Improve Your Growth Investing Game With These 3 Tips
The market is an exciting space right now with many potential growth stocks for retail investors to choose from. Of course, everyone wants to aim for stocks with a 5X or even 10X growth but… which one do we choose? Learn how to be a better growth investor by listening to TFC 111 as we share some factors to consider when evaluating growth stocks!
One can probably name a list of growth stocks very easily. However, deciding which one is worth investing in is not easy but not entirely impossible too. In TFC 111, we list down three key pointers you must consider when evaluating a growth stock: its total addressable market, margin stickiness and smart investor management. As always, our host Reggie expands on each idea by explaining its importance and using clear examples to help you understand how you can up your game in growth investing.
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Reggie: Hey Coconuts! So yes, I know a lot of us are a little bit more stable in our career, we have some sort of stable finances and that’s why we are exploring investing. We have a little bit money sitting around. If not, how to invest?
With that, growth stocks is definitely one of the things that people are talking about out there today. Everyone is talking about growth stocks. Everyone is trying to look for that 5X, that 10X multibagger, but how do you actually evaluate growth stock stuff? Some of the fundamentals are the same. You use fundamental strategies to evaluate their value growth… there is an endless debate, right? We’ll probably organize a debate around this with some of the more leading people in the space sometime down the road.
But today I’m going to spend some time to share with you some of the key ideas that I look out for when trying to evaluate growth stocks. Welcome back!
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Good morning, everyone! I welcome you to another day with The Financial Coconut. In our podcast, we are debunking financial myths, discovering best financial practices and discussing financial strategies that fits our unique life. You get it, ultimately empowering us to create a life we love while managing our finances well.
I am Reggie, your host, and today we’re going to spend some time to talk about how do you evaluate growth stocks? There are a lot of things to talk about, but I’ve picked three pointers that I feel needs to be further expanded to empower you to pick your growth stock. At least… how do I put it? It may not actually grow, but at least be a little bit more cognizant of some of these things while you’re evaluating all these growth companies.
Okay, I need to reiterate… does not mean you listen to this three things and suddenly you can become like this super amazing growth stocks guy, pick up some of the best multibaggers in the next five years, okay? So… many things to learn and we’ve talked about different evaluation strategies around different companies. Looking at financials, we have a whole show around this: TFC Stock Geekout. Follow it if you have not. Like, share, subscribe, review. Drop us a review. Give us five star rating. Cannot paiseh (embarrassed). So do all that for us and help us rise the ranks in this fast growing podcast space.
There are many ways to evaluate growth stocks and I think a lot of people have developed their own way over time. Whether is it factor investing, whether is it… I dunno what else are out there, but there are many different ways and it is true that it is a little bit hard to evaluate growth stocks with just very traditional valuation models and a very traditional way of looking at things.
“This one too expensive, that one too expensive”… growth stocks are never cheap. They rarely come cheap. Only time when they’re cheap is maybe… it’s a very big question about whether can they survive. That’s the only time when they are cheap because people are pricing growth and the company is growing at what, 40, 50, 70%? And they can maybe, in next quarter, they can suddenly have a new product and then it adds per ticket up, per customer and then… “oh, there’s a new revenue stream.”
Some of these growth stocks are in this fast process of just expanding, expanding, expanding, expanding. It’s very hard to use the traditional way to model these companies. But that does not mean you shouldn’t model. You should still try to model them so that through this process of modeling their growth, you will question your assumptions.
Can a company keep growing at 50% every quarter? That’s what you got to ask yourself. Is the finances looking like they can stay intact in this fast growth environment? This one, you gotta ask yourself. Is the equity dilution sufficient to keep them growing? This one, you’ve got to ask yourself.
Some of these things are all things you need to price into your evaluation process, to evaluate this company on its future growth. But today, I’m not going to talk about all the things that we’ve talked about in the older episodes. We are hundreds of episodes in. I don’t know what I’ve talked about before already. I have forgotten a lot of these things, but they’re all recorded. All on record, please go and take a listen.
We are building playlists to help all you newer listeners to know these are the episodes to listen to if this is your particular goal. Soon, you will see these playlists and we’re hoping to work with different gyms, bowling alleys, what have you…. car-sharing company to plaster all these playlists all around so that while people are on their commute and doing that repetitive stuff, they could also enjoy TFC and welcome to our repertoire of content.
