’s unique edge was the power of its consumer brand, sticky customer relationships, and then the ability to use its growth to fuel more marketing spending, turning the flywheel even faster.
#3: Superior Management
A2 Milk’s management team have executed very well on a number of important fronts. The most important of which was management’s ability to build and maintain the premium brand position of the product.
A2 Milk’s management team often described their strategy around the supply chain as ‘keep the channel hungry’. This meant ensuring that no one distribution channel or partner ever had surplus supply that might lead them to discount a2 Milk’s products and thereby tarnish the premium positioning of the brand. Just as the owner of any expensive nightclub knows, you always want to keep a line waiting at the front door.
Management also continued to invest heavily in marketing and distribution. Almost every earnings release saw the company post incredible results, but also partially disappoint analysts by flagging another big step up in marketing spend. Meanwhile the company also built out its direct selling strategy into Chinese Mother and Baby stores – thereby building another major distribution channel and reducing reliance on daigou shoppers.
Finally, to have a chance of being a huge multi-bagger winner the company needs to start off being misunderstood by most of the market. The only way for a company to be significantly undervalued is for most of the market to not understand what the business is truly worth.
Whether it was the business model, or its unique edge, or the power of the brand, a2 Milk has been significantly misunderstood throughout it’s journey.
The fundamental inflection point
All of those traits were incredibly important to the purchase decision. In a2 Milk’s case it also ticked another box that I love to see before I purchase: it was just tipping past several fundamental inflection points.
In late 2015 the Australian Financial Review released an article that included a chart of pharmacy sales data. It showed that a2 Milk had, in just a few months, rapidly taken market share and was gaining ground quickly.
As I wrote in The Hidden Power of Inflection Points, there are several different types of fundamental inflection points that I like to look for. The updated pharmacy data showed that a2 Milk was tipping past not just one, but four:
A new fast growing product/segment, ideally whose early growth has been hidden by a larger flat or declining segment
A major demand side break-through such as a new distribution agreement
Growth company tipping in to profitability (with strong operating leverage)
Hyper-growth company that has just ‘crossed the chasm’ (a topic for another update)
The infant formula product was experiencing explosive hyper-growth thanks to the new distribution channel of daigou shoppers. The demand for a2 products as a category had crossed the chasm from early adopters into a mainstream segment. The growth in infant formula was being partially obscured by the slow and steady fresh milk segment. Finally, a2 Milk was just tipping in to profitability with strong operating leverage – laying the foundation for the spectacular operating profit growth that ensued.
A lot of finding monsters is about spotting anomalies and then digging deeper. I often wonder how many other people read the same article that I did in 2015 but couldn’t put it into the context of the incredible value creation that a2 Milk was about to deliver. It’s rare for a business to be hitting one inflection point, let alone multiple points simultaneously.
When you find one it’s time to pounce.
3) Watch Closely
The price of catching monsters is eternal vigilance. The next step is to clearly articulate your thesis at the time of purchase and then regularly review that thesis as new information comes to hand.
For a2 Milk that meant a big focus on how it was managing its supply chain. There was the constant threat of simply running out of stock – so we were continuously checking supermarket stores to make sure that there was adequate supply. But also, as management said, we wanted to make sure that the channel was ‘kept hungry’ and that there was no large glut of supply that might lead to discounting.
One other method that we stumbled upon after many hours of staring at tins of formula was that we could track the production and expiry dates on tins to keep track of how quickly the stores were turning over the product.
There were plenty of other things to watch along the way too: China’s forever shifting regulatory framework, larger competitors entering the market, the dependence on the manufacturer Synlait, and the role of the large e-commerce platforms in China to name just a few.
As I wrote in The Selling Blind Spotwe need to be prepared to sell quickly if our thesis is broken. But if it is not, then we need to have the patience to hold on.
“To make money in stocks you must have ‘the vision to see them, the courage to buy them and the patience to hold them’. Patience is the rarest of the three.”
100 TO 1 IN THE STOCK MARKET AUTHOR THOMAS PHELPS
Holding on requires enduring the pain of seeing your company’s share price fall and fall, and maintaining the conviction that it will come out the other side stronger.
This is what I like to call a ‘pain chart’ for a2 Milk. This chart shows when, and by how much, a2 Milk shares were below their all-time high. (Periods at 0% show when shares hit a new all-time high). Remember, this was during a period when shares increased more than 2,200%:
There have been five times when a2 Milk’s share price fell 20% or more. And on three occasions the shares fell by 30% or more. In most instances, it took a long time before the share price made it back above its previous high. To enjoy the monstrous gains to date, shareholders needed to avoid giving in to fear and selling out during those troughs of despair. It’s also a challenge to hold when the shares are soaring higher. As I wrote in The Selling Blind Spot if the shares run a little ahead of our intrinsic value estimate the smart move is often to trim the position, rather than to sell out entirely.
It is easier said than done. At the start of this article I said that this story would include one of the greatest blunders in Australian business history, here it is. In late 2015 Freedom Foods (ASX:FNP) had a close partnership with a2 Milk and owned almost 20% of the company. Freedom Foods even made a takeover attempt to buy all of a2 Milk in partnership with a U.S. Foods business.
But then the milk turned sour. After the takeover attempt failed the relationship between the two businesses deteriorated. Despite presumably loving the long-term outlook for a2 Milk just a few months prior, Freedom sold all 117 million shares in a huff in two tranches for A$70c and A$85c each in October and November 2015 – coincidentally right around the time that I was buying. All told Freedom Foods received A$93 million for their stake.
Today that stake would be worth over A$2.1 billion dollars. Freedom Foods had left over A$2 billion dollars sitting on the table. To put that into perspective, the entire market cap of Freedom Foods, a 30 year old company, is today only A$1.2 billion. Ouch.
That transaction was also a great reminder to always do your own deep research, and never automatically assume that you’re wrong just because somebody else has sold. Even if they are a knowledgeable strategic investor in the same industry.
This strong and enduring fundamental growth has proven even more valuable during the current crisis as a2 Milk again demonstrated its resilience. When Chinese mums became more concerned about the health of their little ones than usual, they stocked up on a2 Milk.
Catching monsters is hard. Our view of the future is cloudy at best. A2 Milk has proven incredibly resilient during the early phases of the current crisis, but this could always change in future. Or there could be supply disruption, or regulatory changes. Any number of potential bear theses always lie in wait, as usual. We must continually monitor for any changes in the company’s fortunes.
Above all the story of a2 Milk highlights that we should not spend too much time worrying about the general swings in the broader market when we could instead be doing deep fundamental research. When a business like a2 Milk increases its revenue by 1,000%, and its operating profits by 46,000% over five short years, then it matters very little whether the market goes up, down, or sideways.
Nothing is guaranteed, but if you can demonstrate those three qualities: vision, courage, and patience, you have a shot at aligning your portfolio with these incredible engines of wealth creation that I call monsters. The ride can be bumpy, but it’s also a heck of a lot of fun.
Disclosure: At the time of publishing Matt has a position in a2 Milk. Holdings are subject to change at any time. This report, and disclosure, should not be considered to be a recommendation.
The present moment is a unique combination of a health crisis and a sudden-stop economic shock. This mix has not been seen before in modern financial history, and so is confounding a lot of investors’ attempts to search for a historical precedent.
There is an awkward truth at the root of most cognitive biases: humans are lazy. Our big brains take a lot of energy to get fired up, so wherever possible we like to use the quickest shortcut that we can find. This is the efficient path, so it makes sense most of the time. But in moments of great change – like this one – efficiency can lead us deeply astray.
We have seen this with world leaders that applied the wrong analogy to the virus itself: “it’s just a flu”. Or to investors in February that applied the wrong analogy to the economic impact: “this is just going to be a blip like SARS in 2003”. During the depths of despair in March we also saw the wrong economic analogy: “this is the Great Depression all over again”.
Reasoning by Analogy
The problem with all these takes is that they are reasoning by analogy. We take one thing that looks kind of like another thing, and treat them as being the same. This is one of our brain’s favourite shortcuts. We humans absolutely love reasoning by analogy. Reasoning by analogy is simple, quick, and efficient.
Once we have truly grasped the fundamentals of a situation, we can use analogies to explain our understanding to others. They also help to solidify the understanding in our own minds. At its best, analogy allows us to learn things from each other incredibly quickly. At its worst we arrive at Godwin’s law: the longer an online argument continues, the probability of one side making an analogy comparing the other to Nazis or Hitler approaches 100%.
Analogies are so powerful that we should be careful when they are the only tool being used to convince us. You can find an analogy to fit any argument. If there is a public debate about gun control, the pro-gun lobby will argue that guns are a tool, like knives, and so like knives, should not be banned. The anti-gun lobby will argue that guns kill people, like poisons, and so, like poisons, should be banned. Both of these analogies are tools of explanation, but not tools of fundamental understanding.
The mental shortcut of using an analogy can be incredibly valuable. It saves our precious brainpower. But efficiency is a problem when we quickly travel to the wrong destination. When we are facing something new or different, we should be careful to make sure that the analogy truly fits.
If you are trying to explain a particular view to someone, use an analogy. If you want to improve your understanding of the world, there is a better tool to use.
Reasoning from first principles dates back to Aristotle. It is a cornerstone of mathematical and scientific progress. First-principles thinking requires us to question everything until we have reduced the problem down to its most fundamental truths. Once we have those, we can then build back up to a solution.
Elon Musk is a famous proponent of first-principles thinking. When Elon created Space-X, he had a problem: spaceflight was too expensive. There was no way we could become a space-faring civilization with the cost of spaceflight being so high. If Space-X had reasoned by analogy it would have looked at all the rockets that had been launched before and concluded that low-cost launches were impossible. That was not an acceptable answer. It was time to question everything.
Elon broke the problem down to its most fundamental parts: and asked his engineers to calculate the weight of different materials that make up a rocket: steel, copper, hydrogen etc. and then compute the total cost based on spot prices for those commodities. He could see that radical cost savings were possible. The Space-X team of engineers got to work designing a low-cost launch system from the ground up.
One of the most famous examples of this approach was the development of reusable rockets. Before Space-X, rockets were extremely expensive to produce, and only ever used once. When a rocket blasted off for space it jettisoned huge chunks of itself in stages and sent them crashing back to Earth. Elon asked, why? If Space-X could land and re-use the rocket it would cut up to 75% of the cost of manufacture. In December 2015 Space-X achieved what was previously thought impossible – landing a rocket back on the landing pad. Today, a rocket returning smoothly to earth has become so commonplace that it barely makes the news.
How do we apply first principles thinking to the current investment landscape?
We first need to determine what the fundamental truths are of this crisis, and then reason our way up from there. In late February that primarily meant considering the nature of the virus itself. Now we need to combine this with an understanding of the sudden-stop economic shock. What has been directly locked down? Which activities are no longer happening? Which activities are customers most eager to restart? What psychological impacts will lock down have? Are they temporary or permanent? Once we have some understanding of that, we can then reason our way up from there.
This process is not easy. We don’t just need to consider the fundamental truths of how physical particles behave. Since we are dealing with business and financial markets, we also need to consider some fundamental truths of human psychology. It’s not rocket science, it’s much harder. Thankfully there are some tools we can use to address that.
But first, let’s look at two examples where simple assumptions could have led us astray: funeral services, and cruise ships.
