I like fishing. It takes my mind off markets and gets me out in nature. There are many parallels between fishing and value investing. When fishing, you want to fish where the fish are and the people aren’t. As value investors, this is music to our ears.
In most cases, these great fishing spots hide in the shadows. They’re off the beaten path. You have to crawl under branches. Weed through thorn bushes. Spots you wouldn’t otherwise find should you continue on the foot-trafficked path. But once you cut through the thicket, a honey-hole awaits.
It’s at this point you catch as many fish as you can. Do you tell everyone about the new fishing hole? Yes, of course. But only after you’ve caught all the fish you can take. Once word gets out, the spot dries up. No more fish.
Stock screeners are investing’s fishing holes.
Instead of fishing for bass, we’re fishing for shares of undervalued companies. But the principles still apply!
When you run a traditional “value” stock screener, you’re doing two things:
- You’re “fishing” where every other investor is fishing.
- Reducing your odds of finding something off-the-beaten path.
Using stock screeners prevents you from finding great, unknown companies.
Let’s dissect two types of businesses that won’t appear on any traditional value stock screener:
- Good Co. / Bad Co. Dynamic
- SaaS model Businesses
The Good Co. / Bad Co. Dynamic
The Good Co. / Bad Co. Dynamic is one of my favorite special situation-type investments. Through the following example you’ll learn the power behind this dynamic, and how to profit when you see it.
The Toothpaste and Toothbrush Example
Imagine you find a company, BRUSH Inc. (XYZ) trading for $10/share. BRUSH Inc. makes two products: toothpaste and toothbrushes. The toothbrush business is a great business. It boasts high margins, attractive variable cost structure and tremendous brand power. This segment generates $1.50 per share in operating earnings for the company.
At its current stock price, you could buy XYZ for 6.6x earnings. Not bad.
But remember XYZ’s other business, toothpaste manufacturing. Unfortunately for XYZ, the toothpaste business isn’t a good business. They can’t mix the right product. Sales are shrinking. Management’s R&D investments turn into burnt cash. Margins are slim and they’re losing market share. Due to the above factors, XYZ loses $1.00 per share in operating earnings from its toothpaste division.
This is where things get interesting.
What GAAP (Generally Accepted Accounting Principles) Sees
According to GAAP, BRUSH Inc. generated $0.50 in operating earnings. How did they arrive at $0.50? GAAP subtracted the negative earnings from the positive earnings.
So instead of a 6.6x earnings multiple, investors are paying 20x earnings for the same business. A higher multiple and a lower earnings yield. Double whammy.
Why Screens Don’t Pick Up These Companies
In general, this type of company will have a high P/E ratio. This makes intuitive sense. The business generates lower total earnings based on its two operating segments.
We also know that many traditional value screens have a filter for P/E ratios. Most of which are below 20 – 25x.
In other words, most people aren’t looking at these companies. And it’s not because they don’t have the capacity. Rather they don’t even know they exist. They stayed on the beaten path.
This becomes an opportunity for investors like us. Investors that are willing to look under the hood and get our hands dirty.
Why it Pays To Find These Companies
Finding Good Co. / Bad Co. companies can be an extremely profitable venture. These businesses have potential catalysts at their fingertips. Once triggered, these catalysts can reward investors regardless of broader market trends.
The biggest catalyst for a Good Co. / Bad Co. business is the removal of the unprofitable operating segment. This requires management to check their ego at the door, admit something isn’t working and move on. Easier said than done. But what rewards would shareholders reap?
Let’s go back to our toothbrush/toothpaste example to see the benefits.
Shutting down the toothpaste division flips BRUSH Inc. from earning $0.50/share to $1.50. The stock goes from 20x earnings to 6.6x. The earnings yield catapults from 5% to 15%.
With one simple change, BRUSH Inc. now looks like a classic value stock trading at a massive discount to future earnings. Screens will pick up on this change after a while. Soon enough millions of investors will come to find the stock you knew existed all along.
This is why the good co. / bad co. dynamic is so powerful. If you find these types of businesses you can, in essence, fish where nobody else is fishing.
Which Ones Should You Buy?
Now this isn’t to say that all stocks with Good Co. / Bad Co. dynamics are good investments. Like most off-the-beaten-path areas of the market, discretion is advised.
