| Umberto P. Fedeli
Another strategy we actively employ is investing into companies with durable growth that are building sustainable competitive advantages that we expect to one day become wide moat. Winners tend to win big, which is why we pursue companies that are emerging as winners of their space.
I am not an expert on technology, but I surround myself with people that know it well. I can’t write code, but I do understand software businesses and the power of subscription businesses. Over the past five years we’ve built a portfolio of successful companies in six primary areas: digital advertising, payments, software, e-commerce, cybersecurity, and health tech.
There’s a plethora of companies that show high revenue growth; therefore, it is important for investors to distinguish between the high-quality companies with durable growth and growth traps. There are two main types of growth traps: (1) the lower-quality companies that spend enormous amounts on Sales & Marketing to mask that they don’t have any competitive advantages and (2) quality companies with faster than expected deceleration of growth. All companies have decelerating revenue growth at some point, but companies that decelerate quickly can be growth traps. Finding companies with slow deceleration of growth is important.
We use several metrics to determine if the business has sticky customer relationships and if the Sales & Marketing is creating value. Customer churn shows us if customers are happy or if there just aren’t any better alternatives. With regards to legacy banking in the U.S. for example, the average person keeps the same checking account for 16 years!
A high retention rate is important, but we also look at Dollar-Based Net Retention Rate, which measures the percent increase in revenue from existing customers on a year over year basis. For example, Twilio has a Net Retention Rate of 131%, DataDog has 130%, and DocuSign has 124%.
Retention rates are also important because it increases your Lifetime Value (LTV) of a customer. The LTV is the total revenue a customer will bring in over the life of the relationship. The longer the relationship, the more value is created by acquiring each new customer.
Customer Acquisition Costs (CAC) is the cost related to bring in each new customer. The rule of thumb in sales and marketing is that the LTV/CAC should be at least 3x for high gross margin businesses. It needs to be even high for low gross margin businesses.
Valuation is also important, and it is not easy for companies with high growth because there is a wide range of future revenue growth rates and margin assumptions. However, this also means these companies frequently have dislocations of value. Like so many investors, many of my biggest mistakes have been companies I knew were incredible, but I passed because the valuation looked a little high at the time.
Another area we’ve made mistakes is in quality traps, which are companies that appear to be higher quality than they are. Pattern recognition comes from experience and over time we have developed 27 qualitative criteria to examine when looking at a durable growth company. The most important is assessing the long-term visibility and durability of the company. We then separate companies into 3 tiers based on their quality.
We’ve found over time that when we were right about the company being the winner of its space, we’ve never lost money. We have an allocation rule for durable growth companies: don't put the most money in stocks you might make the most from, put the most into the companies you can't lose money on.
To reduce the impact of mistakes, we use a basket approach and keep about 20 – 25 positions. The future is always uncertain; therefore, investors should focus heavily on avoiding permanent losses and building a portfolio that can endure various states of the world. Writer Nassim Nicholas Taleb called these types of companies antifragile.