All articles : Page 64 of 82 : The Good Investors

3 Lessons From A Stock That Was Held By 3 Legendary Investors

The three legendary investors I’m talking about here are Warren Buffett, Benjamin Graham, and Shelby Davis.

Buffett is perhaps the most well-known investor in the world today, so he does not need an introduction. Meanwhile, his late mentor, Benjamin Graham, is revered as the father of the discipline of value investing. The last investor, Davis, is less known. In a recent article, The Greatest Investor You’ve Never Heard Of, I introduced him this way:

“I first learnt about Shelby Cullom Davis sometime in 2012 or 2013. Since then, I’ve realised that he’s seldom mentioned when people talk about the greatest investors. This is a pity, because I think he deserves a spot on the podium alongside the often-mentioned giants such as Warren Buffett, Benjamin Graham, Charlie Munger, and Peter Lynch.

Davis’s story is well-chronicled by John Rothchild in the book, The Davis Dynasty. Davis started his investing career in the US with US$50,000 in 1947. When he passed away in 1994, this sum had ballooned to US$900 million. In a span of 47 years, Davis managed to grow his wealth at a stunning rate of 23% annually by investing in stocks.”

The stock mentioned in the title of this article is GEICO, an auto insurance company that was fully acquired by Buffett’s investment conglomerate, Berkshire Hathaway, in 1995. In 1976, Buffett, Graham, and Davis all owned GEICO’s shares.

The GEICO link

Back in 1975, GEICO was in serious trouble due to then-CEO Ralph Peck’s decision to relax the company’s criteria for offering insurance policies. GEICO’s share price reached a high of US$61 in 1972, but by 1976, the share price had collapsed to US$2. The auto insurer lost US$126 million in 1975 and by 1976, the company had ousted Peck and was teetering on the edge of bankruptcy. Davis and Graham both had invested capital in GEICO way before the problems started and had suffered significant paper losses at the peak of GEICO’s troubles.

After Jack Byrne became the new CEO of GEICO in 1976, he approached Buffett to come up with a rescue plan. Byrne promised Buffett that GEICO would reinstate stringent rules for offering insurance policies. Buffett recognised the temporal nature of GEICO’s troubles – if Byrne stayed true to his promise. Soon, Buffett started to invest millions in GEICO shares.

The rescue plan involved an offering of GEICO shares which would significantly dilute existing GEICO shareholders. Davis was offended by the offer and did not see how GEICO could ever return to profitability. He promptly sold his shares. It was a decision that Davis regretted till his passing in 1994. This was because Byrne stayed true to his promise and GEICO’s share price eventually rose from US$2 to US$300 before being fully acquired by Berkshire Hathaway.

The GEICO lessons

Davis’s GEICO story fascinated me, and it taught me three important lessons that I want to share.

First, even the best investors can make huge mistakes. Davis’s fortune was built largely through his long-term investments in shares of insurance companies. But he still made a mistake when assessing GEICO’s future, despite having intimate knowledge on the insurance industry. There are many investors who look at the sales made by high profile fund managers and think that they should copy the moves. But the fund managers – even the best ones – can get things wrong. We should come to our own conclusions about the investment merits of any company instead of blindly following authority.

Second, it pays to be an independent thinker. Davis stood by his view on GEICO’s future, even though Graham and Buffett thought otherwise. Davis turned out to be wrong on GEICO. But throughout his career, he prized independent critical thinking and stuck by his own guns.

Third, it is okay to make mistakes in individual ideas in a portfolio. Davis missed GEICO’s massive rebound. In fact, he lost a huge chunk of his investment in GEICO when he sold his shares. But he still earned a tremendous annual return of 23% for 47 years in his portfolio, which provided him and his family with a dynastic fortune. This goes to show that a portfolio can withstand huge mistakes and still be wildly successful if there’s a sound investment process in place. In The Greatest Investor You’ve Never Heard Of, I wrote:

“The secret of Davis’s success is that he started investing with a sound process. He was an admirer of Benjamin Graham, Buffett’s revered investing mentor. Just like Graham, Davis subscribed to the discipline of “value investing”, where investors look at stocks as part-ownership of businesses, and sought to invest in stocks that are selling for less than their true economic worth. Davis’s preference was to invest in growing and profitable companies that carried low price-to-earnings (P/E) ratios. He called his approach the ‘Davis Double Play’ – by investing in growing companies with low P/E ratios, he could benefit from both the growth in the company’s business as well as the expansion of the company’s P/E ratio in the future.

Davis also recognised the importance of having the right behaviour. He ignored market volatility and never gave in to excessive fear or euphoria. He took the long-term approach and stayed invested in his companies for years – even decades, as you’ll see later – through bull and bear markets. Davis’s experience shows that it is a person’s behaviour and investing process that matters in investing, not their age.”

Breaking the rules

There’s actually a bonus lesson I want to share regarding GEICO. This time, it does not involve Davis, but instead, Graham. In Graham’s seminal investing text, The Intelligent Investor, he wrote (emphases are mine):

“We know very well two partners [Graham was referring to himself and his business partner, Jerome Newman] who spent a good part of their lives handling their own and other people’s funds on Wall Street. Some hard experience taught them it was better to be safe and careful rather than to try to make all the money in the world. They established a rather unique approach to security operations, which combined good profit possibilities with sound values. They avoided anything that appeared overpriced and were rather too quick to dispose of issues that had advanced to levels they deemed no longer attractive. Their portfolio was always well diversified, with more than a hundred different issues represented. In this way they did quite well through many years of ups and downs in the general market; they averaged about 20% per annum on the several millions of capital they had accepted for management, and their clients were well pleased with the results.

In the year [1948] in which the first edition of this book appeared an opportunity was offered to the partners’ fund to purchase a half-interest in a growing enterprise [referring to GEICO]. For some reason the industry did not have Wall Street appeal at the time and the deal had been turned down by quite a few important houses. But the pair was impressed by the company’s possibilities; what was decisive for them was that the price was moderate in relation to current earnings and asset value. The partners went ahead with the acquisition, amounting in dollars to about one-fifth of their fund. They became closely identified with the new business interest, which prospered.

In fact it did so well that the price of its shares advanced to two hundred times or more the price paid for the half-interest. The advance far outstripped the actual growth in profits, and almost from the start the quotation appeared much too high in terms of the partners’ own investment standards. But since they regarded the company as a sort of “family business,” they continued to maintain a substantial ownership of the shares despite the spectacular price rise. A large number of participants in their funds did the same, and they became millionaires through their holding in this one enterprise, plus later-organized affiliates. Ironically enough, the aggregate of profits accruing from this single investment decision far exceeded the sum of all the others realized through 20 years of wide-ranging operations in the partners’ specialized fields, involving much investigation, endless pondering, and countless individual decisions.”

