Author: Jeremy Chia

The share prices of SaaS (software-as-a-service) companies have risen massively over the past year. Even after the sharp pullback many of them experienced in late-February and March this year, the share prices of SaaS companies still trade at relatively higher multiples than they did in the recent past.

The chart below by venture capitalist Jamin Ball shows current SaaS company valuations:

The blue line on the chart shows that the median EV-to-NTM revenue (median enterprise value to next twelve months revenue) multiple for SaaS companies has risen sharply in the last two years. And despite the sell-off over the last couple of weeks, SaaS companies still trade at a higher multiple than they did at any other time before mid-2020. 

This has led to some investors assuming that SaaS company valuations are still too high.

On the surface, that may seem the case but it could also be that valuations for SaaS companies were simply way too low in the past.

Justified?

Venture capital firm Bessemer Venture Partners (BVP) has an index of emerging cloud-computing companies – many of which are SaaS companies – that are listed in the US stock market. The chart below shows the performance of the BVP cloud index (EM Cloud) relative to other major US stock market indexes.

The blue line shows the BVP cloud index. Since tracking began, the BVP cloud index has significantly outperformed the rest of the market. It has even outperformed the tech-heavy NASDAQ by 3.6 times. 

Part of the cloud index’s growth was undoubtedly fueled by an expansion in the aforementioned EV-to-NTM revenue multiples that SaaS companies have experienced. But a big part of the growth is also due to the relatively faster revenue growth in SaaS companies.

Doing some quick math and assuming that revenue multiples contract from 14 to 5 times (what they were in 2015), the BVP cloud index would still be outperforming the NASDAQ – the BVP cloud index outperformed the NASDAQ by 3.6 times while the multiple expansion in SaaS companies included in Jamin Ball’s graph was just 2.8 times*. 

Given all of this, rather than assuming that current valuations of SaaS are too high, it could be that historical valuations were actually too low.

Market participants in the past may have underestimated SaaS companies’ growth potential and the sustainability of that growth.

Today, the market may have wisened up to the immense addressable market opportunity of cloud companies and are beginning to better price in their immense potential.

Conclusion

SaaS companies are currently still trading at higher EV-NTM revenue multiples than they were in the past. Just taking this fact alone, one may assume that valuations are stretched now.

But if we take a step back, we can see that SaaS companies may have been mispriced in the past. The pace and sustainability of revenue growth should have warranted a higher valuation back then.

The market may now be smartening up to the wonderful economics that SaaS companies offer. Not only do best-in-class SaaS companies offer a long growth runway, but they also address a huge and growing market.

If their revenues continue to grow as fast it has in the past, SaaS stocks will likely keep going higher.

*Jamin Ball’s universe of SAAS companies and those in the BVP cloud index may not be exactly the same but there is a significant overlap

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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.

This week, The Information reported that Chinese tech conglomerate, Tencent Holdings Ltd (HKG: 0700), has made a killing from its investment portfolio.

In 2020 alone, the tech giant made US$120 billion in unrealised gains from its minority stakes in about 100 publicly listed companies. That’s around six times as much as Tencent’s own projected operating profit for the whole of 2020.

Tencent, which began life as a messaging company, has grown to become a diversified tech behemoth, with operations spanning cloud computing, social networks, enterprise software, mobile payments, and much more. 

But outside of its operational businesses is where all the fun truly begins. China’s largest tech company has minority stakes in companies ranging from electric vehicle manufacturers to e-commerce, music streaming to ride-hailing and payments and much more. 

Without exaggeration, Tencent’s investments in publicly-listed companies look like a who’s who of tech companies. Tencent owns stakes in Meituan (HKG: 3690), Sea Ltd (NYSE: SE), JD.com Inc (HKG: 9618), Pinduoduo Inc (NASDAQ: PDD), Tesla Inc (NASDAQ: TSLA), Spotify (NYSE: SPOT), Nio Inc (NYSE: NIO), Afterpay Ltd (ASX: APT), Snapchat (NYSE: SNAP), and many more.

But that’s just the tip of the iceberg.

Tencent also owns significant stakes in up and coming privately-held companies such as Gojek, Ola, Reddit, Epic Games, Webank ,and many others.