Invocare has around 25% share of the Australian funeral services industry. While most of the market was falling in March, Invocare shares rallied 15% as traders speculated that COVID19 would bring a spike in Australian deaths. It was a pretty morbid and short-term trade idea. It was also poorly thought out.
Traders were reasoning that COVID19 would be analogous to previous increases in the death rate that typically benefit Invocare. The logic hinged not just on more deaths, but on more funerals. Did that make sense? Funerals are the type of gatherings where COVID19 are likely to spread, and therefore one of the most likely to be restricted. Indeed that is exactly what happened. The Australian government limited funeral attendance to just 10 people, and Invocare’s share price fell sharply.
Meanwhile, the Diamond Princess was the subject of huge media attention as it was one of the first recorded major outbreaks outside of the borders of China. The close quarters of a cruise ship made containment very difficult. Despite the crew’s efforts, over 700 of its passengers ultimately caught the virus, and at least thirteen of those passengers tragically passed away. Sydney saw it’s own controversy with the Ruby Princess. In total over 25 other cruise ships have reported cases of COVID19.
A lot of people concluded that the cruise ship industry was over, and compared it to other 20th Century industries that disappeared as the world progressed. But so far it seems they would be very wrong, as the Los Angeles Times reported:
“In the last 45 days, CruiseCompete.com, an online cruise marketplace, has seen a 40% increase in bookings for 2021 compared with 2019, said Heidi M. Allison, president of the company. Only 11% of the bookings are from people whose 2020 trips were canceled, she said.”
What did folks predicting the end of the cruise ship industry get wrong? For starters they ignored that cruise ships have been dealing with health questions for years. Between 2008 and 2014 over 120,000 cruise ship passengers were infected with the gastrointestinal illness known as norovirus. The worst outbreaks made headlines around the world. Yet tens of millions of people still embarked on a cruise, reasoning that those outbreaks were infrequent and unlikely to cause them any harm. Should it have been a surprise that people that love cruise ships would want to return quickly once a one-in-a-hundred-year pandemic had subsided?
Not understanding how cruise ship passengers think is also a symptom of a larger problem that afflicts forecasting. It seems that most (all?) of the people saying that nobody will ever cruise again, were also people that just didn’t like cruises and might have never actually been on a cruise themselves. It is easy to think that an activity will stop after a disaster if you never thought it was attractive to do anyway. Who would want to cruise anyway, especially after a pandemic? Tens of millions of people, it turns out.
Which brings us to one of the most important tools in our investing arsenal: the power of observation.
Escaping our filter bubbles
These examples highlight the importance of not just arriving at a first-principles hypothesis, but also testing it. Once we have an idea we must then ruthlessly search for disconfirming evidence. Is there any information that we can find that will prove our hypothesis is wrong? Space-X doesn’t just run with the first rocket design it comes up with, it tests hundreds or thousands of designs to arrive at what works.
This is particularly important in the present day due to how easy it is for us to avoid interacting with people that have different viewpoints. The more that our activity moves online, the more time we spend in warm little bubbles of our own creation.
Whenever we search for new information on the web, or social media, we are almost always viewing the world through the bias of our own filter bubble. The algorithms of search engines, and social media sites, have been trained by hundreds of thousands of our responses to only show us results that we engage with. These algorithms become our Magic Mirror in Snow White and the Seven Dwarves: “Facebook, Facebook, on the wall, whose opinions are the fairest of them all?” They become a filter on our reality, only showing us what we want to see and reinforcing our chosen tribal identities.
As investors it is critical that we can step outside of our own cozy little bubble, and test whether our view of the world is accurate. It requires what we consider to be one of our four pillars at Maven Funds Management: Deep Research. A core part of that research is to talk with customers, competitors, distributors, and suppliers for our target companies – not just with management.
We should seek to understand the most fundamental truths about a business’ operations and then build our investment thesis up from there. This allows us to gain a firm grasp of how each business is affected by the sudden-stop economic shock, and it will allow us to value the fundamental cash flow impacts.
Crucial to this research is canvassing widely. Speaking with people from different domains, and with different areas of expertise. Each tile of information may not seem too useful on its own but by piecing together thousands of them we are able to create a mosaic of understanding that better represents reality.
We are fortunate to have investors with a wide array of real-world experience. We have already talked to investors excited to join us at launch that are executives, professionals, business owners, CEOs, CFOs, and other domain experts.
Avoid the analogy trap, reason from first principles, get out of your filter bubble, and if you think you might have stumbled upon some part of the world that is tipping past a fundamental inflection point – get in touch!
Hidden within the ASX is a beautifully inefficient market. It’s weird, under-researched, and entirely off the radar of most fund managers. That’s great news for those of us eager to do the work. It means saying no to a lot of companies. Thousands of companies in fact. But that process of elimination leads us to a precious few companies with very attractive underlying economics.
Of the roughly 2,200 publicly listed companies in Australia, approximately 70% of them (or over 1,350 companies) are not included in the ASX All Ordinaries Index. These businesses may be small individually, but they are numerous. Collectively they represent a total market capitalisation of over $80 billion with revenues of over $50 billion. The list includes some large international businesses that have chosen to dual-list in Australia, but for the most part it is hundreds of smaller companies.
Some of these businesses are bizarre. Most of them are terrible. But a precious few are diamonds in the rough. As I wrote in How to Catch a Monster, the greatest market-thumping success stories typically started out small. Our job is to find them.
Turn those rocks
Peter Lynch is one of my all-time favourite investors. Over the 13 years that he ran the Magellan Fund at Fidelity Investments, Lynch generated a 29.2% annual return. That return was more than double the market’s and made Lynch one of the greatest fund managers of all time.
Lynch’s philosophy of expansive research has been hugely influential to our approach at Maven Funds Management. Lynch describes this process as turning over rocks, searching for the hidden gems hiding beneath. Most rocks will turn up nothing, but the more that you flip over, the better your chance of finding a diamond in the rough.
“The person that turns over the most rocks wins the game. And that’s always been my philosophy.” – Peter Lynch
We went through and categorised each of the 2,200 businesses listed on the ASX into one of 20 categories. We did this by hand, one by one. Automated screeners have their place in investing, but it’s hard to replicate a human’s ability to recognise patterns and anomalies, then classify them appropriately. It takes longer, but it’s worth it. Going through thousands of companies individually also helps to train our brain’s pattern recognition system, to identify the few truly exceptional companies, and isolate what makes them stand out.
Without further ado, here are the results of our analysis:
The ASX is dominated by some terrible businesses. The first thing that jumps out is that ‘thrill and drill’ speculative mining explorers alone make up almost a third of all listed companies.
Beyond that initial observation, it’s helpful to consolidate things further. We identify seven broad groups.
#1: The Cash Burners
If these businesses were a Christmas present, they’d be a lump of coal. If that lump of coal also kept asking you to give it more money every six months. Not for us.
There are three groups that we have included in this group: speculative mining explorers, perpetual loss makers, and the mysterious ‘no business’.
When we say mining explorers we aren’t talking about mining companies that have meaningful revenues and also do exploration – we separated those out into their own group. No, these are the speculative explorers that, as a group, destroy shareholder capital. They repeatedly raise rounds of funding, and dilute shareholders, in the hopes of one day striking oil/gold/uranium etc. Every now and then a few of them do, and provide just enough hope to keep the whole party swinging
The perpetual loss makers require some judgement. When we come across a company that has a history of losing money, we need to determine if it’s temporary, or structural. Is the business aggressively investing for growth (potentially a good thing), or is it a money pit with terrible economics (a very bad thing). Unfortunately in our view there are hundreds of businesses that fall into this perpetual loss-making camp on the ASX. A large chunk of these are bio-techs, which are just as speculative as the mining explorers, but perhaps with a little more social purpose.
The ‘no business’ group are companies that have effectively ceased operations. And yet they somehow live on, trudging through the world as zombie shell companies. Typically these are failed mining companies, or biotechs, drifting towards the abyss of bankruptcy. Every now and then a new company that wants to list will come along, inject itself into the zombie, take over its decaying crust, and emerge as a shiny new business. Well at least newish. Often the leftovers of a failed mining company will hang around as the new business is talking up its amazing breakthrough biotech prospects. But that’s a story for another day.
If you simply avoid the 50% of ASX businesses that fall into this cash burner category, you will probably do quite well.
We avoid these cash burners like the plague.
#2: The HeartBreakers
If these businesses were a fiance, they would break up with you via a text message. These businesses are the tricks for new players. The value traps, and the overhyped flops. They’re heart breakers, and a great person like you was always way too good for them anyway.
The biggest component of this group are declining businesses. These companies are in a state of decay, each year worse than the last. These companies trade at low multiples, which attracts some bargain hunting investors. Some investors can make these declining businesses work for them, but for the most part they are ‘value traps’: cheap investments that are forever becoming cheaper.
Also included in this group are the massively overpriced companies that are at the top of a hype cycle. A few may even be compelling short candidates. Sprinkle in some dodgy management teams and you have the perfect recipe for a heartbreak cocktail. Steer clear.
#3: The Mediocre Middle
If these businesses were a seat on an airplane, you know which one they would be. I’m told that some small group of people prefer the middle seat. These people are odd, and should be treated with suspicion. For the rest of us, the mediocre middle are companies to be avoided.
These businesses are not terrible, but they’re not great either. Outside of the weird market that is the ASX, most businesses in the world fall into this category. They don’t generate great returns on invested capital, or attractive profit margins, but they do just well enough to keep the lights on. Business is tough, and these companies are battling for every cent.
It can be tempting to add these businesses to your portfolio to get some diversification. Or just because it’s hard remaining patient until you find great ideas. But hold your nerve, we’re almost there.
#4: Structural Headwinds
These businesses are in a similar boat to the group above. They typically have mediocre returns on capital across the economic cycle, or other structural weaknesses. But it’s not really their fault, it’s their industry.
When it comes to building and holding competitive advantages, certain industries are structurally weak. Airlines are a great example. It’s a capital intensive industry, and those assets can be quickly relocated at the first whiff of a competitor’s profit. Like a pack of hungry seagulls smelling a hot chip, the competing airlines swoop in, and the profits disappear. That’s great news for consumers, but bad luck for investors like us.
Other industries we avoid include: miners, because they are dependent on the vagaries of commodity market swings; property developers, due to their boom-bust economics, and banks, due to their significant exposure to an over-indebted consumer.
These businesses are highly cyclical, and in many cases operate at the whim of regulators. There is a time in each economic cycle where these companies can be quite attractive, and we would consider some of these at the right time, but that time is not now. Playing the cyclical merry-go-round isn’t our ideal game either. We’d much prefer to hold out for companies that we expect to be able to continue growing throughout all (or at least most) economic environments.
#5: Recession prepper kit
Most of our process is knowing which companies to avoid. So far in the previous categories we have already set aside 82% of all ASX listed companies. Don’t your shoulders feel a little lighter just thinking about that? This is where it starts getting fun.
The Discovery Channel show Doomsday Preppers chronicles American families that have started hoarding canned whole turkeys (yes that’s a thing), beans, gold, shotguns, etc, as they prepare for whatever variety of looming apocalypse they think is heading their way. Broadcasting your stash of food and supplies on international television is probably not the smartest survival strategy. But at least they’re thinking ahead.
There are 76 companies on the ASX that we’ve highlighted to return to if when a recession hits Australia. There are two types of businesses that we are interested in here. The first is high quality businesses with very stable and growing cash flows that are currently significantly overvalued. These businesses are too expensive for us to purchase right now, but times of great market panic bring great investing opportunities. When a recession hits, we’re ready to pounce.