Graham’s investment in GEICO broke all his usual investing rules. When there was usually diversification, he sank 20% of his fund’s capital into GEICO shares. When he usually wanted to buy shares with really cheap valuations, GEICO was bought at a price “much too high in terms of the partners’ own investment standards.” When he usually sold his shares after they appreciated somewhat in price, he held onto GEICO’s shares for an unusually long time and made an unusually huge gain. So the fourth lesson in this article, the bonus, is that we need to know our investing rules well – but we also need to know when to break them.

Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life.

What We’re Reading (Week Ending 28 June 2020)

The best articles we’ve read in recent times on a wide range of topics, including investing, business, and the world in general.

We’ve constantly been sharing a list of our recent reads in our weekly emails for The Good Investors.

Do subscribe for our weekly updates through the orange box in the blog (it’s on the side if you’re using a computer, and all the way at the bottom if you’re using mobile) – it’s free!

But since our readership-audience for The Good Investors is wider than our subscriber base, we think sharing the reading list regularly on the blog itself can benefit even more people. The articles we share touch on a wide range of topics, including investing, business, and the world in general.

Here are the articles for the week ending 28 June 2020:

1. Growth Without Goals – Patrick O’Shaughnessy

Jeff Bezos is an incredible figure. He is known for his focus on the long term. He has even funded a clock in West Texas which ticks once per year and is built to last 10,000 years—an ode to thinking long-term.

But I now realize that the key isn’t thinking long-term, which implies long-term goals. Long-term thinking is really just goalless thinking. Long term “success” probably just comes from an emphasis on process and mindset in the present. Long term thinking is also made possible by denying its opposite: short-term thinking. Responding to a question about the “failure” of the Amazon smartphone, Bezos said “if you think that’s a failure, we’re working on much bigger failures right now.” A myopic leader wouldn’t say that.

My guess is that Amazon’s success is a byproduct, a side-effect of a process driven, flexible, in-the-moment way of being. In the famous 1997 letter to shareholders, which lays out Amazon’s philosophy, Bezos says that their process is simple: a “relentless focus on customers.” This is not a goal to be strived for, worked towards, achieved, and then passed. This is a way of operating, constantly—every day, with every decision.

2. Never The Same – Morgan Housel

The halt in business has been stronger than anything ever seen, including the Great Depression. But the Nasdaq is at an all-time high.

The story isn’t over. And it’s political, so it’s messy. But in terms of quickly stemming an economic wound, the policy response over the last 90 days has been a success.

There’s been the $600 weekly boost to unemployment benefits.

The Fed expanding its balance sheet by trillions of dollars and backstopping corporate debt markets.

The $1,200 stimulus payments.

The Paycheck Protection Plan.

The airline bailouts.

The foreclosure moratoriums … on and on.

I don’t care whether you think those things are right, wrong, moral, or will have ugly consequences. That’s a different topic.

All that matters here is that people’s perception of what policymakers are capable of doing when the economy declines has been shifted higher in a huge way. And it’s crazy to think those new expectations won’t impact policymakers’ future decisions.

It’s one thing if people think policymakers don’t have the tools to fight a recession. But now that everyone knows how powerful the tools can be, no politician can say, “There’s nothing we could do.” They can only say, “We chose not to do it.” Which few politicians – on either side – wants to say when people are losing jobs.

3. What comes after Zoom? – Ben Evans

I think this is where we’ll go with video – there will continue to be hard engineering, but video itself will be a commodity and the question will be how you wrap it. There will be video in everything, just as there is voice in everything, and there will be a great deal of proliferation into industry verticals on one hand and into unbundling pieces of the tech stack on the other. On one hand video in healthcare, education or insurance is about the workflow, the data model and the route to market, and lots more interesting companies will be created, and on the other hand Slack is deploying video on top of Amazon’s building blocks, and lots of interesting companies will be created here as well. There’s lots of bundling and unbundling coming, as always. Everything will be ‘video’ and then it will disappear inside.

4. The Anatomy of a Rally – Howard Marks

There’s no way to determine for sure whether an advance has been appropriate or irrational, and whether markets are too high or too low. But there are questions to ask:

Are investors weighing both the positives and the negatives dispassionately?
How do valuations based on things like earnings, sales and asset values stack up against historical norms?
Is that optimism causing investors to ignore valid counter-arguments?
Is the market being lifted by rampant optimism?
Are the positives fundamental (value-based) or largely technical, relating to inflows of liquidity (i.e., cash-driven)?
If the latter, is their salutary influence likely to prove temporary or permanent?
What’s the probability the positive factors driving the market will prove valid (or that the negatives will gain in strength instead)?

Questions like these can’t tell us for a fact whether an advance has been reasonable and current asset prices are justified. But they can assist in that assessment. They lead me to conclude that the powerful rally we’ve seen has been built on optimism; has incorporated positive expectations and overlooked potential negatives; and has been driven largely by the Fed’s injections of liquidity and the Treasury’s stimulus payments, which investors assume will bridge to a fundamental recovery and be free from highly negative second-order consequences.

5. Locusts Are A Plague Of Biblical Scope In 2020. Why? And … What Are They Exactly? – Pranav Baskar

Locusts have been around since at least the time of the pharaohs of ancient Egypt, 3200 B.C., despoiling some of the world’s weakest regions, multiplying to billions and then vanishing, in irregular booms and busts.

If the 2020 version of these marauders stays steady on its warpath, the United Nations Food and Agriculture Organization says desert locusts can pose a threat to the livelihoods of 10% of the world’s population.

The peril may already be underway: Early June projections by the FAO are forecasting a second generation of spring-bred locusts in Eastern Africa, giving rise to new, powerful swarms of locust babies capable of wreaking havoc until mid-July or beyond.

6. As Businesses Reopen, We Should Reopen Our Minds – Chin Hui Leong

Even as the ground beneath businesses shift, we should recognise that some of the key qualities we seek as investors will remain unchanged.

We still want to have good management teams at a company’s helm who are willing to adapt to new realities, innovate, and pivot their business accordingly.

Similarly, a business with strong financials and steady free cash flow rarely goes out of style, as cash would provide the company with the all-important financial firepower to turn strategy into reality.

