We run the risk of losing more than we can afford when we’re shorting stocks. So going short in the stock market can be far riskier than going long.
Shorting is the act of investing in stocks in a way that allows you to profit when stock prices fall. It is the opposite of going long, which is investing in a way that allows you to profit when stock prices rise.
I’ve been investing for nearly a decade now and have done fairly well. But I’ve never shorted stocks. That’s because I recognise that shorting requires different skills from going long. In the financial markets, I only want to do things that I’m sure I know well. In this article, I want to share two real-life examples on why it’s so difficult to short stocks.
My investment club
The first example starts with an informal investment club I belong to named Kairos Research. It was founded by Stanley Lim, Cheong Mun Hong, and Willie Keng. They are also the founders of the excellent Asia-focused investment education website, Value Invest Asia.
I’ve been a part of Kairos for many years and have benefited greatly. I’ve made life-long friends and met countless thoughtful, kind, humble, and whip-smart people who have a deep passion for investing and knowledge. Being in Kairos Research greatly accelerated my learning curve as both an investor and human being.
To join the club and remain in it requires a membership “fee” of just one stock market investment idea per year. It’s a price I’ve gladly paid for many years and I will continue to do so in the years ahead.
Riding all the way up
In one of our gatherings in June 2019, a well-respected member and deeply accomplished investor in the club gave a presentation on Luckin Coffee (NASDAQ: LK).
Luckin is a company that runs coffee stores in China. Its stores mainly cater for to-go orders and the company was expanding its store count at a blistering pace. Within a year or so from its founding near the end of 2017, it already had more than 2,000 stores in China. Luckin is considered a formidable competitor to US-based Starbucks in China; Starbucks counts the Middle Kingdom as its largest international growth market.
At the time of my club mate’s presentation, Luckin’s share price was around US$20, roughly the same level from the close of its IPO in May 2019. He sold his Luckin shares in January 2020, around the time when Luckin’s share price peaked at US$50. Today, Luckin’s share price is around US$4. The coffee chain’s share price tanked by 76% from US$26 in one day on 2 April 2020 and continued falling before stock exchange operator NASDAQ ordered a trading halt for Luckin shares.
Not the first time…
In January 2020, Muddy Waters Research said that it believes Luckin is a fraud. Muddy Waters Research is an investment research firm. Luckin denied the accusations and its share price only had a relatively minor reaction. There was a gradual slide that occurred in Luckin’s share price since then, but it happened with the backdrop of stock markets around the world falling because of fears related to the COVID-19 pandemic.
The wheels came off the bus only on 2 April 2020. On that day, Luckin announced that the company’s board of directors is conducting an internal investigation. There are fraudulent transactions – occurring from the second quarter of 2019 to the fourth quarter of 2019 – that are believed to amount to RMB 2.2 billion (around US$300 million). For perspective, Luckin’s reported revenue for the 12 months ended 30 September 2019 was US$470 million, according to Ycharts. The exact extent of the fraudulent transactions has yet to be finalised.
Luckin also said that investors can no longer rely on its previous financial statements for the nine months ended 30 September 2019. The company’s chief operating officer, Liu Jian, was named as the primary culprit for the misconduct. He has been suspended from his role.
Given the announcement, there could potentially be other misdeeds happening at Luckin. After all, Warren Buffett once said that “What you find is there’s never just one cockroach in the kitchen when you start looking around.”
It’s tough being short
Here’s a chart showing Luckin’s share price from its listing to 2 April 2020:
The first serious allegations of Luckin committing fraud appeared only in January 2020, thanks to Muddy Waters Research. But it turns out that fraudulent transactions at Luckin could have happened as early as April 2019. From 1 April 2019 to 31 January 2020, Luckin’s share price actually increased by 59%. At one point, it was even up by nearly 150%.
If you had shorted Luckin’s shares back in April 2019, you would have faced a massive loss – more than what you had put in – even if you had been right on Luckin committing fraud. This shows how tough it is to short stocks. Not only must your analysis on the fundamentals of the business be right, but your timing must also be right because you could easily lose more than you have if you’re shorting.
Going long though is much less worrisome. If you’re not using leverage, poor timing is not an issue because you can easily ride out any short-term decline.
Even the legend fails
The other example I want to highlight in this article is one of the most fascinating pieces of information on shorting stocks that I’ve ever come across. It involves Jim Chanos, who has a stellar reputation as a short seller. A September 2018 article from finance publication Institutional Investor mentioned this about Chanos:
“Chanos, of course, is already a legend. He will go down in Wall Street history for predicting the demise of Enron Corp., whose collapse resulted in a wave of prosecutions and the imprisonment of top executives — the kind of harsh penalties that have not been seen since.”
The same Institutional Investor article also had the following paragraphs (emphasis is mine):
“The secret to Chanos’s longevity as a short-seller is Kynikos’s flagship fund, the vehicle where Kynikos partners invest, which was launched alongside Ursus in 1985. Kynikos Capital Partners is 190 percent long and 90 percent short, making it net long. Unlike most long/short hedge funds, however, the longs are primarily passive, using such instruments as exchange-traded funds, as the intellectual effort goes into the short side.
Chanos argues that by protecting the downside with his shorts, an investor can actually double his risk — and over time that has proved a winning strategy. Through the end of 2017, Kynikos Capital Partners has a net annualized gain of 28.6 percent since launch in October 1985, more than double the S&P 500. That has happened even though the short book — as represented by Ursus — has lost 0.7 percent annually during the same time frame, according to a recent Kynikos document Institutional Investor has obtained.”
It turns out that Chanos’s main fund that shorts stocks – Ursus – had lost 0.7% annually from October 1985 to end-2017! That’s Jim Chanos, a legendary short-seller, losing money shorting stocks over a 32-year period!
My conclusion
Stocks with weak balance sheets, inability to generate free cash flow, and businesses in rapidly declining industries are likely to falter over the long run. But it’s far easier to identify such stocks and simply avoid them than it is to short them.
Besides, the math doesn’t work in my favour. The most I can make going short is 100% while my potential loss is unlimited. On the flipside, the gain I can earn going long is theoretically unlimited, while my potential loss is capped at what I’ve invested.
When we go short, we run the risk of losing more than we can afford – that’s true even for fraud cases. As a result, I’ve always invested with the mentality that going short in the stock market is far riskier than going long.
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 family’s investment portfolio has held Okta shares for just over a year and it has done well for us. Here’s why we continue to invest in Okta shares.
Okta (NASDAQ: OKTA) is one of the 50-plus companies that’s in my family’s portfolio. I first bought Okta shares for the portfolio in March 2019 at a price of US$79. I’ve not sold any of the shares I’ve bought.
The purchase has worked out well for my family’s portfolio, with Okta’s share price being around US$128 now. But we’ve only owned the company’s shares for slightly more than a year, and it is always important to think about how the company’s business will evolve going forward. What follows is my thesis for why I still continue to invest in Okta shares.
Company description
Okta’s vision is to enable any organisation to use any technology. To fulfill its vision, Okta provides the Okta Identity Cloud software platform where all its products live. Okta’s cloud-based software products help other companies manage and secure access to applications for their employees, contractors, partners, and customers.
The internal use-cases, where Okta’s solutions are used by organisations to manage and secure software-access among their employees, contractors, and partners, are referred to as workforce identity by Okta. An example of a workforce identity customer is 20th Century Fox. The external-facing use cases are known as customer identity, and it is where Okta’s solutions are used by its customers to manage and secure the identities and service/product access of their customers. Adobe is one of the many customers of Okta’s customer identity platform.
There’s a rough 80:20 split in Okta’s revenue between the workforce identity and customer identity solutions.
Source: Okta April 2020 investor presentation
At the end of FY2020 (fiscal year ended 31 January 2020), Okta had more than 7,950 customers. These customers come from nearly every industry and range from small organisations with less than 100 employees to the largest companies in the world.
For a geographical perspective, Okta sourced 84% of its revenue in FY2020 from the US.
Investment thesis
I had previously laid out my six-criteria investment framework in The Good Investors. I will use the same framework to describe my investment thesis for Okta.
1. Revenues that are small in relation to a large and/or growing market, or revenues that are large in a fast-growing market
Okta estimates that its market opportunity for workforce identity is U$30 billion today. This is up from US$18 billion around three years ago. The company arrived at its current workforce identity market size of US$30 billion in this way: “50,000 US businesses with more than 250 employees (per 2019 US.Bureau of Labor Statistics) multiplied by 12-month ARR [annual recurring revenue] assuming adoption of all our current products, which implies a market of [US]$15 billion domestically, then multiplied by two to account for international opportunity.”