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But focus of today’s topic. So today’s topic, the first factor. Okay, enough ah. The first factor that I think you should focus on when trying to understand growth companies is total addressable market.
Total addressable market is something that is under discussed, underdeveloped. All these growth companies will tell you “our total addressable market is $1 trillion, $10 trillion, $500 billion”, what have you. Total addressable market essentially is the whole possible market that they can corner off or they can get. Why is this important? Because if you don’t know how big the market is, you don’t know how to price the growth and you don’t know how to realistically model, how much can it still grow.
Let’s say the total addressable market is $100 million. Let me give you a little bit more cute story, a little bit more colour. Say Geylang Serai market, right? Everybody goes to Geylang Serai market especially during the fasting times and before Hari Raya. It’s been a few years, I hope they come back soon. I hope this whole thing is… this whole Covid thing gets settled and then we can all have a little bit more festivity and what have you, but we will never go back to the old way of life. Already the new normal… I will cover some of these topics down the road.
But say this whole market every year, it has $100 million worth or transaction in the market itself. So everybody comes and buy and consume and buy all sorts of stuff and you are the keropok vendor. You are the makcik, you sell keropok. So then you… every year you sell $1 million worth of keropok. You come to me as an investor and you say “I want to raise money and grow my keropok business. I want to grow my keropok business” and I ask you “what is your total addressable market? You cannot tell it’s $100 million because it’s not the whole Geylang Serai market sell keropok. People don’t just come here to buy keropok.
Total addressable market is the interesting part. How the company tell you and how they define the addressable market is extremely important. If you want to be a better growth investor, you have to be able to see this total addressable market in multiple layers. This is already quite an established concept… I don’t know how many of you guys know but just go and search “total addressable market”. You will see this model where there are three circles: where total addressable market (TAM) is the outside and there are two more circles inside each other. The inner circle is serviceable available market and then the most inner circle is serviceable obtainable market. They give you a little bit more colour.
I’m going to use an example. Let’s say we try to understand WeWork’s business. WeWork, it’s a co-working space. So what is the total addressable market? You can say that a total addressable market is all the workspaces, right? Wherever people work, you think that this is the overall addressable market or they can come and tell you this is the overall addressable market. That one, we will talk about it later.
But assuming work spaces is the total addressable market, do you think WeWork can take every single space? A bit hard because there are many different permutations under work space. There’s the whole office, there’s the building, there’s the co-working space which they are playing in. There is the work from home kind of situation where you have that one table and one Mac, microphone, all that jazz. So there are different ways where people work. There are even work passes, cafes, all these different places.
You can define that as the total addressable market, yes, but what is WeWork’s serviceable available market (SAM)? It’s actually just co-working spaces. WeWork is not building work from home desk. They are not building full fledged office buildings. They are only doing the coworking space part.
While the possible total addressable market is work space… yeah, maybe eventually WeWork will expand into work from home setups, fight Razer… or it will buy out the whole offices and take over whole of downtown. I don’t know. Maybe one day that will happen, highly unlikely… so with that idea, you look at their serviceable available market that is co-working spaces only. It’s a smaller part of the total addressable market and then where are they?
They are even smaller within this scope in their serviceable obtainable market. In other words, can they dominate the whole co-working space network itself? Very hard, because they need capital. They need operation. They need to squeeze out everyone such that the cost of entry is so low that nobody wants to compete with them. So… highly unlikely. That tends to be a duopoly or oligopoly, a few major people that will dominate any market. But even then, the total addressable market sounds very big but how much can they really get… shrinks very fast when you go to a logical analysis of what’s going on and this is prevalent everywhere.
All your tech companies, they always tell you “our total addressable…”, like microchips. Intel come out and say and our total addressable market is this big, but actually do they produce three nanometer? Do they produce five nanometer? They don’t. They’re not in the space. Yes, the whole market is this big but they are not actually in the business.
So when you look at that, you break it down to what is their serviceable available market, that means the market they can actually be in and you break it down one more level to look at their serviceable attainable market, which means based on their current capital and their capacity, where are they and how much can they get?
This gives you the texture to see the whole business. Very important. Why am I telling you this? I’m telling you this because most of the founders, they are trying to run growth companies. They are visionaries. They have all these big dreams and big goals, but the practical idea is can you achieve it within your current situation? Do you have the cash to build up the supply chain? Are you actually in the business?
