Babies and bathwater

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Jason’s Random Words

A lot of companies went public in 2021, taking full advantage of a euphoric stock market and free money (near-zero interest rates) to raise billions of dollars in capital, to fund their growth ambitions and allow early investors to cash out.

We all know the story by now; by the spring of 2022, the markets were in a rout. High-flying tech IPOs and SPACs were crashing.

We’ve already seen more than a few of those fail, a few — 23andMe, Stem, amongst others — at risk of running out of cash, and plenty of others already get acquired.

There have also been a select few of the stocks that got caught up in the height of exuberance, like CrowdStrike, that have seen their shares surge even above their prior peaks, as the businesses just keep winning.

But for every CrowdStrike, you’ll have a handful of Zooms and Blocks (formerly Square) that are perfectly good businesses, but their stocks could take decades — if ever — to fully recover to those prior all-time highs.

I think one of the hardest things for investors to do is to separate the winning businesses out of this group that can still be winning stocks going forward. It’s very hard to see stocks that are down 40%, 50%, or even 80% from highs reached years ago and not automatically assume they’re losers. The proverbial throwing the baby out with the bathwater.

This is one of the biggest reasons why Jeff and I advocate for a business-focused and -led investing framework. The more you study and understand a company, its industry, and its competitors, the more likely you are to make better, more objective investment decisions.

I’ll use Confluent as a recent example. Regular listeners of our podcast know that I’m pretty bullish on the company, and have, at different times, had very high conviction on the stock. I’ve invested a lot of time to learn more about what it does, how it fits in the competitive landscape, and what the big-picture opportunity out there is.

I also know that it awarded $381 million worth of stock-based compensation over the past year, while earning $916 million in revenue. That’s right. Revenue! So the company is awarding over 30% of sales in stock awards. Considering the company earned just over $10 million in operating cash flow over the same period, it’s not likely we will see a share repurchase plan anytime soon…

I also know that it’s probably going to grow revenues from less than $200 million per year to over $1 billion per year, earns more than 80% gross margin, and has a cash flow profile that looks strikingly similar to Datadog back in 2020, and at a much cheaper valuation.

Now, I’m not saying Confluent is going to be the next Datadog or CrowdStrike — they’re up 230% and 330% since the beginning of 2020 — but I absolutely expect it will be a winner.

Of course, I may be wrong. But having the willingness to put in the work to find winning businesses in a sea of losing stocks can help you create real, meaningful wealth.

Jason