For customer identity, Okta estimates the addressable market to be US$25 billion. Here’s Okta’s description of the method behind its estimate: “Based on 4.4 billion combined Facebook users and service employees worldwide multiplied by internal application usage and pricing assumptions.” I am taking Okta’s estimate of its customer identity market with a pinch of salt. But I’m still confident that the opportunity is huge, given the growth and size of the entire SaaS (software-as-a-service) market. A November 2019 forecast from market research firm Gartner sees global SaaS spending growing by 15% annually from US$$86 billion in 2018 to US$151 billion in 2022.
In FY2020, Okta’s revenue was just US$586.1 million, which barely scratches the surface of its total estimated market opportunity of US$55 billion. I also think it’s likely that Okta’s market is poised for growth. Based on Okta’s studies, the average number of apps that companies are using has increased by 52% from 58 in 2015 to 88 in 2019. Earlier this month, Okta’s co-founder and CEO, Todd McKinnon, was interviewed by Ben Thompson for the latter’s excellent tech newsletter, Stratechery. During the interview, McKinnon revealed that large companies (those with over 5,000 employees) typically use thousands of apps.
The high and growing level of app-usage among companies means it can be a massive pain for an organisation to manage software-access for its employees, contractors, partners, and customers. This pain-point is what Okta Identity Cloud is trying to address. By using Okta’s software, an organisation does not need to build custom identity management software – software developers from the organisation can thus become more productive. The organisation would also be able to scale more efficiently.
2. A strong balance sheet with minimal or a reasonable amount of debt
As of 31 January 2020, Okta held US$1.4 billion in cash and short-term investments. This is significantly higher than the company’s total debt of US$937.7 million (all of which are convertible notes that are due in 2023 or 2025).
For the sake of conservatism, I also note that Okta had US$154.5 million in operating lease liabilities. But the company’s cash, short-term investments and long-term investments still comfortably outweigh the sum of its debt and operating lease liabilities (US$1.1 billion)
3. A management team with integrity, capability, and an innovative mindset
On integrity
Todd McKinnon cofounded Okta in 2009 with Frederic Kerrest. McKinnon, who’s 48 years old, has served as Okta’s CEO since the company’s founding. He has a strong pedigree in leading software companies, having been with salesforce.com from 2003 to 2009, and serving as its Head of Engineering prior to founding Okta. salesforce.com is one of the pioneering software-as-a-service companies. Kerrest, 43, is Okta’s COO (chief operating officer) and has been in the role since the year of the company’s founding. Kerrest is also a salesforce.com alumni; he joined in 2002 and stayed till 2007, serving as a senior executive. In my view, the young ages of McKinnon and Kerrest, as well as their long tenures with Okta, are positives.
The other important leaders in Okta include:
Source: Okta website and FY2019 proxy statement
In FY2019, Okta’s senior leaders (McKinnon, Kerrest, Losch, Race, and Runyan) each received total compensation that ranged from US$2.3 million to US$5.1 million. These are reasonable sums. Furthermore, 72% to 88% of their total compensation was in the form of stock awards and stock options that vest over multi-year periods. This means that the compensation of Okta’s senior leaders are tied to the long run performance of the company’s stock price, which is in turn driven by the company’s business performance. So I think that my interests as a shareholder of Okta are well-aligned with the company’s management.
Source: Okta FY2019 proxy statement
Moreover, both McKinnon and Kerrest own significant stakes in Okta. As of 1 April 2019, McKinnon and Kerrest controlled 7.98 million and 3.65 million shares of the company, respectively. These shares have a collective value of roughly US$1.5 billion right now. The high stakes that Okta’s two key leaders have lend further weight to my view that management’s interests are aligned with the company’s other shareholders.
I note that the shares held by McKinnon and Kerrest are mostly of the Class B variety. Okta has two stock classes: (1) Class B, which are not traded and hold 10 voting rights per share; and (2) Class A, which are publicly traded and hold just 1 vote per share. McKinnon and Kerrest only controlled 10.1% of Okta’s total shares as of 1 April 2019, but they collectively held 50.7% of the company’s voting power. In fact, all of Okta’s senior leaders and directors together controlled 54.7% of Okta’s voting rights as of 1 April 2019 (this percentage dipped only slightly to 53.1% as of 31 January 2020). The concentration of Okta’s voting power in the hands of management (in particular McKinnon and Kerrest) means that I need to be comfortable with the company’s current leadership. I am.
On capability
From FY2015 to FY2020, Okta has seen its number of customers increase six-fold (43% per year) from 1,320 to 7,950. So the first thing I note is that Okta’s management has a terrific track record of growing its customer count.
Source: Okta FY2020 annual report and IPO prospectus
To win customers, Okta currently offers over 6,500 integrations with IT (information technology) infrastructure providers, and cloud, mobile, and web apps. This is up from over 5,000 integrations as of 31 January 2017. The companies that are part of Okta’s integration network include services from tech giants such as Microsoft, Alphabet, Amazon.com, salesforce.com and more. Impressively, software providers are increasingly being told by their customers that they have to be integrated with Okta before the software can be accepted.
In my view, the integration also creates a potentially powerful network effect where more integration on Okta’s network leads to more customers, and more customers leads to even more integration. During the aforementioned Stratechery interview, McKinnon shared about the competitive edge that Okta enjoys because of its efforts in integrating thousands of apps:
“[Question]: The average enterprise — maybe it’s hard to say because it varies so widely — how many SaaS services does a typical enterprise subscribe to?
[Todd McKinnon] TM: Especially for any company with over 5,000 employees, it’s thousands of apps. Apps that they’ve purchased commercially, the big ones you’ve heard of, the ones that are in niche industries or verticals you haven’t heard of, and then the ones built themselves, it’s thousands.
[Question]: And then Okta has to build an integration with all of those
[Todd McKinnon] TM: Yeah. One of the big things we did very early on was we got really good at a metadata-driven integration infrastructure, which allowed us to have this burgeoning catalog of pre-packaged integrations, which was really unique in the industry because it is a hundreds or for a big company, it’s thousands of applications.
[Question] And it ends up being a bit of a moat, right? It’s a traditional moat where you dig it up with hard work where you actually went in and you built all of these thousands of integrations, and anyone that wants to come along, if they have a choice of either recreating all the work you did or, we should just use Okta and it’s already sort of all taken care of.
[Todd McKinnon] TM: Yeah, and it’s one of the things people misunderstand on a couple of different levels. The first level is they just get the number wrong. “I think there’s ten, right?” Or I’ve heard of ten big applications, so I think if I connected the ten, that would be enough, which is just off by multiple orders of magnitude.
And then the second thing they get wrong is they think that, especially back in the day it was like, “Oh, there it’s going to be standards that do this.” It’s going to be SAML as a standard. There’s this standard called Open ID. And what we’ve found is that the standards were very thin, meaning they didn’t cover enough of the surface area of what the customers needed, so it might do simple login but it didn’t do directory replication, or not enough of the applications adhere to the standard. So there’s a lot more heterogeneity than people thought of so that moat was a lot wider, a lot faster than people expected.
[Question] Is it fair to say that it’s your goal or maybe it has happened that people thought there would be a standard like SAML that would take care of all of this, but it’s going to end up being that Okta as the standard?
[Todd McKinnon] TM: That is the goal and I think it’s evolving to where there are de facto standards. A big shift is that we have big companies that tell software vendors that if you want to sell to us, you have to integrate to Okta and they have to go to our platform, build the integration, have it be certified. So that’s not a technical standard per se, but it’s a de facto standard of an application that can be sold to a large enterprise.”
I also credit Okta’s management with the success that the company has found with its land-and-expand strategy. The strategy starts with the company landing a customer with an initial use case, and then expanding its relationship with the customer through more users or more use cases. The success can be illustrated through Okta’s strong dollar-based net retention rates (DBNRRs). The metric is a very important gauge for the health of a SaaS company’s business. It measures the change in revenue from all of Okta’s customers a year ago compared to today; it includes positive effects from upsells as well as negative effects from customers who leave or downgrade. Anything more than 100% indicates that the company’s customers, as a group, are spending more – Okta’s DBNRRs have been in the high-teens to high-twenties range over the past few years. There has been a noticeable downward trend in Okta’s DBNRR, but the figure of 119% in FY2020 is still impressive.
Source: Okta FY2020 annual report and IPO prospectus
I also want to point out the presence of Ben Horowitz on Okta’s board of directors. Horowitz is a co-founder and partner in a venture capital firm I admire and that was partly named after him, Andreessen Horowitz (the firm, popularly known as a16z, is an early investor in Okta). Having Horowitz as a director allows Okta’s management to tap on a valuable source of knowledge.
