The purpose of this weekly is to sharpen my thinking by sharing thoughts about industries and companies that fit into powerful long-term investment themes. It is also a place to share insights into decision-making, takeaways from the past week, and random thoughts that arise. Thank you for reading this piece! Feedback is welcomed.
This week:
- Valuing Innovative Companies: Proof and Enthusiasm
- Just Keep Building: LT Value Creation Wingstop Style
- A Few Thoughts This Week
Valuing Innovative Companies
When the market recovers and makes new highs, the debate about valuations in the market becomes front and center. We are getting lots of questions about valuations in the market, so I thought it would be a good time to make it part of the discussion, given its importance in what forward returns will look like.
Before I start on our way of looking at the valuation of innovative companies, I will acknowledge that it is a complicated topic, and many people will have differing views. I have lamented before that seven really good investors could sit with a great company for an hour and walk out with seven different views of how it would create value for their portfolios. So, if it isn’t a debate about whether the company is good or not, then there has to be some art to how each investor looks at valuing companies to choose entry and exit points.
In my more than three decades in the investment business, I have continued to sharpen my thinking and learn from both my failures and successes over the years. I also strive every day to try and make what I do simpler to describe and, therefore, more crisp in my mind.
I view valuation for innovative companies through the lens of two words: proof and enthusiasm. This borrows from the concepts that legendary investors such as Howard Marks and Warren Buffet refer to when they talk about valuation and the impact of human emotion.
Proof is the entire portfolio of what has happened to date, and the kind of business model that the company has in place for future success. It includes the metrics of the business, such as revenue, cash flow, assets, etc. It can also include the duration that the company has been posting impressive (or not) financial metrics.
Enthusiasm varies due to a number of factors. One overarching factor is the enthusiasm (or not) in the market at the time. It includes the market’s view of the company’s forward prospects as well.
In this framework, in theory, a company that proves itself to be a great business for a long period should get a higher valuation than those that have not posted good results or have done so for a short period of time. Also, companies that have a lot of potential to grow to be a sizeable company and post great future results will be valued more richly than those with less potential. The combination of the two produces a powerful catalyst and can propel the most valuable companies in the market.
I like to use the analogy to buying and selling a home for those that don’t value equities for a living. The proof in selling a home is the location, and its reputation, plus what the comparable homes in the area have sold for. The enthusiasm comes from a tight housing market due to a short supply of homes or a shortage of homes in a particular area. Or it could come in the form of the desire for the neighborhood or improvements made, etc. In addition, interest rates play a large role in the valuation of residential real estate – the lower the rates, the higher the prices. Ultimately, the house is only worth what someone else is willing to pay.
The use of both words allows for a disaggregation of two important concepts. I have made the mistake myself of viewing the company through a lens of thinking it is expensive even before I look at the fundamentals (proof). This can produce errors of omission, which in growth investing, can be as damaging as errors of commission.
The nirvana for value investing, defined as buying a stake in a company that is undervalued, is finding a company with high proof and low enthusiasm. We are human, though, and many discussions center around justifying whether a company is good or not based on a perception of the level of enthusiasm. Part of the problem with leading with the view that the company in question is too expensive, meaning that the market enthusiasm is too high, is that it assumes that our ability to predict the future is strong. I won’t go down that rabbit hole, but let’s assume the ability to forecast the future is pretty weak for most people.
In the investment business, many professionals will make statements like “the stock is cheap” or “it’s too expensive.” Skilled investors will have gone through the exercise of studying the company and will consider market enthusiasm for the company and the overall market when they make that statement. We like to use the two separate words to make sure that we are thinking through both aspects before arriving at a conclusion. Really great companies do not come around often, so when we find one, we want to make sure we are clear about both aspects of valuation.
Ideally, instead of just saying “it’s cheap,” we would say “it is a very good company, they have proven that. I am more enthusiastic than the market and expect more of the same or better in the future.” Conversely, instead of saying “it’s expensive,” we would say “I’m not sure they can continue to do what they have proven” or “others are more enthusiastic about their prospects, I disagree.” These are nuanced but important because being clear on why specifically is important to calibrate skill and to learn.
Investing in growth and innovation is different than other asset classes, so these descriptions are tailored to that pursuit. I wrote in an earlier piece that Lululemon has compounded growth and stock returns since they went public at an extraordinary rate. If one bought at valuations at the high end of their historical range, the return to investors was still very good, despite paying a premium. Of course, the returns were better when investments were initiated at the lower end of the valuation range. What is unique about innovative companies with proven business models is that investors can pay a high price and get bailed out by the growth of the company. In this framework, this would be greater than expected proof.
A challenge for growth and innovation investors is that market enthusiasm can widely vary. On a company level, large swings in the valuation and price of the stock are normal. In addition, the market enthusiasm has an outsized impact on
valuations for innovative companies. In 2022, the market took swift action in repricing high-growth companies lower as enthusiasm dropped when interest rates increased. Higher rates change a number of variables including the cost of capital and future economic activity.
To circle back to the current situation, it is important to recognize that the swings we have encountered in the last four years are quite amazing. Consider the
pandemic, its impact on the economy, and the fear and uncertainty it provided. Combine that with the wide variation in interest rates over that time period – wow.!
