5 Sensational Stocks Focused On Disruptive Innovation

Summary

• Wayfair is one to watch closely as it continues to disrupt the furniture and home goods market by capturing the secular shift from brick-and-mortar retail.
• Global e-commerce penetration is still small enough to allow for plenty of winners, and explosive growth suggests a disruptive nature to Etsy's business model.
• Stitch Fix has found a growing niche in a massive industry, and the company is reinventing, if not disrupting, the shopping experience through one-to-one personalization with its customers.
• Fiverr is changing how many work in today's modern economy, and its shares are trading below our fair value estimate.
• Snap is working hard to 'reinvent the camera,' and the company's long runway for growth may be underappreciated by the market.

Photo by hatchakorn Srisook/iStock via Getty Images

In the above video, Valuentum's President of Investment Research Brian Nelson, CFA, explains why there are not really value and growth stocks, why most of the research in quantitative finance is spurious and needs to be redefined on a forward-looking basis, and why enterprise valuation (not the efficient markets hypothesis) should be the organizing principle of finance. Nelson explains his views about valuation, what it means to be a value investor, and investing in the context of Oaktree Capital Howard Marks' latest memo, "Something of Value," January 11, 2021.

Introduction

Investing is supposed to be simple. In most cases, the more complex an investment process, the more likely it is that things can go wrong. During the past few months, for example, we've seen some stumbles at hedge funds such as Melvin Capital and Archegos Capital.

These investment firms were caught either on the wrong side of a short trade or overleveraged in areas that were way overpriced. The average everyday investor shouldn't be shorting, in my view, and taking on leverage with little regard to valuation will always be a recipe for disaster.

However, there is risk that an investment strategy may be too simple, too. For example, buying index funds and/or pursuing what has become an industry standard 60/40 stock/bond allocation may leave investors disappointed. Here is what I wrote in the book Value Trap:

Asset Prices Tend to Collapse in Unison During Most Crises

Source: ValueTrap

Image: As shown above, year-to-date through March 18, 2020, the prices of most asset classes from U.S. stocks and foreign stocks to gold and hedge fund strategies weakened considerably in unison, with the prices of MLPs (AMLP), crude oil (USO), and Bitcoin (OTC:GBTC) even collapsing during the measurement period. Every sector in the S&P 500 also fell materially during the COVID-19 market crisis. Source: YahooFinance.

A 60%/40% stock/bond portfolio, as measured by the Vanguard Balanced Index Fund Investor Shares (VBINX), for example, fell 17.6% year-to-date through March 18, 2020, and it only "saved" investors from a mere 8 percentage points of underperformance during the worst of the COVID-19 swoon relative to the S&P 500 during that time. However, according to Vanguard's website, the relative cost to an investor that held the VBINX for its diversification benefits during the 10-year period ending July 30, 2020--arguably to protect against the volatility of the exact adverse market outcome as that driven by the COVID-19 crisis--was over 110 percentage points of cumulative total return underperformance compared to the S&P 500, or roughly $11,324 on an initial $10,000 investment. That was a huge price to pay during the past 10 years through the time of this writing.

Over a longer-run measurement period, the comparison does not get much better. Since inception in November 9, 1992, returns after taxes on distributions and sales of fund shares for the VBINX came in at 6.5% through June 30, 2020, while the same measure since inception in January 22, 1993, for the S&P 500, as measured by the S&P 500 ETF Trust (SPY), came in at 8.12% through June 30, 2020. Though more than 1.5 percentage points of underperformance per year does not sound like much, it compounds quite a bit over a near 30-year period. When it comes to retirement, are investors going to care more about their risk-adjusted returns or more about how big their nest eggs grew after saving for 30 years? I think the latter. For long-term investors and entities with indefinite lives, perhaps they should be concerned that MPT does, in fact, sound a lot like "empty."

There is a big middle between 1) shorting or leveraging up overpriced bets versus 2) pursuing indexing and a 60/40 stock/bond allocation that may leave one sorely disappointed in the long run. But within that big middle lies a strategy that I think is very helpful to the investor. As I outlined in the video to begin this article, investors can go astray by relying too much on quantitative labels such as the P/E ratio or P/S ratio or other single-year snapshot valuation measures. I think that the discounted cash flow model is the best lens by which to view a company's valuation.

Having a firm foundation and an understanding of the cash-based sources of intrinsic value, as in the discounted cash flow model, is par for the course for our team at Valuentum. However, we also think share price momentum offers valuable clues as to whether a company is truly undervalued - meaning that while we think the discounted cash flow model is important to learn to understand market price movements, we don't rely on the discounted cash-flow model, by itself.

In theory, because the two schools of thought (value and momentum) tend to be at odds with each other, we view the potential for alpha at the intersection of DCF value and share-price momentum as likely. There's more to this strategy, of course, but combining the DCF with share price momentum offers a good place for investors to start their analysis. After all, if you think a company is underpriced based on the DCF and the market thinks it's underpriced based on strong share-price momentum, you could be on to something.