On innovation
Okta is a pioneer in its field. It was one of the first companies that realised that a really important business could be built on the premise of a cloud-based software that secures and manages an individual’s digital identity for cloud-based applications. To me, that is fantastic proof of the innovative ability of Okta’s management. Stratechery’s interview of Todd McKinnon provided a great window on the thinking of him and his team in the early days of Okta’s founding:
“[Question] When Okta first came on the scene, it was Single Sign-on, so you could sign on in one place and then you’d be logged into other places, now it’s an Identity Cloud. Is that an actual shift in the product or strategy or is that just a shift in a marketing term?
[Todd McKinnon] TM: It’s interesting. When we started the company, you could see that cloud was going to be the future. We started 11 years ago, so in 2009, Amazon Web Services was out, Google Apps for Domains was out. So you could kind of see that infrastructure was going to go to the cloud, you could see that collaboration apps were going to go to the cloud. I was working at Salesforce at the time, so it was really clear that the apps stack was going to be in the cloud and we got really excited about what could be possible or what new types of platforms could be built to enable all this.
When we started, it’s funny, we called the first product, which was going to be a cloud single sign-on, we called it Wedge One. So not only was it the wedge, but it was like the first, first wedge. Now it turns out that in order to build cloud single sign on you had to build a lot of pretty advanced stuff behind the scenes to make that simple and seamless, you had to build a directory, you had to build a federation server, you had to build multi-factor authentication, and after we were into it for two or three or four years, we realized that there’s a whole identity system here so it’s much more than a wedge. In fact, it really can be a big part in doing all that enablement we set out to do.
[Question] That’s very interesting, so are you still on Wedge One? Did you ever make it to Wedge Two?
[Todd McKinnon] TM: (laughs) The Wedge keeps getting fatter. The Identity Cloud is pretty broad these days. It’s directory service, it’s reporting analytics, it’s multi-factor authentication, it does API Access Management. It’s very flexible, very extensible, so really the Identity Cloud now is an Identity Platform, it’s striving to really address any kind of identity use cases a customer has, both on the customer side, customer identity, and on the workforce side.
What’s interesting about it is that at the same time over the last eleven years, identity has gone from being something that’s really important maybe for Windows networks or around your Oracle applications to there are so different applications connected from so many types of devices and so many networks that identity is really critical, and we’re in this world now where ten years ago people were telling me “Hey, I’m not sure if it’s possible to build an independent identity company” to now it’s like everyone says, “Oh, it’s such an obvious category that the biggest technology companies in the world want to own it.” So it has been quite a shift.”
4. Revenue streams that are recurring in nature, either through contracts or customer-behaviour
Okta runs its business on a SaaS model and generates most of its revenue through multi-year subscriptions, which are recurring in nature. In FY2020, 94% of Okta’s total revenue of US$586.1 million came from subscriptions. The company’s average subscription term was 2.6 years as of 31 January 2020 and iInterestingly, Okta’s contracts are non-cancelable. The remaining 6% of Okta’s revenue in FY2020 was from professional services, where the company earns fees from helping its customers implement and optimise the use of its products.
It’s important to me too that there’s no customer concentration in Okta’s business. No single customer accounted for more than 10% of the company’s revenue in each year from FY2018 to FY2020.
5. A proven ability to grow
There isn’t much historical financial data to study for Okta, since the company was only listed in April 2017. But I do like what I see:
Source: Okta IPO prospectus and annual reports
A few key points to note about Okta’s financials:
Okta has compounded its revenue at an impressive annual rate of 70.2% from FY2015 to FY2020. The rate of growth has slowed in recent years, but was still really strong at 46.7% in FY2020.
Okta is still making losses, but the good thing is that it started to generate positive operating cash flow in FY2019 and positive free cash flow in FY2020..
The company’s balance sheet remained robust throughout the timeframe under study, with significantly more cash and investments than debt.
At first glance, Okta’s diluted share count appeared to increase sharply by 29.5% from FY2018 to FY2019. (I only started counting from FY2018 since Okta was listed in April 2017, which is in the first quarter of FY2018.) But the number I’m using is the weighted average diluted share count. Right after Okta got listed, it had a share count of around 91 million. Moreover, Okta’s weighted average diluted share count showed an acceptable growth rate (acceptable in the context of the company’s rapid revenue growth) of 9% in FY2020.
6. A high likelihood of generating a strong and growing stream of free cash flow in the future
Okta has already started to generate positive free cash flow and positive operating cash flow. Right now, the company has a poor trailing free cash flow margin (free cash flow as a percentage of revenue) of just 4.7%.
But over the long run, I think it’s likely that there is plenty of room for Okta’s free cash flow margin to expand. I showed in my recently published investment thesis for Alteryx (NYSE: AYX) that there are other larger SaaS companies such as Adobe, salesforce.com, and Veeva Systems that have much fatter free cash flow margins. Here’s the table I showed in my article on Alteryx:
Source: Companies’ annual reports and earnings updates (data as of 23 March 2020)
Valuation
Okta has a target to grow its revenue by 30% to 35% annually from now till FY2024, and to have a free cash flow margin of between 20% and 25% at the end of that period. These goals were communicated by management just earlier this month during Okta’s Investor Day event. For perspective, Okta is projecting total revenue growth of 31% to 33% in FY2021.
Right now, Okta has a market capitalisation of US$16.08 billion against trailing revenue of US$586.1 million, which gives rise to a pretty darn high price-to-sales (PS) ratio of 27.4.
For perspective, if I assume that Okta has a 25% free cash flow margin today, then the company would have a price-to-free cash flow ratio of 110 based on the current P/S ratio (27.4 divided by 25%).
But there are strong positives in Okta’s favour. The company has: (1) Revenue that is low compared to a large and possibly fast-growing market; (2) a software product that is mission-critical for users; (3) a large and rapidly expanding customer base; and (4) sticky customers who have been willing to significantly increase their spending with the company over time. I believe that with these traits, there’s a high chance that Okta will continue posting excellent revenue growth – and in turn, excellent free cash flow growth – in time to come.
The risks involved
Okta has a short history in the stock market, given that its IPO was just three years ago in April 2017. I typically stay away from young IPOs. But I am willing to back Okta because I think its business holds promise for fast-growth for a long period of time (the company’s identity-as-a-service business is very important for the digital transformation that so many companies are currently undergoing). But Okta’s young age as a publicly-listed company is still a risk I’m keeping tabs on.
Competition is a risk I’m watching too. In its FY2018 and FY2019 annual reports, Okta named technology heavyweights such as Alphabet, Amazon, IBM, Microsoft, and Oracle as competitors. In its FY2020 annual report, Okta singled out Microsoft as its “principal competitor.” All of them have significantly stronger financial might compared to Okta. But I’m comforted by Okta’s admirable defense of its turf – the proof is in Okta’s strong DBNRRs and impressive growth in customer-numbers over the years. Moreover, in late 2019, market researchers Gartner and Forrester also separately named Okta as a leader in its field.
Okta’s high valuation is another risk. The high valuation adds pressure on the company to continue executing well; any missteps could result in a painful fall in its stock price. This is a risk I’m comfortable taking.
Hacking is also a risk I’m keeping an eye on. Logging into applications is often a time-sensitive and mission-critical part of an employee’s work. Okta’s growth and reputation could be severely diminished if the company’s service is disrupted, leading to customers being locked out of the software they require to run their business for an extended period of time.
The COVID-19 pandemic has resulted in severe disruptions to economic activity in many parts of the world, the US included. I think that the mission-critical nature of Okta’s service means that its business is less likely to be harmed significantly by any coronavirus-driven recession. But there are still headwinds. In an April 2020 statement, Okta’s CFO William Losch said:
“We continue to closely monitor the business environment and impacts related to COVID-19. We remain optimistic about the demand for our solutions. Our highly recurring business model enables a high degree of predictability and allows us to maintain confidence in our revenue outlook for the first quarter and fiscal year 2021, which we are reaffirming.
We do, however, expect some near-term billings headwinds as customers adjust to the current business environment. Conversely, we expect our operating loss and loss per share to be better than expected as a result of reduced spend. This is primarily related to lower sales and marketing costs, driven in part by temporary travel restrictions, lower employee-related costs, and moving Oktane and other events to virtual formats. We have the ability to further adjust spend depending on the market environment and will be flexible in how and when we invest to extend our market leadership.”
Lastly, the following are all yellow-to-red flags for me regarding Okta: (1) The company’s DBNRR comes in at less than 100% for an extended period of time; (2) it fails to increase its number of customers; and (3) it’s unable to convert revenue into free cash flow at a healthy clip in the future.
The Good Investors’ conclusion
In summary, Okta has:
A valuable cloud-based identity-as-a-service software platform that is often mission-critical for customers;
high levels of recurring revenue;
outstanding revenue growth rates;
positive operating cash flow and free cash flow, with the potential for much higher free cash flow margins in the future;
a large, mostly untapped addressable market that could potentially grow in the years ahead;
an impressive track record of winning customers and increasing their spending; and
capable leaders who are in the same boat as the company’s other shareholders
Okta does have a rich valuation, so I’m taking on valuation risk. There are also other risks to note, such as competitors with heavy financial muscle, and headwinds due to COVID-19. But after weighing the pros and cons, I’m happy to continue having Okta be in my family’s investment portfolio.