These factors remain timeless.

And we have to keep learning.

We will continue looking for instances and data points that will either validate or break our assumptions on how things may change in the future.

It’s an ongoing process that we, as investors, have to adopt and be willing to change our mind if the situation calls for it.

Ultimately, keeping an open mind and a long term view is key.

New, unexpected developments could take shape in ways we cannot predict ahead of time.

7. Transcript: Jeremy Siegel – Barry Ritholtz and Jeremy Siegel

RITHOLTZ: And I thought I recall didn’t Ben Bernanke specifically saved that to Milton Friedman at some …

SIEGEL: Absolutely. During his 90th birthday. He was the head of ceremonies for his 90th birthday party. He stood up — and this is well before the financial crisis. Milton Friedman died in 2006. Before the financial, it was 2004, he was 90, stood up in front of a group of people. I couldn’t be there because of another engagement and I kicked myself for not being there.

But he said, Milton, the influence of your book and I’m going to promise you, the Great Depression shouldn’t have happened and because of what you did and wrote, it’s not going to happen again. We will not let it happen again.

He said that in 2006 to the face of Milton Friedman — I mean, 2004. Two years later, Friedman passed away. Two years later, Bernanke had to take the playbook from that mammoth monetary history and put it into effect and saved us from the Great Depression.

RITHOLTZ: How incredibly prescient in 2004.

SIEGEL: Wow. Yes. Wow.

Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life.

My Daily Routine

What a typical day looks like for me.

A reader of The Good Investors sent me a message on LinkedIn recently asking what my daily routine is like. The reader mentioned that there’s likely to be strong interest in what goes on in a typical day for me.

I have no idea if there really will be reader-interest in this topic. But I thought why not write about it anyway. A few years from now, it will also be fun to look back at this.

So, I’m usually up by 7am or earlier. There are two things that I tend to do once I’m awake (besides washing up!): (1) Meditate, and (2) catch up on my favourite Twitter accounts.

I don’t have an active Twitter account. But one of the great things about Twitter is that anyone can still access the platform and read tweets. Over the past 1.5 years or so, I’ve found Twitter to be an amazing place to catch up on great articles on life, business, technology, and more. It is also a wonderful resource for condensed pieces of knowledge. Some of the people I follow on Twitter are (in no particular order):

Usually, there will be a lot of good articles shared through these accounts. I will then read through them.

As for meditation, I have found it to be profoundly useful in helping me deal with the stresses in life with equanimity. Sometimes, I meditate first before catching up on Twitter. Then there are days where I catch up on Twitter first, read the articles that pop up there, and then meditate.

When both activities are done, it’s usually around 9:30am. This is when I start my reading/research/writing on companies for my just-launched fund’s investment activities, or for articles for The Good Investors. The wonderful thing about investing for a living, and writing an investment blog as a passion project, is that the work done for both activities often overlap in huge ways. I see it as killing two birds with one stone!

I will usually stop around 12:30pm or 1pm for lunch, then resume the research/writing. Some days, I start working out around 4pm. But if I’m not working out at 4-ish, then I will continue my investment research/writing till 6:30pm or so and then work out. I try to exercise every day.

Dinner typically starts at 7:30pm for me. After dinner I will hang out with my loved ones. After which, I carry on reading till I sleep. Some days I will be watching Youtube before bed. It depends on my mood. But even when I’m watching Youtube, I often will think about something like “Hang on, from my morning reads, I remember Company ABC having a unique management team. Let’s do some research!”… And off I go into a rabbit hole.

Bedtime for me is around 11:30pm or 12 midnight. And then it all starts again!

My daily routine has changed over time. Just 3 years ago, exercising at the gym would be the first thing I do in the morning after waking up. But now I prefer to exercise at a time when my energy is waning (late afternoon or early evening). I prefer to use the time when my mind is the most alert for reading/research/writing. Who knows when my routine will change again. But for now, this is what works for me!

Can Novocure Revolutionise The Way Cancer is Treated?

Novocure could be changing the way cancer is treated. It sells a wearable device that has been shown to disrupt cancer cell reproduction.

Cancer is a brutal disease and one of the leading causes of death in the developed world. Worldwide, the disease struck more than 17 million people in 2018 with that figure expected to mushroom.

One company that is doing its part in the fight against cancer is NovoCure Ltd (NASDAQ: NVCR).

Founded in 2000, NovoCure has developed a cancer therapy called tumour treating fields, which inhibits tumour growth and may causes cancer cells to die.

In this article, I take a look at the medical research behind its technology and whether NovoCure is a potential multi-bagger.

Technology behind Novocure

Novocure was founded 20 years ago by Professor Yoram Palti who believed that he could use electric fields to destroy cancer cells.

I don’t want to go too deep into the technicalities but to appreciate Novocure, it is important to understand the basics behind its technology.

In short, cellular proteins in cancer cells need to position themselves in a particular way during cell division in order for cells to divide. Tumour treating fields use alternating electric fields specifically tuned to target cancer cells, disorientating the position of the cell proteins and disrupting cell division.

It is equally important that tumour treating fields also do not stimulate or heat tissues and has minimal damage to healthy cells, with the only side effect being mild to moderate skin irritation.

From theory to practice

Novocure has done an excellent job of turning Professor Palti’s theory into real-life clinical practice. Today, tumour treating fields is approved in certain countries for the treatment of adults with glioblastoma and in the US for mesothelioma. These are two of the most difficult forms of cancer types to treat.

For instance, life expectancy for newly-diagnosed Glioblastoma, the most common type of brain cancer in adults is typically less than two years.

Today, there is a growing body of research that shows that tumour treating fields therapy can extend the life expectancy of patients when it is used together with other therapies.

The chart from Novocure’s investor presentation shows the survival rate of patients with and without tumour treating fields (Optune) treatment.

Source: Novocure investor presentation 2020

Out of the cohort of 450 patients, 388 received a survival benefit from the use of tumour treating fields. The 5-year survival rate was 13% in the cohort that used tumour treating fields combined with chemotherapy (TMZ or Temozolomide) compared to just 5% in the cohort that used chemotherapy alone.

In fact, the efficacy and minimal side effect of Tumour treating fields as a therapy has led to the National Comprehensive Cancer Network promoting it to a category 1 recommendation for newly diagnosed Glioblastomas,

Growing the number of indications

Tumour treating fields as a therapy could potentially be used on a wide variety of other cancer types. As mentioned earlier, it is FDA approved for (1) recurrent and (2) newly diagnosed glioblastoma and received FDA-approval for (3) Mesothelioma last year.