Should other tech giants follow in Tencent’s footsteps?

The apparent success of Tencent’s investment arm has led to the question: Should other big tech companies follow in Tencent’s footsteps?

US-based tech giants such as Alphabet Inc (NASDAQ: GOOGL), Facebook Inc (NASDAQ: FB), Apple Inc (NASDAQ: AAPL), and Microsoft Corporation (NASDAQ: MSFT) boast tens – sometimes hundreds – of billions of dollars on their balance sheets and generate billions more in cash each year.

With so much cash lying around, their shareholders may be asking if these tech giants are doing enough with their heaps of cash.

Tencent’s strategy to put its excess cash to use through investments in public equities and young startups are starting to pay off and seems to be the perfect blueprint for other cash-rich companies to follow.

Why minority investments may make sense

Tech giants are usually not known to make minority investments in companies but rather prefer buying up whole companies to reap the benefits of synergies.

But, arguably, minority investments may actually be an even more cost-efficient way to put their capital to use. Acquiring whole companies is a more tedious process, which regulators scrutinise. In addition, the acquirer tends to have to pay a big premium to purchase a company outright.

On the other hand, minority investments can be made much less publicly and usually at relatively better valuations.

Taking minority stakes also offers the US tech giants the ability to dip their toes in a range of different companies that would not be possible if they wanted to make whole acquisitions. Moreover, the US tech giants also have a significant advantage as they can provide portfolio companies with expertise, networks, and partnerships.

It therefore would not be surprising to find that young companies may want to have these tech giants as investors to leverage their technology and expertise. This could open the door for the US tech giants to get in on some of the most sought after companies in the world.

Maybe the US tech giant that is most akin to Tencent is Alphabet. The parent company of Google has two investment arms, one of which is called GV, formerly known as Google Ventures. GV’s current assets under management is only around US$5 billion, less than 5% the size of Tencent’s portfolio but it is a good start. GV has investments in companies such as Medium, Uber, Stripe, Impossible Foods and many more. 

Expertise required…

Despite the apparent upside, making minority investments in companies is by no means an easy task.

Investing in early-stage companies, or even publicly-listed entities, requires patience and expertise. Tencent, though, seems to have found a winning formula with many of its investments working out extremely well so far. But other big tech companies, with their access to talent, should be able to replicate Tencent’s success should they choose to follow a similar path.

They will need time and money to bring the best talent to manage their vast amounts of capital but, if successful, the fruits of these investments could be substantial.

The bottom line

Tencent is a great example of how companies that generate billions of dollars in cash every year can put their excess capital to use. Tencent has created a tech behemoth that spans numerous businesses and has diversified its investment portfolio to an extent that is unmatched by any company in the world.

Other tech giants could potentially follow suit.

Rather than letting their cash build up, or simply returning cash to shareholders through buybacks or dividends, investing the capital through minority-stake investments could be an even better use of cash.

While the market’s bull run in tech companies in 2020 may never be replicated, there is still value being created by tech companies around the globe today. With billions of dollars in their banks, the Apples and Facebooks of this world can certainly look to capitalise on that.

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. I currently have a vested interest in the shares of Afterpay, Alphabet, Apple, Facebook, Meituan, Microsoft, Tencent, and Tesla. Holdings are subject to change at any time.

A company’s earnings conference call can be extremely informative. Not only does it provide information on how a company has done in the last quarter, but management also gives investors a glimpse into the early trends shaping the company’s future.

With many companies having reported their full-year earnings results for 2020, here are some of the key management insights on what to expect in the year ahead. 

Video conferencing is here to stay…

Leading video conferencing company, Zoom Video Communications Inc (NASDAQ: ZM) capped off a truly remarkable year as it reported a 369% year-over-year increase in revenue for the fourth quarter of its fiscal year ended 31 January 2021 (FY2021).

On a full-year basis, Zoom saw revenue increase by 326%. More impressively, the company expects to build on that solid performance as management forecasts a further 42% increase in revenue for FY2022.

Zoom’s founder-CEO, Eric Yuan, said:

“As the world emerges from the pandemic, our work has only begun. The future is here with the rise of remote and work-from-anywhere trends.”