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.
Markets are volatile and earnings are likely to sink. Nobody knows when the economy will return to normal. How can we approach investing during COVID-19?
“Fear incites human action far more urgently than does the impressive weight of historical evidence.”
Jeremy Siegel, Stocks for the Long Run
The COVID-19 pandemic has thrown markets into a frenzy. The month of March was likely the most volatile period in stock market history. Traders were zig-zagging in and out of the markets, causing daily swings of up to 10% in the S&P 500.
COVID-19 is indeed a black swan event. No one really knows what will happen and how the market will pan out in the short-term. With so much uncertainty, what should long-term investors do now?
Focus on things that you can predict
There are many things we can’t predict in the stock market. But investing is not about accurately predicting everything that will affect stock prices. Instead, it’s about focusing on stuff that you can predict. It’s about investing in companies that are likely to succeed in the long-term.
Terry Smith is the founder of Fundsmith, the manager of the UK’s largest fund, Fundsmith Equity Fund. Here’s what Smith wrote in a recent letter to his investors:
“What will emerge from the current apocalyptic state? How many of us will become sick or worse? When will we be allowed out again? Will we travel as much as we have in the past? Will the extreme measures taken by governments to maintain the economy lead to inflation? I haven’t a clue. Rather like some of the companies we most admire, I try to spend very little time considering matters which I can neither predict nor control and focus instead on those which I can affect.”
Don’t forget that the stock market is the best place to invest for the long term
In times such as this, it is easy to forget that the stock market is actually the best place to invest your money for long-term returns.
According to data from NYU finance professor Aswath Damodaran, US stocks have outperformed bonds and cash by a wide margin over the long run. From 1928 to 2019, US stocks produced an annual return of 9.7%, while bonds (10-year treasuries) had a 4.9% return per year.
In a recent video, Motley Fool co-founder David Gardner shared:
“From day one, when we started the Motley Fool 27 years ago, we said three things. Number one, the stock market is the best place to be for your long-term money. Number two, the stock market tends to rise 9 to 10% a year. That includes every bad week, quarter, month, year, bear market… and number three, make sure that you are invested in a way that you can sleep well at night.”
Don’t try to time the bottom
One of the most-asked questions among investors today is “Have we reached the bottom?”
I think that nobody really knows the answer to that. But it should not stop us from investing.
If you insist on only buying at the trough, you might miss a few good opportunities. In fact, I’ve heard of stories of investors who planned to enter the market at the bottom but missed out when their preferred-bottom never came. As stocks rose and got more expensive, they couldn’t bring themselves to buy and missed out on years of gains.
Billionaire investor Howard Marks mentioned in his latest memo:
“The old saying goes, “The perfect is the enemy of the good.” Likewise, waiting for the bottom can keep investors from making good purchases. The investor’s goal should be to make a large number of good buys, not just a few perfect ones.”
But remember to pick the right stocks
If you intend to invest in individual companies rather than an index-tracking fund, then it is important to remember that not all companies are created equal.
The well-followed S&P 500 index in the US has risen steadily over the long-term but a lot of its return can be attributed to only a handful of outperforming companies.
In fact, my blogging partner Ser Jing reported an interesting statistic in an earlier article. He wrote:
“ A 2014 study by JP Morgan showed that 40% of all stocks that were part of the Russell 3000 index in the US since 1980 produced negative returns across their entire lifetime.”
That’s an astounding statistic and goes to show that simply investing in any random stock will not guarantee you positive returns, even if you hold for the long run.
Picking the right companies is as important as choosing the right asset class to invest in. It is perhaps even more important for times such as today, where poorly-managed companies with weak balance sheets are fighting for their survival. As Warren Buffett once said, “Only when the tide goes out do you discover who’s been swimming naked.”
Stay calm and keep investing…
It is an understatement that markets are volatile. We are also likely going to see sharp drops in earnings from many companies in the next few quarters. Already Starbucks has guided for a 46% fall in earnings for the first quarter of 2020 and I expect to see many more companies reporting similar if not worse figures than this.
However, over the long-term, I expect earnings for well-run companies to return and for life to eventually return to normal.
Instead of focusing on the next few quarter results, I am keeping my eye on long-term results and which companies can survive the current economic standstill.
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.
Company earnings in the US are expected to fall drastically. Shouldn’t the S&P 500’s price go much lower then? Not if earnings normalise in the future.
Some investors may be wondering why stocks have not fallen more. The S&P 500 in the US has rebounded sharply in recent days and is now down by just 15% year-to-date.
Yet US companies are expected to see their earnings decline much more than 15% in the next few quarters. This will make their price-to-earnings ratios seem disproportionately higher than they were last year.
So why is there this gap between stock prices and earnings?
Discounted cash flow
The answer is that stock prices are not a reflection of a single year of earnings. Instead, it is the accumulation of the future free cash flow or earnings that a company will produce over its entire lifetime discounted back to today.
This economic concept is known as the discounted cash flow model. Investor Ben Carlson wrote a brilliant article on this recently.
For example, let’s assume Company ABC is expected to earn $10 per share per year for the next 10 years. After discounting future cash flows back to the present day, at an 8% discount rate, the company’s shares are worth $67.10.
But let’s assume that because of the COVID-19 crisis, ABC’s earnings in the first year is wiped out. But it still can generate $10 a year in the remaining nine years after that. Using the discounted cash flow model, ABC’s shares are still worth $57.84
Despite a 100% decline in earnings in the coming year, ABC’s share price is worth just 14% less.
Other bad case scenarios
There are worse scenarios that can play out, but as long as a company’s long term future cash flow or earnings remains somewhat stable, its share price should not fall as much as its near-term earnings.
For instance, let’s assume that instead of earning $10 per share in the coming year, Company ABC now makes a loss of $10 per share. But in year 2 onwards, business returns to normal and it can generate its usual $10 per share for the next nine years. In this case, Company ABC’s shares are now worth $48.58, or 28% less than before.
Let’s make the situation worse. Let’s assume Company ABC has a $10 per share loss in year 1 and has zero cash flow in year 2. Let’s also assume that business only returns to normal in year 3. Its shares, in this case, are still worth $40.01, a 40% decline.
History shows that stocks fall less than earnings
This is the reason why stocks tend to fall far less than short-term earnings declines. We can look at the Great Financial Crisis as a reference.
According to data from Nobel Prize-winning economist Robert Shiller, the S&P 500’s earnings per share fell 77.5% from $81.51 in 2007 to $18.31 in 2008.
But the price fell much less. The S&P 500 closed at 1520.71 in July 2007 and reached a low of 757.13 in March of 2009. That translated to a 50% decline in stock prices.
Simply put, a 77.5% decline in earnings translated to ‘only’ a 50% decline in stock price.
Not only did the S&P 500’s price fall much less than earnings, but the subsequent years have also shown that stocks may have fallen too low. Investors who bought in at the troughs of 2009 enjoyed better-than-normal returns over the next 10-plus years.
Assuming stock prices fall in tandem with one-year forward earnings is short-sighted and does not take into account all the future cash flows of a company.
Last words on the price-to-earnings ratio
I guess the takeaway for this post is that you should not be scared off stocks by the high price-to-earnings ratio of companies that will likely appear in the coming months (a high price-to-earnings ratio because of a large decline in earnings but less drastic fall in share price).
The fall in earnings, if only temporary, should logically only cause a small decline in the value of the company, especially if it can continue to make profits consistently over the extended future.
It is natural that the PE ratio will be high if a company’s earnings disappear in the coming year. But the disappearance of the earnings could be temporary. When COVID-19 blows over, some companies – not all – will see business resume.
For now, the PE ratio is a useless metric as earnings are battered down temporarily, making the figure appear disproportionately high. We should instead focus on normalised earnings and whether a company can continue to generate free cash flow in the future.
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.
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 12 April 2020:
1.Message from Ser Jing’s friend
Last week, Ser Jing’s friend shared a list of wholesome activities we can all do to add more meaning to our lives during this difficult Circuit Breaker period. It bears repeating:
– Picking up a book that you have been wanting to read – Taking this period of time to rest and re-calibrate yourself – Spending quality time and doing stuffs for your loved ones – Taking up online courses. Think Coursera and etc – Starting up your own side line business – Developing a new skill or hobby – Practicing meditation, yoga and journalism to master your inner thoughts and emotions (Ser Jing meditates regularly) – Spending some time alone in nature – Getting in touch with your friends – Spend time reflecting
“Although they knew about the flu and did what they could to prevent it from coming, it arrived anyway,” says Katherine Ringsmuth. “The disease struck so quickly, most people didn’t have a chance to respond.” A fall in salmon stocks may have ultimately helped the Egegak village. “It was a terrible year for salmon as they had been producing so much canned salmon for the war effort in Europe, it caused the fish numbers to decline.