On top of that, it is undergoing phase III trials for four other indications, namely (1) brain metastasis, (2) non-small cell lung cancer, (3) pancreatic cancer and (4) ovarian cancer. This could significantly increase the company’s addressable market opportunity.

It is also in Phase II trials for liver cancer and preclinical trials for a host of other cancer types. The charts below summarise where the company is at in terms of commercialising its product for the other indications.

Source: Nocovure Investor relations website

Source; Novocure Investor relations website

In its 2019 annual shareholder letter, CEO Asaf Danziger and executive chairman Bill Doyle, reiterated their commitment to innovation saying,

“We are increasing investments in engineering efforts intended both to improve time on therapy and to maximize the energy delivered to patients’ tumours. Specifically, our teams are working to design and develop improvements to our transducer arrays and to our transducer array layout mapping software intended to increase Tumor Treating Fields intensity and, as a result, survival.
We believe innovation has the potential to improve patient outcomes and to extend our intellectual property protection into the future as we invent enhancements to our products. Our commitment to innovation resulted in 33 new patent applications in 2019, alone.”

From an investors point of view

From a medical standpoint, Novocure’s Tumour Treating Fields technology looks very promising.

But as investors, we also want to see that the company has the finances to continue funding its research and can drive adoption to grow its revenue.

There are two things I want to see in a promising company like Novocure- (1) a solid balance sheet so that it does not need to raise too much capital to fund its growth and (2) at least some signs that the company is turning its FDA-approval into meaningful revenue growth.

Novocure has both.

The chart below illustrates its net revenues from 2016 to the first quarter of 2020.

Source: Novocure investor presentation 2020

Novocure has also partnered with a Chinese company, Zai, to launch its Tumour treating fields in China. The partnership is already starting to bear fruit with US$2 million in net revenue recorded in greater China in the first quarter of 2020, a 100% increase in from Q4 of 2019.

It is worth noting that Novocure turned operationally and free cash flow positive in 2019. Novocure also has a robust balance sheet with around US$332 million in cash, cash equivalents, short-term investments and restricted cash and no debt.

Market opportunity

According to Novocure’s S-1 in 2015, Tumour treating fields is broadly applicable to a variety of solid tumours with an annual incidence of 1.1 million people in the United States alone.

Novocure charges around US$21,000 per month for Optune, its tumour treating fields device that is used to treat glioblastomas. Supposing that Novocure sells its other tumour treating fields products at a similar price range, Novocure will have a market opportunity of US$277 billion ($21,000 x 12 months x 1.1million patients) in the United States alone.

That’s of course assuming that Tumour Treating Fields therapy can be FDA-approved for the whole range of applications.

Valuation

At the time of writing, Novocure had a market cap of US$6.3 billion. On the surface, that seems expensive if you use traditional metrics to value the company. Novocure only had US$351 million in net revenues and US$262 million in gross profits in 2019.

Based on current share prices, it trades at 17.9 times 2019’s sales and 24 times gross profit. Those numbers are hard to stomach and would certainly be deemed expensive for most companies.

However, Novocure, to me, is not like most companies.

In the most recent quarter, revenue grew 39% from a year ago. The growth figure could start to accelerate as its core markets mature and Tumour treating fields gains FDA-approval for other indications.

It is also worth remembering that based on my calculations it has a US$277 billion market opportunity. If it can penetrate just 5% of that, its current US$6.7 billion market cap will be a steal.

Final words

Novocure has all the makings of an excellent company. Its technology can potentially be used in a wide array of different indications and is already generating positive free cash flow.

It has a solid track record of growing revenue. Gaining FDA-approval for other use cases could potentially be a catalyst for much greater things for the company. With all that said, it does look like Novocure has all the ingredients for success.

That said, I do acknowledge that as with any biotech firm, there are risks. The risks that it cannot get FDA-approval for other indications or adoption of its product is slower than expected can hinder growth and can lead to other companies catching up with it.

The technology is also very new and widespread adoption will depend on how quickly Novocure can push clinicians to recommend it as a form of treatment.

But despite these risks, to me, the probability and magnitude of the upside outweigh the risk. With its market cap still small compared to its total addressable market opportunity, I think if it can execute and fulfil its vast potential, Novocure could easily become a multi-bagger based on today’s price.

How Should We Invest In A Low Interest Rate Environment?

The US benchmark interest rate is back to an all-time low. How should we invest, and what returns can we expect over the long run?

A few months back, the US Federal Reserve slashed its benchmark interest rates to between 0% and 0.25%. The last time it was this low was in late 2008, during the throes of the Great Financial Crisis. Now, with the near-term economic impact of the COVID-19 crisis still unknown, there’s also the possibility that the benchmark interest rate in the US could move into unprecedented negative territory.

This gives us investors a dilemma. In this low rate environment, should we invest in higher-returning but riskier asset classes, or stick to lower-risk but ultra-low-yielding investments?

The search for higher returns

Interest rates are an important determinant in the long-term returns of most asset classes. In a low-interest-rate environment, corporate bonds and treasuries naturally have low yields. Holding cash is an even less attractive proposition, with bank interest rates almost negligible.

In a bid to get higher returns, stocks may be the best option for investors.

How much is enough?

According to Trading Economics, interest rates in the US had averaged at 5.59% from 1971 to 2020. Meanwhile, the S&P 500 returned approximately 9.3% annually during that time. In other words, investors were willing to invest in stocks to make an additional 4% per year more than the risk-free rate.

This makes sense, given that stocks are also more volatile and are considered a riskier asset. Investors, therefore, will require a return-premium to consider investing in stocks.

But interest rates then were much higher than they are today. With the benchmark interest rate in the US now at 0% to 0.25%, what sort of expected returns must the stock market offer to make it an attractive option?

I can’t speak for everyone but considering the options we have, I think that as in the past 50 years, a 4% spread over the risk-free rate makes stocks sufficiently attractive.

The big question

So that naturally leads us to the next question. Can investing in the S&P 500 index at current prices give me a 4% premium over the current risk-free rate.

Sadly, I don’t have the answer to that. The S&P 500 is a basket of 500 stocks that each have their own risk-reward profile. With so many moving parts, it is difficult to quantify how the index will do over the long run. Similarly, other indexes are difficult to predict too.

However, I know that there are individual companies listed in the global stock markets today that could provide an annual expected return of much more than 4% over the risk-free rate.

