I recently saw a tweet that noted “fundamentals tell me what to buy, and technicals tell me when & where.” I complete agree with this philosophy, though an extreme generalization. Technical analysis is a great tool for choosing entry/exit points, setting stop-levels, and overall assessing the demand for a stock. Fundamental analysis is even more important, however, as it gets you into stocks well before a technician would take notice, and gets you out well before a technician, as it is simply a reflection of the fundamentals. Fundamentals often get a bad rap, and deservingly so, as the “old-school” textbook teaching on stock valuations are far too general to apply to a market made up of thousands of stocks. Each industry has certain metrics more important than others, which is why using relative valuation techniques is a modest improvement on using the basic ratios like Price/Earnings (PE), Price/Sales (P/S), Price/Book (P/B), Price/FCF (P/FCF), EV/EBITDA, etc. You can take things a step further by customizing your own valuation metrics, having a numerator of Price, and dividing by an industry-centric metric as a denominator. The complexity can grow adding a third value, and often using a scatter plot view of an industry is helpful in quickly assessing “value.”
I consider myself a fundamentalist at heart, but utilizing an approach that accounts for momentum. When I talk about momentum, I am not talking about a chart that “goes from the lower left to upper right”, but more the momentum of the various financial metrics important to the company. I guess I would call myself a “Momentalist.” Traditional valuation metrics would have seen you miss just about every great investment of our time, talking Amazon (AMZN), Netflix (NFLX), Google (GOOG) and hundreds of others. One of the simple reasons is the short-sightedness of the metrics you are reading at Yahoo Finance, FinViz, Bloomberg, etc., which are looking at a moment in time or 1-year forward. It is important to understand where a company is on its growth cycle to understand what metrics to use. A company that has reached its terminal growth rate is fair to value using PE, a discounted cash flow model, or a number of other traditional metrics. Now, a company that is experiencing growth that is 2X or even 10X that of the market average should be valued more uniquely, whether using a traditional metric but extrapolating its value out to a period of time where growth matures, or using custom unique metrics. The notion of why being a long-term investor trumps being a day-trader also is clear here as the great growth stories have plenty of shakeouts during 5, 10, 15, or even 20 year bull cycles of its business, and the true fundamentalist can overlook price, which is not forward looking, and focus on the core of the business and whether the investment rationale remains in place.
To make this easier to understand I came up with 7 of the different classes of great investments that I tend to see. I surely have overlook a few and welcome feedback, and I also do not plan on going into great detail as entire books can be dedicated to each of these 7 classes, and I am not currently looking to write a book.
- Pure Revenue Growth in Large and Growing Markets – These are your top growers and will tend to be in the Tech or Healthcare industry. These are the innovators, often taking a new market by storm and growing rapidly. Reverse engineering can often be used to find these names, basically looking at the other side of the equation to see what companies are seeing revenues slow, lose market share, and then determining who and why. Arista Networks (ANET) is an example, a stock that has tripled in 18 months and has been seen revenues triple since 2014, while Cisco (CSCO) is on the other side of this equation losing market share and struggling for growth. com (CRM) is another example with the push to the cloud a major theme in Tech, it being a leader, and consistently growing revenues 25-35% per year since 2011 while Oracle (ORCL) and IBM (IBM) have struggled to find growth and have needed to pivot strategies to enter into these growth markets while the legacy business continues to weigh on overall results. These kind of companies are not difficult to find if you simply track earnings every quarter and then look over the earnings presentation or transcript, it will put you right on the edge of leading trends. These stocks tend to be best for investors that are willing to be somewhat active, ensuring to follow the earnings reports and make sure that growth is not slowing, or the companies have maxed out available markets, because then it becomes time to sell.
- Sustainable MOAT – An economic moat is a sustainable competitive advantage, and can be due to a number of reasons such as brand loyalty, barriers of entry, cost advantage and scale, and more. It basically is the cream of the crop companies that are unlikely to be disrupted from maintaining market share and consistent profits. You can include names like Visa (V), Boeing (BA), Amazon (AMZN), Union Pacific (UNP), and Coca Cola (KO). These also tend to be for longer term focused investors that want stability, though once in a while big time growth names like Amazon (AMZN) and Salesforce (CRM) can be included in this group.
