Podcast Summary
Valuation Metrics vs Real Growth Potential: While price to earnings, price to gross margin, and price to sales ratios can provide insights, they may not be the most relevant or accurate indicators for a company's worth, especially during certain stages of its life cycle. Considering growth potential and competitive advantages is crucial in assessing a company's value.
While metrics like price to earnings, price to gross margin, and price to sales can be useful in valuing a company, they are not always the most relevant or accurate indicators, especially during certain stages of a company's life cycle. Brian Feroldi shared a personal experience where he passed on investing in Salesforce.com based on its high PE ratio, only to see it skyrocket in value and leave him with a missed opportunity for a significant return. This highlights the importance of considering other factors, such as the company's growth potential and competitive advantages, when assessing its worth. Brian also emphasized the difference between real and fake moats, and shared his thorough assessments of Alphabet, FIGS, and Axon. Overall, this conversation underscores the importance of a nuanced and thoughtful approach to valuation and investing.
Revenue growth becomes the primary driver of stock returns over the long term: Over a 10-year period, revenue growth accounts for 74% of stock returns, emphasizing its importance over valuation in the long term, but recognizing the relevance of valuation in different market phases
While valuation plays a significant role in determining short-term stock performance, its importance diminishes over the long term. As demonstrated in a study by Morgan Stanley and BCG, over a 10-year period, revenue growth becomes the primary driver of stock returns, accounting for 74% of the outperformance. This is because the stock price is tied to a company's earnings over an extended period. However, it's essential to recognize that there are phases in a company's growth cycle where focusing on valuation is more relevant than others. For instance, during a market bubble, such as the one in 1995, where Home Depot was trading at a high PE ratio but still outperformed, valuation becomes less important. Conversely, during periods of market correction or bear markets, when stocks are undervalued, valuation becomes crucial. Ultimately, the quality of the business remains the most critical factor in the long term. As Ben Graham famously said, the stock market functions as a voting machine in the short term but a weighing machine in the long term.
PE ratio not reliable for early-stage companies: Don't rely on PE ratio for evaluating early-stage companies. Instead, focus on metrics like revenue, EBITDA, or gross profit.
The Price to Earnings (PE) ratio is not a reliable metric for evaluating companies during their founding, launch, and hypergrowth stages. When a company is first founded, there are no financial statements, making the PE ratio infinite and meaningless. In the launch and hypergrowth stages, companies are focused on top-line growth and often losing money, making the PE ratio useless due to the lack of earnings. It's only when a company reaches true operating scale and optimizes for profits that the PE ratio becomes meaningful. Therefore, when assessing a company earlier in its life cycle, investors should focus on other metrics such as revenue, EBITDA, or gross profit.
Evaluating a Company's Competitive Advantage: When assessing potential investments, focus on a company's sustainable competitive advantage, not just temporary popularity or hit products. Use financial metrics like price to gross profit ratio and price to sales ratio to value companies at different growth stages, but ultimately, a company's ability to maintain its advantage is key.
When evaluating companies for investment, it's crucial to consider their competitive advantage and the durability of that advantage. A company's popularity or hit product doesn't necessarily equate to a sustainable moat. In fact, some products can be considered "fake moats" if their popularity is temporary. Examples of such fake moats include GoPro, Fitbit, and Michael Kors. Therefore, it's essential to look beyond short-term financial indicators and assess the long-term competitive position of a company. The price to gross profit ratio and price to sales ratio can be useful metrics for valuing companies at different growth stages. However, the most important factor is the company's ability to maintain its competitive advantage and protect its profits from competition.
Unexpected challenges impacting financial performance: Successful companies can face unexpected challenges leading to short-term financial struggles, such as negative earnings and layoffs. Adjusting to new realities and reassessing investing theses is crucial.