With employers getting used to remote working conditions, many are starting to embrace the convenience, efficiencies, and cost-savings associated with it. In addition, employees prefer the flexibility of working remotely.

We have already seen companies such as Shopify (NYSE: SHOP) announcing a permanent shift toward remote working. As forward-looking employers pave the way, the shift towards permanent remote work is only just beginning.

E-commerce growth to normalise but upward trend to persist

There was an interesting chart put up by Shawspring Partners earlier this year showing the e-commerce penetration growth that took place in early 2020 as countries around the world began lockdowns to combat COVID-19.

As the chart shows, e-commerce penetration in the USA grew as much as it did in the eight weeks leading up to April 2020 as it did in the 10 years before then.

Consequently, the leading e-commerce marketplace for entrepreneurs and DIYers, Etsy (NASDAQ: ETSY) saw a 107% increase in annual gross merchandise sold on its platform in 2020. Meanwhile, e-commerce enabler Shopify experienced 96% year-on-year growth in the gross merchandise volume (GMV) facilitated by its platform during the year.

Although e-commerce growth rates are expected to normalise, the overall upward trend should persist.

Shopify CFO, Amy Shapero, said in the company’s 2020 fourth-quarter earnings conference call:

“Our outlook coming into 2021 assumes that as countries roll out vaccines in 2021 and populations are able to move about more freely, the overall economic environment will likely improve, some consumer spending will likely rotate back to offline retail and services and the ongoing shift to e-commerce, which accelerated in 2020, will likely resume a more normalized pace of growth.”

Similar to how remote work is advantageous over traditional office set-ups, e-commerce holds many advantages over traditional retail. 

Online purchasing is more convenient, offers shoppers a wider selection of products, and tends to be cheaper. It is inevitable that these advantages will result in an eventual migration of more purchases from offline to online over the longer term. 

The rise of BNPL (buy now, pay later)

Consumers are increasingly looking for smarter ways to pay for their purchases.

Enter buy now, pay later services. As the name suggests, buy now, pay later – or BNPL – allows customers to buy a product or service and pay for it in instalments, often interest-free, over a few weeks after the purchase is made.

Millennials increasingly prefer this option as it provides greater cash flow flexibility. And unlike credit cards, BNPL does not result in expensive interest expenses snowballing should they miss any payments.

This year, Shopify teamed up with Affirm (NASDAQ: AFRM) to offer its merchants the ability to accept BNPL functions from customers.

Meanwhile, digital payments giant, Paypal (NASDAQ: PYPL), has also gotten in on the act, as it launched its BNPL service late in 2020. The take up was so good that Paypal CEO Dan Schulman said in the 2020 fourth-quarter earnings conference call:

“I would also highlight the rapid growth of our buy now, pay later functionality. We saw tremendous and growing demand throughout the quarter and witnessed the fastest start to any product we have ever launched.”

Afterpay (ASX: APT), a leading BNPL provider, also reported a staggering 106% increase in underlying sales in the six months ended 31 December 2020.

With the rise of e-commerce and millennials increasingly looking for better ways to manage their cash flow and expenses, it seems that BNPL companies are set for a bright future.

Final thoughts

Covid-19 accelerated the digitalisation of the world.

Although economies will eventually reopen, the way we live, work and play will have changed. As the world adapts, companies that embrace these changes stand to gain the most.

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. I currently have a vested interest in the shares of Afterpay, PayPal, Shopify, and Zoom. Holdings are subject to change at any time.

The company with the deepest pockets often wins.

Having more money than your competitors can further your technology advantage, allow you to market more aggressively to get a stronger network effect, or simply to scale up production more quickly.

This is why founders can be found scrambling around Silicon Valley trying to raise capital. But raising capital is not reserved solely for privately held startups. 

In fact, many fast-growing public companies are increasingly looking for ways to raise capital cheaply, be it through debt or secondary equity offerings.

Raising capital through secondary equity offerings

One of the more common ways to raise money in today’s market is through a secondary offering. A secondary offering is simply the sale of new shares to investors by an already public-listed company. This is especially appealing for a company when its stock price has increased to a lofty valuation, a likely phenomenon for tech stocks in today’s market.