By carefully building a portfolio out of such stocks, I think investors can navigate safely through the current low-interest environment and still come up with decent returns over the long term.

A few months ago, my blogging partner, Ser Jing, shared his investment framework that helped him build a portfolio of stocks that compounded at a rate that is meaningfully higher than 4% a year (19% to be exact) from October 2010 to May 2020.

Using a sound investment framework, such as his, to build a portfolio may be all you need to navigate through this low-interest-rate climate.

Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life.

Quick Thoughts on Glove Manufacturers

Glove manufacturers have seen their share prices climb to all-time highs in recent months because of Covid-19. Has the market gotten ahead of itself?

The glove manufacturing industry has been one of the few beneficiaries of the Covid-19 outbreak. Share prices of glove manufacturers have skyrocketed in the past few months (some are up more than 100%!) with many of them touching record highs earlier this month.

The share price performance is backed by solid business results as shown by the table below.

Source: Respective company’s earnings results

The four glove manufacturers I’ve studied – Riverstone, Top Glove, Hartalega, and Supermax – have seen sharp increases in revenue. These companies have not only benefited from a rise in sales volumes, but also an increase in the average selling prices of their gloves. The increase in demand has also resulted in their factories operating closer to full capacity, which have resulted in greater economies of scale and fatter margins.

Growth to continue for the next few quarters

Although the spread of Covid-19 is slowing down in parts of the world, demand for rubber gloves is expected to remain high as authorities place greater emphasis on hygiene and prevent a rapid spread of the virus.

In its earnings results for the quarter ended 31 May 2020, Top Glove said:

“The Group’s extraordinary performance was attributed to unparalleled growth in Sales Volume, on the back of the global COVID-19 pandemic. Monthly sales orders went up by some 180%, resulting in long lead times, which went up from 40 days to around 400 days, whereby orders placed now would only be delivered over a year later.
However, Top Glove has endeavoured to allocate capacity to as many countries as possible, to ensure its life-saving gloves reach those most in need, while also prioritising its existing customers. It also accommodated requests from various governments of hard-hit countries who approached the Group directly to procure gloves.”

Will the growth last?

The near-term outlook for glove manufacturers looks distinctly positive but the question is: How long will it last?

Based on comments made by Top Glove, the glove manufacturing industry as a whole probably has a large backlog of orders. This will provide them with steady revenue streams and high margins for the next few quarters. However, what happens after this?

It is likely that this current spike in orders is a one-off occurrence. Some countries are stocking up in case there is a second wave of Covid-19, while others that have yet to feel the full effects of the pandemic are preparing for the worst. But when this blows over, glove demand could fall- maybe not to pre-pandemic levels – but likely below the current unsustainably high levels.

Frothy valuations

As mentioned earlier, glove manufacturers have seen their share prices skyrocket recently.

The table below illustrates the price-to-annualised earnings ratios of the same four glove manufacturers I had mentioned. I used the most recent quarterly earnings to calculate the annualised earnings for these companies.

Source: Author’s calculation using figures from Google Finance

As you can see, each of these companies have an annualised P/E ratio of close to 30 or higher. Although I understand the optimism surrounding glove manufacturers, to me, their share prices have surged to what seems like rich valuations.

There is also the risk that if demand falls, the glove manufacturers will see average selling prices drop to more normal levels leading to lower gross margins.

I also want to point out that part of the expansion in the glove manufacturers’ profit margins was the lower price of butadiene, a key raw material used in the production of nitrile-based gloves. As glove manufacturers have little control over the price of this commodity, there is an additional risk that if butadiene prices return to previous high levels, profit margins will decline.

Final words

The stars seem to have aligned for glove manufacturers. Not only has demand increased, but gross margins have also been boosted by lower raw material prices. It is also likely that the demand for rubber gloves will continue to be high for an extended period of time. And with the large backlog of orders, glove manufacturers will have their hands full for the next few quarters.

However, there are still risks worth noting. Current fat profit margins may not be sustainable over the longer term. When capacity eventually catches up to demand, average selling prices are likely to fall and margins will normalise.

On top of that, the glove manufacturers’ share prices have surged to all-time highs and they are currently sitting on extremely rich valuations. To me, it seems that much of the upcoming profit growth of glove manufacturing companies has already been priced in.

Webinar: “Active vs Passive Investing: Lessons Learned with Ser Jing”

A recent webinar with Samuel Rhee, Chairman and Chief Investment Officer of Endowus, to talk about active investing versus passive investing.

Endowus is a roboadvisor based in Singapore. In March 2020, Jeremy and myself had the pleasure of meeting Samuel Rhee and Chiam Sheng Shi. They are Endowus’s Chief Investment Officer and Personal Finance Lead, respectively.

On 17 June 2020, I participated in a webinar hosted by Endowus, where Sam and I talked about active investing and passive investing. I want to thank Sam and the Endowus team (especially Sheng Shi) for their kind invitation. Sam is one of the wisest investors I’ve met, and I learnt a lot from him in our 1.5 hour conversation.

Active versus passive is one of the hottest topics in the investing world today and Sam and I covered a lot of ground during our session. Check out the video of our chat below!

Some of things we talked about include:

My journey in active investing
Sam’s journey in the active investing world before Endowus
The “Three P’s of Institutional Investing”
Advantages that institutional investors have
Endowus’s focus on doing three things very well for their investors: Access to great investment products; providing good evidence-based investing advice; and lowering costs for investors
The foundational building blocks of Endowus’s service. In particular, Sam dug deep into Endowus’s innovative full trailer-fee-rebates and how that benefits individual investors. Trailer fees are fees that a fund manager pays to an investment advisor or investment products distributor – and these fees come directly from the investors who purchase the funds. I admire Endowus for rebating the trailer fees it receives, because these fees are a huge hidden cost that eats into the returns investors earn; the presence of trailer fees is also a big reason why fund management fees are so high in Singapore.
Endowus’s investment philosophy:
- Maximise returns by minimising cost
- Enduring belief in power of markets
- Time in markets vs market timing
- Asset allocation is everything
- Strive for the efficient frontier
- Diversification improves risk-return
- Optimise based on personal risk tolerance
- Know your limitations
My investment philosophy
Traits of a good active investor
Etymology for the words “invest” and “投资” (Mandarin word for invest) and how this may be affecting investor-behavior in Western and Eastern societies.
Capital-flows into active vs passive funds
Evidence showing why active investing often fails
- My thoughts on why it’s still possible to beat the market
The reasons why previously successful active managers end up underperforming
My book recommendations for new investors: Thinking, Fast and Slow by Daniel Kahneman, and One Up On Wall Street by Peter Lynch.
The importance of having low costs in the investment products we’re investing in
How Endowus provides industry-leading low cost investment solutions for investors
Investors’ behavioural mistakes during the COVID-19-driven market panic seen in the first half of this year
The important distinction to be made between the terms “active” and “passive” when applied to investing. Passive investing is often understood to be the use of passively-managed index funds as the preferred investing vehicle. But is someone who often jumps in and out of these index funds a truly passive investor? Is a person who picks stocks, but who then holds these stocks patiently for years, active or passive?
How I manage cash in an investment portfolio
On hindsight, are there any changes to our investments we wish we had made during the market panic in the first half of 2020
Endowus’s desire to constantly improve their offerings for investors whenever they find better investment products.