The second type may seem counterintuitive. These are businesses that we think will be hit hard in the next recession, but where we expect the business to survive. These businesses should then bounce back strongly as fundamentals in the economy improve. In the meantime, we wait. As I wrote previously in ‘The Hidden Power of Inflection Points’ the time we’ll be looking to buy is when there is clear evidence that the recovery is already underway. A combination of temporarily depressed cash flows and multi-year low valuations can be a powerful way to see a stock surge.
In times of stress it is critical that we play offence and not defence. Keeping a ‘Recession prepper kit’ is a key component of that strategy.
#6: Watching brief
There are two main types of companies in this group. The first are those with potential as classic value investments. These are solid businesses with decent returns on invested capital. They often have a legacy competitive advantage that allows them to earn those returns. But they aren’t currently able to leverage that advantage into sustainable growth. We want to keep an eye on these businesses. As I wrote in ‘The Hidden Power of Inflection Points’ if these businesses are able to reignite their growth engine, and we can catch them early, we’ll be in an excellent position.
The second type included are those companies that we call ‘Intriguing’. They’re not good enough to make it into our hunting ground. Perhaps the fundamentals aren’t quite there yet. But there is something about them that we think is interesting enough to keep an eye on. Maybe it’s a unique product, or an emerging new market, or an unusual intangible asset. Whatever it is, we see some potential for this to one day become a great business. But we are also mindful that most ‘going to’ companies don’t end up going anywhere.
We keep an eye on these businesses, if we see signs that they are gaining traction, we’re ready to pounce.
#7: Our hunting ground
We’ve saved the best for last. These companies are the rare few we consider having the potential to be worthy of further research. This group of 136 companies represent just the top six percent of our investment universe.
These are high-quality businesses that demonstrate several of the following characteristics: fast growth, competent management, high returns on incremental invested capital, growing competitive advantages, rock-solid balance sheets, and attractive unit economics. Ideally these businesses will be tipping past a fundamental inflection point, and be trading at an attractive valuation. We’ve written a lot about these businesses previously. These are the type of companies that have the potential to be significant long-term winners.
The next step
This manual screening is just step one. What comes next is the real work of deep research. Ultimately, we want to filter down to the very best 1-2% of businesses in our investment universe.
It’s not easy saying no. It’s even harder to say no thousands of times. The process requires us to ruthlessly cast aside the pretenders that don’t measure up. But by doing so we give ourselves the best chance to identify those precious few Monsters that generate the vast bulk of the market’s total long-term returns.
Thank you all for your support. Over the past year many of you have written in to express your interest in what I will be working on next. I have always said that as a subscriber to this website, you will be the first to know when I have something to release publicly. That time is now.
I have founded the investment management company, Maven Funds Management, where I will be the Chief Investment Officer. I will be investing the majority of my family’s total wealth in to the fund, alongside our clients.
Introducing Maven Funds
As I prepared to leave my prior role as Portfolio Manager of Motley Fool Pro I expected to only manage investments on behalf of my family and close friends. Perhaps over time I would advise a few private clients.
When I officially announced my departure from Pro that plan began to change. I was blown away by all the messages of support and thanks. Many of you wrote in to share how much you’d developed as investors, and how your family’s financial well-being had improved. Several of you emailed personally to share how your investment portfolio had allowed you to give back to your community, including some incredibly generous gifts to charity. It is a privilege to know that our investment advice had contributed to that in some small way.
I was honoured and deeply humbled to receive those messages of support, which were easily the highlight of my professional investment career. They also planted the seed for creating something new.
I wanted to take my time to design my ideal investment vehicle for long-term investing. First, because it is important to get the right structure for you, our clients. But also because I knew I would be investing the majority of my family’s wealth in to the fund, and that I would plan to operate it for many years to come. In our view, there are a few problems with the traditional investment management industry that we wanted to address.
As the recent Royal Commission demonstrated, the financial services industry is deeply conflicted. Most advisors will happily sell their clients a product that they won’t invest in themselves. Most fund managers are more concerned with protecting their salary than creating value for clients. Most portfolio managers lack the patience to hold for long-term gains, because they are impatiently chasing quarterly returns.
Setting aside the conflicts, there is also a problem of strategy. Many portfolio managers that invest in growing companies, have no method for how to value a business. They end up overpaying, or over-trading, jumping from one hot momentum stock to the next. Meanwhile many traditional value investors have not adapted to a changing world where wealth-creation is driven by intangible assets like software and networks. Both of these strategy mistakes negatively impact their client’s returns.
I also knew that I wanted to keep all of the strengths of the Pro portfolio: our investment approach, our patience and long-term focus, our combination of a growth-mindset with valuation discipline, and most importantly our savvy client base. However I wanted to address the challenge of entering and building positions while limiting our price impact.
Maven is different. We adopt an investment strategy that combines high-quality growth businesses, with valuation discipline and smart portfolio management. We invest the majority of our investment team’s personal wealth in to our funds, right alongside you, our clients. Lastly, we will closely monitor the capacity of our fund, and limit our capital base when necessary.
There are four pillars of our investment approach that you can read more about at the Maven Funds website. For those of you that are former clients, or have been regularly reading this blog, the investment strategy will be very familiar.
There is one pillar that I would like to dig in to further, which is you, our clients. We are extremely grateful for the support that we have received over the past year. Your long-term focus is the bedrock of our ability to find and hold the champion companies of tomorrow. We have many business owners, professionals and other domain experts amongst our subscriber base. For those willing to share, we will be finding ways to put that collective knowledge to work for the benefit of all of us.
Register your interest
If Maven Funds Management sounds like it may be of interest to you, I would like to invite you to register your interest today.
Over the next few months we will be releasing a lot more investment research, analysis, attending investment conferences, and sharing video insights. We’ll also get into all the specifics of our fund closer to launch.
Thank you all for your support and interest, and if you have any questions please don’t hesitate to contact us here: email@example.com.
Over the past 22 years, the shares of Monster Beverage (NASDAQ:MNST) — best known for its large cans of Monster brand energy drinks — increased in value by a mind-numbing 2,300-fold. That is almost too big of a number to wrap our heads around, so let’s put it like this: for every $10,000 invested in 1997, a shareholder that held on would be sitting on $23,200,000 today.
In 1997 that $10,000 could have bought a decent second-hand car. Today, after investing in Monster Beverage it would buy them a helicopter to go with their cliff-top mansion.
Monster Beverage is one of my favourite investment stories of the last few decades. It’s not just because of the spectacular returns. It’s because it was an easily understood business, and at several points in its journey, clearly undervalued. Monster Beverage demonstrates a particular path to massive wealth creation for shareholders. A path that doesn’t require lucky flukes, or taking huge risks.
While most of the market is mired in mediocrity, there is a small group of companies that generate insane returns for shareholders. I call these companies Monsters for the way they dominate their industries and transform portfolios. A few years ago I set out to study these huge monster winners, reading books like ‘100 to 1 in the Stock Market‘ and trawling through Standard & Poors data to see if I could identify any common traits. Most importantly, I wanted to see if it was possible to identify these winners early, before they started their huge run, and the rest of the market caught on.
The Four Steps
As I see it, there are four steps to catching a Monster:
Choose your hunting ground – avoid pretenders to the Monster throne.
Catch your monster – identify key traits.
Watch closely – continuously monitor and sell quickly if your thesis is broken.
Hold on – be able to stomach the volatility without selling too early.
I’ll talk through each step in turn.
Choose your Hunting Ground
Investing is an art of negative space. What you don’t buy is at least as important as what you do. The best investors say no to potential ideas early and often.
The vast majority of companies have no shot at generating monstrous returns. These businesses should be avoided entirely. They are either struggling to keep the lights on, or they have already begun their long descent into obscurity. If you buy mediocre businesses you’re not going to be able to capture the kind of returns we are seeking.
But there are also four other types of companies that can generate big returns, that I don’t count as Monsters. These are companies that rely on luck or high risk. And for that reason, even though they can deliver high returns, I still avoid them:
If these companies had a motto, it would be: ‘it’s better to be lucky than good’. There is nothing wrong with being lucky, but it’s not a repeatable strategy. Winning the lottery 5 times in row is pretty rare.
Speculative mining companies are the archetypal example. Every now and then some bonfire for shareholder capital actually manages to strike oil/gold/lithium and hits the big time. There’s a reason Australia is called the Lucky Country, and there are plenty of these stories around. The problem is that there are several hundred speculative miners on the ASX. The vast majority of these businesses are cash-infernos. Accurately forecasting winners in that space is almost impossible.
Speculative biotech and pharmaceutical research companies are a similar breed. At least they are attempting to do something more useful than put holes in the ground. But good intentions don’t equal a good investment.
I avoid these speculative ‘lotto tickets’ entirely. Good luck to all players. Not my game.
Commodity price swings
These are companies that soar due to a sharp change in the supply-demand ratio for a basic commodity. The commodity price rockets, taking the company’s shares with it.
This tempts many otherwise smart investors: use your big brain to identify some commodity that will be in high demand, and buy the producers of that commodity before the price rises. In practice, it is extremely difficult to forecast these commodity price swings, and even harder to profit from them. Increased demand typically brings in legions of new suppliers, which ultimately send prices crashing back to earth faster than a lump of unwanted coal.
If you think you can forecast commodity prices well enough to pull this off reliably, you should probably be day-trading commodity futures. Good luck with that.
Companies which have a huge amount of debt can have some interesting properties. If the debt is large enough, and the business manages to avoid being crushed under its own weight, it acts as a big amplifier of returns, good or bad.
The math of leverage explains why. If a business has total debt of $90m, and a market cap of $10m, we would say it has an enterprise value of $100m. If the business doubles in value to $200m, this extra $100m of value would all go to the equity i.e. to shareholders. So a 100% increase in business value results in the company’s market cap increasing ten fold to $100m, and the shares soaring 1,000%.
On the other hand, if the business’ value falls by even 10%…
These highly leveraged companies can be very profitable for shareholders, but the leverage is a double-edged sword. If things don’t work out these companies’ share prices face a large ‘crash risk’, and the sword stabs its owner in the leg. The debt can even overwhelm the company and push them in to bankruptcy.
I like my thai food spicy, but not my shares. Pass.
Back from the brink of bankruptcy
These are zombie companies that were once on death’s door and have now re-entered the land of the living. Buying companies that are going through a panic, or financial distress, can be a winning strategy if the business makes it out the other side.
In times of significant market panic even great companies can be priced like they are going out of business. That would get my attention. But generally speaking, I will leave the zombie wars to others.
That’s four categories I avoid, now let’s talk about true Monsters.
Catch Your Monster
Monsters are businesses that deliver huge shareholder returns by compounding high returns on invested capital. These businesses generate strong free cash flows, and most importantly, the business is able to reinvest those cash flows at high rates, and for a very long time. That reinvestment has a compounding effect over time, with the company’s value building up faster than a snowball rolling downhill.
Altium, Appen, a2 Milk etc. all fall into this camp. I have found there are four key traits these monsters tend to have at the start of their journeys:
#1: They start out small
This might be an obvious one, but it’s important. It is much easier for a company to increase in value 100-fold or more, if it is starting from a low base. Today Amazon is valued at $900 billion. The shares are up 1,200x because the company started off small. For Amazon to increase another 1,200x from here would give it a market cap of over 1 quadrillion dollars. That’s a sum so large it is greater than the value of every financial asset on earth. Jeff Bezos has some ambitions for Space exploration so perhaps we shouldn’t write it off. But it is safe to say that growing gets tougher the bigger you are.
