Investing in the right high growth businesses can create transformational wealth. Yet, the journey isn’t made easy. The stocks are volatile and their profiles look different compared to more established businesses. Investors commonly trip up on a couple of key things. I’ve made several of these errors when assessing growth businesses in the past myself.
Mistake #1 : This stock has already gone to the moon, it can’t keep going up
As investors, we often underestimate to what extent strongly growing businesses with sustainable growth characteristics and competitive advantages can keep increasing. I myself have done this time and time again. While I have matured enough as an investor to not cheat myself out of prematurely taking profits, thinking that something has “gone up too much” has prevented me from averaging up and owning more of a winner than I already have.
The “FAAAM” (Facebook (FB), Apple (AAPL), Amazon (AMZN), Microsoft (MSFT), and Alphabet (GOOG) (GOOGL) are all very good examples of businesses that investors have consistently underestimated over a long period of time and which have continued to grow and compound and maintain growth rates that seemingly defy gravity for businesses of such large scale.
Some may argue that this is simply the benefit of hindsight and being able to cherry-pick from a very small list of businesses while others have withered away. I’d suggest this is not the case and that the formula of sustained competitive advantage in large and growing markets which are typically winner take all have accounted for the strong success of these businesses.
To provide another less well-known, more personal example from my own portfolio, I own a business called MercadoLibre (MELI) which I first acquired about 5 years ago. At that time, the business was a rather small and unknown e-commerce in Latin America. After first acquiring it near $90 a share, I watched with some curiosity as it proceeded to triple in the next few years. At that point, I felt that I didn’t own enough of the business in my portfolio and proceeded to top up my holding.
At the time, I felt nervous paying 3 times the price that I had initially paid to acquire the business, a price that seemed expensive. What I missed was the fact that MELI’s revenues had more than doubled and that user and merchant acquisition had substantially increased in that time. This meant that MELI was a far better business than what it was when I first acquired it.
The business had better strengthened its competitive position on both sides of its multi-sided network platform, with substantially more users and substantially more merchants. This made it less likely that either users or merchants would defect to a competitive platform.
It also managed to build up a captive base of users that could be monetized in additional ways, such as through digital payments. With such a long runway for market growth in digital commerce and digital payments, even though the business has increased more than 12x since I first bought it, I believe it’s quite possible that the business could still triple over the next five years given the significant distance that it has put between its competitors.
Dominant platforms with captive users who can be monetized in many ways can continue to grow revenues and improve economics for long periods of time, more than what may seem apparent at first glance. It’s a formula that Apple has used successfully to develop a multi-billion-dollar service revenue stream from its App Store business and which Facebook has used to develop new offering such as Market Place and Facebook Dating. Even Microsoft has leveraged from its successful windows productivity software to drive broader success in workplace collaboration.
Just because a growth business is large and dominant with a massive revenue base, it doesn’t mean that it can’t continue to get even larger and more dominant and that its share price won’t increase accordingly with that growth.
Mistake #2 : High short interest must mean there’s something lurking under the covers with this business
When I first started my investing, I steered away from businesses that had high short interest because I thought that it meant that the savvy investors knew something about this business that I didn’t.
Of course, in some instances, it’s possible that where there is smoke there is fire. However, I have since come to realize and appreciate that it’s equally likely that in many instances those placing the short interest don’t necessarily have a good understanding of the business and how it executes and what makes it grow and why.
In many cases, a self directed investor can actually exploit a “time horizon arbitrage”, where short investors are more focused on near-term results which may not be stellar, but which are eventually overcome by solid fundamental long-term growth prospects and secular tailwind that strongly grow businesses eventually deliver.
Good examples of this are businesses like Tesla (TSLA) and Twilio (TWLO). As these businesses have improved their revenues and enhanced unit economics, share prices have followed improvements in the fundamentals of the business and short interest has accordingly decreased over time.
Having a longer-term outlook on the growth and the prospects of a business can naturally help a self-directed growth investor ignore near-term volatility caused by spikes in short interest and, ultimately, benefit from shares that eventually need to be brought back by shorts at higher prices.
Mistake 3 : This growth looks good now, but wait till the competition comes
There is a tendency to look at rapidly growing businesses and come to the conclusion the new competitors enter and compete the growth away. No doubt, the examples of Blockbuster been dethroned by Netflix (NFLX) and Blackberry’s (BB) very rapid overhaul by Apple are relevant ones here.
