Every investment manager will tell you that they buy exceptional companies that have competitive advantages. Even we say it. But without additional context, that statement has become almost meaningless. In today’s fast-changing environment, what seemed a competitive advantage for decades can quickly become a burden. Think of every retailer that believed enormous department stores were an advantage—until those stores stopped drawing in crowds. Enduring competitive advantages are most driven by the business model a company uses, working symbiotically with the unique attributes of its particular products.
Big picture, we believe the strongest sign of a competitive advantage is the ability to draw more and more revenue from the same customers, without having to spend more and more on marketing. At the strongest companies, this can occur through various avenues. The business can successfully expand its offerings, of course; or, it can increase prices regularly without losing sales; or, the company sells a service that becomes more vital the more a customer uses it, and customers pay based on usage. Best of all is when a company enjoys all three traits.
To judge this, we are increasingly measuring the Annual Contract Value (ACV, or barring contracts, just annual revenue dollars) earned per average customer at the companies we consider for investment. This is simply the average annualized revenue earned per customer, and we want to see it steadily increase by a factor greater than inflation. This measure is becoming more prevalent as more companies move to subscription-based sales, which is a business model attribute we favor. We are sector and industry agnostic, so we invest wherever we believe we see an attractive opportunity—whether it’s in healthcare, energy, industrials—but we are most drawn to businesses that enjoy organically recurring revenue coupled with growing ACV.
We prefer those exceptional attributes, but we demand much more from our companies. We know that concentrated investing—owning 50 or fewer stocks, say, rather than hundreds—means the big winners you keep will be more meaningful to your results. In fact, having such winners, and keeping them, is what sets many of the best investors apart. Just one or two large long-term winners can change your financial situation permanently. We are seeking to own several and keep finding more. To increase our odds, we want to see:
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Growing annual contract value—or simply dollar value—per customer.
As just described, this is when a company earns more revenue from each customer, on average, each year, typically by expanding its product line, raising prices, or increasing customer usage—or all three. Plus, we want this revenue to be recurring in nature. Software-as-a-Service (SaaS) companies are leading the charge, but are far from alone. Companies with strong network effects, where their offerings get stronger the greater the number of customers using it, also typically see usage-based revenue grow annually.
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Expansive market opportunities driving revenue higher.
Although we’ll jump on a discounted stock in an “old school” industry, by and large we prefer the opportunities seen by companies in younger industries that are expanding rapidly and have the potential to grow at market-beating rates for decades. Revenue growth is step one toward long-term value creation at a company. Rising revenue doesn’t guarantee success, but without sales growth you are all but guaranteed that you won’t see much value creation. We seek strong revenue growth thanks to large, long-term market opportunities.
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An aligned management team with clear communications skills.
We want to invest in management teams that win when the company wins, and that lay out their vision clearly. A clear strategy is, we believe, necessary to achieve goals and then keep growing, building upon past success. We want to avoid companies that are hoping to someday succeed, and be invested in those that are seeing success, however early.
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Financial tailwinds.
The numbers that matter most to us for each company will vary, but will include revenue growth, operating margins, free cash flow prospects, returns on investment, and cash and debt balances, among others. We want these numbers to be moving in the right direction, pushed along by the business model itself. The financials, either now or in the near future, need to be a strong propellent behind the business, and not a drag on its prospects.
These advantages matter, along with other traits we’ll discuss in future articles.
—Jeff Fischer, Chief Investment Officer, 1623 Capital