This is why I focus on fast-growing small companies with long growth-runways ahead.
#2: Unique edge
The company must have some kind of durable competitive advantage that forms a barrier to competition. This barrier allows the company to earn those high returns on invested capital, and to ensure that those returns are not eroded over time by new competitors.
These advantages can come in many forms. They include consumer brands, patents, intellectual property, switching costs, economies of scale etc. The most powerful edge usually comes when a company combines both demand advantages and supply advantages. The very best businesses are then able to link these two edges together in a positive feedback loop or ‘flywheel effect’.
My goal is to identify companies with these competitive advantages, and where the advantages are increasing over time.
#3: Superior Management
The importance of high quality management is magnified in a small fast-growing company. If the captain of a large ocean liner steers the boat off course, it takes a long time for the effects to be felt. But if a small speed-boat captain turns the wrong way, they can quickly find themselves on the rocks.
We need a management team that thinks long-term, and has the vision to understand their competitive playing field. This is why we focus on identifying high-quality and aligned management teams. Ideally the founders are still in charge, or management at least hold a large number of shares and behave like owners.
Assessing management is so important to my process that it is very rare that I haven’t met with a management team before buying shares, and often I meet with them several times before becoming comfortable enough to initiate a position.
I left this for last because it is the most important. There is no business so beautiful that it can’t become an ugly investment at the wrong price.
To achieve truly spectacular returns, a company has to start off with a valuation that does not fully reflect its market-thumping future. Ideally it will begin its journey with a valuation that is downright cheap, and then the market’s rising expectations will add a multiplier effect to its growth.
Ultimately the most important step in determining whether to add a potential Monster to the portfolio is to assess its intrinsic value and then to buy at a significant discount to that valuation. And to be undervalued is to be misunderstood.
Whenever we are deciding to buy a business we are asking ourselves what our variant perception is compared to the market. What do we believe that the market disagrees with us on? Perhaps the market doesn’t think that growth will stick around for as long as we do. Maybe it’s not giving credit for new products or geographies. Whatever the reason, their mistake is our potential to profit.
Buying companies at a discount to their intrinsic value is at the core of all sensible long-term investing, Monster-hunting is no different.
The price of catching monsters is eternal vigilance.
Once you have caught your monster, the next step is to clearly articulate your thesis at the time of purchase and then regularly review that thesis as new information comes to hand. Actually writing out your thesis is important.
Not every company that I thought had Monster potential actually delivered. So a core part of my strategy has been to sell quickly when my investment thesis has been invalidated. Class Software is the clearest example of being willing to cut bait quickly when a thesis is broken, as I covered in detail in The Selling Blindspot.
Hold on tight
Catching Monsters takes patience. But even more than that, it requires conviction.
Holding on to a company is much tougher than just passively waiting for the cheques to come in. It means enduring the pain of seeing your company’s share price fall and fall, and maintaining the conviction that it will come out the other side stronger. There is a critical tension here between holding on and selling quickly. The deciding factor is your investment thesis. If it is intact, hold on and ignore the market’s price swings. If the business’s quality is eroding, be prepared to sell quickly.
This is what I like to call a ‘pain chart’, inspired by a Morgan Housel article, for a2 Milk. This chart shows when, and by how much, a2 Milk shares were below their all-time high. (Periods at 0% show when shares hit a new all-time high). Remember, this was during a period when shares increased more than 1,600%:
There have been five times when a2 Milk’s share price fell 20% or more. And on two occasions the shares fell by 30% or more. To enjoy the monstrous gains to date shareholders needed to avoid giving in to fear and selling during those troughs of despair. Those shareholders also needed to avoid the temptation to lock in a profit when the shares were up 30%, 100%, 500%, or even 1,000%.
To hold for that wild ride, investors need to develop, and maintain, a high level of conviction that their investment thesis is correct. Then, ultimately, they need to be proven right.
Most of the market is incredibly short-term oriented. This applies to individual traders as well as large fund managers. These investors are always trying to own the hottest-stock-this-quarter while missing the 100x Monster that is growing beneath their feet.
If you can tune out the market’s noise you will separate yourself from the others.
Vision, Courage, Patience
Catching Monsters is hard. Our view of the future is cloudy at best. The power of compounding means that the biggest winners will create most of their value many years, or even decades, from today. Forecasting that far in to the future is not easy.
Investors need the imagination to be able to think big. To visualise how the company could be performing in the distant future. But then they also need the discipline to bring that big vision back to the reality of the present day, and value it appropriately. That marriage between lofty big picture thinking, and the cold hard facts of present day valuation, is tougher than it sounds.
“To make money in stocks you must have ‘the vision to see them, the courage to buy them and the patience to hold them’. Patience is the rarest of the three.”
100 to 1 in the Stock Market author Thomas Phelps expanding on a quote from financier George F. Baker.
If you can demonstrate those three qualities: vision, courage, and patience, you have a shot at aligning your portfolio with these unstoppable engines of wealth creation. The ride can be bumpy, but it’s also a heck of a lot of fun.
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Disclosure: No part of this report, or disclosure, should be considered to be a recommendation or financial advice. At the time of publishing, Matt holds shares in a2 Milk.Holdings are subject to change at any time.
Most acquisitions fail. Yet a few serial acquirers have created immense value for shareholders. What makes the difference? Can we separate the good deals from the bad eggs before they are announced? Let’s take a look at a live example.
Pushpay’s Profit Inflection Point
Pushpay tipped passed a fundamental inflection point earlier this year as the business scaled in to cash flow positive territory. The market’s reaction has been positive: the shares are up 43% from their December lows. Most of the Church giving software provider’s operating costs are fixed, so when revenue continues to grow from here, Pushpay is set to gush cash.
Pushpay gave operating profit (EBITDAF) guidance for the first time this year. Last week the company upgraded that guidance further to be between US$18.5 to US$20.5 million. Not bad considering that we are only three months into Pushpay’s financial year.
Pushpay has signaled that they will be using these cash flows to fund the acquisition of other software businesses in the faith sector. The platform is now at scale, so any incremental revenue Pushpay can add will fall to the bottom line faster than one of Scrooge McDuck’s money bags.
At Pushpay’s AGM earlier this week, the company’s new CEO Bruce Gordon, noted that the company is looking at several potential acquisitions that could add to Pushpay’s product suite and scale. Australasian banks have indicated they will be comfortable lending up to 3 times Pushpay’s EBITDA, which indicates a potential acquisition war-chest of US$60 million. Pushpay also has a few options to increase their firepower such as issuing the vendors with shares based on how the acquisition performs after purchase.
The Art of the Deal
News that a company is about to start making acquisitions should be taken with caution for one simple reason: most acquisitions fail.
Cultures clash, synergies no-show, and shareholder value is squandered. McKinsey found that only 17% of mergers deliver the revenue synergies that management were forecasting at the time of the deal. Meanwhile a KPMG study found that over 80% of mergers and acquisitions fail to create shareholder value. Those are rough odds. Statistically speaking, you’d get a fairer shake from a spin of your local pokie machine.
But acquisitions can be extremely successful. One of the best performing companies in the world has been built on a virtuous cycle of continuous acquisitions. Constellation Software’s shares are up 3,700% over the past 10 years alone, thanks to a smart, disciplined, and well-executed acquisition strategy.
So what separates the good deals from the bad eggs? Super-achieving acquisitions tend to share a few common traits. Typically the target company:
Has an employee culture that matches the acquirer (or can be successfully operated in a completely separate silo).
Delivers a new technology/product to the acquirer that saves development time, or adds scale.
Has sticky customer relationships with high switching costs (so that the newly acquired customers don’t run away if there are any stumbles).
Has genuine revenue and cost synergies with the acquirer.
Provides a new competency or other strategic value.
Is available at an attractive valuation.
That last point, valuation, is always the most important. Choosing the right target company matters a lot, but paying too much can turn even the sweetest milkshake sour.
So let’s review six of the company’s most likely acquisition options.
Option 1: The worst deal
The worst possible option in my view would be to purchase a business from Ministry Brands.
Ministry Brands is a private-equity backed holding company that has rapidly acquired a collection of 31 different faith-based software companies over the past few years. Ministry Brands is big. It reports to have 55,000 church customers and in 2017 generated over $100 million in EBITDA. That size is the result of an aggressive slash-and-burn acquisition strategy that is straight out of the private equity playbook. Ministry Brands buys a software company, cuts staff numbers to the bone, reduces investment, strips out any costs it can, and raises prices for customers.
That is never a beloved business model, and is particularly despised in the principles-driven faith-based software sector. Ministry Brands has a poor reputation with churches, and rock-bottom staff satisfaction. The approach is so disliked that some church software companies now publicly reassure clients that they are ‘not for sale’.
The private equity company that owns Ministry Brands is now looking for potential buyers, so the whole collection is potentially up for grabs. The entire package would be too big for Pushpay to purchase outright (excluding some insanely leveraged deal). However Pushpay could be tempted to purchase one or two of the 31 software companies that form part of the collection.
This would be the simplest deal to get done, since Ministry Brands is both experienced at these types of transactions and is a willing seller. But it would likely be a bad move. Pushpay would be buying from a sophisticated private-equity seller that has already done everything legally possible to squeeze all the juice out of the lemon before they sell it. It’s possible that there are some gems hiding in the dirt, and any asset can become attractive at a low enough price. But this deal should come with a big ‘Buyer Beware’ sticker. Avoid.
Deal rating: 3 out of 10
Option 2: Tackle the Innovator’s Dilemma
For many years Pushpay had a broad brush, signing up churches of all shapes and sizes. But in mid 2017 the company narrowed its approach, restricting its sales efforts to what it termed ‘Medium and Large’ sized churches. Medium churches are defined as those with over 200 weekly attendees, while large churches are those with 1,100 or more. The largest U.S. churches can have over 40,000+ weekly attendees.
This shift was probably the right call. At the time Pushpay was still in heavy cash-burn mode, and its internal analysis found that larger churches were vastly more profitable. These customers had bigger budgets, so could afford to pay more for Pushpay’s software, and generated higher payment processing fees. The bigger churches also tended to fully implement Pushpay’s giving solutions and admin platform, and so they had much higher retention rates. Pushpay calculated that small church revenue retention rates were just 80%, compared to over 100% for large churches.
Lastly, the weekly attendance of the largest ‘mega-churches’ has been growing fast as younger people prefer the energy and scale of a bigger church. That growth has come at the expense of the smallest churches, which typically see their weekly attendance slowly decline. Roll it all together and the large church segment is vastly more attractive for Pushpay.
So Pushpay stopped selling to small churches and focused their energy exclusively on larger clients. This allowed Pushpay to get to profitability faster, as has been demonstrated in the latest results.
But by doing so, Pushpay opened the door for a lower-cost competitor to target this small-church customer segment. This presents Pushpay with a potential Innovator’s Dilemma: when a small competitor is able to challenge a much larger incumbent by offering a lower-cost product. Initially the low-cost product is inferior, but over time, and with enough scale, the new upstart can sometimes challenge the incumbent on quality too. When a low-cost competitor can also sell a high-quality product, it’s often game over (just ask any business that has tried to take on Amazon head-on).