The valuations for companies that are high in proof, as measured by continued growth in revenue and cash flow, have recovered nicely. Those without proof, where the business has slowed due to an increase in interest rates or the slowdown in housing or the economy, have lagged behind.
I wrote last time about two companies that went public around the same time, Hubspot and Wayfair. In the case of valuation, the results of both companies and their stocks break down well in this framework.
In the case of Hubspot, the company has grown consistently and has a high-margin structure conducive to generating cash at scale, so they have a lot of proof. During the pandemic, the valuation went well above its historical average when there was
extremely high enthusiasm in the market. When interest rates increased, the valuation dropped precipitously as enthusiasm left the market. Since the middle of 2022, the company has delivered on growing revenue at the same growth rate and has earned back prior levels of enthusiasm in the market.
Wayfair was a different story. The company has a business model that has not been proven out at scale either by the company or other players. The company’s ability to produce cash is not clear either in level or timing. The company was a pandemic beneficiary, as the market became very enthusiastic about all companies that provided goods or services to people stuck at home. The valuation increased significantly, approaching $30B (it is $5B today). The company did follow through with proof of growth and some profits, but it was not able to sustain those levels. With less enthusiasm in the market for their business model and its ability to produce cash, the company is valued at a lower level than when they went public.
Ultimately, for long-term value creation, a company must continue to show proof in the form of growth in revenue and cash generation. If proof moves up and to the right on the chart, so will the stock price over time. It is important to keep in mind that this is what the company can control. Enthusiasm in the market for the company’s prospects will change over the course of the long term. This becomes a bit of a horse race, where at times, the valuation may show high enthusiasm that requires proof to catch up, and conversely, the valuation will need to catch up to the proof.
Just Keep Building
Recently, I was marveling at the job that the management team of Wingstop have done over the last 7 plus years. When I first came across the company several years ago, I wondered how the company could continue to add shareholder value at the same high rates. I was struck at the time about how tight their strategy was to scale locations, and how protective they were about their brand. Since that time, they have continued to grow and innovate, to the delight of shareholders. Over the last 5 years, the company has had a revenue compound growth rate of 17% and its stock value has grown 36% annualized over the same period.
What is so impressive is the way that the company has kept building thoughtfully despite the wild swings that have occurred due to the pandemic. The pandemic was particularly difficult for restaurants. The management team navigated the pandemic protocols and became a beneficiary as takeout and delivery became more important. Since then, the company has added franchise locations, improved same-store sales, and produced a ton of cash flow.
The key takeaways in studying this long-term value creator are:
- Protect the brand. They have protected the brand by being careful with awarding franchises, and by maintaining high standards for each franchise. They speak of the company as “the brand,” signaling the importance of brand for long term growth.
- Stick to your knitting. The company has grown locations within a successful real estate strategy. They choose class “B” real estate where it is easy to access by car and avoid high priced locations. There is always temptation to expand and believe that you can pull it off. If there is runway to grow within a winning formula, that is wise.
- Reinvestment is the key to long-term growth. The company had the ability to charge its franchisees more allocation for advertising, and when they saw an opportunity, they took it. They had seen positive results from their ad campaign and decided to lean into it. The result of the reinvestment in advertising was a win-win for the company and its franchisees, with higher same store sales growth being the output.
Proof and Enthusiasm
In the case of Wingstop, the company had a massive event (COVID) occur and had to adjust. Then, they had to adjust to stronger demand as takeout and delivery were in high demand. After the pandemic ended and the world went more back to normal, they had to adjust again. The company has executed and shown a lot of proof in the form of revenue growth and cash generation. The stock, as I mentioned, has compounded 36% but it hasn’t gone up in a straight line. The stock has had two pullbacks greater than 50% over that period. The first was during the initial shutdown in 2020, and the second was during the growth stock bear market of 2022. In both cases, there was a lack of enthusiasm, to say the very least. I would describe it more aptly as straight fear.
In both periods, the company just kept building and adding more economic value. Today, the company is trading near all-time highs, rewarding those with the patience to ride it out.
Thoughts This Week
As an entrepreneur and business owner, I am inspired by the Wingstop example. Just keep building.
If the economy remains in good shape, consumer companies are due for a rebound in business and market enthusiasm. To date, as a broad group, they have not seen either during 2023 or 2024 year to date.
More reports keep coming out about massive spending plans for AI-related infrastructure. Nvidia has said publicly that AI will require a complete re-tooling of data centers. It will be an interesting year in terms of actual results i.e. proof….
Note to readers: Arrowside Capital holds positions in Nvidia, Wingstop, and Hubspot.
My story
I am an investor and entrepreneur, having started two investment companies. I am the Founder and CIO of Arrowside Capital (http://www.arrowside.com), based in Boston, MA. I have more than 30 years of experience in the investment business, investing in companies geared toward innovation and growth. The blog is named
The Zen Innovation Investor because I believe it is so important to remain calm and focused during the rapid pace of change in the world today. I am keeping a view of the long term while also keeping abreast of developments in the world of
innovative companies. I view this as a place to sharpen my thinking and provide some insights that are thought provoking.
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