One way to add a margin of safety is to invest in companies that are growing their profitable operating segment. You don’t want a business with a shrinking profitable segment. Soon you’ll end up with two negative operating segments and one bad investment.
Insider purchasing is another helpful indicator. If management’s about to make a change that will affect the stock price, this is where they’ll tip their hat. Remember, people sell for a variety of (legitimate) reasons. But they only buy for one: appreciation.
Knowing How Much To Pay
I like to calculate how much I can buy the good operating segment for, and in turn, get the bad business for free. If you’ve read previous Value Ventures letters, you know this is one of my favorite strategies.
I want to find companies where I don’t have to pay for a lackluster part of their business. Plus, if we think the business would be better off without the negative earning segment, why should we pay for it?
Software-as-a-Service (SaaS) Models
To understand why SaaS companies don’t screen well, we need to know a few key items. First, we need to know how they get customers. Second, we need to know how they receive revenue from those customers. Finally, we need to know the difference between the cost associated with acquiring the customer and the revenue generated from that customer.
The last part is often referred to as the Lifetime Value of the Customer (or LTV for short). Let’s use an example from a fictitious company, XYZ Software Solutions (SOFT).
Understanding Lifetime Value of the Customer
XYZ Software (SOFT) sells customer relationship management software on a subscription basis. They charge their customers $100/month with average contracts lasting 3 years. Let’s also assume they have high profit margins, around 75%.
This means that each customer generates around $3,600 in revenue and $2,700 in profit. This is our LTV.
Yet we know customers aren’t free. Given its sales & marketing spend, XYZ estimates its customer acquisition cost around $400.
On the surface, things look great. XYZ spends $400 to receive $2,700 in profit value per customer. Who wouldn’t want to invest in a model like that?
There’s just one problem. GAAP Accounting doesn’t see it that way.
What GAAP Sees
Under GAAP, XYZ must recognize the costs (expenses) to acquire the customer up-front. XYZ then recognizes revenue once XYZ provides the service. Instead of booking $3,600 as revenue from the customer, you have to recognize it over time, say per-month.
Doing that clouds the financial performance of the company. Now you have $400 of expenses up-front and only $300 of revenue coming in the door. That’s -$100 in losses for each new customer. That looks nothing like our above assessment of the company’s LTV.
GAAP accounting creates a natural distortion between the costs associated with acquiring the customer, and the profit from that customer. As you can see, this translates to optically negative financial statements. Which in turn, leads many SaaS businesses off value stock screens.
We’re Investors, Not Accountants
When it comes to analyzing SaaS businesses, GAAP won’t help us all that much. Instead, we should focus on four metrics:
- Bookings (or sales)
- Monthly Recurring Revenue
- Churn Rate
- Recognized & Deferred Revenues
Let’s dive into each category.
Think of this as the dollar value of the contract each customer signs. For example, if XYZ signs a $200K contract for their software, that’s $200K in bookings.
Remember, we can’t count all $200K as recognized revenue. This is the amount of revenue the business expects to receive over the lifetime of the contract. Tracking this figure provides a more realistic picture of top-line revenue growth.
Monthly Recurring Revenue
Many SaaS companies use Monthly Recurring Revenue (MRR) as their Key Performance Indicator (KPI). MRR serves as a baseline for all revenue the company generates on a monthly basis.
For example, if XYZ has five customers with $200K/year contracts, they’re Monthly Recurring Revenue (per customer) is $16,666. This becomes recognized revenue at this point. I’ll explain why.
Recognized & Deferred Revenue
As the name suggests, recognized revenue is revenue that is booked by the company after they provide the service requested in the contract.
Deferred revenue is simply the opposite. These are revenues that are “booked” (see bookings above), but the company hasn’t yet provided the actual service.
Under GAAP, Deferred Revenues are liabilities on the balance sheet.
This makes intuitive sense. When XYZ signed the $200K contract, they hadn’t provided a years worth of service to that customer. In other words, deferred revenues would be $200K on day of contract. Check out the photo on the right for an example:
Deferred revenue decreases while recognized revenue increases as the company provides their service.
Churn Rate (Customer vs. Revenue)
Customer Churn Rate is the percentage of customers that stop their subscription during a given period of time. For example, say XYZ had 100 paying subscribers in Q1. But by the start of Q2 that number fell to 75.