- Market Share Takers in Large TAMs – These are often referred to as “disruptors”, companies that are taking aim at large markets and ready to take share, whether it be due to new technology, a better business plan, or a cost-advantage. Tesla (TSLA) is a name that comes to mind right away, the auto industry is massive, and it has major brand recognition tied to the electric vehicle market that is still a very tiny piece of the auto market pie, but growing. These companies often can also pivot into new verticals, like Tesla is with SUV’s, Trucks, and other markets. Edward’s (EW) is another name I think of with its excellent products for the cardiovascular market allowing it to cut into the share of large medical device companies, and Healthcare remains a large and growing sector. The main problem with the disruptors group is that companies quickly realize when they see success stories, so competitive forces become an issue. You have to stick to the best of breed names that cannot easily see the market share gained, fade away, and requires fairly active investing, at least keeping on top of industry trends and quarterly earnings reports.
- Product Mix Shift, Margin Expansion – These two tend to go hand in hand, and also would throw in the model shift group as a mix story. When thinking about business model shifts, at least in Tech, the first two names that come to mind are Adobe (ADBE) and Autodesk (ADSK), which went from a traditional software license model to a cloud subscription model. Each of those two stocks have been top performers consistently in Tech. The new model allows for revenue predictability as subscriptions tend to be highly recurring, and also enables them to upsell and cross-sell other products/tools. The move from a perpetual model to a recurring model initially results in sharp drops in net income, which often scares away investors not understanding the long term vision. The new model also improves product and user experience, and puts new metrics into focus like ARPU and ARR, as well as deferred revenue and unbilled backlog. Netflix (NFLX) is another example when it moved from DVD rentals to streaming, enabling it to save on shipping/logistics as well as entering a subscription model for more stable revenues. There are many companies seeing the benefits of Technology and digital result in higher margins, and as these parts of the business become a bigger piece of the whole, it becomes a product mix story. Margin expansion can also be achieved the old fashioned way, through cost cutting and improved operational efficiency, often brought on by activist investors, but not always. Deere (DE) is a recent example. Pricing can be another driver of expanding margins, and often seen with Chemical companies, some recent success stories like Celanese (CE) and Chemours (CC) come to mind. The video game stocks EA, ATVI, and TTWO is one of the prime examples with digital downloads allowing for healthier margins and also creating an additional revenue stream from in-game buys.
- Accelerating Growth – Re-Rate’s – Much like the market, companies & industries operate in cycles, and at cycle bottoms valuations tend to reflect the low growth, but if you can effectively time the cycle, you get the double positive of rising earnings and a rising multiple. Microsoft (MSFT), a sizable Tech company, is one recent example as its cloud business caused a surge in revenues, set to see Y/Y revenue growth of 16% in 2018, it’s highest since 2008. MSFT has been an outstanding performer the past two years with significant growth in earnings/revenues, but also re-rating higher to a 20.5X PE. Oracle (ORCL) is in that situation now as its cloud business becomes larger than the legacy business and its 15X PE is set to expand with revenue growth in 2018 set to be the strongest since 2011.
- Product / Replacement Cycles – These stories tend to be high flying growth stories that last a few years and then the stocks tend to flatten out as growth peaks, but the long term market potential remains robust enough to hold up the multiple. Once these innovators release a new product to the market there becomes a replacement cycle that drives a return to outsized growth and multiples tend to expand to reflect the rising expectations. Apple (AAPL) is a very well-known stock that trades with product cycles, often a case of buy the launch and sell the actual numbers. Two names that are currently in robust replacement cycles are Intuitive Surgical (ISRG) and Illumina (ILMN) due to new product cycles. eBay (EBAY) is a different type of example where it used technology enhancements to benefit customer experience and drive stronger sales.