Enter Tithe.ly. Founded by a former pastor, Tithe.ly has a similar modern digital approach to donations management as Pushpay. I have been monitoring the company since 2016, and for many years Tithe.ly was not a concern. It was sub-scale and severely under-funded. The company’s low prices and small church clients meant that it could not afford to invest in sales, product, systems, or customer support on nearly the same scale as Pushpay. Tithe.ly had not raised meaningful capital, and as of April 2017 was processing just ‘tens of millions’ of dollars in donations, compared to the billions that Pushpay was processing each year.
Pushpay’s exit from the small church segment changed all that. Pushpay’s sales machine was no longer targeting the small churches, which allowed Tithe.ly to hoover up thousands of these customers over the following years. Tithe.ly has used this new found momentum to raise meaningful capital, starting with two US$2m funding rounds in 2017 and 2018. Then in March of this year Tithe.ly raised a USD$15 million funding round, which valued the company at USD$129 million. Tithe.ly plans to use the cash to hire up to 30 more engineers over the next year to build out its platform.
Today Tithe.ly counts over 10,500 churches as customers and is reportedly growing fast. These small church customers are significantly less valuable than Pushpay’s, so in total giving and revenue terms Pushpay is still many multiples larger. But the recent funding round, and the potential for Tithe.ly to disrupt from the low end, makes it a very credible threat to watch.
Pushpay could respond to this threat in a few ways. It could continue to focus its energy on robustly defending the Medium and Large church segment. If Pushpay can make its product sticky enough, it may be able to avoid low-end disruption altogether. Some of the other acquisition options we will talk about later can help this.
Alternatively, Pushpay could launch its own low-cost brand. Airlines have been using this strategy for years (think Qantas and Jetstar) with mixed success. This has the advantage of being cheaper, but could easily distract management.
An even bolder move would be to acquire Tithe.ly outright. But given the culture clash of premium Pushpay and low-cost Tithe.ly, the acquisition would likely flop unless they were able to run the two businesses independently. Also the tech startup scene is frothy, so Tithe.ly’s valuation may already be outside Pushpay’s budget.
This deal would have the potential to solve a major long-term challenge, but it would come with a lot of risk. Whether it is by acquisition, or other means, Pushpay need to be taking this Innovator’s Dilemma threat seriously. One to watch.
Deal rating: 6 out of 10
Option 3 – Go vertical: Buy a Church Management System
At the core of every large church is a Church management system or ChMS. These are similar to an enterprise resource planning system. A ChMS allows the church to do everything from manage their services, keep track of child check-ins, and roster volunteers. It’s an integral system of record, with very high switching costs.
Pushpay’s giving solutions integrate with numerous ChMS’s. Until now, Pushpay has avoided offering its own ChMS so that it is not competing with its own distribution channel. But as the market has matured it has become more common for payments providers to do both.
There are numerous potential ChMS’s that Pushpay could acquire. Church Community Builder (CCB) is a ChMS that Pushpay has had a longstanding relationship with, and which serves over 4,000 church clients. However CCB’s software stack is outdated and generally not up to the premium quality of the rest of Pushpay’s products. The move here would be to acquire the business primarily for the sticky customer relationships. Pushpay could cross-sell its giving product to those CCB customers that don’t already have it, and then modernise the software itself over time.
Another approach could be to buy a ChMS which is smaller but has more modern tech. The software would be up to Pushpay’s standard much more quickly, but with the trade off that there are fewer customers on day one.
The dream purchase in my view would be a ChMS like Planning Center which is growing fast, has over 50,000 church customers, and a very clean and modern user interface. Planning Center has no sales team, it reinvests all its cash in to product development. Planning Center’s product is modular with nine different products that can be sold individually. This makes it a great complement to Pushpay who could let their formidable sales team loose with a high-quality product suite. It does raise the risk of a culture-clash, but given the other strategic similarities this may not be such a big deal. Unfortunately Ministry Brand’s slash and burn approach to acquisitions has led Planning Center to publicly declare to clients that it is “not for sale” so it may be tough for Pushpay to win over the founders.
In any case, acquiring a ChMS would significantly deepen Pushpay’s relationship with its customers, boosting retention rates and increasing switching costs. It would also give Pushpay the opportunity to market a new product to its existing clients.
Overall it’s a solid acquisition opportunity. But I would caution against purchasing a sub-standard technology product with the plan to improve it. When a team of developers need to constantly patch over holes in a leaking ship, it can be tough to take the time to build a new, modern software product.
Deal rating: 7 out of 10 [Add one point if Pushpay buys a modern ChMS, add two points if they somehow pull off acquiring Planning Center]
Option 4: Buy a competing Engagement App
Pushpay is more than just a payments processor, it also provides churches with ‘systems of engagement’. In other words, apps for churches. These apps become core to the church’s interaction with their members. The attendees can watch past sermons, follow along with bible verses, and register to attend a particular session. Most importantly for Pushpay, these apps also integrate a giving button which then allows a user to make a one-off or recurring donation.
That last feature is key. Most church app providers make the vast majority of their revenue from providing the software. Pushpay charges for the app software, but generates most of its profits from the donation processing fees. This leads to some sweet alignment as Pushpay is incentivised to maximise both engagement with the app, and total giving. Churches win because they receive greater donations, and Pushpay wins by receiving a cut of the increased processing volumes.
There are two main competitors that Pushpay could look to acquire here, Subsplash and Aware3. These companies are both currently the app providers for thousands of church customers. However neither are meaningful players in donation processing. That means that the customers of both Subsplash and Aware3 are more valuable to Pushpay than they would be to the companies themselves. That’s an attractive feature when making an acquisition. Pushpay could acquire either business, and use it’s more advanced sales team to cross-sell their giving solution to thousands more churches.
One wrinkle is that both Aware3 and Subsplash have been trying to emulate Pushpay’s donation processing business model (without significant success), so they may be reluctant to sell out and give up on the big prize for themselves. Also Subsplash and Pushpay have battled aggressively in the past in their marketing, so there is the risk of a culture-clash if Subsplash is acquired.
If Pushpay are looking for a safe bet for their first major acquisition, the purchase of Aware3 would be a leading candidate.
Deal rating: 7 out of 10
Option 5: Buy a Catholic software product
To date, almost all of Pushpay’s customers have been evangelical and Protestant Christians. That leaves a very large denomination where Pushpay has yet to gain traction: the Catholic Church.
Catholic churches are large, with just 20,000 churches serving 59 million attendees (that’s around 3,000 attendees per church). That should be a good fit for Pushpay’s product. But the Catholic church tends to be slower to adopt new technology. It is also more hierarchical in its decision making. One high level decision can see a certain software solution adopted by an entire region. That makes any new deal harder to win, but potentially much more valuable.
By acquiring an existing Catholic software company, Pushpay would gain a foot in the door. It could then leverage that existing trusted relationship to demonstrate its full suite of giving and engagement products. It won’t be an automatic win, but the potential is big enough that it is worth serious consideration.
Deal rating: 7.5 out of 10
Option 6: Buy an adjacent product
Pushpay currently has two products: giving and engagement (apps). It is also working on its own donor management module so that it can deepen the relationship with its customers. But there is a big church software world out there with many other new products that Pushpay could develop or acquire.
A strong acquisition for Pushpay would be to buy a fast-growing small software company that provides one of these adjacent products. For example Brushfire provides an events management and ticketing product that helps churches manage events outside of their usual weekly service. The product itself doesn’t have the incredible unit economics of Pushpay’s giving solution, but it would make Pushpay’s customers even more likely to stick around. It would also provide a new product that Pushpay’s sales team could sell to their existing customers, and earn some high-margin incremental revenue for their trouble.
There are many products like this that Pushpay could acquire, significantly reducing their time to market. These companies would likely be well within Pushpay’s budget, add a lot of strategic value, and are likely to be a good cultural fit.
Deal rating: 8 out of 10
Pushpay’s Next Adventure
Pushpay has tipped past a fundamental inflection point, and its strong operating leverage means the business is set to gush cash. Pushpay can now put that cash to work on some smart acquisitions. The core platform has reached scale, so any new high-margin revenue will generate additional free cash flow. That could enable further acquisitions and accelerate the value-creation flywheel.
Pushpay will need to avoid the traps, and find a business that fits both strategically and culturally. Most importantly in this frothy market, Pushpay will need to maintain valuation discipline and pay a reasonable price. If it can do all that, a smart value-creating acquisition could be a match made in heaven.
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Disclosure: At the time of publishing Matt has a position in Pushpay. Holdings are subject to change at any time. This report, and disclosure, should not be considered to be a recommendation.
Peter is a pretty incredible guy. When he was eighteen he built a rocket in his garden shed, strapped it to a custom-built bicycle, and took it for a spin in a local parking lot (and hit speeds of over 150km per hour). If you don’t know much about Peter, this quick four minute video gives a great overview.
With plenty of other news outlets already asking about Peter’s extraordinary background, I instead focused my attention on the company’s business model. Due to size limits, most of our conversation could make it in to the final article. So for the folks that have asked, here is the full length interview:
I know your story pretty well. I am keen to hear in your own words, your story, and why you decided to start Rocket Lab?
Peter Beck: So, for me it was always very obvious that Spacecraft were going to shrink. So when you analyse what is in a spacecraft there is a bunch of electronics, batteries, solar panels, and a sensor . And all of those things are on rapid trajectories either down in size or up in performance. So it was always really obvious to me that small spacecraft were going to become a key element to building a space infrastructure in the future. So really their limiting factor and enabler for that future was the ability to get those spacecraft up in orbit regularly, affordably and frequently. So there is a good reason why we’re currently the only small launch vehicle delivering spacecraft to orbit and that’s because we saw that before others did. And also we were able to rapidly develop the capability. That’s what it is really all about.
It’s a super exciting time in space right now when you think about it. The best way I try to explain it to people is go back to when the Internet was brand new and somebody had just sent their first email. It was obvious that was pretty handy as a messaging tool. But if you went and sat beside that person at that time who sent the first email and explained to them all of the things the Internet was going to create it would largely seem like fantasy. And really with space, we have just sent that first email. That’s pretty much where we are at. Because space has been a domain that has been so hard to get to. So closed. So expensive. That it’s a domain that’s very hard to innovate and do these things in.
It’s an incredibly, incredibly,- exciting time. The biggest thing to be done in space is yet to even be thought of. People often ask me what do you think about are the various aspects of what is going on in space. What do you think of earth observation, and all these things. I think they are great. But the application of what they are providing is going to be dwarfed when we have full access to the domain of space.
I am keen to talk to that, and the economics that go with it. What do you think has sparked the small satellite revolution. What are the big enablers that have come together to allow Rocket Lab to work, and cubesats, and everything that goes with it?
There are a number of things that have combined at the right point in time. First there is the technology. That’s obviously a key enabler. That’s kind of a no-brainer. But technology by itself doesn’t necessarily enable a revolution. There are all kinds of different aspects.
Silicon Valley really saw it very early that space was something that was right for disruption. If you think of all of the domains where you build infrastructure: in the sea, on land, in the sky. Those have all gone through all their major disruptions. And its very incremental from here on in. But space is one of those things that hasn’t had a giant disruption. You could draw a line on a piece of paper that could show where you could create a disruption that didn’t require development of crazy new technologies or the usual billions of dollars that governments need to shell out to do these kind of things. So you had a perfect storm of technology that was ready to be used, investors that could see the opportunity and were ready to take the leap in to space, and a new generation of engineers and entrepreneurs who weren’t afraid of the space. Who broke out of the mold of space as a domain for governments to be in. it was kind of like, screw that, we can go there too. So I think that’s pretty much what has resulted in this industry.