What We’re Reading (Week Ending 21 June 2020)

The best articles we’ve read in recent times on a wide range of topics, including investing, business, and the world in general.

We’ve constantly been sharing a list of our recent reads in our weekly emails for The Good Investors.

Do subscribe for our weekly updates through the orange box in the blog (it’s on the side if you’re using a computer, and all the way at the bottom if you’re using mobile) – it’s free!

Here are the articles for the week ending 21 June 2020:

1. The Age of We Need Each Other – Charles Eisenstein

It was a painful yet beautiful clarifying experience that asked me, “Why are you doing this work? Is it because you hope to become a celebrated intellectual? Or do you really care about serving the healing of the world?” The experience of failure revealed my secret hopes and motivations.

I had to admit there was some of both motivations, self and service. OK, well, a lot of both. I realized I had to let go of the first motive, or it would occlude the second. Around that time I had a vision of a spiritual being that came to me and said, “Charles, is it really your wish that the work you do fulfill its potential and exercise its right role in the evolution of all things?”

“Yes,” I said, “that is my wish.”

“OK then,” said the being. “I can make that happen, but you will have to pay a price. The price is that you will never be recognized for your role. The story you are speaking will change the world, but you will never get credit for it. You will never get wealth, fame, or prestige. Do you agree to pay that price?”

I tried to worm my way out of it, but the being was unyielding. If it was going to be either-or, how could I live with myself knowing in my heart of hearts I’d betrayed my purpose? So I consented to its offer.

2. John Collison – Growing the Internet Economy – [Invest Like the Best, EP.178] – Patrick O’Shaughnessy and John Collison

Yeah, again, just like people kind of had a hard time believing that we weren’t done with the payment systems that we had at the time. Similarly, I think people don’t really intuit this. I mean, if you look at the raw numbers, the internet economy is a very small fraction of the overall economy depending on who you believe, five, 6%, something like that, but the vast majority of internet, of the economic activity is not internet enabled. I think it’s fairly clear to all of us that that is going to flip. We’re going to end up with actually a majority that’s internet enabled, but that means we’re really at a shockingly early point in that Sigmoid growth curve.

The thing that gets me excited, and one of the things that we spent a lot of time thinking about at Stripe and trying to drive is what the second order effects are of that shift, and I think people spend lots of time thinking about first order effects of technology changes and so if you were an analyst looking at the growth of computers in the fifties and sixties, you might be wondering what are the effects going to be of computers getting faster? Presumably you’d say, well, banks are going to be able to run their calculations faster and airlines are going to be able to handle even more routes in the route calculation computers.

You’d look as what computers were already used for and just kind of project that forward more and faster. You would never forecast video games. I mean, to someone in the fifties, it would seem absurd, the notion that you could have so much excess computing power and it’s so cheap that we’re just going to use this for this wildly wasteful rendering of triangles. I don’t know if you saw the Unreal Five demo, but imagine showing that to somebody in the 1950s. It really, I think their brain might have exploded, or similarly with smartphones…

… I mean, I still find technology some of the most interesting, one of the most interesting places to look, because what I find so exciting about technology is from a business point of view, it’s positive-sum, right? So many other businesses are essentially, I mean, they learn not to talk about them this way, but there’s all these like business euphemisms for the fact that, there’s a fixed amount of supply in this industry and we’re getting really good price discipline. That’s one of these like investor-y euphemisms and for not competing too much on price or revenue optimization and things like that, as you look at something like real estate, in many kinds of parts of the world, barriers to building mean that part of what makes it a good business is the fact that there’s a fixed number of assets that can be monetized.

3. We Can Protect the Economy From Pandemics. Why Didn’t We? – Evan Ratliff

Kraut, however, had an even more ambitious idea in mind. What if, instead of simply hedging its own life insurance business in the case of a pandemic, Munich Re could use the same concept to insure other businesses against them? Business interruption insurance, the policies that protect companies against income losses from disasters like fires or hurricanes, often explicitly excluded disease. (And when it didn’t, insurers could still use the ambiguity to deny claims.) The risk was thought to be too large, too unpredictable to quantify. But Munich Re had already proven it could cover its own life insurance risk in pandemics, and now it had a partner in Metabiota that specialized in seemingly unpredictable outbreaks. What if they could create and sell a business interruption insurance policy that covered epidemics, starting with acutely vulnerable industries like travel and hospitality? They could then pass on the payout risk from those policies to the same types of investors who had bought their life risk. “There is a bit of financial alchemy to the whole thing,” Wolfe told me later. “You really are creating something from nothing.”

At the same time, Wolfe had been working to operate Metabiota more like a technology company. In 2015, he hired Nita Madhav, an epidemiologist who’d spent 10 years modeling catastrophes at a company called AIR Worldwide, one of a handful of firms the insurance industry relies on to compute extreme risks. (Munich Re, in fact, had worked with AIR epidemiological models in its life insurance calculations.) Madhav’s mandate at Metabiota was to build the industry’s most comprehensive pandemic model. Her team, which eventually grew to include data scientists, epidemiologists, programmers, actuaries, and social scientists, began by painstakingly gathering historical data on thousands of major disease outbreaks dating back to the 1918 flu. Her colleagues had recently created what they called the Epidemic Preparedness Index, an assessment of 188 countries’ capacity to respond to outbreaks. Together, the two efforts informed an infectious disease model and software platform. A user could begin with a set of parameters around a hypothetical virus—its geographic origin point, how easily it was transmitted, its virulence—and then run scenarios exploring how the disease spread around the world. The goal was a model that could, for example, help a manufacturer understand how a disease might impact its supply chain or a drug company plan for how a treatment would need to be distributed.