While even products with unique IP can eventually be redesigned and re-engineered in different ways and alternate distribution channels created, it’s very hard to unseat growth businesses that become embedded within processes or systems within an enterprise. The challenge with all high growth businesses is to take that product innovation and build a workflow or process moat around it to ensure the longevity of that innovation.
This is something that businesses such as Alteryx (AYX), ServiceNow (NOW), and Salesforce (CRM) have all successfully done. While there are competing products that offer data analytics preparation or sales pipeline management, customers of all these businesses continue spending more with them every single year, evidence not only of a good product but one that is also woven deeply into existing process and workflow of organization such that even lower priced or better products are unable to displace them.
That’s not to say that investors shouldn’t be alert to challenges that come in the form of large competitors with strong existing customer relationships, which is something that Slack (WORK) is finding out now with its war against Microsoft teams.
That said, some level of process innovation or single or double sided network effects can be very good ways to ensure that competitors are kept at bay and ensure that a company can grow and own a space for years to come.
Mistake #4 : This business is giving away the company through constant fundraising
As companies look to acquire market share rapidly in winner take all markets, most growth businesses are content to defer profitability and heavily reinvest as much as possible into sales and marketing and research and development. This isn’t just limited these days to the very early stage, post IPO businesses but something which even extends to the likes of larger capitalized businesses like Tesla or Twilio.
Investors worry that the effect of such external capital will be heavy dilution of long-term ownership in the business. While this may certainly be the case in a business that is not successful in growing the pie, for a business that’s able to put those incremental dollars to use to earn high returns on invested capital, the pie can grow substantially bigger.
More aggressively taking market share earlier can be a trade off that’s well worth the while for retail shareholders. The capital raising that each of Twilio and Tesla undertook earlier in the year has paid off in leaps and bounds for investors in these businesses with the share price of both businesses tripling (or more) since this time. Each was able to aggressively grow and acquire share over the last few months where competitors struggled.
Venture-backed entrepreneurs are told to accept dilution to increase the overall size of the pie. With high growth businesses sacrificing profitability for market share, it’s a trade off that retail investors should also be increasingly prepared to accept.
Mistake #5 : This business has been loss making for years and I will never make any money
This seems to be a very common complaint from retail investors who look at a growth business but are put off by the seemingly poor economics that these businesses have. With profitability running at nominal levels for years, this gives the impression that these businesses are poor stewards of capital that don’t have the ability to make any money.
However, this lack of below line profitability doesn’t mean that there’s not significant value creation that’s taking place. It could mean that the business is engaging in an arms race to acquire the maximum number of customers that it can in rapidly growing markets before its competitors do. This is because once those customers are acquired, they become captive and reliant on the mission-critical software that these high growth businesses provide and become locked in for life.
Atlassian (TEAM) is a business that I own that provides cloud-based project management software for IT teams, helping them to manage complex project implementations. When it comes to the value of spending heavily upfront to see deferred, long-term payback there are probably few businesses that provide a better illustration of this.
Atlassian estimated in its S1 that $1 spent today would lead to approximately $7 in revenue within 5 years as a result of incremental license expansion, software renewal and new products that it could push to customers who became captive once acquired.
In this case, showing poor financial statement profitability is ultimately worth it for the business, and in fact Atlassian could significantly improve profitability by dialing down sales and marketing and research and development expenses to normalized levels, however the business chooses to play the long game in the understanding that there is significantly more share to be acquired.
In Atlassian’s case, complex derivative transactions also make the profitability look worse than it is. However poor profit can’t mask the strong cash flow generation taking place within the business, an indicator of market dominance.
In SaaS (Software as a Service) businesses, this effect is compounded because revenue is earned over the lifetime of a customer, yet the acquisition cost of that customer is expensed upfront, leading to a perverse situation where the business looks like it continues to lose money the more customers that it acquires.
The key here is to be able to look through the financials to see evidence of strong customer retention and increasing customer spend. The best businesses such as Twilio and Alteryx have customers who spend between 30 or 40% more every year.
Growth businesses have increasingly caught the attention of self-directed investors for their ability to continue growing while other more traditional businesses have floundered as a result of the pandemic.
However when evaluating some of these businesses investors are put off by share prices which may have doubled in a short space of time, high short interest or even a lack of consistent profitability. Taking the time to understand the reasons for some of these elements and what is actually going on beneath the surface can be a useful exercise to ensure that long-term gains aren’t missed.
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Disclosure: I am/we are long TEAM, MELI, GOOG, FB, AMZN, AYX, NOW, CRM, TWLO. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.