When investing, we actively employ a strategy of investing into companies with durable growth that are building sustainable competitive advantages that we expect to one day become wide moats. Winners tend to win big, which is why we pursue companies that are emerging as winners of their space.
I am not an expert on technology, but I surround myself with people who know it well. I can’t write code, but I do understand software businesses and the power of subscription businesses. Over the past five years, we’ve built a portfolio of successful companies in six primary areas: digital advertising, payments, software, e-commerce, cybersecurity and health tech.
A plethora of companies show high-revenue growth; therefore, it is important for investors to distinguish between the high-quality companies with durable growth and those that are growth traps. There are two main types of growth traps — lower-quality companies that spend enormous amounts on sales and marketing to mask that they don’t have a competitive advantage, and quality companies with faster-than-expected deceleration of growth. All companies have decelerating revenue growth at some point, but those that decelerate quickly can be growth traps. Finding companies with slow deceleration of growth is important.
We use several metrics to determine if the business has sticky customer relationships and if sales and marketing are creating value. Customer churn shows if customers are happy or if there just aren’t any better alternatives. A high retention rate is important, but we also look at Dollar-Based Net Retention Rate, which measures the percent increase in revenue from existing customers on a year-over-year basis.
Retention rates are also important because they increase your Lifetime Value (LTV) of a customer. The LTV is the total revenue a customer will bring in over the life of the relationship. The longer the relationship, the more value is created by acquiring each new customer.
Customer Acquisition Costs (CAC) is the cost related to bring in each new customer. The LTV/CAC should be at least 3x for high-gross-margin businesses. It needs to be even higher for low-gross-margin businesses.
Valuation is also important, and it is not easy for companies with high growth because there is a wide range of future revenue growth rates and margin assumptions. However, this also means these companies frequently have dislocations of value. Like so many investors, many of my biggest mistakes have been companies I knew were incredible, but I passed because the valuation looked a little high at the time.
Another area we’ve made mistakes is in quality traps, which are companies that appear to be higher quality than they are. Pattern recognition comes from experience, and over time, we have developed 27 qualitative criteria to examine when looking at a durable growth company. The most important is assessing the long-term visibility and durability of the company. We then separate companies into three tiers based on their quality.
When we were right about the company being the winner of its space, we’ve never lost money. We have an allocation rule for durable growth companies: Don’t put the most money in stocks you might make the most from, put the most into the companies you can’t lose money on. To reduce the impact of mistakes, we use a basket approach and keep about 20 to 25 positions. The future is always uncertain; therefore, investors should focus heavily on avoiding permanent losses and building a portfolio that can endure various states of the world. Writer Nassim Nicholas Taleb called these types of companies antifragile.
Umberto P. Fedeli is CEO of The Fedeli Group