We need to look no further than one of 2020’s hottest stocks, Tesla Inc (NASDAQ: TSLA). The electric vehicle company took advantage of its rising stock price to raise money no less than three times last year. Tesla first raised US$2 billion in February at a split-adjusted share price of around US$153. It quickly followed that up in September and December, raising another US$5 billion each time as its share price soared.

Despite raising around US$12 billion in capital through secondary offerings in 2020, Tesla’s effective dilution to shareholders was likely less than 5% from all the offerings combined. This is a huge advantage that Tesla has over its competitors. 

The leading electric vehicle company now has deeper pockets, giving it the ability to scale production faster and to invest more to improve its battery and software technology. 

Tesla is not the only company that has taken advantage of soaring stock prices. Singapore’s e-commerce and gaming company, SEA Ltd (NYSE: SE), and communications API leader, Twilio Inc (NYSE: TWLO), are just two other examples of prominent large companies that have pounced on their soaring share prices to raise relatively inexpensive capital through secondary share offerings.

Debt markets

Another way to raise money is through the debt markets. Rather than diluting shareholders, bond offerings and bank loans are another way to raise capital. 

Even though companies incur interest expenses and will eventually need to pay back their creditors, debt does not dilute shareholders. In addition, the current low-interest-rate environment enables companies to issue bonds or take up loans at very competitive rates.

Netflix Inc (NASDAQ: NFLX) is an example of a company using the debt market effectively. In the past few years, Netflix’s operating cash flow was negative, as it was spending heavily on content creation. As such, the company needed more capital. Netflix CEO Reed Hastings and his team decided that rather than dilute shareholders through equity offerings, it would issue high yield bonds to pay for its expenses. The result was that the company managed to get the required capital, whilst not diluting existing shareholders. 

Although Netflix’s balance sheet may look weak because of the debt, the streaming giant has a clear path to free cash flow generation and should be able to start paying off some of its debt this year.

Over the longer term, Netflix shareholders could start reaping the returns of management’s careful planning and the fact that they were not diluted from Netflix’s debt offerings.

A mix of both?

So far I have discussed companies that have raised capital through secondary share offerings and debt. Another way for companies to raise capital is through an instrument that could be considered a mix of both – and it may be the best way to raise capital.

Convertible bonds are bonds that can be converted to shares at a certain date or when a certain event occurs. These bonds tend to have very low coupon rates and if converted, are usually done so at a large premium to current share prices.

For instance, leading website creation company, Wix.com Ltd (NASDAQ: WIX) raised US$500 million in August 2020 by issuing convertible bonds that are due in 2025.

Get this. The bonds have a 0% coupon, meaning that Wix does not pay any interest to bondholders. On top of that, these bonds convert to Wix shares at a whopping 45% premium to Wix’s last reported share price prior to the announcement of the sale of the bonds.

As such, if the bonds do get converted to shares, the amount of dilution is lower than if the company simply offered a secondary offering which is usually priced at a discount to current share prices.

Why then would anyone want to buy such an instrument? Personally, I much rather buy equity directly than to own convertible bonds. Nevertheless, convertible bonds do serve a purpose for more risk-averse investors.

First of all, bondholders will get their principle back even if the company’s shares fall below the conversion price. They also have a more senior right to the company’s assets should the company run into financial trouble – this provides additional downside security for investors. The convertible aspect of the bonds also offers bondholders “equity-like” upside if Wix’s share price rises beyond the conversion price. However, bondholders are paying a huge premium for the hedge, which I personally would not want to do for my portfolio.

Closing words

The ability to raise capital cheaply is a competitive advantage for a company that is often overlooked by investors.

Having deep pockets could give companies a leg up against their competition in a time when scale and technology are increasingly important.

Shareholders may sometimes frown on companies that are issuing new shares or taking on more debt. But if the company uses its newfound financial muscle to good effect, the new capital could be the difference between emerging a winner or ending up as an obsolete wannabe.

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. I currently have a vested interest in the shares of Tesla, Twilio, Netflix, and Wix.com. Holdings are subject to change at any time.

Technology is changing the world, fast. The COVID-19 pandemic has accelerated software and other technology adoption around the globe. And this is likely just the beginning of a multi-year trend. With this in mind, here are some tech trends that I am keeping an eye on.