“It might have meant no one had any reason to visit the area. It was just chance.”
Survival, it seems, can sometimes come down to blind luck.
Covid-19 has separated workers into two clearly defined buckets: Those who can work from home and those who can’t.
You can break it out further into those who work for companies that can do business online and those that can’t.
In human terms, there are now flight attendants and waiters whose careers vanished overnight, and lawyers/bankers/consultants/programers who continue earning their nice salaries and benefits while in their pajamas.
That’s generalizing. There are exceptions on both sides. But it’s directionally accurate. And it’s a big deal because a key income inequality characteristic over the last three decades has been the disparity between those who work with their hands and those who work with their heads. That trend just sped up exponentially.
Ser Jing here: Fundsmith is one of the best fund management companies I know of. Its founder, CEO, and CIO (chief investment officer), Terry Smith, is one of the best fund managers I know of. In late February 2020, Fundsmith held its annual shareholders’ meeting for the investors in its funds. Smith gave a presentation and answered questions from his investors together with his team. The entire meeting was recorded on video and it is 1 hour and 30 minutes of pure investing goodness. One of my favourite parts of the video is when Smith talked about investing during recessions and the current COVID-19 crisis (watch from 34:20 onwards).
Said another way — if stocks don’t have the risk of a Great Depression-like crash on the table, does that mean expected returns should be lower going forward?
Looking at valuations over the long-term, you could make the case that the market has been pricing this in for some time now. Robert Shiller has pieced together U.S. market data going back to 1871 to calculate his cyclically-adjusted price-to-earnings ratio.
This valuation measure is far from perfect but it is telling to see how the averages have changed over time:
There is an obvious upward move in the average over time. There are a number of explanations for this increase — interest rates and inflation have fallen over time, accounting rules have changed on corporate earnings, the underlying structure of the market has changed (think more tech companies), the U.S. economy and markets are more mature, etc.
But another reason for this is the Fed now plays a larger role in the economy and management of the financial system, and thus, financial assets. If the stock market is “safer” over time, in that the Fed will do its best to smooth economic cycles, it would make sense that valuations should rise over time.
At least I didn’t commit what Mr. Murtha considers the most serious error, which is to sell into a steep decline. “That’s where people really get hurt,” he said. “Once you’re out, the emotional leverage works against you. Either the market drops further, which confirms your fear. Or it goes up, and you don’t want to buy after you just sold. Then it gets further and further away from you. People don’t realize how hard it is to get back in.”
The old saying goes, “The perfect is the enemy of the good.” Likewise, waiting for the bottom can keep investors from making good purchases. The investor’s goal should be to make a large number of good buys, not just a few perfect ones. Think about your normal behavior. Before every purchase, do you insist on being sure the thing in question will never be available lower? That is, that you’re buying at the bottom? I doubt it. You probably buy because you think you’re getting a good asset at an attractive price. Isn’t that enough? And I trust you sell because you think the selling price is adequate or more, not because you’re convinced the price can never go higher. To insist on buying only at bottoms and selling only at tops would be paralyzing…
…The bottom line for me is that I’m not at all troubled saying (a) markets may well be considerably lower sometime in the coming months and (b) we’re buying today when we find good value. I don’t find these statements inconsistent.
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.
Blindly following famous investors is incredibly dangerous. “I’m buying because Warren Buffett is buying” is not a valid investment thesis.
Financial markets all over the world have been in a state of turmoil in recent weeks because of the COVID-19 crisis. In uncertain times like these, you may look up to famous investors to emulate their actions. That’s understandable. After all, following authoritative figures can provide a sense of security.
But I’m here to tell you that following famous investors blindlyis incredibly dangerous.
Blind faith
A few weeks ago, I recorded a video chat with Reshveen Rajendran. During our conversation, Resh shared the story of his friend’s investment in Occidental Petroleum (NYSE: OXY), an oil & gas company. Resh’s friend had invested in Occidental’s shares at around US$40 each, only to see the share price fall sharply. At the time of recording, Occidental’s share price was around US$16 (it is around US$14 now). Resh’s friend did not know what to do with his/her Occidental investment.
After we finished recording, I had a further discussion with Resh. I thought there could be a really good educational element in the story of his friend’s investment in Occidental.
I found out that the friend’s investment thesis for Occidental was to simply follow Warren Buffett. But here’s the thing: Buffett’s investment in Occidental is radically different from what we as individual investors can participate in.
Buffett’s bet
In August 2019, Buffett invested in Occidental through his investment conglomerate, Berkshire Hathaway (NYSE: BRK-A)(NYSE: BRK-B). What Buffett bought was US$10 billion worth of preferred shares in Occidental. He wanted to provide Occidental with capital to finance its planned US$38 billion acquisition of Anadarko Petroleum Corporation, a peer in the oil & gas industry.
Occidental’s preferred shares that Buffett invested in are not publicly-traded. So individual investors like you and I can’t invest in them. The preferred shares come with an 8% annual dividend that Occidental is obliged to pay until they are redeemed; the dividend means that Occidental has to pay Berkshire US$800 million every year (8% of Berkshire’s US$10 billion investment) in perpetuity or until redemption of the preferred shares happen. Occidental has the option to redeem the preferred shares at US$10.5 billion any time after August 2029. In other words, Berkshire is guaranteed to make a return of at least 8% per year from its Occidental preferred shares as long as the oil & gas company does not go bust.
Investing in Occidental’s preferred shares the way that Buffett did is very different from buying Occidental shares in the stock market. The normal Occidental shares we can purchase (technically known as common shares or ordinary shares) don’t come with any dividend-guarantees. Occidental is also not obliged to redeem our shares at a small premium to what we paid. If we buy Occidental shares, how well our investment will do over a multi-year period will depend solely on the business performance of the company. Buffett’s investment in the preferred shares comes with protection that we can’t get with the ordinary shares.
No cover
To the point about protection, consider the following. In March 2020, Occidental slashed the quarterly dividend on its ordinary shares by 86% – from US$0.79 per share to just US$0.11 per share – to save around US$2.2 billion in cash. That was the company’s first dividend reduction in 30 years. Occidental needed to take extreme measures to protect its financial health in the face of a sharp decline in oil prices. Meanwhile, there’s nothing Occidental can do about the 8% dividend on Buffett’s US$10 billion preferred shares investment – Occidental has to continue paying the preferred dividends. To add salt to the wound, Occidental’s US$0.11 per share in quarterly dividend works out to just US$392 million per year, which is less than half of the US$800 million that Buffett’s preferred shares are getting in dividends annually.
Yes, Buffett did buy some ordinary Occidental shares after his August 2019 investment in the oil & gas company’s preferred shares. But the total invested sum in the ordinary shares is tiny (around US$780 million at the end of 2019, or an average share price of US$41.21) compared to his investment in the preferred shares.
We can end up in disaster if we follow Buffett blindly into an investment without understanding his idea’s key traits. Buffett’s reputation and Berkshire’s actual financial clout gives him access to deals that we will never have.
Following authority into disaster
Resh’s story about his friend’s investment in Occidental shares reminded me of something that Morgan Housel once shared. Housel is currently a partner with the venture capital firm Collaborative Fund. Prior to this, he was a writer for The Motley Fool for many years. Here’s what Housel wrote in a 2014 article for the Fool:
“I made my worst investment seven years ago.
The housing market was crumbling, and a smart value investor I idolized began purchasing shares in a small, battered specialty lender. I didn’t know anything about the company, but I followed him anyway, buying shares myself. It became my largest holding — which was unfortunate when the company went bankrupt less than a year later.
Only later did I learn the full story. As part of his investment, the guru I followed also controlled a large portion of the company’s debt and and preferred stock, purchased at special terms that effectively gave him control over its assets when it went out of business. The company’s stock also made up one-fifth the weighting in his portfolio as it did in mine. I lost everything. He made a decent investment.”
Housel also committed the mistake of blindly following a famous investor without fully understanding the real rationale behind the investor’s investments.
In conclusion
It’s understandable if you want to follow the ideas of famous investors. That’s especially so during uncertain times, like the situation we’re in today. But before you do, please note that a blind adherence can be dangerous. Famous investors can invest in financial instruments in the same company that we can’t get access to. Or, their investment motives may be completely different to ours even for the same shares.
It’s always important to know why we’re investing in something. “I’m buying because Buffett or [insert name of famous investor] is buying” is not a valid investment thesis.