Back to the example of WeWork itself. If WeWork… next quarter or next, next year, they suddenly say, “oh, we are going to release a WeWork work from home desk setup”. Okay, then they have created a whole new supply chain and they are trying to take on a bigger part of this total addressable market under the WeWork brand. So then there is a strategy to attack the whole market, if not everything is a dream.
“Yeah, this is the overall market. Yes, yes, it’s very possible, but we are nowhere near, but we will tell you that is the total addressable market.” That’s the biggest problem that I have with a lot of people evaluating growth stocks. Most of your founders, most of your entrepreneurs, they come up, they will tell you a little bit bigger dream, they need to sell the dream. Their board tell them they need to sell a bigger dream. If not, nobody will invest.
But as an investor, you want to be more sophisticated. You’ve got to ask yourself. Yes, this is the whole market, but how much can you actually get now and how much can you get in the future? What is the changes into the business that you need to do to actually take on all these additional “addressable markets”?
So with this idea or more sophisticated idea of understanding total addressable market, please go and reevaluate all these other companies and all the people that are telling you “we are trying to do this. This is our overall addressable market.” Ask yourself: what do they need to get there? How much scale do they need to build up? Where are they now? Do they actually have a product for that or is it just “oh, potentially we can get there”?
I’m not saying that they will never get there but you have to observe that and be very aware of this idea so then you can factor that into the trajectory of the business and evaluate whether the management is being honest with you or are they like a little bit too fluffy and what is actually happening.
Yeah, don’t just take total addressable market as what it is. People tell you $10 billion, you take as $10 billion. Please do a little bit of thinking, break it down and you will become a lot better. If you want to learn a little bit more about it, please go and search “total addressable market”. It’s a very developed theory. Go and improve yourself, which brings me to point number two.
Point number two of being a better growth investor is you got to watch out for the stickiness of the margins and I’ll elaborate a little bit more after a word from our sponsor.
Okay, point number two: stickiness of margin or margin stickiness, however you wanna to put it. The idea here… why is it important to watch out for margin to be sticky? A lot of people say software companies are asset light. Asset light, high profit, high margin. You like it but let me add an additional theory in for you. If you think about it, all companies that have some dominant negotiation power, which means whatever that they’re producing, other people cannot produce. Whatever they are doing, other people cannot do, they all have very high margins.
So when they have very high margins, because they are not selling based on commodities. If I sell you a T-shirt, the other person also sell a T-shirt, it’s like we are all commodities or we are the same thing. But if a third person sell you a T-shirt with a particular brand that you cannot actually print and there’s a lot of protection against fakes then okay, that’s a different thing.
That’s why Nike can sell you expensive T-shirt. Adidas can sell you the… I saw someone on the train the other day, Adidas [indiscernible]. I was like “are you sponsored?” But anyway, that is a low level kind of margins essentially. Because of brand, they can charge a lot higher. They got pricing power.
A lot of people when they look at tech companies, because… okay, why point out tech companies? Because a lot of growth companies today are in tech. A lot of people when they look at tech companies, they always think tech companies very high margin, asset light. Very good for growth and what have you.
I’m going to put out a statement once again. I mean, I’ve talked about this in other shows. If you think about it, whatever that is considered high margin is asset light. There was probably a time when some of these semiconductors were considered asset light because relative to opening a warehouse or relative to opening a supermarket, they set up this supply chain of building microchips, buildings semicon stuff, the amount that they can make is so much more, so the margin is very high. They’re considered asset light. But when the margins start to shrink, then you think that “wah, very heavy to keep up this whole production and the margins are shrinking. Then you start to say that they’re asset heavy.
Same for software companies. Software companies today broadly are still considered very asset light because the margins are very high, but as a lot of these softwares become more and more commoditized, you’re seeing a lot of software companies able to do what other software companies also can do. Then you’re starting to see the margins shrink, right? As the margins shrink, you will say that this is asset heavy because the manpower asset that they need to service and keep up with to continue their business makes them very asset heavy relative to this whole new other sector… metaverse or genomics or what have you.
So instead of seeing a sector and saying that this one sector is asset light or asset heavy, I want you to recognize margins. If the margins are high relative to the cost of operation and cost of production, this is asset light essentially. When the margins are low, it’s considered asset heavy.