The Customer Churn Rate would be 25% since a quarter of their customers churned through their subscription during the quarter.
Revenue Churn is the same principle as above, but uses revenue as the input instead of number of customers. Revenue Churn is a much more important metric for SaaS businesses that offer various pricing packages/deals. Why? Let’s break down the difference between the two.
Losing five customers sounds worse than losing one customer. And in some cases that’s true. If everyone pays the exact same amount, losing five is worse than losing one. Yet many SaaS business models offer varying pricing packages.
Things look different if a business loses one large “Enterprise” customer paying $150/month versus losing five “Starter” customers paying $10/month.
Example: SharpSpring, Inc. (Scott Miller of Greenhaven Road)
SharpSpring is a great example of the power of looking beyond GAAP accounting and quantitative screens.
I found the idea from one of Scott Miller’s quarterly letters. His thesis for the company played out well. There is one key aspect about SharpSpring that makes it a great case study. It hasn’t generated an operating profit.
So what did Miller see in SHSP?
- High recurring revenue business model with tremendous unit economics.
- The LTV per customer was significantly higher than their customer acquisition cost.
So, SHSP did what any reasonable company should do in that situation. They plowed all their profits into acquiring as many customers as they could. This makes sense.
Yet by investing all their cash back into the business, they had nothing left to show for “earnings”.
What did Miller have to say about SHSP’s capital allocation strategy?
“The right way to run this business [high LTV/CAC ratio], in my opinion, is to spend every available dollar on sales and marketing to build the customer base, not worrying about short-term profitability.”
How To Find Stocks That Don’t Screen Well (How To Beat Machines)
This isn’t going to be a popular answer. It’s not one you’d see on a Motley Fool ad, either. The best way to find these types of companies — the ones that don’t screen well — is through brute force work.
I know. We live in an age where automatic processing is eating the world. Computing power reaches new levels each day. Yada yada.
Yet the only way to beat the machines is to find things that machines can’t pick up.
Quant-centered funds run exclusively on (you guessed it), quantitative data. Moreover, these funds, strategies and screens focus on historical data. They’re backwards looking.
Here lies the opportunity.
We have the benefit of being able to look forward into the future. Three to five years beyond the immediate horizon. We can make reasonable guesses as to where a business might end up in the next five years. Quants don’t care about that. They only care about what the company did in the past.
This isn’t a fault of quants themselves, but the strategies they use. Algorithms use old data to make buy/sell predictions about the current price. What these algorithms don’t (and can’t) understand are special situations when things change. Sometimes dramatically, sometimes due to GAAP accounting.
Method 1: Download Excel File of Ticker Symbols
You read that correctly. The first method to find stocks that don’t screen well is to download an Excel file and go through each stock symbol.
There’s three main benefits to doing this grunt work:
- You learn about a lot of different businesses, economic models and management teams.
- It improves your ability to quickly say “No” and quickly put companies in the “too hard” bucket.
- You’ll find hidden gems — if you look hard enough.
This is obviously the most time consuming method of finding companies that don’t screen well. But if you’re serious about investing, this is the best method. No time is wasted as you learn about businesses, say no to companies quicker and find your preferable industry.
Method 2: Change How You Screen
The tendency when screening is to focus on one objective: refine, refine, refine. If you’re going to use screens, cast a wider net.
The best way to widen your screen is to focus on higher-level variables. Variables like:
- Market Cap
- Enterprise Value
- Insider Ownership
These types of variables aren’t as dependent on financial or balance sheet metrics. They provide a more qualitative feel to your screen.
My Favorite Screens
If I’m not going through companies one-by-one, I like to use a screen filtered by insider ownership. The screen still spits out 300+ names. I’ll then go through each of those one-by-one.
Ronnie Coleman is one of the greatest bodybuilders of all time. When asked what it took to reach his level, he had this to say:
“Everybody wants to be a bodybuilder, but nobody wants to lift no heavy ass weights.”
Change a couple words and the quote applies to value investing.
“Everybody wants to be a value investor, but nobody wants to research no long ass list of stocks A-Z”
Value investing isn’t about hitting home runs and watching your gains fly. Yes, that can be an end result. Value investing is about the desire to understand businesses at deeper levels. It’s a longing to learn as much as you can. A lifetime of discovery.