Programmatic advertising

Programmatic advertising is a way to automatically buy digital advertising campaigns across a wide spectrum of publishers rather than from an individual publisher. Instead of going to a specific vendor to reserve a digital space on their website, advertising real estate is aggregated in ad exchanges where they can be bought or sold. Programmatic advertising software, in turn, communicates with these ad exchanges to buy and sell these advertising spaces, streamlining and optimising the advertising campaigns for advertisers.

In 2021, a whopping 88% of all digital display advertising in the USA is projected to be transacted via programmatic advertising.

According to Research And Markets, the global market for programmatic advertising platforms is estimated at US$5.2 billion in 2020 and is expected to reach US$33.7 billion in 2027, a nearly 31% compounded annual growth rate.

Alphabet (NASDAQ: GOOGL)(NASDAQ: GOOG), the parent company of Google, is likely going to be a key beneficiary of this as they dominate the programmatic advertising space with their Adwords platform. Amazon Inc’s (NASDAQ: AMZN) demand-side platform for advertisers has also gained market share in recent years. But we shouldn’t write off independent specialised programmatic advertising companies such as The Trade Desk (NASDAQ: TTD).

A key advantage that an independent programmatic advertising platform such as Trade Desk has over Google Adwords is that it is truly independent, so it will help ad buyers purchase the best digital ad-spaces the platform can find for the buyers’ needs. Google Adwords, on the other hand, may have a preference for Google properties, which may not be the best properties for ad buyers on certain occasions.

Whatever the case, with programmatic advertising exploding in popularity, there will likely be room for multiple winners in this space.

Solar energy

Under the Paris Agreement, participant countries have set a goal to limit global warming to an increase of preferably less than 1.5 degrees celsius compared to pre-industrial levels. This can only be achieved if more of the electricity the world produces comes from clean sources.

One of the most reliable sources of clean energy will be the sun. Solar power is 100% clean, renewable, and reliable. As such, governments around the world are creating policies to incentivise greater use of solar energy for homes and for commercial purposes.

Just as importantly for uptake, the cost of solar energy is coming down. According to the International Renewable Energy Agency, since 2010, the cost of energy production has dropped by 82% for photovoltaic solar and 47% for concentrated solar energy.

Global solar production capacity has also risen from 40GW in 2010 to 580 GW in 2019, suggesting the global demand for solar energy is taking effect. China continues to lead this space, accounting for 35.4% of the global market in 2018. This is driven by huge government initiatives in China in a bid to accelerate clean energy adoption.

In the USA, with the environment-conscious Democratic party taking the majority of the Senate, political observers expect greater impetus for the US government to support solar power.

Companies such as First Solar (NASDQ: FSLR), SolarEdge (NASDAQ: SEDG), JinkoSolar (NYSE: JKS), Enphase Energy (NASDAQ: ENPH), and ReneSola (NYSE: SOL) could stand to benefit.

Electric vehicles

In a similar vein to solar energy, electric vehicles are a cleaner alternative to ICE (internal combustion engine) vehicles. In the past, electric vehicles were slow to gain adoption due to the high cost of batteries and slow charging times. There were also the concerns of short range (distance that can be driven before the vehicle requires charging again) and poor charging infrastructure for electric vehicles due to a lack of charging stations.

But all of this has changed.

The infrastructure in many countries have slowly taken shape while the specifications of electric vehicles are improving at a tremendous pace. Most prominently, charging times, range, and cost have all improved, leading to greater demand from environmentally conscious consumers.

In addition, governments have stepped in to implement policies to encourage the sales of electric vehicles. California has gone as far as to ban the sale of new gasoline-powered vehicles by 2035.

Global passenger electric vehicle sales jumped from 450,000 in 2015 to 2.1 million in 2019. But there is still huge room for growth. In 2020, only 2.7% of total vehicle sales were electric. That figure is expected to rise to 10% by 2025. In the next decade, more than 100 million electric vehicles are expected to be sold around the world.

Tesla (NASDAQ: TSLA) is the largest electric vehicle player in the market, delivering close to 500,000 vehicles in 2020. But this is just the beginning. Tesla is ramping up production quickly, breaking ground on new factories in Berlin and Texas. It is also expected to start production of vehicles in its New York factory which used to be solely for solar panels.