This is something that I think people should change their thinking a little bit. Why is this important as a prelude to the point of margin stickiness? Because in the early days of growth, in the early days of a company when you’re trying to evaluate growth companies, you tend to want to look for the unique guys that are best in class. Other people cannot do whatever they’re doing and they are growing very fast because the market wants it and they can charge very high margins.
With that, they have additional float because for every dollar, you have an 80% margin. Every dollar you charge, you make 80 cents. My goodness, you used 20 cents to make 80 cents and then you take the 80 cents, put back into your business growth and then you acquire more customer and then the 80 cents keep compounding. Wow, that is crazy. So high margins, fast growth. That’s the power of it and especially when the market is big, there’s adoption.
That’s why a lot of these companies, they fly and they have a period of time where they really fly. The numbers will grow like mad, but if they are in a business where… like software, it’s a very quick cycle. After a while, someone else will do the same thing. Maybe three years, five years, depending on what’s the cycle. Other people can compete. They can do the same thing already. This thing becomes less and less special. So… becomes less and less special, the margins start to shrink because other people can also sell the same thing.
If I’m the first guy that sell prata in London, I can charge you $5 for one piece of prata. I’m sure you guys have seen that before. You study overseas, you work overseas, you travel and… what the hell? Why is this chicken rice $15? Yes, because they’re the only one that sells in London. But after that, there’s 20, 30 chicken rice stall coming. It will commoditize. Prices will come down.
Same idea. Sell software also same. Not saying software guys and chicken rice guys same, but that’s the idea. Margins will shrink and as margins shrink, it will affect the growth of the business because before that, they were at 80%. They were growing like crazy because they have a lot of float and a lot of business coming in. But now got competitor. Competitor take your market share, reduce your revenue, still reduce your margin. My goodness, it’s a different situation now. Which is why when you are looking at growth companies, you have to make sure that their margins are sticky. That means if you are evaluating 80% or 70% margins, gross margin, then you want to make sure that it stays there, it stays consistent, at least it does not depreciate too fast.
If they start to throw in a lot of promo, discounts, trying to fight their competitor and the competitor prices keep coming down, they keep re-adjusting their prices, then you see the margin from 80% to become 60%, you got to reevaluate your whole model. At that point in time, you got to ask yourself: what is the next growth cycle? Can this growth company create a new product that their customers want and then make that their new growth engine?
Check out for margin stickiness. I think this is one of the great signs of evaluating growth companies. If the margins are held sticky, there tend to a little bit more runway to go. That means competitors are not in yet. But if the margins keep coming down, signal signal! Maybe the growth is not so crazy anymore. You got to ask the company what’s next for you. This is something that I always look out for in the margins: how strong are they held? That is point number two.
Which brings me to point number three and that is smart investor management. This is super, super, super important. A lot of investors, when they invest in growth companies, they always think “aiya, don’t keep diluting us.” Because every time the company wants to raise money… like recently, Sea Limited raises $6.3 billion in the market, some with debt, some with new equity. Every time when these growth companies, they sell equity, they’re raising cash and (when) they raise cash, they dilute you. You may not be putting in new money.
At first, there’s 1 million shares in this company. Then if they sell another 200,000, so now there’s 1.2 million shares in this company, bu you still own 10 shares. Overall, your fraction of the whole company shrinks. This is share dilution and a lot of people are very uncomfortable when they see these kind of companies keep selling more equity and raising more money and investors keep getting diluted.
I will actually agree with you if the company was relatively matured. If it is a very mature company already, then you don’t want them to dilute unless they have some big acquisition that they are trying to do. Let’s say Walmart wants to acquire Walgreens and then they’d be like “okay, we want to merge.” Highly unlikely…. anti-monopolistic.
But let’s say… what company? Okay, let’s think of something. Sheng Siong wants to acquire Deliveroo. I dunno why, but okay. Let’s say Sheng Siong wants to acquire Deliveroo to expand their delivery networks so that they can get direct to you. What do they do? They sell more equity of Sheng Siong shares to raise money to invest in Deliveroo. Okay, that one I think I can understand. There is a reason behind why they do that.