So the Silicon Valley guys started investing in spacecraft very early on and in the very beginning it was earth observation because there was really only one giant monopoly company that was providing earth observation services, that was a printing press for money. So it was ripe for disruption. A number of companies started down that road, and build space craft. And then they tried to launch them. And that’s when it all fell to bits.
So when all the investors in Rocket Lab had [previously] felt the pain of launch. They all invested heavily in to small satellite companies. Only to have the satellites sit on the shelf for years. So when we turned up and said, hey look there’s a really big problem and there is a really big pipeline of spacecraft coming, and they go I know! We’ve got some of them. So it was a very very short line to draw to a launch vehicle that provided regular and rapid service to orbit.
What was your pitch to Venture Capital investors? You have been very successful targeting some top end VC firms. Was it ‘this is the world in 40 years’? Or was it, we have the technology now, and you already know the problem?
I was very targeted with who I wanted to invest in the company. It just so happened that the VCs I wanted involved in the company had big aspirations for large companies and large projects. But they also had felt the pain of launch. So that bit of the pitch didn’t need explaining. But you also have to realise that I had turned up, a New Zealander, from the country that had no space heritage. We had obviously done a lot at Rocket Lab, and we were going to build a small orbital launch vehicle. It was going to be using materials that nobody had ever used before, technologies that nobody had ever used before. From a launch site that required a bilateral and a whole regulatory framework to come together to make happen.
Launch vehicles are an enormous challenge. We often joke that the medical guys think they have a hard time getting a product in to market, boy you want to try a rocket. You’ve got everything against you from physics to regulation.
How do you think being from New Zealand and something of an outsider to what was happening in the States change the way you approached the problem?
Something that we did that was very different was we looked at the problem holistically. We said, it’s not just about the rocket. Basically I wrote two requirements on a piece of white paper: must be launched weekly, and must be affordable. And the affordable bit is relatively simple to model and understand. The launch regularly bit is the bit that everybody misses. So the only reason why we have operations in New Zealand even though we are a U.S. company, is because of the launch site.
We went to every single launch site in America and said look we want to launch ever 24 hours, and while everybody agreed that’s what needed to happen, they also reminded us that every time you launch a rocket you delay national air travel. So when Elon’s Falcon Heavy flew earlier in the year, there were 562 commercial air flights that were delayed or cancelled. So people get a bit antsy about that kind of stuff, and when you are trying to do it every 24 hours, ironically it was one of the few things that didn’t scale in America.
So I tell everybody that Rocket Lab is a third the rocket, a third regulatory, and third infrastructure. And the infrastructure and regulatory bit aren’t as romantic and sexy like a rocket, but they are actually more the enablers than the rocket itself.
Thinking through segmenting your customers, who is the typical Rocket Lab customer, and what are they trying to accomplish?
Yeah, look, I wish there was a typical one to be honest with you. It is very varied. We have at one end of the spectrum a high school student with a 1U* cubesat which we are flying on this next mission, through to a government trying to build a sovereign capability, and everything in between.
*[Matt’s note: Cubesat’s are the new generation of tiny satellites. As you might guess they are cubes, and 1U here denotes one ‘Cubesat unit’ which means a satellite that can fit entirely within a box with the dimensions of 10cm x 10cm x 10cm. Rocket Lab is taking bookings for cubesats of all sizes, with one rocket ride containing up to 82U worth of cubesats. A single launch can carry 20 different cubesats, each ranging in size from 1U to 12U. In addition Rocket Lab also offers bespoke flights for just one satellite with a typical payload capacity of 150kg. ]
So what are the current use cases today? Is it mostly imaging? Experiments? Without going in to the specifics for any particular customer. What are the use cases that you are seeing?
Sure. I think statistically based on the manifests next year we have a majority of weather spacecraft. So you know weather is something that has typically needed to be done by governments, at a pretty low government-type level of technology sophistication. So its one that is really ripe for disruption. So the high-fidelity that you can provide, not only am I get married today. They will make decisions like, am I going to build this infrastructure project this month. So really big decisions get made on weather data. So statistically speaking weather is probably next year, our biggest flight rate. Imaging is definitely there. Also a lot of technology development. So we have got a NASA payload that has 13 payloads on board, and all of those are basically technology demonstrators and sensor experiments and things like that. And that’s probably the vast majority that would be one of those three things.
Okay cool, and putting the Sci-Fi hat on, do you have any sense of where you see it ten or twenty years? Or are you trying to avoid any crazy predictions? Where do you see it could potentially go? I think you talked about a space Internet previously?
I am not even going to care to guess because like I said at the beginning, I think the most significant thing that is going to be done in space is yet to be even thought of. The most interesting thing for us is we see ourselves as the enablers of this. We already see it now. People are designing spacecraft for the Electron environment. It’s a very very smooth ride to space. Smoother than any of the other rides out there. It’s a big fairing volume and they can design spacecraft in a totally different way. And we already see that occurring and we see some really really unusual missions. So another example is that the traditional way that spacecraft are getting to orbit right now is that they are ride-sharing on the side of big rockets. But those big rockets only go to certain orbits. Now with our launch site we’ve got a huge range of orbits. So all of a sudden totally new missions are being developed. Totally different weather missions are being developed. Different earth observation and comms missions are being developed. Because all of a sudden you have access to all these different trajectories and all these inclinations to provide different services to different countries. So it’s already starting to happen. And that to me is one of the most exciting things is to see payloads that have been designed specifically for Electron, and those payloads would not have existed without the vehicle.
Absolutely. I think you mentioned that a lot of people are designing to the Electron specifications now which is pretty cool to see. What do you think are the top say 3-5 most important factors for a Rocket Lab, in rough order of importance? I’m guess frequency is pretty high up there, but what do you think is number one most important roughly and then down the list?
It’s control of destination and timeline. That’s the number one thing. “I’m going to this orbit on this day” because that’s one thing that [traditional] ride share can never offer. Because you just don’t know where you are going to go, when you are going to go. So that’s pretty much the order of conversation when someone comes and sees you is “I have got this spacecraft that requires to get to this orbit on this day, is that good?” Then other discussions occur later, like the environment of the vehicle and price, and all of that kind of stuff. But really that’s the number one thing that people need.
For us its a huge responsibility because a lot of these, especially these early stage guys, they are building their business plans off the back of us. They’re building their business off the back of us, to get them in to orbit and to get them generating revenue quickly.
Morgan Bailey (Rocket Lab’s Communications Manager): Just to point out too, those two factors are something that we offer a wider range of than anybody else. Not to mention that we are the only ones that have made it to orbit so far, but if you are looking at launch schedule, as well as where you want to go in orbit, we’ve got the widest range of orbital inclinations that you can reach from one site in the world. We also have the most launch frequency out of any site in the world and we are upping that and developing more schedule freedom by developing a U.S. launch site. So we have heard the market and really responded to that.
Peter I’d be keen to hear your thoughts on Rocket Lab’s ‘Master Plan’ thinking ten, or twenty years in the future, where would you like the company to be at that stage?
Well the first point here is that everybody thinks we’re going to build a bigger launch vehicle [rocket]…
I wasn’t going to ask that question… I think you’ve been asked that one too many times, and might be sick of answering it…
No, good, good, good good good. Yep. So the definition of success for me is that we are able to enable these companies to get on orbit to do the things that they want to do. And the things that they want to do are going to have a huge effect on everybody down here on earth. So you know, we don’t have aspirations of going to other planets, or taking humans in to space. Where I honestly believe we can move the needle for the human species in the most significant way, is actually to create space as an accessible domain for people to innovate. So if everything has gone well in 5-10 years, the world will be a totally different place. And we’ll be able to trace some of the origins at least, back to our program.
I’m keen to ask about the economics. So you have Space-X going in the opposite direction building a very large rocket. Do you see that [Space X] being the option if someone was looking at a launch and not worried about frequency and control of destination for whatever reason, it might be the low-cost option, versus Rocket Lab’s [more premium option]. You once talked about a freight train vs. a Fed-Ex truck. Do you see Rocket Lab more serving the more frequent and more targeted end of the market? Is that how you see the market breaking out?
The ironic truth is that we are pretty much the same price. You know the cost of a ride-share. We targeted the cost of the vehicle to basically equal the cost of a ride-share. So there is not a whole lot of advantage…
So there’s not that much price difference in it is what you are saying?
No! There wouldn’t be a whole of advantage for anybody to do that. And we are reaping the rewards of that decision right now.
Have you ever had contact with Space X or Elon Musk? You’re often compared to Elon. Is there a Space Club that you guys all hang out at?
A Space Club?! (laughing) No, no, there’s not a space club. Obviously the community is relatively small so we all kind of know each other, or know of each other.
[Matt’s note: Clearly it was foolish of me to ask about Space Club. As a good friend later pointed out, the first rule of Space Club is ‘Don’t talk about Space Club!’]
How have you found it building a lot of the R&D in New Zealand. How have you found that process? Was there a pool of engineers waiting for something like Rocket Lab to come along? Did you bring in a lot of expats? How was that recruiting process?
Yeah I don’t think it’s unique to New Zealand, but any company that grows at the speed that we have grown at struggles with that. We have recruited from all around the world, and New Zealand, and in our U.S. operations. It’s three to five new starters a week for us, pretty consistently. So its always a struggle. And I can say that operating both Rocket Lab USA and Rocket Lab New Zealand. It’s not unique to either one of those sites. There is a lot of competition for the talent up in the U.S. with Space X and Blue Origin. So it doesnt matter where you are in the world, it’s always a challenge.
How would you describe the culture at Rocket Lab? What kind of culture are you trying to build?
This is a place where you come if you really want to see what you are capable of. This is not a biscuit factory. This is a place where we try and attract the very best talent in the world, we give them all the resources, and the most amount of time that we can, and ask them to go and do incredible things. And the wonderful thing about Rocket Lab is we are at a size where you can still come here and own a really significant thing and be in charge of it and responsible for it. Once you get up to Space X and Boeing and those kind of sizes you end up being very siloed on one particular project or outcome. The one thing here is people can come here and own as little or as much as they want to, and really reach their full potential as an engineer.
I’m keen to dig in the economics. The price of a launch at the moment is around USD$5.7 million. When you are at scale, what kind of gross margins do you expect to generate?
Generally as a private company we don’t talk too much about that. But the starting price is $5.7 and depending what service you want service you want that changes. Like we said before it’s pretty competitive to rideshare. And we are anticipating being cash flow positive this year. So that should give you an indication of the financial footing of the company, and the financial performance of the product.
Something that is interesting about Rocket Lab is how much work you have done on the foundations. It’s not just vertically integrated, you’ve got your own monitoring sites around the world, you’ve built your own launchpads. So I am keen to hear more about that strategy? I imagine you have got a lot of fixed costs but after that you are able to pump out as many [rockets] as you can?
Exactly. There is nothing like owning it in my experience. Once you have got to ask somebody to borrow theirs, or rent theirs, then that gets a little more difficult. So the strategy is always to be as vertically integrated as possible. Owning that infrastructure is a key element because we have complete control over our launch windows, we have complete control over, basically everything. Whereas when you go on to somebody else’s launch range, and there is other people there and other customers there, and other activities there, you are always in a compromised position.
