Source: Syed Balkhi
The SaaS space is rife with valuation pitfalls. If investors are conversant with these pitfalls, they can improve the signal to noise ratio of the investing factors to be considered when creating a portfolio. This article highlights some of the common pitfalls in the tech space.
Timing TCO (total cost of ownership) pivot
Most enterprises buy the latest productivity tools and services to stay ahead of competitors. However, at some point, the C-level wants to understand the metrics justifying the superior ROI of these tools. While most SaaS companies grow off the huge sales and marketing success of selling the capabilities of their offerings, oftentimes, competitors come up with cheaper options, making the case to renew subs or extend service contracts tough to argue. When a company is growing off the premium pricing of its offerings, management needs to develop tools that will justify the deployment of more of its services; else, it risks facing a drawdown in product renewals when enterprise CFOs don't feel bullish about the market outlook during refresh cycles.
For all its dominance in cybersecurity, Norton-Lifelock (NLOK) didn’t escape this pitfall. It recently had to offload its enterprise security division while discounting its offerings in the consumer security space. TCO conversations happen when an industry is commoditized either by a growth in the adoption of open source technologies, low entry barriers, or encroachment on a competitive feature of a big tech company. A lot of SaaS companies like New Relic (NEWR), Atlassian (NASDAQ:TEAM), Slack (WORK), and Palo Alto Networks (PANW) are riding on the premium pricing of their offerings. Therefore, investors with huge exposure to these stocks need to recalibrate their risk appetite.
Studying early investment roadmaps
Until you dig up the pre IPO thesis of the tech stocks in your portfolio, you can never understand these companies well enough. For example, understanding the valuation of Uber (UBER) is a function of your faith in Uber's early-stage roadmap towards transforming into the largest mobility platform of the ride-sharing space. This roadmap is driven by Uber's huge total addressable market if it becomes the mobility platform it is positioning to be. Miscalibrating this potential will impact your bias towards Uber’s valuation and the potential of the company. The same goes for Tesla (TSLA). Not reading the initial roadmap and the updates laid out by Elon Musk will cause a foundational misunderstanding of the stock and the key drivers of its valuation.
Relying on models
Financial models are good. However, the fastest way to go bust in this field is to put too much faith in a model. 80% of the time, when I got a thesis wrong, it was due to the anchoring bias created from a model. This is because models are based on assumptions. Assumptions that lead to a conclusion that sways from the consensus put you in a dangerous situation. A DCF model is notorious for this. I have DCF models of nearly a hundred tech companies, which I update yearly. The biggest lesson I’ve learned from the creation of these models is that I should rely less on them for my investment decisions. The solution I found to this modeling pitfall is a combination of a cohort and risk analysis. A cohort analysis to study the evolution and investing behavior of institutional and retail investors who bought into the company when it went public. Risk analysis to gauge the evolution of their risk appetite. Next time you want to understand the trading behavior of a stock, perform a cohort analysis of stocks that IPOed in the same year as your target company. Preferably, using more filters like stocks trading in similar industries or sectors can provide a fine output to begin your study. At the end of the exercise, you will understand the investing behavior of the bulls that are on your side and the bears that are against you.
Market cap before multiples
If a stock has a low multiple and it trades at a low market cap, if it doesn't exhibit network effect, the potential for it to break out is extremely slim. This is one of the greatest investing pitfalls. Due to the law of large numbers, small-cap stocks have often outperformed large and mega-cap stocks. However, they've also exhibited the largest volatility. Unless a stock IPOes at a mid or large-cap valuation, retail investors can fall into the erroneous exercise of trying to label it a winner or potential ten-bagger. Sifting for winners is hard, and buying a basket of small-cap stocks as a factor investing strategy can be likened to participating in a coin-flipping contest. I fell for the small-cap bias in my early investing years until I learned about the network effect and the potential for companies to exhibit it.