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.
It may not make sense to depend on broad economic conditions to tell you when to invest in stocks. Really good stocks find a bottom way before the economy.
This is a short article about important data you have to note if you’re reading broad economic conditions as a gauge for when to buy stocks. It was inspired by a recent question from a friend:
“While I understand that it’s impossible to time the market precisely, doesn’t it make sense to sell stocks and keep cash when you are fairly certain of a sustained economic decline (e.g. Covid)?”
During the 08/09 Great Financial Crisis, the S&P 500 in the US bottomed in early-March 2009. But interestingly, many stocks actually bottomed months before that, in November 2008. In The Good Investors, I have shared my investment theses for a number of US-listed companies in my family’s investment portfolio. Some of these companies were listed back in November 2008, and they include Netflix, Berkshire Hathaway, Amazon, Intuitive Surgical, MercadoLibre, Booking Holdings, and Mastercard.
The chart immediately below shows the share price changes from January 2008 to December 2009 for the individual stocks mentioned and the S&P 500. Notice the two red bubbles showing the time when most of the individual stocks bottomed (the one on the left) versus when the S&P 500 bottomed (the one on the right).
The individual stocks I talked about – Netflix, Berkshire, Amazon, Intuitive Surgical, MercadoLibre, Booking, and Mastercard – are companies that I think have really strong business fundamentals. They wouldn’t be in my family’s portfolio, otherwise!
Now, let’s look at another chart, this time showing the US’s economic numbers from 1 January 2008 to 31 December 2010. The economic numbers are the country’s unemployment rate and GDP (gross domestic product). Notice the red bubble: It corresponds to November 2008, the time when most of the aforementioned stocks with strong business fundamentals bottomed. Turns out, the US’s GDP and unemployment rate continued to deteriorate for months after the individual stocks bottomed.
The observations I just shared have never been widely discussed, based on my anecdotal experience. But they highlight something crucial: It turns out that individual stocks – especially the companies with strong fundamentals (this is subjective, I know!) – can find a bottom significantly faster than economic conditions and the broader market do.
The highlighted thing is crucial for all of us to note, in today’s investing environment. Over the next few months – and maybe even over the next year – It’s very, very likely that the economic data that are going to be released by countries around the world will look horrendous. But individual stocks could potentially reach a bottom way before the deterioration of economic conditions stops. If you miss that, it could hurt your portfolio’s long run return since you would miss a significant chunk of the rebound if you came in late.
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.
We are hosting a one-day investment webinar. Come join us!
It’s only a few days into the second quarter of 2020, but what a year it has already been. COVID-19 has wreaked havoc on the lives of billions of people in practically all countries around the world, including Singapore, our home. The human suffering, especially when it comes to our frontline heroes – those in healthcare, food & beverage, delivery, law enforcement, and countless other essential services – is immense. But so is the courage and grace and grit that has been shown. Corporations are also stepping up, overhauling their manufacturing lines and/or working on overdrive to produce all-important masks, sanitisers, ventilators, face shields, cures, vaccines, and more.
At The Good Investors, Jeremy and I have been looking to see how we can help in this fight against COVID-19. Our efforts are miniscule compared to what I just described above. But we do what we can.
One of the things we have been doing is to guide people toward better investment behaviours by regularly providing the appropriate context and information about the current market situation. “The investor’s chief problem – and even his worst enemy – is likely to be himself,” the legendary Ben Graham once said. We are our own worst enemies, and this is a problem Jeremy and I have been trying to help tackle at The Good Investors. If we succeed in helping even just one investor exhibit better investment behaviour in this current climate, then society as a whole, will come out of this crisis in slightly better financial shape.
To widen the reach of our good fight, Jeremy and I are partnering with Online Traders’ Clubfor a one-day investment webinar that is open to the general public. Online Traders’ Club is a non-profit organization formed in 2005 for members who have a deep interest in the financial markets. Learn more about it here. Online Traders’ Club has kindly offered to handle all the logistics and provide a webinar-platform for Jeremy and I to share our investing thoughts.
Access: Access from any connected devices. There is nothing to install. Please update your desktop/mobile browser (eg. Chrome) to the latest version.
What Jeremy and I will share during the webinar: (1) The key mindsets you need to be a good investor; (2) my investment framework for evaluating companies; (3) how to find long-term investment opportunities during the COVID-19 crisis; (4) Q&A
The key takeaways you will have: (1) Understand what the stock market is; (2) understand the right mindsets to be a successful investor; and (3) have a sound framework to analyse investment opportunities
Cost of attending webinar: FREE!
Capacity for webinar: (1) 200 pax, for webinar room where attendees can ask questions; (2) Unlimited pax for Watch-Only experience on Youtube
Jeremy and I hope to see you at the webinar in 2 weeks! In the meantime, stay safe, and stay strong. We. Will. Get. Through. This.
Editor’s note: We published the recorded webinar and the presentation deck on 27 April 2020. They can be found here.
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.
Some Singapore REITs will be providing quarterly updates soon. I’ll be keeping a close eye on any updates on rebates, distributions, and cashflow.
As an investor with a very long-term focus, I usually don’t pay much attention to quarter-to-quarter fluctuations in earnings. But these are not normal times. And as someone who invests in Real Estate Investment Trusts (REITs) in Singapore’s stock market, I will be paying close attention to the following elements in their upcoming earnings announcements.
Cash flow
I suspect that REITs will continue to record the usual rental income on the income statement. However, actually collecting the cash from tenants is a different matter.
In the next earnings release, I will be keeping an eye on the cash flow statement. In particular, I’m watching the changes to the cash flow from operation.
The most important thing to look at in the balance sheet is the changes to the “Trade and other receivables” line. If that number increases disproportionately, it could be a sign that some tenants have not been able to hand over their rental payment to the REIT.
Updates on how they will help tenants
The Singapore government has stepped in to support businesses that are impacted by the COVID-19 pandemic. Restaurants, shops, hotels and tourist attractions will pay no property tax for 2020.
Property owners, such as REITs, are expected to pass these cost savings onto their tenants.
In the coming earnings update, I will be keeping my ears peeled on how the REITs will pass on these cost savings to tenants. This could be in the form of rental waivers or simply cash rebates.
SPH REIT was the first REIT to commit to helping its tenants. It said in its latest earnings announcement:
“To assist our tenants, SPH REIT will pass on fully the property tax rebates from IRAS announced by the Singapore Government on 26 March 2020, which will be disbursed in a targeted manner. On top of the Government’s property tax rebates, SPH REIT has provided further assistance to help tenants through this difficult period. In February and March 2020, tenant rebates amounting to approximately S$4.6 million have been granted to those affected tenants. This is part of the Tenants’ Assistance Scheme under which SPH REIT has rolled out to provide tenants with rent relief for February and March.
SPH REIT will extend Tenants’ Assistance Scheme for the months of April and May, for which the rebates will be granted according to the needs of the tenants. For the most affected tenants, they will be granted rental rebates of up to 50% of base rent. In addition, the full property tax rebates will be passed on to these tenants. Effectively, the most affected tenants will have their base rents waived for up to 2 months.
For tenants who are required by the Government to cease operations such as enrichment centres, SPH REIT will grant a full waiver of rental for the period of closure.”
I think this is the right way to go for REITs. Although landlords are not obliged to support their tenants through rent waivers, I think that providing some aid could be beneficial in the long term. Tenants that get support are more likely to remain a going concern and consequently can continue to rent the space in the future.
Distribution per unit
REITs are required to pay out at least 90% of their distributable income to receive special tax treatment. However, I think many of the REITs may opt to distribute much less than that in the first quarter of 2020.
SPH REIT was the first to slash its distribution per unit. It cut its distribution for the quarter ended 28 February 2020 by 78.7% despite a 12.2% increase in income available for distribution.
There are a few reasons I believe more REITs will follow in SPH REIT’s footsteps.
First, they may need the cash to tide them through the rest of the year if they foresee rental defaults or lower occupancy.
Second, as demonstrated by SPH REIT, some REITs are using their own cash to help tenants ride out this challenging period.
And third, the REIT is only required to pay out more than 90% of distributable income within the whole financial year. So REITs may opt to keep the cash first as a precaution. If the REIT doesn’t need the cash in the future, it can always distribute it in future quarters.
Updates on a rights issue
With REIT prices slashed this year, the last thing that investors want is a REIT being forced to raise money through a rights issue.
Unfortunately, this may be the case for REITs that are highly geared and that have trouble paying their interest expenses.
In addition, if a REIT’s rental yield falls, asset prices may decline and gearing levels will rise. REITs with a high debt-to-asset ratio may, in turn, have to pay higher interest rates when they refinance their loans. As such, it is possible that REITs with a high gearing ratio may choose to raise capital through a rights issue to deleverage their balance sheet.