But like I said its from the vision from the beginning, which is, how can we get to a launch every 24 hours, or more. Really that comes down to, you have to own it all, you have to have these dedicated assets that serve your business and nobody else’s.
And once you are at scale, what do you think most of the cost of each rocket launch would be? Is there a lot fuel component there, is it a lot of man hours going in to construction? Whats the biggest driver of your costs once you are at scale?
Great question. So, fuel is irrelevant. So basically the cost of fuel is a rounding error. That’s because liquid oxygen is cents per kilogram. The kerosene we use, we use almost, bugger all of it. So that’s kind of in the weeds. The way we have designed the vehicle, its designed for manufacture. So while we use very expensive and exotic materials such as carbon fibre, and inconel superalloys and things like that, we don’t use very much of them. And the processes that we use, like the 3D printing of the rocket engines, means that while the material itself is very expensive, because we 3D print them, there is no wastage in the material. It’s additive manufacturing rather than subtractive manufacturing.
So the cost of the vehicle is pretty well equally broken up between raw materials and labour. Labour would be the higher cost component to the vehicle. But the great thing about that of course is that because the vehicle is designed for production, there are just huge automation opportunities just designed in.
I think you mentioned somewhere else with the batteries, you have already seen a 2X improvement in the size and cost over time. So that’s a driver for Rocket Lab as well, you are positioned to benefit from all those scaling effects in different technologies.
Yeah exactly. We stood back and said well what are the technologies that are either going to reduce in cost or improve in performance. Composites is one of them. 3D printing is another one. And batteries is another one. So there is no coincidence why a lot of the solutions we have chosen align with the trajectories of those either materials or technologies.
Something you’ve addressed elsewhere that I am sure our audience is interested in is the idea of [rocket] re-usability and why doesn’t that work so well for Rocket Lab, and why you haven’t pursued that to cut costs?
Yeah so the vehicle has been designed for manufacture from day 1. So to re-use a vehicle you end up making a lot of trades with propellant and mass. So some things scale very well, a reusable on something like a Falcon 9 scales very well. It’s important to note though that on a Falcon 9, the average payload mass that vehicle lifts is 3 tonnes. Yet it’s capable of a 13 tonne lift. And when you re-use a launch vehicle it takes about a third of all of your payload capacity to do that. Which is fine when you have a very large vehicle that can lift a lot and you are not lifting very much with it. But something like a small launch vehicle, that doesn’t scale very well.
Yes and as you say there is one third [of the business that is] infrastructure, all the other stuff that potentially goes with it if you have a robotic drone-ship out there trying to catch it [the rocket] and that probably doesn’t scale too well either.
This is a tough question because it is likely so varied, but what do you think the cost that Rocket Lab presents to your customers as a percent of their total costs. So if a customer is trying to put a satellite up, how much do you think Rocket Lab represents of that? Is it half the cost of the program for what they are trying to do? Is it a quarter? I’m trying to get an idea of Rocket Lab’s position in the economics of the business.
Yeah, you’re right Matt it really depends on the spacecraft. So if you’ve got a 3U cubesat that costs nothing to build, then you’ve got the launch element that is a much larger section of it. But when you are talking a government payload you are a small fraction of the cost of the development of that payload. Simply because of the cost of doing business as a government, or the complexity of the payload itself. So I am not sure where that would sit on an average. I would just say that it varies quite widely. So if you are an early-stage startup, then we’ll probably represent a significant portion of your costs. If you’re an established large Corporation or a Government that is flying one-hundred to two-hundred million dollar payloads, then we represent a relatively small section of the cost.
Something I noticed while browsing your website [www.rocketlab.com] which is very cool and lets me imagine I can buy a cubesat slot itself, it looks like you are significantly booked out already. I’m curious to hear, is sales much of a role at your company given the demand that you have now? What is the sales process like for Rocket Lab?
Not surprisingly this has been talked about and dreamed about, this capability, for many many years in the community of small spacecraft. So when something turns up, it’s greeted with much [excitement]. And there are so many people out there that have promised it for so long and never even made it to the pads, let alone to orbit. That it’s like pulling the path on a bathtub. We’re very busy and next year we’ve had to put more rockets on to try and meet the demand of our customers. And going out to the later years as well its still incredibly busy for us. But this is not surprising to us. This was always, this is the plan. For us it’s just about scaling up as fast as we can to service those customers. So that they can do the incredible things that they do on orbit.
You’ve made a lot of improvements that others are now following, with 3D printed engines, carbon fibre. What’s next in tech? Are there any other big step changes that you see? Or are these the main things and it’s just refining and cutting costs as it goes?
Oh look we’re not done yet. Not by a long shot. So, you would have seen the kick-stage which we announced on the second flight. That is hugely enabling for a lot of our spacecraft customers, we can deploy multiple spacecrafts at different orbits. So expect to see a steady stream of innovation from Rocket Lab. That’s what we’ve built ourselves on.
[Matt’s note: you can watch a video about the epic Mars cubesat project here]
Oh yeah look there is a lot of growth in that field right now. I just came back from the small satellite conference in Utah last week, and there must have been a dozen companies doing cubesat propulsion systems. Either electric ion thrusters, or chemical. And look it makes perfect sense. You put an asset up there, that assets lifetime is determined by how quickly it re-enters so you can increase its life by doing station keeping burns but then all of a sudden you can do all this other stuff, you know, like go to Mars. So this is kind of what I am talking about at the beginning, that the biggest thing is yet to be done or even thought of. Because we are just now seeing some of those innovations. Even five years ago if you would have said to me that you are going to put a hall thruster on a cubesat and take it to Mars you would just think: what!? But now that’s just like, oh ok, that makes sense.
On funding, do you have any plans in the future for an IPO, or are you quite happy not having to deal with all that side of things right now?
Oh well never say never. Right now we are fully funded and on a great trajectory. We’ll see what the future brings. It would be interesting to see a rocket company IPO’d for sure. I’m not sure if Space X is no doing that any time soon.
Peter, what’s been your proudest moment with Rocket Lab so far?
Oh jeepers…well the cop out answer is going to orbit. When we put that spacecraft in orbit, there were a lot of firsts there , first carbon fibre rocket, first private launch site, first 3D printed engine and blah blah blah. That was a defining moment for the industry. You know to do it out of New Zealand was great. You can imagine that not many people ever thought that the first one ever was going to be coming out of New Zealand. If you were a betting man ten years ago, that one would have been long odds. But that certainly is [a proud moment] but there are so many highs and lows that it’s hard to say. But really I guess I am proud for the team is the real answer there, because you know you take a couple of hundred of the brightest people on the planet, jam them in a little room, and feed them pizza and coke, and watch the magic happen.
I guess the humanity star was potentially quite a full circle moment given your origins as a kid looking up at the stars and deciding to get in to it?
Yeah that was bitter-sweet because not everybody liked that.
Yes that was a bit of a bizarre reaction.
Yeah but for every negative comment we saw on that, we got probably two positives. It makes a better story to have some tension there. But still I maintain I would do that again in a heartbeat. That was a great mission. And to see just the thousands that wrote in and actually that overview experience where they looked up and it was like ‘oh okay I am on this rock in the middle of the universe, maybe some of these things aren’t as big of a deal as I thought’. So that was a wonderful project.
Last one from me. What do you think is most misunderstood about Rocket Lab?
It depends if you are in the industry or out of the industry. If you are in the industry then we are pretty well known and understood. The easy one is that we are actually a U.S. company, not a New Zealand company. The New Zealand bit is really about launch. But out of the industry you’ll see Space X and Blue Origin and Virgin Orbit and those companies really talked about a lot. But out of all those companies it’s only Space X that has ever been to orbit. So that’s probably the one thing. There are two private companies in the history of this planet that have been to orbit and it’s Space X and it’s Rocket Lab and that’s it.
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Kiwi technology startups have reached a tipping point. In everything from rockets to Saas software, the tech tinkerers that used to hide away in their garden sheds are striding out proudly, building big companies, and taking their place on the world stage.
I recently returned from a research trip to New Zealand. I was fortunate to be able to meet with CEOs, founders, CTOs, angel investing groups, and major private investors. Those meetings demonstrated the revolution that is happening in kiwi technology businesses.
From Sheds to Startups
New Zealand has a proud history of resourcefulness and ingenuity. The country sits in a remote corner of the South Pacific. If something wasn’t working, generations of kiwis took it upon themselves to fix it. If you did not grow up in New Zealand it is entirely possible that you are completely unaware of this. But for those of us who did, New Zealand’s list of innovations, from splitting the atom, to the jet boat, to the electric fence, has been hammered in to our brains since before we were old enough to bungy.
New Zealand might have been a nation of backyard tinkerers. But most inventions never became businesses. There was a culture of innovation and invention, but little commercialisation.
A few years ago that began to change. TradeMe’s sale in 2006 was a seminal moment (for Australians, imagine one business that combines Gumtree, REA Group, Carsales, and Seek all in to one). A business started in 1999 was sold for $NZ750 million to Fairfax just seven years later. Kiwi entrepreneurs began to realise that they could build a big technology business too.
3 Key Lessons From Xero’s Big Win
If Trademe unlocked the door to New Zealand’s tech success, Xero knocked it off its hinges. The cloud accounting software company’s founder, Rod Drury, was a technology veteran. Before starting Xero he had already created and sold two software companies (Glazier Systems: $7.5 million, Aftermail: US$45 million). This time was going to be different. This time he wasn’t going to sell, he was going to take on the giants at their own game.
Today, thirteen years after founding, Xero has over one million small business customers, and a market cap of over $6 billion.
Xero had three major impacts on the NZ tech scene. First, it demonstrated that to build a massive global company required a new skill-set: sales and marketing. Second, it raised the bar. Kiwi entrepreneurs now aimed to build global scale businesses themselves. Third, the wealth created for early investors, and the skills developed along the way, meant that there was a new group of sophisticated technology investors.
Lesson #1: The Power of Story
“Our only option really was to tell a big story, and explode early from day one” — Rod Drury
Xero developed some pretty great cloud accounting software. But Xero’s biggest innovation wasn’t their tech, it was their sales and marketing strategy. Xero turned accountants in to raving fans.
Accountants could see how much easier Xero made their lives, and so they pushed their small business customers to sign up. Xero brought them in on the deal, with accountants effectively earning a cut of the monthly Xero subscription. It was a masterstroke. Xero invested heavily in the relationship, developing new features to make sure that accountants remained the company’s biggest cheerleaders.
Pushpay, a payments and engagement software company for the faith sector is another kiwi success story that understood the power of sales. Pushpay’s technology was highly innovative, but it was their sales team that really drove their success over the past few years. In just eight years the company has gone from an idea, to processing over US$4 billion of donations annually, and with 55 of the 100 largest U.S. churches as customers. That was only possible because the company developed a sophisticated sales and marketing process.
New Zealand’s culture of humility means that selling is an underdeveloped skill set for many businesses. But companies miss this lesson at their peril.
One small publicly listed software company that I met with had been close to running out of cash after multiple failed sales strategies. The original founder had wasted millions on ineffective international sales teams that did little more than book meetings. A new CEO has stepped in and is currently rebuilding the business, and the marketing process, on a surer footing. I am watching with interest.
Lesson #2: Think Global, Scale Global
It used to be that kiwi tech startups would only think about international sales once they had exhausted their local opportunities. Today the best New Zealand tech companies are global from inception.