On top of that, its Shanghai and Fremont factories are both not producing at full capacity yet. The two existing factories can increase their annual output in the next few years. Some are projecting Tesla to deliver between 840,000 to 1 million cars in 2021.

With no shortage of demand and no need for advertising (due to incredible consumer mind share), ramping up production will lead to more car sales and more revenue and gross profits for Tesla.

Tesla has also recently taken advantage of its soaring share price to raise new capital. It raised at least US$10 billion in the second half of 2020 through issuing new shares, and these moves provides the company with ammunition to accelerate its production capacity further.

But Tesla is not the only electric vehicle company in town. In the USA, legacy automobile manufactures such General Motors Company (NYSE: GM) and Ford Motor Company (NYSE: F) have been investing in their own electric vehicle models.

Global giants, Toyota (TYO: 7203) and Volkswagen (ETR: VOW3), have also signalled their intent to pivot their business. Other pure play electric vehicle startups in China such as Nio (NYSE: NIO), Li Auto (NASDAQ: LI), and  Xpeng (NYSE: XPEV) are also jostling for a piece of the pie. Analysts estimate that there will be 500 different models of electric vehicles globally by 2022.

Whatever the case, multiple winners are set to emerge from this fast-growing space.

Conscious eating

Sticking to the same theme of environmentally conscious consumers, fake meat is becoming the next big trend in conscious eating.

Fake meat refers to either plant-based protein, or lab-grown cell-based protein. In the plant-based space, proteins are extracted and isolated from a plant and then combined with plant-based ingredients to make the product taste and look like meat. Examples of plant-based proteins are Beyond Meat (NASDAQ: BYND) and Impossible Meat.

In lab-grown cell-based meat, an animal cell is extracted from an animal and grown in lab culture. This technology is still not yet in mass production as far as I know, but Singapore was the first to approve lab-grown meat for commercial sales.

Although fake meat is clearly better for the environment, consumer take up has not been rapid due to the high cost of production. Like electric vehicles, in order for fake meat to truly become mainstream, it needs to reach or exceed cost parity with traditional meat – and it needs to taste good.

Temasek-backed Impossible Foods is on the path to reduce cost to consumers. Earlier this year, Impossible Foods announced that it will be lowering prices by around 15% for its open-coded food service products, its second price cut since March 2020.

Another key driver of growth is the sale of fake meat in restaurant chains. McDonald‘s (NYSE: MCD) has decided to debut its own plant-based meat alternative called McPlant in 2021, which Beyond Meat helped to co-create.

According to the research firm, Markets and Markets, the plant-based meat market is estimated to be US$4.3 billion in 2020 and is projected to grow by 14% per year to US$8.3 billion by 2025.

Final words

We are indeed living in exciting times. The world is so dynamic and with new technologies and trends emerging, companies at the forefront of these shifts in demand are primed to reap the rewards.

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. I currently have a vested interest in the shares of Amazon, Alphabet, The Trade Desk and Tesla. Holdings are subject to change at any time. Holdings are subject to change at any time.

Positive returns in stocks are never a guarantee. Stay far, far away from anyone who tells you otherwise.

Company-specific risks, such as competition or regulatory risk, plus market-wide systemic risks, such as interest rates hikes and global recessions, pose risks to a stock’s long-term return. These risks result in what I call a wide distribution of outcome probabilities. 

And yet, in today’s stock market, it seems that more and more investors are starting to ignore these risks and go big or even all-in on just a single stock. Some argue that the large spread in returns between winners and laggards makes a concentrated portfolio more appealing.

But before diving headfirst into building a super-concentrated portfolio, consider the following risk.

What is the distribution of outcomes?

Let’s start with the basics.

When I talk about the distribution of outcomes, I am referring to the probability-distribution of the long-term returns of a stock. For example, a company can have a 20% chance to go to zero, a 60% chance to double up and another 20% chance to triple in value over five years (note that the probability percentages add up to 100%).

As such, there is a distribution of outcome possibilities, each with its own probability of occurring.

In the example above, over a five year period, investors in the company have a 20% chance to lose all their money, a 60% chance to double their money, and a 20% chance to triple their money.