Below are five stocks that we analyze across this combined DCF-momentum (also called "valuentum") spectrum, with an emphasis on the first part of our process in this article, the discounted cash-flow model. We provide a DCF-derived fair value estimate of shares below, as well as our thesis on each name. We think these are some sensational ideas, but not all of them have the most attractive prices at the moment. Patience may be in order with the following list, but given that each of them are disrupting their industries one way or another, the names below are worthy of being on your radar, in our view.

Wayfair Inc. (W) -- Fair Value Estimate: $300

Image: Valuentum

Wayfair makes shopping for the home easy. The company has one of the largest online selections of home décor, including furniture, housewares, and other home accents. Wayfair's target customer is a 35- to 65- year old woman with above-average household income. Its offices are located in Boston, and the US is its largest market.

Extensive experience in the home goods category, substantial investment in logistics and customer service, and the need to hold minimal inventory are key attributes of Wayfair's business model. The company thrives on convenience and value, and increased engagement from existing customers will be key. It is estimated that more than half of Wayfair's orders in 2019 came from customers that have made three or more purchases before. It may be a matter of time before many more customers become comfortable with buying home goods online.

That said, traditional brick-and-mortar retail remains highly competitive. From Ashley Furniture, IKEA, Bed Bath and Beyond (BBBY), and big box giants including Home Depot (HD), Lowe's (LOW), Target (TGT) and Walmart (WMT), the list of rivals is long. However, the US home goods market is huge, estimated at nearly $300 billion, and offers Wayfair a long runway for continued growth.

In the long run, the company is guiding for 25%-27% gross margins and adjusted EBITDA margins in the range of 8-10%. We think its capital-efficient business model will lead to explosive growth in free cash flow. Right now, shares are trading at $333 each, which means they fall within our fair value estimate range at the moment. The high end of our fair value estimate range is $375 per share, however.

We think Wayfair is one to watch closely as it continues to disrupt the furniture and home goods market by capturing the secular shift from brick-and-mortar retail.

Image: Valuentum

ETSY Inc. (ETSY) -- Fair Value Estimate: $165

Image: Valuentum

Etsy operates the online marketplace Etsy.com, which connects creative entrepreneurs with consumers looking to find unique crafts and goods. In August 2019, the company acquired Reverb, an online marketplace dedicated to selling new and used musical instruments. In 2019, both marketplaces connected nearly 3 million sellers with over 45 million buyers.

Etsy makes money by collecting fees from sellers that use its marketplace services (e.g. listing goods to sell, completing the transaction). The company also generates services revenue such as advertising sales from sellers looking for prominent placement of their products on the Etsy marketplace. The company is making inroads in a niche area within a business model that eBay (EBAY) largely defined a couple decades ago.

Buyers are attracted to Etsy because sellers offer items that generally can't be found anywhere else, while Etsy offers sellers a marketplace with millions of buyers. It is building a nice network effect in the niche arena of creative crafts and items. Top categories include home furnishings, jewelry, craft supplies, and apparel, and 80%+ of sellers identify as women.

A critical component of Etsy's continued growth will be its ongoing relationship with sellers, which remain a strong component of the foundation of its competitive advantage. The unique items on its marketplace are what attracts buyers, and therefore more sellers, and so on and so forth.

Right now, shares are trading at ~$207 each, so they are trading above our fair value estimate, but not higher than the high end of our fair value estimate range of $223. Global e-commerce penetration is still small enough to allow for plenty of winners, and explosive growth suggests a disruptive nature to Etsy's business model. Shares may be worth a further look.

Image: Valuentum

Stitch Fix (SFIX) -- Fair Value Estimate: $52

Image: Valuentum

Stitch Fix was founded in 2011 and provides customers with personalized shipments ('Fixes') of apparel, shoes and other items that are hand-picked by the company's stylists. It doesn't have physical store locations and makes money by charging styling fees on purchased items and from selling annual Style Passes online. Stitch Fix operates in the US and UK and has roughly 3.8 million active clients.

Though Stitch Fix has encountered GAAP losses more recently, it has been free-cash-flow positive, averaging $40 million during the past three fiscal years (2018-2020). Cash flow trends look encouraging in fiscal 2021, with the company off to a strong start.

Stitch Fix's business is gaining momentum. During the first quarter of its fiscal 2021, for example, the company set a number of new records, including one for sequential-quarter client additions. Management believes its outlook is bright and is guiding fiscal 2021 revenue expansion to be robust. We think the company may exceed expectations.

Initially, Stitch Fix focused on women's apparel, but it has since expanded into other segments, including men's and kid's apparel, shoes and accessories. These markets are absolutely huge, and Stitch Fix is tapping into connecting with customers on a personal level to drive demand. Data science remains integral to its business model.