But if a company is relatively matured, you don’t really want them to liquidate you unless they have a big strategy going forward. When you are a growth investor, investing in a company that’s trying to grow and get market share and they need a lot of cash to grow, what is so wrong of them diluting you? Because they are trying to make more money and sometimes, the evaluation is a bit too wild. At that kind of valuation, multiples are like 80, 90, 100 PE (Price-to-earnings). What is wrong with diluting? Sell more lah because you are already highly priced. So you dilute, get more cash and then you can grow the market.
As an investor, you’ve got to ask yourself: is it about dilution or is it about what is the reason behind dilution? As they sell more shares and dilute you, how are they investing the money? If the top line growth is going at 30, 40, 50% revenue growth… it’s growing that fast. Margins are held constant, cost of management and cost of the whole operations is held aligned with the growth of revenue. That means, margins are not moving that much. If that’s the case and the dilution for shareholders is only at 10%, then what is so bad? You are diluting yourself at 10%, but the top line growth is at 50%.
The pie is way bigger now, so you need to be aware of this. You cannot just see as “the company keep diluting me. I don’t really like it. My portion keeps getting smaller. My PE ratios keep changing.” This is something that I think a lot of retail investors are not aware of and they don’t think like that.
So ask yourself when you invest in this growth company, which stage are they at? Are they really in a relatively mature stage or are they still in the early stage, what we call a land grab stage where they’re trying to get market share. They’re trying to grab land, which is why I am very irritated when Spotify announced the $1 billion buyback of shares. I was like what are you trying to do? Are you trying to buy your shares so that you can bring up the share price and meet your management goals? Why don’t you spend this $1 billion to expand your content so that you can win the land grab, fight Amazon, fight Google, fight Apple? What are you trying to do? Why you give back investors the $1 billion?
I sold my Spotify position because of that and I think this is (an) important thing for a lot of people to recognize. I sold some… I never sell everything, but I sold some. This is not advice, not recommendation. I’m just sharing you for context sake.
The right company must perform in the right way. Growth companies must focus on growth. They’re young, they’re here to grow, they’re here to develop and they should try their best to get good money and more money so that they can burn and grow. The problem is when they burn, when they spend the money to invest the money, but they don’t grow as much and that’s the problem.
So as an investor, you shouldn’t be too uncomfortable with them diluting you by selling more equity. You should be okay with that if their growth on the upside is even bigger than the dilution on the downside or if they have a very big strategy that they are trying to adopt and they need a lot of cash… let’s say buy out their competitor. What is wrong with buying out the competitor and they dilute you 20%? Hey, then there’s no more competitor. They consolidate the market, they can keep their margins and they have taken up a bigger pie of the total addressable market. So it’s not all a bad thing for dilution.
Be very aware of this. Ask yourself as an investor, what are they trying to do and is it okay for me to be diluted if let’s say they’re doing something that is going to help me grow a bigger company and grow a bigger pie? I think that will make you a better growth investor.
So I’m going to sum up today, the three pointers. Number one is to recognize that total addressable market has different textures. The whole market can be this big, but how much can the company actually get? Go and read up a little bit more about this. This gives you the context when you are listening to all these founders, listening to all this management trying to tell y’all “this is what we are trying to do. This is what we are trying to do. Our big market is this…” But really, you ask yourself: is this really the whole market that they can get or is this the dream that they can potentially get, and where are they? What do they need to get there?
Number two is the margin stickiness. You want to make sure that their margins, the gross margin, the business is held stable. You don’t want them to have shrinking margins. It’s not healthy for their business. It makes it very competitive. It’s also a sign that competitors are coming in and their service is getting extremely commoditized. Not a great sign for any growth company.
Number three is you want to see smart investor management. If the valuation of the company is very sky high, then the management should sell more shares. If the management wants to acquire a competitor, yeah, they should sell more shares. They shouldn’t buy back if let’s say they have a strategy to grow.
So as an investor, don’t just keep thinking that they’re diluting you and it’s very good for them to give you back money. No, you’re investing for growth and this company needs this money to grow and go through the land grab.
Work with these three factors and integrate them into whatever you have already done so far and I hope you become a better growth investor. I hope you learnt something useful today. See ya!
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Okay. So yeah, that is for growth stocks. Of course, it is a lot more factors, but these are some things that people don’t talk about as much and I think you, if you want to be really good growth investor, you have to recognize these things. So yes, any particular growth companies that you want us to talk about, come to our Telegram group, name drop them or email them. Let us know and then we can figure something out and get some people to comment on our TFC Stock Geekout.
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