- Consolidators – Synergy Stories – M&A can be an effective way for companies to lower costs and increase profits when there are synergies. It is a favorite of the smart money option traders that like to rise these acquirer stories a long way as the market tends to underestimate and management tends to low-ball the potential realization of synergies from M&A deals. The recent performance of Dow Chemical (DOW) and DuPont (DD) is one that comes to mind, and there are numerous others still working out after 2-3 years of robust M&A in markets. When Kraft (KHC) bought Heinz (HNZ) it saw shares continue to rise for months after the deal, and now they are back at the table looking at more acquisitions. Anheuser Busch’s acquisition of SAB-Miller is another synergy play. Constellation Brands (STZ) has been effective with M&A in the consolidating beverage industry.
I feel that most of your best performers in the market can fit inside one or multiple of these categories, and the best analysis was not looking at the same ratios every person can see over at Yahoo Finance, it was having forward vision of why these companies are successful, and how they will continue to be successful. One common theme across these categories is a great management team, which is why listening to conference calls and investor presentations can be so insightful.
As an exercise I want to look at some of the top 5/10/15 year returns in the market to see if we can fit these names into one of these 7 categories. Sometimes you get a name that fits into multiple categories, even better…
Netflix (NFLX) fits into at least four categories as a revenue growth name in a large and growing market, sustainable MOAT, a market share taker in a large media industry, and was a mix story when it transitioned to streaming. People continue to underestimate NFLX’s potential as it is taking over the way we consume content, and has substantial pricing power as well as untapped growth opportunities. It may trade 85X Earnings, but with International subscriptions only penetrating 5.7% of broadband households, and broadband continuing to increase its penetration, it has a long road of growth ahead with competitive threats minimal considering its original content lineup and brand loyalty.
Priceline (PCLN) fits into many of the same categories as Netflix (NFLX) as it changed a massive travel industry and has major brand leadership. PCLN continues to take market share in a large and growing industry, yet trades at a 21.3X multiple which is nearly in-line with the overall market.
Amazon (AMZN) became an accelerating growth story in 2015 as the cloud business really started to grow, and also remains a name that completely change commerce, and online remains a very small percentage of overall retail while AMZN continues to expand into new markets. AMZN has amazing brand loyalty and is an innovator. It is a market share taker and also became a mix shift story with profitability being driven by its booming AWS segment. It continues to target large and growing markets and has the scale to be able to quickly gain leadership positions in new markets, so despite the 123X PE, it remains one of the top names to own.
Incyte (INCY) has been a pure revenue growth story in Biotech with its Jakafi being a product story as well as allowing it to have a sustainable MOAT. INCY also falls into another category that is Biotech specific, pipeline potential, with its oncology assets. With five products in late stage development it can pick up the pace as Jakafi growth cannot sustain forever due to the cycle in Biotech of peak sales potential from a projected target market.
Without going into much more detail I will list briefly a few names below without the back-story, and just the category.
Regeneron (REGN) – Revenue Growth and Sustainable MOAT Shifting to New Product Cycle
Baidu (BIDU) – Revenue Growth, Market Share Taker, Expanding Eco-System, Sustainable MOAT
Celgene (CELG) – Revenue Growth, Sustainable MOAT, Product Cycle, Market Share Taker (Oncology)
Salesforce.com (CRM) – Revenue Growth, Sustainable MOAT, Market Share Taker, Mix Shift
Apple (AAPL) – Product Cycle, Sustainable MOAT
Illumina (ILMN) – Revenue Growth, Product Replacement Cycle
American Tower (AMT) – Sustainable MOAT
Intuitive Surgical (ISRG) – Product Replacement Cycle, Accelerating Growth Re-Rate
Monster Beverage (MNST) – Revenue Growth, Product Cycle, Market Share Taker
I hope to eventually go into much more detail and possibly add to this write-up. Please leave any feedback via responses on Twitter.
If you are interested in investing utilizing my unique approach, check out Relativity Capital