Stitch Fix has found a growing niche in a massive industry, and the company is reinventing, if not disrupting, the shopping experience through one-to-one personalization with its customers. Shares had rocketed to over $100 recently, but have come back down to the $50 mark. They could be poised for a bounce back based on our fair value estimate range.

Image: Valuentum

Fiverr International (FVRR) -- Fair Value Estimate: $282

Image: Valuentum

Fiverr is changing how many work in today's modern economy. Its digital marketplace unites freelancers with businesses that are looking to get work done. The company transforms the traditional staffing-type process into an e-commerce one, facilitating the buying of digital services on the web with clearly defined scope and price. Its principal offices are in Tel Aviv, Israel.

With its 'Service-as-a-Product' model, Fiverr offers more than 300 categories of product listings ('Gigs'), which range from logo creation and video editing to website development and writing and beyond. Its sellers include freelancers and small business from 160+ countries. Repeat buyers are 55%-60% of sales.

Fiverr's business model is rather straightforward. It generates revenue mainly through transaction and service fees. Growth has been impressive since its founding, too. Sales leapt more than 40% in 2019, and there's plenty of room for further expansion as it adds more languages to its platform. Most of its revenue still comes from English speaking regions of the world.

The company's take rate - revenue as a percentage of GMV - was 26.7% and 25.7, during 2019 and 2018, respectively. This take rate is fairly high and reflective of the value it provides to link buyers and sellers. Gig verticals include: Video & Animation, Graphics & Design, Digital Marketing, Writing & Translation, Music & Audio, among others.

Fiverr is a young and fast-growing company, and while we're forecasting profitability in coming years, competition remains intense. The company's business is in tune with the modern gig economy, however, and it offers a comparatively attractive valuation with shares trading at ~$224 (our fair value estimate stands north of $280 at the moment). It may be the most attractive on this list from a valuation standpoint, but it also may be the most risky.

Image: Valuentum

Snap Inc. (SNAP) -- Fair Value Estimate: $63

Image: Valuentum

Snap is working hard to 'reinvent the camera.' The company's best-known product is Snapchat, which allows family and friends to send images through both videos and images, which are shortly deleted afterwards. It views itself as a camera company, and its key product verticals are as follows: Camera, Chat, Discover, Snap Map, Memories, and Spectacles. Its offices are in Santa Monica, California.

As it relates to its revenue model, Snap is primarily an advertising company, much like that of its social media peers. The company is focused on increasing user engagement, and it benefits greatly from having a user base with high monetization potential. R&D remains a very large expense as Snap continues to innovate.

Snap believes it is still in the early innings of developing its advertising business, noting that many customers have just started working with the firm. Revenue has increased to $1.7 billion in 2019 from $58.7 million in 2015. US and UK federal and state net operating loss carryforward of ~$7.6 billion should keep cash taxes low for some time.

Minority shareholders won't have much to say in the future direction of the firm. Snap's two co-founders Evan Spiegel and Robert Murphy control ~99% of the voting power of the company's outstanding capital stock. Snap has also put up an accumulated deficit of $6.9 billion since inception, though profits may be just around the corner.

Snap faces a plethora of competition. Apple (AAPL), Facebook's (FB) Instagram and WhatsApp properties, Google's (GOOG) YouTube, Twitter (TWTR), TikTok, Pinterest (PINS), and Tencent (OTCPK:TCEHY) directly or indirectly compete with Snapchat for user engagement and advertising dollars.

That said, the company has a long runway of growth. With shares trading at ~$54 at the time of this writing, there is upside on the basis of our fair value estimate. Snap should be on your radar.

Image: Valuentum

Concluding Thoughts

A successful investment process should fall somewhere in between indexing and modern portfolio theory versus shorting and overleveraging on momentum equities. We like to look at the discounted cash flow model and overlay that with share-price momentum to add greater conviction within our valuation perspective.

In this article, we focused on the DCF-derived fair value estimates of five sensational companies that are disrupting their respective industries. We like the discounted cash flow model because it does not suffer from the same shortcomings as single-year snapshot multiples such as the P/E ratio or P/S ratio.

Fiverr and Snap are trading below our fair value estimates at this time, but these two may offer the greatest risk. Wayfair and ETSY provide investors with exciting e-commerce opportunities, while Stitch Fix may have found itself a very attractive niche revolutionizing the shopping experience. We think all 5 should be on your radar.

Analyst’s Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Brian Nelson owns shares in SPY, SCHG, QQQ, DIA, and IWM. Brian Nelson's household owns shares in HON. Some of the other securities written about in this article may be included in Valuentum's simulated newsletter portfolios. This article is for information purposes only and should not be considered a solicitation to buy or sell any security. Valuentum is not responsible for any errors or omissions or for results obtained from the use of this article. Contact Valuentum for more information about its editorial policies.