The Four Quadrants of Investability
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There are two things I think about when evaluating a potential investment. One is if/how the financials of the underlying business will change (the fundamentals). The second is if/how the valuation the company trades at will change. This allows me to classify an investment into four different quadrants, based on what I believe to be true about the company:Valuation re-rating to the downside No fundamental growthValuation re-rating to the upside No fundamental growthValuation re-rating to the downside Growth in FundamentalsValuation re-rating to the upside Growth in fundamentals
The top-left quadrant (decreasing fundamentals and valuation) is something to avoid at all costs. This can lead to a 50%+ drawdown and a potential wipeout of all capital invested. Why? Because if the market decides the company you are invested in deserves only half its current earnings multiple and the underlying earnings that multiple is based on are getting worse, a negative compounding effect can start to occur.
I believe Uber currently sits in this quadrant. Right now the market gives the company a multiple of 6.7x its trailing twelve-month sales (TTM). It also has shown it is quite a long way from profitability (it lost $1.1 billion on $3.1 billion in revenue) even though its food delivery business will never have a better market environment. Yes, ride-hailing is in a bad market environment, but once things get normalized won’t food delivery counteract the rebound for this segment?
I don’t want to bag on Uber forever because that is not what this post is about, but I think investors may be headed for a valuation re-rating of 2-3x sales and optimistically flat to high-single-digit revenue growth with no sign of operating leverage.
The top-right quadrant is a company that has no fundamental growth but could get a valuation re-rating to the upside. I believe there are sometimes investable companies within this category, but it is a lot riskier than strictly relying on the underlying growth of the business. Why? Because in this situation you are relying on what you think other investors will think about this business in the future. That is a difficult game to play.
A company I think belongs in this category is Altria Group. Investors have beaten down the stock because of the debt-fueled JUUL acquisition that was likely a gross overpay. However, this has brought the FCF multiple to single-digit or at best around 11. Investors in the company will likely do fine even without a valuation re-rating, but if the market decides this stable, high margin business with tons of pricing power deserves an earnings or sales multiple in the high teens’ shareholders will be rewarded.
This quadrant is where growth-style investors have to make difficult choices. When a company (especially today) trades at a nosebleed sales or earnings multiple, people aren’t holding shares because they think it will trade there in the future. No, they own shares because they believe the fundamental growth in the business will counteract any contraction in valuation.
Since this is what a ton of investors are contemplating today, I’ll go through an example of a company I think maybe investable and one I think will run into trouble.
First is Peloton, a company I think will have a valuation re-rating to the downside but could make up for it with strong fundamental growth. Right now it trades at an EV/sales of 12.5 (trailing), but with gross margins below 50%, it likely will trade no higher than an EV/sales of 5 at maturity. However, if the business can average high double-digit sales growth and achieve some form of operating leverage over the next five years, any contraction in valuation could be counteracted by 5x’ing its sales.
An example of a company I think will continue growing but will be a bad investment simply on valuation is Shopify. It’s TTM EV/sales is 42 with gross margins only at 52% (based on last quarter’s results), leading me to think that the company will get a 5x sales multiple at scale unless it can expand its gross margins by a wide amount (20% FCF margin at 5x sales is an EV/FCF of 25, which a quality company like Shopify deserves at maturity). The company is close to triple-digit sales growth, but can it really grow so much to counteract an eventual steep decline in what the market deems a fair valuation? I have my doubts, but have been proven wrong on this one in the past.
The last quadrant is the sweet spot, and where a lot of potential upside can be found. These are companies that are seeing growth in the underlying business but also could get a positive valuation re-rating at scale. As you might expect, stocks in this category are few and far between. However, I think I have a current example of this with Stitch Fix.
Stitch Fix regularly achieves 44%+ gross margins, has consistent mid-teens sales growth (outside of a few COVID-effected quarters), and only trades at an EV/sales of 2.2. Yes, marketing spend as a % of sales has come up, which may cap long-term cash flow margins, but if the company can get to 15% FCF margins at scale it could easily get a sales multiple of 3.5 to 4 because of the quasi-recurring nature of its revenue. If this happens, investors in Stitch Fix not only will get returns from fundamental growth but from the multiple the market attaches to it.
Remember, this is only a framework
Just because a company is in one of the quadrants now doesn’t mean it will stay there forever. There are also many examples of companies that may sit on the border of two, with investors not really sure what will happen to the business or what multiple the market will assign to it in the future. All this exercise does is help me understand in simple terms why I’m investing in a company and what the downside could be if that thesis is incorrect.
Disclosure: The author is not a financial advisor, and may have an interest in the companies discussed.