Even successful companies can encounter unexpected challenges that may impact their financial performance. During unprecedented times, such as the COVID-19 pandemic, businesses may overestimate demand and invest heavily to meet it. However, if the actual demand does not materialize as anticipated, these companies may be left with excess capacity and may need to right-size their operations. This can lead to short-term financial struggles, such as negative earnings, and even layoffs. The example given was Shopify, which saw a massive surge in demand for e-commerce during the pandemic and responded by investing heavily in capital expenditures. However, as shoppers have returned to physical stores, Shopify and other e-commerce companies have been forced to adjust to the new reality and scale back their operations. This highlights the importance of having a clear investing thesis and being prepared to reassess it when circumstances change.
Shopify's Long-Term Growth Thesis Intact Despite Short-Term Challenges: Shopify's ability to provide small businesses distribution channels and expanding capabilities sets it apart from companies experiencing demand destruction, making it a long-term growth investment.
While Shopify's recent financial results show losses and potential layoffs, its continued double-digit revenue growth indicates that the e-commerce platform's long-term growth thesis remains intact. This is in contrast to companies like Peloton, which are experiencing demand destruction and declining revenue. Shopify's competitive advantage lies in its ability to provide small businesses with their own distribution channels, as opposed to Amazon's marketplace model. However, Shopify is also expanding its distribution capabilities to better compete with Amazon. The trend of younger generations using TikTok as a search engine could potentially benefit Shopify through cross-promotion agreements. It's important to note that the investment perspective is focused on the long-term growth potential of Shopify, and short-term challenges are expected.
Different Investors, Different Approaches to Valuation: Investors have varying perspectives on valuation, from strict value investing to disregarding it entirely, and successful investors exist at various points on the spectrum.
There is no one-size-fits-all approach to valuation in investing. Buffett, known for his value investing approach, has shown that he deviates from his "buy a dollar for 50¢" mindset at times, as seen during the 2020 COVID correction when he bought stocks near decade highs. On the other hand, venture capitalists like Marc Andreessen disregard valuation in favor of focusing on the potential upside. The investing world is a spectrum, and successful investors exist at various points on it. Ben Graham, the godfather of value investing, broke his own rules when he invested in GEICO and turned a $712,000 investment into $400,000,000. This example demonstrates that even the most disciplined investors can make exceptions and still achieve significant returns. Ultimately, each investor must find their unique perspective on valuation based on their goals, risk tolerance, and investment horizon.
Ben Graham's Success from a Growth Stock: Great companies with strong growth potential can lead to substantial returns, even in traditional value investing. Identifying exceptional companies is crucial as most stocks underperform the index, but the gains from top performers make up for losses.
Even legendary value investor Ben Graham, considered the father of value investing, had a significant portion of his success attributed to a single growth stock, GEICO. This highlights that great companies with strong growth potential can lead to substantial returns, regardless of the initial valuation. Traditional investing, like venture capital, requires identifying such exceptional companies, as the majority of stocks underperform the index, with 66% falling short and 40% suffering catastrophic losses. However, the gains from the 7% of top-performing stocks make up for these losses, driving the market higher over time. Alphabet (Google) is an example of a company with significant growth potential, having recently underperformed its all-time highs.
Google's earnings influenced by investments: Google's core business grows at a double-digit rate, and its investments in YouTube hold potential for future growth, but earnings can be impacted by performance of investments
Google's PE ratio is attractive due to its dominant position in online advertising and ownership of valuable internet real estate. However, it's important to note that Google's earnings are influenced by the performance of its investments in other companies, which can cause underestimation or overestimation of its earnings power. Despite this, Google's core business continues to grow at a double-digit rate, and its investments in other businesses, such as YouTube, hold significant potential for future growth. Overall, Google's future looks bright, and the potential for one of its bets to pay off adds to its long-term potential.
Consider both financials and qualitative factors for informed decisions: Investing decisions should be based on a combination of financial data and qualitative factors like management quality, employee satisfaction, and optionality to fully understand a company's potential
When making financial decisions, it's crucial to consider both the financial data and qualitative factors. While financials provide insight into a company's past performance, qualitative factors such as management quality, employee satisfaction, and optionality can indicate a company's future potential. For instance, Google, a company with astronomical growth and a massive market cap, is worth considering not just for its financials but also for its leadership team, insider ownership, and expanding product offerings like Google Cloud. As investors, it's essential to keep an eye on both the financial wake and the dashboard to make informed decisions.
