Finding Tech Stocks That Will Survive a Bear Market
Having a tech investing methodology with a strict set of rules doesn’t mean your approach can’t change when the market changes. As the availability of easy cheap capital dries up, our “revenue at all costs” mantra is shifting to “revenue at reasonable costs.” Spending $1.5 to acquire $1 in revenues won’t be sustainable, so we need to start considering how likely a business can survive without having to raise additional capital. While everyone can debate whether we’re in a bear market or flirting with one, we can all agree that funding appears to be drying up across the board.
We believe it’s critically important to keep things simple because we’re simple people. That’s why our tech investing methodology is easy to read and understand with no prior background needed of any kind. Today, we want to talk about ways for investors to identify companies that are most likely to survive – even possibly thrive – during difficult times.
We all understand that revenues are what a company receives when they sell a product or a service. If a company is not selling a product or a service, we’re not going to invest in them because they haven’t demonstrated traction. It’s that simple. When valuing companies that are selling things, we use our simple valuation ratio which takes last quarter’s revenues, annualizes them (multiplies them by four to pretend like that’s a year’s worth of revenues), and then divides market cap by that number. It’s a simple and responsive way to see how a company is valued over time. These days, many quality companies can be found trading in the single digits.
|CrowdStrike Holdings, Inc. (CRWD)||31,879||380||21|
|Confluent, Inc. (CFLT)||5,123||120||11|
|Okta, Inc. (OKTA)||14,349||351||10|
|UiPath, Inc. (PATH)||7,781||221||9|
|Palantir Technologies Inc. (PLTR)||14,912||433||9|
|Schrodinger, Inc. (SDGR)||1,522||46||8|
|Darktrace PLC (DARK)||2,934||96||8|
|Unity Software Inc (U)||8,959||316||7|
|C3.ai, Inc. (AI)||1,480||58||6|
|Splunk Inc. (SPLK)||15,271||665||6|
|Alteryx, Inc. (AYX)||3,631||174||5|
Just because a company is fairly valued doesn’t mean it’s risk-free. A bigger concern would be one of survival.
As they teach you in bee school, the ultimate goal of every business is to survive. The smartest management teams should have made hay while the sun shined and raised capital while the going was good. That cash now sits on their balance sheet providing them with runway – the estimated amount of time a company can last without having to raise money. To calculate runway, we can simply take the total cash and cash equivalents and divide it by the annual negative operating income. If Guardant Health is burning about $100 million a quarter, and they have $1.6 billion in cash and equivalents, then they have about 4 years of runway left. If Desktop Metal has $206 million in cash and they burned $70 million last quarter, then they have about 9 months left of runway. Adjust as needed. This is a metric we’ll look at more going forward in addition to gross margin.
The Importance of Gross Margin
We always hate to start throwing around words like “net” and “gross” because then you need to start paying attention to definitions. It’s much easier to use a term like “profit margin.” It’s a concept that everyone can easily conceptualize. Johnny spends $10 buying sugar, lemons, and cups. He then sells 20 cups of lemonade for a dollar a cup. His profit margin is 50% ($20 revenues – $10 cost of goods sold). We can also call that his gross margin.
But then Johnny gets smart and has Sally stand around in a skimpy bathing suit waving a sign advertising the lemonade and pays her $5 for the favor. In the same scenario, his gross margin is still the same, but his net margin is now 25% ($20 revenues – $10 cost of goods sold – $5 marketing.) That added expense is referred to as overhead, and something most companies classify under “sales and marketing.” There are many other overheads like executive assistants, office managers, and Gwyneth from human resources who now sends nastygrams to Tommy because he asked Sally to wear a skimpy bathing suit.
Companies that grow quickly usually end up with a lot of fat that can be trimmed when times get tough. Any good sales manager can easily point out the rock star BSDs who are responsible for closing most big deals. Axing the bottom 20% of your sales team is an easy way to cut overhead when times get tough. If you’re a business that’s not profitable with a very high gross margin, then you should be able to start trimming fat when times get tough and generating a profit. Unity Software expects to do that by the end of this year. That’s because their gross profit is a healthy 77%. While Unity isn’t a pure software-as-a–service (SaaS) business, a large chunk of their revenues is SaaS-related. Typically, SaaS businesses have very high gross margins. Below, you can see the gross margins calculated for the 24 pure-SaaS companies found in our tech stock catalog (company names link to our latest research).
|Company||Gross Margin||Company||Gross Margin|
You might be wondering why Toast has such a low gross margin. So were we, and it turns out Toast was incorrectly classified as “pure-SaaS” in our catalog instead of “some-SaaS.” The intern responsible for that mistake has been chastised by Gwyneth from HR, and we promise to fix the problem in our next catalog release, but it’s a good lesson learned. Pure-SaaS companies almost always have healthy gross margins (unless they’re space SPACs, apparently). The great thing about holding companies with high gross margins is that you can be sure there’s a healthy business underneath all those losses that’s just waiting to mature – like a fine Opus One.
Why We Love SaaS Companies
In our recent piece on How to Avoid Losing Money on Tech Stocks, we talked about how only investing in quality companies means you won’t end up being a bag holder because rarely does a firm with growing revenues goes bankrupt. (If you invest in pre-revenue companies, then that’s a different story.) SaaS firms are desirable for any number of reasons including the following:
- They typically use industry-agnostic metrics that anyone can easily understand and use to monitor business health
- Multi-year contracts make switching difficult
- Some, like UiPath, help companies save money, the perfect thing to be selling during a bear market
- The incremental cost of adding a new customer is low which means adding customers expands margins
- Even if a SaaS firm isn’t adding new customers, revenue is still growing because of average net retention rates around the 120s
These are just some of the reasons why we’re particularly attracted to SaaS companies. Of the 36 tech stocks we’re holding in our own tech stock portfolio, nine can be found in the above list of SaaS stocks.
Looking at our portfolio right now, at least half the names are up 10% or more. You think we’d be happy, but we’re anything but. What you’ve been observing lately is a great deal of volatility as measured by the VIX, but it’s easy enough to observe yourself on days like this. When stock price movements start to resemble a roller coaster, it’s a sign that investors are behaving irrationally and using emotion to navigate the markets instead of logic.
If we’re going to be greedy when others are fearful, we need to make sure we’re only buying quality companies that can withstand whatever surprises the market has in store for us. SaaS companies typically bring quality to the table in terms of high gross margins. Investors can then check to see if there’s sufficient runway for them to reach the finish line of profitability.
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