4. The Observer Effect: Marc Andreessen– Sriram Krishan

Well, I will pick three! It’s kind of the holy trinity of our modern dilemma. It’s health care, it’s education and it’s housing. It’s the big three. So basically, what’s happened is the industries in which we build like crazy, they have crashing prices. And so we build TVs like crazy, we build cars like crazy, we make food like crazy. The price on all that stuff has really fallen dramatically over the last 20 years which is an incredibly good thing for ordinary people. Falling prices are really, really good for people because you can buy more for every dollar.

There are two ways here: you get paid more or everything you buy is cheaper. And people always really underestimate, I think, the benefits of everything getting cheaper. And so the stuff that we actually build is getting cheaper all the time. And that’s fantastic. The stuff we *don’t* build, and very specifically, we don’t have housing, we’re not building schools, and we’re not building anything close to the health care system that we should have – for those things the prices just are skyrocketing. That’s where you get this zero sum politics.I think people have a very keen level of awareness. They can’t put it into formal economic terms but they have a keen awareness of the markers of a modern western lifestyle. It’s things like – I want to be able to own a house, I want to live in a nice neighborhood and I want to be able to send my kids to a really good school and I want to have really good health care.

And those are the three things where the price levels are increasingly out of reach. However we built those systems in the past, it’s failing us. And so we need to rethink. Quite literally, it’s like, okay, where are the schools? Where are the hospitals? Where are the houses?

5. The Resilience Of Markets – Jamie Catherwood

Wall Street and American markets have endured the tests of many challenging episodes in history. The Buttonwood Agreement was signed in 1792, and since then the United States of America has experienced its fair share of wars, recessions, political upheaval, Presidential assassinations, natural disasters, disease, terrorist attacks, and more. Despite all these adversities, however, the institution of Wall Street and US markets have held firm as a bastion of American finance. Take a moment to really consider this feat, as it’s truly remarkable. Much has changed in the centuries since the Buttonwood Agreement was signed by 24 stockbrokers outside of 68 Wall Street on May 17th, 1792. Yet, much has stayed the same. If you read any archival document from the years between 1792 and 2020, it is quickly evident that investors have always found reasons to fear the continued function of American markets due to some new policy or action by an institution.

However, New York is still considered the global capital of financial markets, and Wall Street continues to be revered by investors worldwide. So, this week’s Sunday Reads will focus on the first decades of financial markets in the United States, and the groundwork that our predecessors laid for investors today.

6. Five Tips for Recovering From Covid-19 Panic Selling – Barry Ritholtz

No. 1. Recognize what happened: What motivated you to sell? Was it something you heard on the news? An emotional impulse? Did you give any thought to how selling fit in your broader investment strategy? Or was it merely an itch that had to be scratched?

Figuring out what goes into your own decision-making is the key to reducing mistakes. Analyze your process: Determine what factors should have an impact when making buy and sell decisions. Then, face up to what actually drives those decisions. If there is a mismatch between those two, recognize it and make adjustments.

If you don’t know how you got lost, what is to stop you from getting lost the next time this happens? Remember, there always is a next time.

7. Same As It Ever Was – Morgan Housel

The nuclear bomb was developed to end World War II. Within a decade, America and the Soviets had bombs capable of ending the world – all of it.

But there was a weird silver lining to how deadly these bombs were: countries were unlikely to use them in battle because they raised the stakes so high. Wipe out an enemy’s capital city and they’ll do the same to you 60 seconds later – so why bother? John F. Kennedy said neither country wanted “a war that would leave not one Rome intact but two Carthages destroyed.”

By 1960 we got around this predicament by going the other way. We built smaller, less deadly nuclear bombs. One, called Davy Crocket, was 650 times less powerful than the bomb dropped on Hiroshima, and could be fired by one person like a bazooka. We built nuclear landmines that could fit in a backpack, with a warhead the size of a shoebox.

These tiny nukes felt more responsible, less risky. We could use them without ending the world.

But they backfired.

Small nuclear bombs were more likely to actually be used in combat. That was their whole purpose. They lowered the bar of justified use.

It changed the game, all for the worse.

Should a Company Ever be Worth Less Than Its Net Cash?

In the stock market, you may find companies trading at less than the cash it owns. But they don’t neccessarily make good investments. Here’s why.

When I first started investing, the “deep value” style of investing resonated with me. This style involves buying shares in a company that is trading at a discount to its net cash. It seemed like a sensible thing to do.

Buying a dollar for less than a dollar sounded like a common-sense approach that couldn’t go wrong.

But the net cash is just one aspect of a company. The company could be burning cash at unsustainable rates and destroying shareholder value. In this case, buying said company below its net cash will still turn out to be a bad investment.

Given this, investing in a company should not be based purely on its net cash but on the future cash flows that the company can generate.

How can a company be worth less than the cash it owns?

This is why I believe that it may even be possible for a company to be worth less than the net cash on its balance sheet.

If a company is burning money every year and management does not make any changes, it will eventually run out of cash. Shareholders will then be left with nothing. In other words, a company with a lot of cash but a terrible business model that does nothing but destroy shareholder value should very reasonably trade less than its net cash. The example below can illustrate my point.

Company ABC has $10 million in cash and no debt. However, it is going to burn cash at a rate of $1 million a year over the next 10 years. How much should this company be worth?

Using the discounted free cash flow method and an 8% discount rate on future cash flows, the company is worth only $3.29 million. That’s a 67% discount to its net cash.

Valuation screens only tell half the story

So how should we apply this to our investment decisions? I think the key takeaway is that we should not base our investment decisions solely on the valuation of a company.

A company may look cheap using traditional valuation metrics, but in reality, it may not be cheap if you take into account the future cash flow of the company.

For example, even the trailing price-to-earnings ratio may not be a good indicator of a company’s cheapness. “Trailing earnings” is a historical figure. John Huber of Saber Capital Management brought up a great point in a recent video interview.

In the past, trailing earnings for many companies were a good guidepost for future earnings. This was why the price-to-earnings multiple was used to value a company.

However, the divergence today between future earnings and past earnings is huge. There are numerous companies being disrupted, while well-run technology companies are building new and rapidly growing markets for themselves. In today’s world, past earnings may not be a good representation of future earnings for many companies anymore.

How to apply this principle?

As investors, our goal is to buy companies at a discount to their real value. But that value can no longer be derived largely from using metrics such as the price-to-book or price-to-trailing earnings ratios. We need to look at the company’s likelihood in generating future free cash flow.