Challenging times for REITs…
REITs are not spared in this challenging period for business.
Investors of REITs should pay close attention to the news the next few months to see which REITs are best positioned to ride out these unprecedented times.
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.
DocuSign has only been in my family’s portfolio for a short time, but it has done well for us. Here’s why we continue to own DocuSign.
DoucSign (NASDAQ: DOCU) is one of the 50-plus companies that’s in my family’s portfolio. I first bought DocuSign shares for the portfolio in December 2018 at a price of US$41 and I’ve not sold any of the shares I’ve bought.
The purchase has worked out very well for my family’s portfolio thus far, with DocuSign’s share price being around US$79 now. But we’ve not even owned the company’s shares for two years, and it is always important to think about how the company’s business will evolve going forward. What follows is my thesis for why I still continue to hold DocuSign shares.
Company description
DocuSign provides DocuSign eSignature, currently the world’s leading cloud-based e-signature solution. This software service enables users to sign a document securely using almost any device from virtually anywhere in the world. It is the core part of the broader DocuSign Agreement Cloud, which is a suite of software services – again all delivered over the cloud – that automates and connects the entire agreement process. DocuSign Agreement Cloud includes:
Automatic generation of an agreement from data in other systems;
Support of negotiation-workflow;
Collection of payment after signatures;
Use of artificial intelligence (AI) to analyse agreement-documents for risks and opportunities; and
Hundreds of integrations with other systems, so that the agreement process can be seamlessly combined with other business processes and data
At the end of its fiscal year ended 31 January 2020 (FY2020), DocuSign had over 585,000 paying customers and hundreds of millions of users. From its founding in 2003 through to FY2019, the company had processed over 1 billion successful transactions (around 300 million in FY2019 alone). DocuSign defines a successful transaction as the completion of all required actions (such as signing or approving documents) by all relevant parties in an Envelope; an Envelope is, in turn, a digital container used to send one or more documents for signature or approval to the relevant recipients.
DocuSign serves customers of all sizes, from sole proprietorships to the companies that are among the top 2,000 publicly-traded enterprises. The company’s customers also come from many different industries, as the chart below illustrates.
For a geographical perspective of DocuSign’s business, its users are in over 180 countries. But in FY2020, 82% of the company’s revenue came from the US.
Investment thesis
I had previously laid out my six-criteria investment framework in The Good Investors. I will use the same framework to describe my investment thesis for DocuSign.
1. Revenues that are small in relation to a large and/or growing market, or revenues that are large in a fast-growing market
Has it ever occured to you that the innocuous act of signing documents with pen-and-paper can actually be a significantly wasteful activity for companies? The thought struck me when I was doing research on DocuSign before I bought its shares. Think about it. Signing a paper document requires you to fax, scan, email, snail-mail, courier, and file. DocuSign’s solution can save us both time and money.
There are many use-cases for DocuSign’s software services, ranging from sales contracts to employment contracts, non-disclosure agreements, and more. In fact, DocuSign has a customer that has implemented over 300 use-cases. DocuSign documents are legally accepted and protected with cryptographic technology from tampering. The documents also have a full audit trail, including party names, email addresses, public IP addresses, and a time-stamped record of each individual’s interaction with a document.
DocuSign estimated that it had a total addressable market of US$25 billion in 2017, using (1) the number of companies in its core markets, and (2) its internal estimate of an annual contract value based on each respective company’s size, industry, and location. This estimate remains unchanged (it was mentioned in the company’s FY2020 annual report), though recent business moves may have significantly expanded its addressable market. More on this later. At just US$974.0 million, DocuSign’s revenue in FY2020 is merely a fraction of its estimated market opportunity.
I believe that DocuSign’s addressable market will likely grow over time. There are clear benefits to e-signatures. A 2015 third-party study by Intellicap (commissioned by DocuSign) found that the company’s enterprise customers derived an average incremental value of US$36 per transaction (with a range of US$5 to US$100) when using the company’s software as compared to traditional paper-processes. In FY2020, 82% of all the successful transactions that flowed through DocuSign’s platform were completed in less than 24 hours, while 50% were completed within just 15 minutes. DocuSign’s services help companies save money and time.
2. A strong balance sheet with minimal or a reasonable amount of debt
As of 31 January 2020, DocuSign held US$895.9 million in cash, short-term investments, and long-term investments. This is nearly twice the company’s total debt of US$465.3 million (all of which are convertible notes). For the sake of conservatism, I also note that DocuSign had US$183.2 million in operating lease liabilities. But the company’s cash, short-term investments and long-term investments still comfortably outweigh the sum of the company’s debt and operating lease liabilities (US$648.5 million).
3. A management team with integrity, capability, and an innovative mindset
On integrity
Leading DocuSign as CEO is Daniel Springer, 57, who joined the company in January 2017. Among other key leaders in DocuSign are:
Scott Olrich, Chief Operating Officer, 48
Michael Sheridan, Chief Financial Officer, 55
Loren Alhadeff, Chief Revenue Officer, 41
Kirsten Wolberg, Chief Technology and Operations Officer, 52
Most of them have relatively short tenure with DocuSign, but have collectively clocked decades in senior leadership roles in other technology companies.
Source: DocuSign proxy statement
DocuSign has opted not to share details about its compensation structure for senior management because of its status as an “emerging growth company.” And Springer’s total compensation for FY2019 was a princely sum of US$13.4 million. But I take heart in this: 94% of Springer’s total compensation in FY2019 came from stock awards, and around 70% of the stock awards vest over a period of four years. The multi-year vesting of the stock awards means that Springer’s compensation is tied to the long run performance of DocuSign’s stock price, which is in turn governed by its business performance. So I think Springer’s interests are aligned with mine as a shareholder of the company.
Notably, Springer also controlled 2.3 million shares of DocuSign as of 31 March 2019, a stake that’s worth a sizable US$211 million at the current share price.
On capability
From FY2013 to FY2020, DocuSign has seen its number of customers increase more than 10-fold (41% per year) from 54,000 to 585,000. So the first thing I note is that DocuSign’s management has a terrific track record of growing its customer count.
Source: DocuSign June 2018 investor presentation and annual report
To win customers, DocuSign’s software service offers over 300 pre-built integrations with widely used business applications from other tech giants such as salesforce.com, Oracle, SAP, Google, and more. These third-party applications are mostly in the areas of CRM (customer relationship management), ERP (enterprise resource planning), and HCM (human capital management). DocuSign also has APIs (application programming interfaces) that allow its software to be easily integrated with its customers’ own apps.
I also credit DocuSign’s management with the success that the company has found with its land-and-expand strategy. The strategy starts with the company landing a customer with an initial use case, and then expanding its relationship with the customer through other use cases. The success can be illustrated through DocuSign’s strong dollar-based net retention rates (DBNRRs). The metric is a very important gauge for the health of a SaaS (software-as-a-service) company’s business. It measures the change in revenue from all of DocuSign’s customers a year ago compared to today; it includes positive effects from upsells as well as negative effects from customers who leave or downgrade. Anything more than 100% indicates that the company’s customers, as a group, are spending more – DocuSign’s DBNRRs have been in the low-teens to mid-teens range in the past few years.
Source: DocuSign IPO prospectus and earnings call transcripts
On innovation
I think DocuSign’s management scores well on the innovation front, since the company has been busy with using blockchain technology and AI to improve its services.
Blockchain technology is the backbone of cryptocurrencies and DocuSign has been experimenting with blockchain-based smart contracts since 2015. In June 2018, DocuSign joined the Enterprise Ethereum Alliance and showed how a DocuSign agreement can be automatically written onto the Ethereum blockchain. Here’s an example of a smart contract described by DocuSign:
“A smart contract turns a contract into something like a computer program. The Internet-connected program monitors data and triggers actions relevant to the contract’s terms. For example, a crop-insurance smart contract might use a trusted Internet feed of weather data. If the temperature goes above 85 degrees Fahrenheit in April, the smart contract will automatically trigger a crop-insurance payout, again via the Internet. This total automation eliminates ambiguity and promises large savings in time and effort for all parties involved.”
It’s early days for DocuSign’s use of blockchain, but I’m watching its moves here. DocuSign’s management acknowledges that many of the company’s customers don’t yet see the value of blockchain technology in the agreement process. But the company still believes in blockchain’s potential.
DocuSign has been working with AI since at least 2017 when it acquired machine-learning firm Appuri during the year. In February 2020, DocuSign inked an agreement to acquire Seal Software for US$188 million. The acquisition is expected to close in the first half of DocuSign’s FY2021. Seal Software was founded in 2010 and uses AI to analyse contracts. For example, Seal Software can search for legal concepts (and not just keywords) in large collections of documents, and automatically extract and compare critical clauses and terms. Prior to the acquisition, DocuSign was already tacking Seal Software’s services onto DocuSign Agreement Cloud. The combination of Seal Software and DocuSign’s technologies have helped a “large international information-services company” reduce legal-review time by 75%. Ultimately, DocuSign thinks that Seal Software will be able to strengthen DocuSign Agreement Cloud’s AI foundation.
