Finding My Hook
The "Crux of the Biscuit" of the investment
During my years as a financial advisor, I built financial plans for clients. These covered areas such as college funding, second homes and retirement planning, among others. Financial plans are sometimes complicated beasts. Even if you start from relatively simple principals, when you consider 401ks, IRAs, 529 plans, insurance, investment strategies, etc., etc., etc. it can get complicated quickly. I always tried to find a “hook” in the plan for clients. This is some part of the strategy or plan that drove much of the long-term results. I tried to make it simple, like: “For the next three years, your focus should be to increase your contribution to your 401k until you reach the limit”. A simple statement that they could rally around to make sure they were taking the right actions.
This concept has spilled over into my investing life. When I am looking at a company, I am often looking for a hook, or the “Crux of the Biscuit” for the investment case. Finding the hook is my moment of clarity for an investment. Sometimes it happens quickly, more often I find it after a period of relatively detailed analysis. I have reached a point that if I don’t find my hook, I often give up. It means investment is either too complicated for me to understand, or outside my realm of experience.
By way of example, I will look at Spotify. It’s a well-known company, and most people will understand the basics of what they do. After only a bit of research, the bear case for Spotify becomes clear. I will summarize it like this:
“It’s the gross margins, you idiot. Spotify’s margins are structurally challenged and will not be able to improve. Every song they play, most of the revenue goes to the labels as royalties." - me
This is no great insight. Almost every investment case you read about Spotify leads with this as the challenge. As I spent more time reading about it, the more interesting the company became. You see, Spotify is something of an odd duck. It is a “tech” company in the SaaS (Software-as-a-Service) space. Investors in this type of software space are frequently enamored by the gross margins of the companies. Gross margins can be 60% for average SaaS companies and 80%+ for great ones. Spotify’s gross margins are somewhere in the mid 20% range. That is not something that the investors in this space particularly like. Normal metrics like “monthly average users” (MAUs) aren’t as meaningful. And at these margin rates, dramatic increases in users does not necessarily drop heaps of cash to the bottom line. None of this is lost on Spotify, of course, if pajama-clad researchers like me can see this, you can be assured that the management of the company know it. Indeed, most of their strategic initiatives such as podcasting and advertising are targeted at adding high margin revenue streams to the mix. As a result, over time, my hook started to become something more like:
“It’s the gross margins. Spotify’s margins are currently structurally challenged. Over time, the investment success will rely on driving improvement in this area.” - Also me
It may not seem like much of a difference, but it helps cut through the noise. Now when I look at their results, I’m much less focused on traditional SaaS like metrics, and much more interested in other initiatives they are working on that are targeted at margins. Incidentally, since a lot of these are more recent initiatives, the results don’t really show in their financials (yet) but should become apparent over time. As a result, it is important to listen to their investor calls (or read the transcripts) to understand what they are doing to impact margin. I don’t think I would identify it just by looking at their financials.
I’m not sharing this because Spotify is or is not a good investment. I’m sharing it to illustrate the thought process that I go through to reach my “hook”. (Full disclosure: I own shares in Spotify as of this writing. I may sell it at any time. This is not investment advice. Please do you own due diligence.) For me, trying to distill things to a hook really helps me cut through the inevitable noise as I monitor my investment over the years.