Equity/Country Risk Premium
Source: Author
Investors overlook this factor a lot. The equity risk premium is the premium investors incorporate into their discount factor when estimating future cash flow. In volatile industries, mature industries with declining growth, and industries with exposure to strong macro headwinds, the ERP is often the biggest driver of valuation multiples. Therefore, we often observe EM equities or companies trading in shrinking industries exhibiting range-bound valuation multiples for a lengthy period. Stocks like BlackBerry (BB), Jumia (JMIA), Talend (TLND), and Opera (OPRA) are examples of the gravitational effect of shrinking industries or EM risk exposure. Investors should expect stocks with huge risk premiums to be more volatile and unpredictable. This means you have to lower the exit EBITDA multiple for your exit year valuation.
Mid-market or Fortune 100?
If a company doesn't brag about selling into Fortune 100 companies and instead replaces this metric with its success with the Global 2000 or a similar watery metric, it won't enjoy the lofty valuation multiples of some of its peers. Large enterprise deals matter a lot, and their needle-moving impact cannot be overemphasized. Fortinet (FTNT) suffered this bias in its early days, and it wasn't until last year that investors caught up to this mispricing that Fortinet wasn't just a firewall vendor that sells into the midmarket, in fact, it had the capabilities to be the market leader in its industry. The valuation of mid-market SaaS plays revert to the mean faster than SaaS companies that sell into large enterprises. The takeaway for investors is to perform an extra level of due diligence when understanding a company's strength in the enterprise space.
Pitstops: Refuel or return cash to shareholders?
Often times, a company has enough cash on its balance sheet to take out rising innovators. If such a company is witnessing growth deceleration, efficient capital allocation becomes a headache for managers. When BlackBerry got a cash largesse from its arbitration win with Qualcomm (QCOM), it had the mandate to either initiate a buyback or invest in the future of the company. Given BlackBerry's exposure to some of the fastest-growing cybersecurity segments, making an acquisition to improve its value proposition was a no brainer as it exposes it to tech industries that command huge valuation multiples.
Symantec did the opposite after divesting its enterprise security division to return a special dividend to shareholders. The company is now focusing on its high margin consumer and cyber safety business, where it wins on brand penetration, distribution, and economies of scale. Though, it still has to invest in widening its total addressable market by convincing prospects about the importance of an identity theft solution, which I think is a risky bet. Investors seem to be happy about this decision in the short term as long as EPS is growing. However, my argument before the sale of its enterprise division was for Symantec to keep the enterprise assets and fight for market share due to the rise of a host of challengers proving the strong demand in the enterprise security space.
Companies suffering a similar dilemma include NetApp (NTAP), Nutanix (NTNX), Check Point Software (CHKP), and Nokia (NOK). If there is a strong case for management to go after market share acquisition and it hesitates even for a quarter to pitstop and refuel, it risks losing out completely if its share buyback program doesn’t buffer the downside effect of declining growth. This is even worse if competitors are aggressive about displacing its customers during refresh cycles. The takeaway here is for investors to reduce their exposure to stocks navigating a turnaround. The turnaround might not happen before your exit year, and you might get stuck in a value trap.
Conclusion
I believe a core essence of investment research is to dig up risk factors that bulls have overlooked while matching it with catalysts that bears have missed. Until you get to that stage, your research isn't complete, and your valuation is going to be subject to a lot of bias. Though, nothing hastens the understanding of a stock like having some Skin In The Game. However, for investors who don't want to test the depth of the river with both feet, do two things:
1. Study early-stage investors (VCs) until you understand why they took the company public, including their future roadmap for the company if they are still invested in the business.
2. Don’t stop your research until you find key risk factors that bulls are overlooking. This process can be hastened by performing a cohort analysis to understand underlying investment bias in post IPO investors. If you don't find the bias in your target company, you will find it in one of its peers. You begin to understand if a company simply attracted speculators due to the availability of cheap capital. It's even more interesting when you realize that a company is in the process of becoming the largest platform in its industry or segment, and this might be the reason why it is trading at 30x P/S. Another interesting insight to dig up is that the company is a strategic partner with big tech companies on some of their fast-growing infrastructure. If a company's growth is tied to the growth of AWS, Azure, or Google Cloud, I don't want to be on the other side of the company.
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Editor's Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.