Speaking of DocuSign Agreement Cloud, it was released in March 2019. As mentioned earlier, it includes multiple software services. DocuSign sees DocuSign Agreement Cloud as a new category of cloud software that connects existing cloud services in the realms of marketing, sales, human resources, enterprise resource planning, and more, into agreement processes.
I see two huge positives that come with the introduction of multi-product sales. Firstly, it will likely lead to each DocuSign customer using more of the company’s products. This means that DocuSign could be plugged into an increasing number of its customers’ business processes, resulting in stickier customers. Secondly, DocuSign thinks that covering a wider scope of the entire agreement process could roughly double its market opportunity from the current size of US$25 billion to around US$50 billion.
4. Revenue streams that are recurring in nature, either through contracts or customer-behaviour
DocuSign’s business is built nearly entirely on subscriptions, which generate recurring revenue for the company. Customers of DocuSign gain access to the company’s software platform through a subscription, which typically ranges from one to three years. In FY2020, FY2019, and FY2018, more than 93% of DocuSign’s revenue in each fiscal year came from subscriptions to its cloud-based software platform; the rest of the revenue came from services such as helping the company’s customers deploy its software efficiently.
It’s worth noting too that there is no customer-concentration with DocuSign. There was no customer that accounted for more than 10% of the company’s revenue in FY2020.
5. A proven ability to grow
There isn’t much historical financial data to study for DocuSign, since the company was only listed in April 2018. But I do like what I see:
Source: DocuSign annual reports and IPO prospectus
A few notable points from DocuSign’s financials:
DocuSign has compounded its revenue at an impressive annual rate of 40.4% from FY2016 to FY2020. The rate of growth has not slowed much, coming in at a still-impressive 38.9% in FY2020.
DocuSign is still making losses, but the good thing is that it started to generate positive operating cash flow and free cash flow in FY2018.
Annual growth in operating cash flow from FY2018 to FY2020 was strong, at 45.1%. Free cash flow has increased at a much slower pace, but the company is investing for growth.
The company’s balance sheet remained robust throughout the timeframe under study, with significantly more cash and investments than debt.
At first glance, DocuSign’s diluted share count appeared to increase sharply by 30.7% from FY2019 to FY2020. (I only started counting from FY2019 since DocuSign was listed in April 2018, which is in the first quarter of FY2019.) But the number I’m using is the weighted average diluted share count. Right after DocuSign got listed, it had a share count of around 152 million. Moreover, DocuSign’s weighted average diluted share count showed acceptable year-on-year growth rates (acceptable in the context of the company’s rapid revenue growth) in the first, second, and third quarters of FY2020.
Source: DocuSign quarterly earnings updates
6. A high likelihood of generating a strong and growing stream of free cash flow in the future
DocuSign has already started to generate free cash flow. Right now, the company has a poor trailing free cash flow margin (free cash flow as a percentage of revenue) of just 4.5%.
But over the long run, I think it’s likely that there is plenty of room for DocuSign’s free cash flow margin to expand. I showed in my recently published investment thesis for Alteryx (NYSE: AYX) that there are other larger SaaS companies such as Adobe, salesforce.com, and Veeva Systems that have much fatter free cash flow margins. Here’s the table I showed in my article on Alteryx:
Source: Companies’ annual reports and earnings updates (data as of 23 March 2020)
Valuation
Right now, DocuSign has a market capitalisation of US$14.34 billion against trailing revenue of US$974.0 million. These numbers give rise to a price-to-sales (P/S) ratio of 14.7, which makes the company look pretty darn expensive. For perspective, if I assume that DocuSign has a 30% free cash flow margin today, then the company would have a price-to-free cash flow ratio of 49 based on the current P/S ratio (14.7 divided by 30%).
But DocuSign also has a few strong positives going for it. The company has: (1) revenue that is low compared to a fast-growing addressable market; (2) a business that solves important pain points for customers; (3) a large and rapidly expanding customer base; and (4) sticky customers who have been willing to significantly increase their spending with the company over time. I believe that with these traits, there’s a high chance that DocuSign will continue posting excellent revenue growth – and in turn, excellent free cash flow growth – in the years ahead.
The current high valuation for DocuSign does mean that its share price is likely going to be more volatile than the stock market as a whole. I’m also keeping in mind that stocks have been very volatile of late because of COVID-19 fears. But the potential volatility is something I’m very comfortable with.
The risks involved
DocuSign has a short history in the stock market, given that its IPO was just two years ago in April 2018. I typically stay away from young IPOs. But I’m making an exception for DocuSign because I think its business holds promise for fast-growth for a long period of time. But the company’s young age as a publicly-listed company is still a risk I’m watching.
Adobe is a much larger SaaS company with trailing revenue of US$11.7 billion. Through its Adobe Sign product, Adobe is the primary competitor of DocuSign. So far, DocuSign has defended its turf admirably. This is shown in DocuSign’s strong revenue and customer growth rates. But Adobe’s larger financial might compared to DocuSign means competition is a risk.
Another important risk for DocuSign relates to data breaches. DocuSign handles sensitive information about its customers due to the nature of its business. If there are any serious data breaches in DocuSign’s software services, the company could lose the confidence of customers and the public, leading to growth difficulties. The signing of documents may be highly time-sensitive events. So if there is any significant downtime in DocuSign’s services, it could also lead to an erosion of trust among existing as well as prospective customers. So far, DocuSign has done a great job by providing 99.99% availability in FY2020.
Valuation is another risk to consider. DocuSign’s high P/S ratio means that the market expects rapid growth from the company. So if the business performance disappoints subsequently, market sentiment could turn quickly on DocuSign, leading to a cratering stock price.
Earlier, I discussed the advantages that the launch of DocuSign Agreement Cloud brought to the company. But there are downsides too. For instance, multi-product sales involves higher complexity and a longer sales cycle; these factors negatively affected DocuSign’s billings growth and net dollar-based retention rate in the first quarter of FY2020. The ongoing COVID-19 pandemic has caused business activity around the world to slow tremendously, with many countries being in various states of lockdown. A lengthy sales cycle could hamper DocuSign’s business in the current environment. For now, DocuSign’s business does not seem to have been impacted by COVID-19. Here’s CEO Dan Springer’s comment on the matter in DocuSign’s FY2020 fourth-quarter earnings call:
“[T]he vast majority of our implementations are done remote. And of course, if you think about the perfect example of that it’s our web and mobile customers, where they never actually have to speak. Not only do they don’t have to have us in person they don’t need to speak to us to onboard. … We do find with some of our larger enterprise customers that they get more value when some of the installation is done on their premises. But we have not had the opportunity in the past to consider doing that completely remotely. And it may be in the new way of business over the next X period of time here then we’ll do more of it.”
And when DocuSign’s management was asked in the same earnings call if its growth would be affected by a recession, Springer answered:
“Yes, I don’t. Because, I think, for most of our customers, at least half of the focus is around efficiency. And people see the incredibly high ROI. And I can’t speak for all-digital transformation programs, of course, but as I think about the ones that are DocuSign-centric people are laser-focused on the ROI they get from getting rid of those manual processes, the wasted labor, getting rid of things like the transportation cost, the shipping, et cetera.
That’s a big focus. So I don’t think in a recession you would see people pull back on that. I would say that any time if you had a significant recession, you expect people to kind of shoot first ask questions later and that could lead to some delays. But, in general, we think the business case just gets stronger when people need to find those efficiencies.”
Lastly, the following are all yellow-to-red flags for me regarding DocuSign: (1) The company’s DBNRR comes in at less than 100% for an extended period of time; (2) it fails to increase its number of customers; and (3) it’s unable to convert revenue into free cash flow at a healthy clip in the future.
The Good Investors’ conclusion
Summing up DocuSign, it has:
Valuable cloud-based software services in the agreements space that solves customers’ pain-points;
high levels of recurring revenue;
outstanding revenue growth rates;
positive operating cash flow and free cash flow, with the potential for much higher free cash flow margins in the future;
a large, growing, and mostly untapped addressable market;
an impressive track record of winning customers and increasing their spending; and
capable leaders who are in the same boat as the company’s other shareholders
The company does have a premium valuation, so I’m taking on valuation risk. There are also other risks to note, such as strong competition and a longer sales cycle that may not be conducive for a business environment that’s struggling with COVID-19. But after weighing the pros and cons, I have to agree with the idea of having DocuSign continue to stay in my family’s investment portfolio.
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