Instead of focusing my energy looking at historical ratios, I try to dig deep into a company’s business, its competitive moat, market opportunity, and the ability of management to grow or at the very least maintain said company’s cash flow. By doing so, I get a better understanding of how much free cash flow a company could generate in the future and the probability it can achieve these projections.

These factors will eventually determine the real value of a company in the long-term, and not its historical earnings nor book value.

Thoughts On Datadog Inc: A Best-in-Class SaaS Company

Datadog is one of the fastest growing SaaS companies. But with its stock trading at around 45 times its annual revenue run rate, is it too expensive?

As a B2B (business-to-business) cloud software provider, Datadog Inc (NASDAQ: DDOG) may not be a household name to non-developers and IT engineers. However, it definitely caught my attention.

The monitoring and analytics platform for developers, IT operations, and business users is one of the fastest-growing software companies and has some of the best-in-class metrics to boot.

Despite less than a year as a public company, Datadog’s share price is already double from its first trading day in September 2019. In this article, I share my thoughts on Datadog.

A huge market opportunity

Companies that house their data in the cloud can end up with a complex web of data and information that is difficult to monitor. This is where Datadog’s platform can help. It provides monitoring services across public cloud, private cloud, on-premise, and multi-cloud hybrid environments.

Datadog estimates that the IT Operations Management market will represent a US$37 billion market opportunity in 2023, with the company’s services addressing US$35 billion of that.

Compare that to Datadog’s 2020 first-quarter annual revenue run-rate of around US$524 million, and you can see just how much potential lies ahead.

Growing into its own

Datadog is doing a great job in executing its growth strategy. The software-as-a-service (SaaS) company saw its revenue grow by 98% and 83% in 2018 and 2019 respectively.

In the first quarter of 2020, revenue increased by 87% year-over-year as the number of large customers (with an annual run rate of US$100,000 or more) surged to 960 from 508 a year ago.

Moreover, management expects revenue to increase to between US$555 million and US$565 million for the whole of 2020.

Growing customer base

But, to me, the most appealing thing about Datadog’s business is that the company has some of the best-in-class metrics for SaaS companies.

Datadog has recorded gross margins of 75% to 77% over the past three years, and even had positive GAAP (generally accepted accounting principles) operating income in the first quarter of 2020.

Recording a profit is pretty amazing for a company that is growing as fast as Datadog is.

The reason why Datadog can be so operationally efficient even at this high rate of growth is that it has one of the best-in-class customer acquisition cost (CAC) ratios. The CAC payback period measures how long the company takes to earn back the marketing dollars spent to acquire a new customer. It is calculated as the implied annual run rate gross margin from new customers divided by sales and marketing spend of the prior quarter.

Alex Clayton, general partner at venture capital firm Meritech Capital, recently provided a fantastic chart comparing Datadog’s CAC payback period against other listed SaaS companies (note, the lower the number, the better).

Source: Medium.com article by Alex Clayton

From the chart, you can see that Datadog recovered all its marketing cost to acquire a new customer in around 10 months. That’s only behind video-conferencing software provider Zoom, and well below the 30-month median for SaaS companies.

Customers spending more on its platform

Datadog’s existing customers also continually spend more on its platform. In the first quarter of 2020, Datadog’s dollar-based net retention rate (DBNRR) was above 130% for the 11th consecutive quarter. The DBNRR measures the change in spending for all of Datadog’s customers a year ago compared to the same group of customers today; it includes positive effects from upsells and negative effects from downgrades and customers who leave.

Datadog charges customers base on usage, so the more users (the customer’s employees) that use the platform, the more the customer pays Datadog.

In addition, Datadog has consistently introduced more products on its platform. Datadog uses a land-and-expand growth model. The company first wins customers over to use one product before cross-selling other products to them.

The chart below, taken from Datadog’s IPO prospectus, shows the annual revenue run rate of cohorts (customers that started using the platforms) from 2012 to 2018.

As you can see, each colour on the graph fattens over the years. This means that the cohorts are collectively spending more money on Datadog’s platform.

Robust balance sheet

Datadog raised around US$648 million during its September 2019 IPO. As of March 2020, Datadog had US$794 million in cash, cash equivalents, and marketable securities and no debt. This is a great financial position.

In addition, Datadog announced in late May 2020 that it is raising US$650 million through a convertible notes offering. The conversion price of US$92.30 per share represents a 21% premium to the company’s share price at the time of writing.

The offering should further strengthen Datadog’s balance sheet. The convertible price after 5 years should not dilute shareholder interests by too much as well. As the company is already free cash flow positive (more on this below), I expect management to use the new-found cash to make strategic acquisitions to improve its core offering, or invest in R&D to launch new products.

Free cash flow

As mentioned above, Datadog is already generating free cash flow. In fact, the company generated positive operating cash flow in 2017, 2018, and 2019; and had positive free cash flow in 2018 and 2019. In the first quarter of 2020, Datadog had US$19.3 million in free cash flow.

That’s equivalent to a free cash flow margin of 14.7%, decent for a company that is seeing such strong growth.

As the company grows, I expect Datadog’s free cash flow margin to widen and easily settle at 30% or more.

History of successful innovation and new products

Much of Datadog’s success has come from its constant innovation and creation of new products. The firm initially offered just infrastructure monitoring but soon expanded its service to monitor the entire technology stack.

This single pane view of the entire technology stack proved extremely popular and is one of the reasons why the company’s DBNRR is so high.

Going forward, innovation and technology upgrades will be key in ensuring that Datadog maintains its market position in this highly competitive space.

Final words

Datadog has the potential to become one of the top dogs in its industry.

But there are also risks such as execution risk and the threat of competition. It also hard to ignore Datadog’s extremely rich share price: The company’s market capitalisation is around 45 times its annual revenue run rate (based on revenue for 2020’s first quarter). This means that a lot of Datadog’s future growth is already being baked into its share price.

However, if Datadog manages to fulfill its potential and captures just 10% of its market opportunity, I think its future market capitalisation will be much higher than it is today.

Moreover, given its recurring income stream, position as a leading player in its space, high margins, operational efficiency and history of innovation, I think Datadog has a good chance of rewarding shareholders five to ten years down the road.

*Editor’s note: The article mistakenly stated that the free cash flow for the first quarter of 2020 was US$23 million and free cash flow margin was 17.3%. However, the correct figures are 19.3% and 14.7%. The article has since been updated to reflect that.