Every stock has a different distribution of outcomes. The probabilities of returns and the range of returns will also differ drastically from stock to stock.

You found a great investment… now what?

Most stocks have a curve of different outcomes but for simplicity’s sake, let’s give the example of a stock that has just two possible outcomes.

This particular stock, let’s call it Company A, has a 30% chance to go bankrupt and a 70% chance to triple in value in five years. Simple mathematics will tell you that this is an amazing bargain. A gambler will take these odds any day.

We can calculate the average expected return we get from this stock by multiplying the probabilities with the outcomes. In this scenario, the expected return is 110%* (calculation below) in five years. Annualised, that translates to an excellent 15.9% return per year, which easily outpaces the returns of the S&P 500 over its entire history.

As such, any investor should happily take this bet. But don’t get too carried away. Even though this stock is a great investment, there is still a 30% possibility that we lose our entire investment in this stock. Would you be willing to take that risk?

Diversification reduces the risk

This is where diversification comes into play.

Instead of making a single bet on Company A, we can add another company into the portfolio.

Let’s say we find another company, Company B, that has slightly lower expected returns than Company A. Company B has a 35% chance of going broke and a 65% chance to triple in value, giving it an expected return of 95%**(calculation below).

The table below shows the probabilities of investing solely in Company A or Company B or investing half into each company.

	Company A Only	Company B Only	Half Each
Expected Annual Return	15.9%	14.3%	15.2%
Chance to Lose it All	30%	35%	10.5%

From the table above, we can see that the odds of losing your entire portfolio drops to 10.5% after splitting it between the two companies.

This seems counter-intuitive. Even though you are adding Company B into the portfolio, a stock that has a higher chance of going bust than Company A, the combined portfolio still ends up with a lower chance of going to zero.

The reason is that in order for the combined portfolio to go to zero, both companies need to go broke for you to lose your entire portfolio. The probability of both companies going bankrupt is much smaller than either of Company A or Company B going broke on its own. This is true if the two companies have businesses and risks that are not co-related.

What this shows is that we can lower our risk of suffering portfolio losses by adding more stocks into the portfolio.

Even though investors sacrifice some profits by adding stocks with lower expected returns, the lower risks make the portfolio more robust.

The sweet spot

This leads us to the next question, what is the sweet spot of portfolio diversification? Ultimately, this depends on the individual’s risk appetite and one’s own computation of an investment’s probability of outcomes. 

For instance, venture capital firms bet on startups that have a high chance of failing. It is, hence, not uncommon for venture capital funds to lose their entire investment in a company. But at the same time, the fund can still post excellent overall results.

For instance, venture investments in any single company may have a 95% chance of going to zero but have a small chance of becoming 100-plus-baggers in the future. A single winning bet can easily cover the losses of many failed bets. Given this, venture capital funds tend to diversify widely, sometimes betting on hundreds of companies at a time. This is to reduce the odds of losing all their money while increasing the odds of having at least some money on a spectacularly winning horse.

Similarly, in public markets, the same principle applies. Some early-stage companies that go public early have significant upside potential but have relatively high risks. If you are investing in these stocks, then wide diversification is key. 

Key takeaway

Many young investors today see the stock market as a place to get rich quick. This view is exacerbated by the raging bull of 2020 in some corners of the stock market across the world. 

They are, hence, tempted by the allure of making huge wins by concentrating their portfolio into just one or two companies. (You likely have heard stories of many Tesla shareholders becoming millionaires by placing their whole portfolio on just Tesla shares)

Although expected returns may be high, a concentrated portfolio poses substantial risks to one’s portfolio. 

I can’t speak for every investor, but I much rather sleep comfortably at night, knowing that I’ve built a sufficiently diversified portfolio to lower my risk of losing everything I’ve worked for

Nevertheless, if you insist on building a concentrated portfolio, it is important to learn the risks of such a strategy and make sure that you are financially and emotionally prepared with the very real possibility of losses.

*(0x0.3+300%x0.7-100%)=110%

**(0x0.35+300%x0.65-100%)=95%

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. I currently do not have any vested interest in the shares of any companies mentioned in this article. Holdings are subject to change at any time.