First principle thinking has gotten a lot of coverage recently. Popularized by luminaries such as Elon Musk and Ray Dalio, first principles provide a framework for breaking down a complex space into a working model from which decisions can be made. In its simplest terms, a first principle is a basic assumption that cannot be deduced from other assumptions. First principles can then be combined to form a working model for making decisions.
I thought it would be useful to kick off this blog with an outline of my basic tenets. These will provide the foundation for the coverage, scope and conclusions that readers can draw from the coverage of software stack companies.
Scope
- It is commonly advised to “invest in what you know”. I am a long-time software engineering leader and systems architect. Therefore, this blog will focus on the companies that provide tools and services for building modern software applications (the software stack). These are sometimes referred to as software infrastructure companies.
- I will not try to cover technology companies outside of this narrow space, like semis, devices, etc. I think some analysts in the investment community try to provide perspective on a broad swathe of companies across many sectors. This seems to dilute their understanding of each and limits the depth of coverage beyond financials.
- Companies covered are those that provide solutions used by software engineers and information workers to build and support modern software-driven enterprises. This is sometimes referred to as a “picks and shovels” approach. Examples of components of the software stack include hosting, data storage, communications, application monitoring, customer service, machine learning, collaboration, analytics and security. A few examples are Twilio (TWLO), MongoDB (MDB), Zendesk (ZEN), Okta (OKTA), DataDog (DDOG) and Alteryx (AYX).
- This coverage will not include consumer-oriented offerings that have a software underpinning. Examples of these companies are Uber (UBER), Spotify (SPOT), Wayfair (W), Teledoc (TDOC), etc. Most of these end-user experiences utilize the products of covered software stack companies. Therefore, they are important to examine from that perspective. However, I will not try to cover the companies themselves, as I think that analysis requires a deep understanding of the core industry (transportation, music, furniture, health care) and success is more influenced by demand for the generic service than their technology enablement. This distinction is important as many software-enabled companies masquerade as technology plays.
- Coverage of these companies will skew towards the products and technology solutions they offer and how those fit into the broader software ecosystem.
- The assumption is that product fit and popularity with developers will ultimately determine the company’s market opportunity and share. These will translate into growth of the company’s stock price over time, assuming the addressable market for their services is growing rapidly. This is usually the case with many software stack providers, but TAM is a consideration in coverage.
- I will not focus significant effort on deep financial analysis. Review of financial performance is easily accessible on other popular investing sites, like Seeking Alpha. Also, while an important part of an investment decision, I think that that current financial results represent a trailing indicator relative to product roadmap, addressable market and competitive set.
Investing Philosophy
- Companies covered tend to be considered “growth” stocks. Based on my selection criteria, I favor companies that are rapidly growing their share of a large addressable market.
- In terms of measures, I am interested in revenue growth. I think the highest potential companies are those that currently, or will, achieve greater than 20% annual revenue growth. As revenue growth normalizes to GDP growth, stock price appreciation tends to mirror the overall market.
- However, some stocks with high revenue growth are rewarded with a stock price that seems excessive. My measure for this is the price to sales ratio. This ratio takes the market cap of a company and divides it by revenue over a 12 month period. I will look at both trailing 12 month and estimated forward 12 months revenue. For a more precise check of this ratio, I will consider the enterprise value, which takes into account cash on hand and debt.
- For high-growth companies, I think the P/E ratio is a secondary indicator. I am not as concerned with the current P/E ratio, but do want to see increasing EPS over reporting periods. The best software stack investments are in companies that are experiencing high revenue growth and incremental projected annual growth in EPS, even if negative for several years.
- My timeframe for investment recommendations is 5 years. This blog will not try to provide advice for short term movements or opportunities. This isn’t a blog for traders, unless you are willing to hold the stock for 5 years to work through short term price volatility.
- We can expect a fair amount of volatility in the stock price for high-growth companies. There will always exist a tug-of-war between growth and value investment philosophies that will impact multiples almost whimsically. Witness the correction in August-September of 2019, in which high EV/Revenue multiple stocks had values shaved by 25% without a commensurate change in their potential.
- A longer timeframe will allow these short-term variations to smooth out. A popular investment advice service, The Motley Fool, also advocates for a long term investment approach.
- With that said, if the prospects for a company’s market opportunity, position or developer adoption changes in a way that will impact its long term value, then I will call that out and recommend a change in investment allocation. An example is the rapid growth of Hortonworks (HDP) in 2015, based on the rise of Hadoop for large data processing. As other alternatives for data processing and pipelining emerged, the opportunity for Hadoop diminished and ultimately impacted HDP’s growth.
Secular Tailwinds
- I like investing in software stack companies because they provide the building blocks that leverage major secular growth tailwinds. Software based services are rapidly expanding the capabilities of existing businesses and more importantly, enabling the launch of brand new ones. Consumer expectations are raised every day by new product offerings, which in turn demand better software-enabled capabilities in data management, machine learning, communications and mobility.
- Uber and Lyft have revolutionized on-demand transportation. Behind these operations are thousands of developers and enormous software installations.
- Opentable allows consumers to make restaurant reservations online, skipping the tedious process of calling the restaurant and trying to determine the optimal time.
- Spotify and Netflix recommend media by applying collaborative filtering and machine learning to large data collections.
- The list goes on.
- As these types of software-driven experiences are available to consumers at a broad level, other companies in the space are quickly forced to bring their offerings to parity. This drives additional investments in software.
- I highly doubt consumer expectations will go backwards, or that the examples listed above will revert to being less convenient, automated, or informative.
- Many traditional companies in mundane or commoditized businesses are using software as a way to differentiate their offerings. Instead of purchasing large off-the-shelf software packages to run their businesses (which are available to their competitors), they are opting to invest in custom software development as a means to differentiate themselves.
- This represents a more recent development (circa 2019) being raised on quarterly conference calls (TWLO – Q2 2019 as an example).
- Many companies are claiming they are a software company or at least that software provides a differentiator. Witness GE’s advertising campaign appealing directly to software developers.
- As more companies shift investment towards software engineers and projects, the companies that provide the best software tooling and infrastructure will naturally benefit.
- Beyond custom software development, most of the global 2000 companies are engaged in some sort of “digital transformation” effort. Fundamentally, this represents applying software automation and data analytics to deliver an improved customer experience. I have seen estimates in the trillions of dollars associated with projected digital transformation spend over the next decade.
By leveraging these secular tailwinds, we can identify the software companies that will benefit the most. Using these as a basis for a target stock investment list should yield superior returns over the next 5-10 years.