Google's other businesses to drive growth: Google's core business might be slowing, but its other ventures like YouTube, Google Cloud, and Other Bets are expected to accelerate growth. Axon, a surprising company, uses software to make bullets obsolete and grows at an impressive 17-44% annually, thanks to its sticky software and expansion into new markets.
Google's core business may be slowing down, but its other businesses like YouTube, Google Cloud, and the Other Bets are expected to pick up the pace and ensure continued growth. Google's strong balance sheet with over $164 billion in cash and low debt also positions the company well for future opportunities. A surprising company with impressive growth is Axon, which provides tools and products that are making bullets obsolete through its Taser devices and body cameras. Axon's approach to connecting its products with software, such as its Axon Cloud, creates a stronger moat and reinforces the importance of its offerings. The company's top line has grown robustly at an average of 17% for the Taser and 44% for the software business over the last 5 years. The stickiness of Axon's software, which stores valuable evidence, makes it difficult for police forces to switch to other solutions, and the company is expanding into other markets by integrating its camera into police officers' holsters.
Innovative companies disrupting industries: Axon revolutionizes police work with body-worn cameras and cloud software, while FIGS provides comfortable scrubs for healthcare workers through direct customer relationships, achieving strong margins.
Both Axon and FIGS are innovative companies disrupting their respective industries. Axon, with its body-worn cameras and cloud software, is revolutionizing police work by minimizing record-keeping burdens and enabling evidence sharing among departments. With a massive return on investment since its IPO and a strong balance sheet, Axon is a force to be reckoned with. FIGS, on the other hand, is the first company to IPO with two female founders and is making high-quality, comfortable scrubs for healthcare workers. By establishing a direct relationship with its customers through its app and website, FIGS has bypassed traditional distribution models and achieved strong margins. Both companies have impressive growth stories and are worth keeping an eye on.
FIGS expanding into new industries with brand strength: FIGS, a workwear company for healthcare professionals, is expanding into dental and potentially footwear industries. While its brand is strong, growth is not as high due to the physical nature of its product and expansion costs. Potential for international growth exists, but competition from established brands is a concern.
FIGS, a company specializing in workwear for healthcare professionals, is expanding into new industries such as dental and potentially footwear. With a strong brand and a direct relationship with customers, the company has seen significant success in North America and has the potential for international growth. However, the moat surrounding the business is primarily based on its brand, which is considered weaker compared to other desirable factors such as network effects, high switching costs, or durable cost advantages. The company's growth rate is not as high as some other companies due to the physical nature of its product and the costs associated with expansion. Despite its lower quality score, FIGS has a relatively small market cap and could potentially see significant growth if it executes well. The competition, particularly from established brands like Lululemon, is a factor to consider.
Exploring investment opportunities with Brian Feroldi: Brian Feroldi shares valuable research and analysis on potential investment opportunities in various stocks. Sign up for his free weekly newsletter at mindset.brianferaldi.com for more insights.
The insightful discussion on potential investment opportunities in various stocks, as shared by Brian Feroldi. Brian, a frequent guest on the show, provided valuable research and analysis that is sure to pique the interest of the audience. If you're interested in learning more about Brian and staying updated on his investment insights, you can find him on Twitter and YouTube under the name Brian Feroldi. He also offers a free weekly newsletter, which you can sign up for at mindset.brianferaldi.com. Trey Lockerbie, another valuable resource for investors, can be found on Twitter at Trey Lockerbie. Don't forget to check out all the resources available at theinvestorspodcast.com or simply search for TIP Finance. Remember, this show is for entertainment purposes only, and before making any investment decisions, consult a professional. TIP is copyrighted by The Investors Podcast Network, and written permission is required for syndication or rebroadcasting.