But thinking global is only half the story. Companies can’t be everywhere, so they must pick a few key markets, and ensure they scale up aggressively there before then expanding further. That means delivering on customer needs, and building depth in every geography you enter.
Xero serves customers in dozens of countries, but focuses on just three major markets: Australasia, the UK, and the U.S. Pushpay similarly realised early on that there isn’t enough large churches in New Zealand and Australia to reach their ambitions. The company set up their headquarters in Seattle, and built an efficient U.S. sales machine that employs hundreds.
When companies lack a scalable sales and marketing process, thinking too big can actually be a trap.
I met with the very smart founders of kiwi tech startup StretchSense. The company develops sensors that can be stitched into clothing to measure body movement – with fascinating applications for everything from precise Virtual Reality gloves, to biomechanical measurement. Early in its life StretchSense had won a major contract with a Japanese retail giant to develop a suit which gave customers exact body measurements to check if products bought online would fit them.
The agreement would have valued the company at over $100 million. But the demand was vastly greater than the small startup was able to deliver. The deal eventually fell through, and StretchSense had to lay off 140 staff. The company pivoted quickly and has been able to rebuild with a new business model, but the near-death experience highlights the lesson: think global, scale global.
Lesson #3: Sign up Sophisticated Tech Investors
Early in its journey Xero was able to secure investment from billionaire, and Silicon Valley legend, Peter Thiel. That stamp of approval put Xero on the map and attracted both top talent and further capital. Rocket Lab followed a similar strategy, heading straight to Silicon Valley to fund the business, and attracting one of the world’s leading venture capital firms, Khosla Ventures.
For a long time New Zealand struggled with a lack of experienced technology investors. But today’s tech success is creating a virtuous cycle. The wealth created by early investors in Trademe, Xero, Pushpay, and other startups, and the skills developed on the ride, mean that there is now a growing pool of skilled and wealthy technology investors.
As these investors gain experience from multiple technology investments, the companies they invest in are able to benefit from this accumulated knowledge. Taking one example, the Huljich family have had a string of successful technology investments from pre-IPO all the way through to multi-million dollar exits. They have invested in several Saas software successes, from Diligent, to Pushpay, and recently Valocity. Other early investors in Pushpay such as the Bhatnagar family have likewise gone on to fund further tech startups. These sophisticated technology investors thereby ensure that lessons are passed on from one generation of startups to the next.
The Kiwi tech ecosystem has reached an inflection point. Pioneers like Xero have pointed the way, and a new generation of startups are striking forth on to the world stage. Kiwi tech companies are taking on the world by understanding the power of story, the need to scale globally, and the value of attracting sophisticated technology investors. The revolution is fun to watch, and with most of the world still to pay attention, a lucrative place to find new investment opportunities.
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Selling is a big blind spot for investors. For every thousand articles about when to buy a company, we’re lucky to find one about when to sell. Yet selling has a huge impact on our long-term performance. And the evidence is clear: most people are no good at it. But this weakness also provides the opportunity for a massive competitive advantage.
It’s well known that a lot of individual investors suffer from selling biases like loss aversion. Recent research shows that the professionals struggle too. An impressive study found that professional fund managers, although pretty good at buying, are terrible at selling. It was a landmark study, so let’s unpack the findings.
“We document a striking pattern: while the investors display clear skill in buying, their selling decisions under-perform substantially…selling decisions not only fail to beat a no-skill strategy of selling another randomly chosen asset from the portfolio, they consistently under-perform it by substantial amounts.”
The sell decisions of professional investors are so bad that they performed worse than chance. That’s rough. But the buy decisions did add value, so it’s not that fund managers have no idea about investing. Instead the authors found a flawed process where selling doesn’t receive adequate attention:
“We present evidence consistent with the discrepancy in performance between buy and sell decisions being driven by an asymmetric allocation of cognitive resources, particularly attention…We conjecture that PMs [Portfolio Managers] in our sample focus primarily on finding the next great idea to add to their portfolio and view selling largely as a way to raise cash for purchases”
“PMs in our sample have substantially greater propensities to sell positions with extreme returns: both the worst and best performing assets in the portfolio are sold at rates more than 50% percent higher than assets that just under or over performed. Importantly, no such pattern is found on the buying side – unlike with selling, buying behavior correlates little with past returns and other observables”
Most professionals have no good process for selling. They focus on buying, and only think about selling when they are fumbling around to free up cash. When they do sell, it is with little research. So they sell whatever sticks out the most: the biggest gainer or the biggest loser. It’s not logical, and they don’t think about the future prospects. The result is decisions that are so bad, they would have been better off throwing darts at a board to pick a position to sell.
This focus on past returns is also mirrored in much of the folk wisdom that floats around about selling:
‘Sell when a stock doubles (or is up 20%, or 30%, or whatever arbitrary number)’
‘Never sell at a loss’
‘Nobody ever went broke taking a profit’
‘Sell anything that falls by 10%’
‘Water your flowers and trim your weeds (sell companies whose share price has fallen)
Intelligent investing is supposed to be forward-looking. It’s the future that counts. Yet all these rules of thumb, and the trading of the average fund manager, is based on past price movements.
The core problem is that most people’s sell process abandons all that is good about their buy process:
It’s a big problem. But there is a better way. My style of fundamental growth investing, led me to adopt two core selling principles:
Principle #1: Sell quickly when a thesis is broken
This principle has been a core driver of investment performance for me. Selling quickly when a thesis is broken allows you to ‘lose small’ when you have made a mistake. More importantly, it allows you to quickly re-deploy your precious capital in to a new high-conviction idea.
Like running a marathon, it is simple, but not easy.
There are five steps:
Identify your thesis (actually write it out)
In that initial thesis, identify what would cause you to sell
Continuously monitor the company, its competitors, customers etc.
Update your valuation estimate and avoid thesis creep
Sell quickly if the thesis is broken
Let’s work through those steps with a real-world example: Class (ASX:CL1). Class provides a SaaS software product that helps Self-Managed Super Funds (SMSFs) manage their accounts. It’s a sizable industry in Australia, with over 500,000 SMSFs. It’s a growing market: each year more people’s retirement balances hit a size where it becomes worthwhile to consider managing it themselves.
Step 1: Identify your thesis (actually write it out)
Few investors clarify their thinking on why precisely they are buying a company. Even fewer take the time to actually write down that investment thesis. If you do, you will be ahead of the pack.
We must have a clear idea of what our logic is in the first place, so that we can know when that thesis is broken.
We first bought Class shares shortly after the IPO in early 2016. It was a simple thesis. Class was disrupting traditional desktop software – an inevitable shift to the cloud was underway. At the time of purchase, Class was dominating the new cloud-based market, and winning over two thirds of new cloud customers.
Even better, Class’ major competitor, the incumbent BGL Super, had stumbled with their first launch of a cloud product. We initiated a position and over the next two years Class’ share price rose over 80%.
It looked like the ideal investment, a scalable software business that was dominating a sticky niche, while a sluggish incumbent failed to adapt.
But that would change.
Step 2: Identify what new evidence would cause you to sell
The moment before you buy a stock is the last time you will be thinking objectively. It is crucial that you use this moment to write down precisely what new evidence would cause you to sell in future.
We identified multiple risks that could have befallen Class. The government could have changed the rules around SMSFs. A major security breach could have broken client’s trust in Class’ cloud service. Neither of those came to pass.
Another risk was that a competitor could somehow crack the market and start stealing share. Class would not be so lucky on this count.
Step 3: Continuous monitoring
Eternal vigilance is the price of superior returns.
We must continuously monitor for thesis-breaking evidence. That means keeping tabs on the company, its staff morale, its new products, customers, competitors, regulators, suppliers, etc. There are many tools that can help this along: Glassdoor, Google Trends, product forums, Google Alerts, investing forums. But that should be just the beginning. Superior returns require superior portfolio monitoring.
In the example of Class there was one obvious source of intelligence that most of the market somehow missed. Remember that big incumbent BGL? Well BGL would regularly release announcements about how their new cloud based product was progressing.
For a long time these press releases were mostly hot air. Every company claims that their products are market-leading, next-generation, cutting-edge. But in early 2017 it became apparent that BGL’s new cloud products were gaining traction. Talking to BGL’s customers, it seemed that the incumbent may have started to get its act together.
No company goes without serious competition forever though. So we were careful to avoid a knee-jerk response.
That all changed in October 2017.
Step 4: Re-evaluate and avoid thesis creep
Thesis creep is one of the great traps that ensnare investors, particularly value investors. The company reports some bad news, and rather than recognise the mistake and sell, the investor holds on.
The share price has usually fallen by this stage, which can allow the original thesis to sneakily creep its way to something new: “Sure, we originally thought the company would do XYZ, and it clearly hasn’t, but it’s just so darn cheap now, we couldn’t sell at this price”.
There were two new pieces of information that were released on the 5th of October. First, Class’ reported its latest quarterly update. It showed that the company’s net new account additions had fallen, dramatically.
In the comparable quarter a year earlier Class had added 11,880 new SMSF accounts. The same number in 2017 showed just 6,232 new accounts. A fall of 47%. And this was after a soft June quarter, which the company had guided would quickly rebound. To make matters worse, the chart the company usually reported which would have shown this fall clearly was no longer included.
Something had changed.
Later that day it was confirmed. BGL announced that it had now surpassed 100,000 accounts on its own cloud-based product. Worse still (for Class), their biggest competitor had added 23,402 accounts during the latest quarter.
When we first purchased shares, Class was winning approximately 66% of new cloud accounts. Now it appeared to be winning just 20%. That’s a huge swing in competitive position. We updated our intrinsic value estimate with the new information. Lower growth and higher acquisition costs meant the shares were significantly overvalued.
It was time to face a tough truth.
Step 5: Sell quickly when the thesis is broken.
Class had been a star of our portfolio. I had even interviewed the CEO in a fireside chat at a client event. It wasn’t easy to reverse course and admit that we were wrong. But when a thesis is broken, we must be decisive.
We reached our sell decision on the same day the news broke. Although the shares were already down slightly, it would take many months for the market to fully absorb the new competitive paradigm. We were able to exit our position for a 67% gain.
It worked out well. Today, almost 18 months later, the shares are now over -50% below where we sold.
Sell quickly when a thesis is broken.
Principle #2: Sell if you would not be buying today
Holding is an active decision, not a passive one. It just doesn’t feel like it.
Each day the market offers us the opportunity to buy or sell our shares. Every day that we hold a position we are effectively choosing to ‘re-purchase’ it at today’s prices, and in today’s position size. If we don’t think that the current position size is the best possible allocation of our precious capital, we should sell.
This principle – to sell if you would not be buying today – includes those situations mentioned in the first principle. But it also adds the hard edge of a valuation-based sell. If the share price has risen so much that you would not be buying the shares today, it is time to sell. No business is so great that its share price can’t rise high enough to render it an unattractive investment.
It sounds simple, but again the execution takes work. It requires maintaining an accurate estimate of the company’s intrinsic value, and being willing to trim the position, or even sell out entirely, when share prices rises too far above intrinsic value.
My personal approach to investing in high growth businesses is to sell slowly when the motivation is purely based on valuation. This is to reflect the ability of truly superior businesses to consistently outperform even the most optimistic estimates. It is both an art and a science, but ultimately we must be disciplined: sell if you would not be buying today.
Selling is a big blind spot for most investors. But that weakness means we have a huge opportunity to improve. If you adopt a sound selling process, based on the future and not the past, you will gain a massive competitive advantage over other investors.
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