What do you mean by quality?
The first time I was asked this I didn’t really know what to say, it seemed so obvious. You know it when you see it!
But you can learn a lot trying to pin down a common phrase like this, so we gave it a lot of thought. ‘Quality’ is often ascribed to a long list of factors, like diversity of customer base, recurring revenue, balance sheet strength, cash flow generation, scale, perhaps some discussion of Porter’s 5 forces, and so on.
Sometimes these translate into a high-returning investment, but sometimes they certainly do not. Many of the highest returning investments don’t display any of these.
The answer that has proven most helpful to us when defining investment quality, and is core to our investment process, is whether the customers truly love the product.
Through this lens a multitude of perplexing equity market behaviour starts to make sense, including why companies like Tesla and Afterpay have posted such astonishing performance, against the expectations of the professional investor community.
We owned Tesla many years ago from $80 to $200, and wrote about why, and an early version of this quality argument in 2015.
The clue was in the quality: that customer love. For years, Tesla sold every car they could make. Even now, the equity value lies in their ability to drive demand for their current and future products. Other companies may be more efficient at manufacturing, but those are limited by their ability to sell. Other ‘high quality’ car companies (by our definition) like Ferrari have performed extraordinarily well, those with well-known brands, but no real love, have not.
Apple, which we first bought in 2011, also fits this answer nicely. Customers were willing to camp outside for days for the chance to buy new Apple product. Until recently, the stock traded at a steep discount to the market, but there has never been any doubt over the loyalty of the apple fanbase or their willingness to pay up for what they love.
For another example, compare Afterpay to the countless financial start-ups that have tried their hand in this country and elsewhere. It’s hard to think of another financial firm that generated so much customer support.
This lens of customer love seems to give all the right answers to some of our other questions, and they’re often very different to those given by traditional equity analysis. We’d guess this is because customer love gives insight into future customer behaviour, independent of whatever happened last quarter.
Once you start thinking about it, you see this concept everywhere. Bitcoin, one of the best investment of our generation? Users raved about it, obsessed about it, quit their jobs to learn, develop and build on it, all while the price was confusing practically everyone.
In our portfolio the biggest advocates of Shopify, Carvana, Pinduoduo, Afterpay, Alteryx and MongoDB are the firms’ very own users.
This expresses itself in software developer conferences, where hundreds of developers improve the platform in an orgy of free R&D. You don’t need unique insight into the customer hive mind: the evidence is right there in the rate of customer acquisition and customer loyalty.
The best part is that there are many ways to track loyalty and customer acquisition, so you can constantly test your hypothesis against new data.
There’s an important component of this in the life sciences too: many drugs pass all the tribulations associated with regulatory approval, only to fail at the commercial stage. There is a perfect storm brewing in CART and CRISPR right now, as multiple companies are developing treatments to sickle cell disease, beta-thalassemia and leukemia.
Having ventured this idea to a few friends, Uber came up twice as a counter-example. Isn’t that widely loved and also a market laggard right now?
Firstly, it was an incredible investment when customer love was high, one of the greatest VC investments ever. I’d hazard that Uber’s value has tracked it’s customer support quite closely.
Secondly, this also applies to the second part of Uber’s business, the drivers. Again there was immense driver support for Uber for many years, but it’s fair to say much of that has now dissipated. The company was careless with customers, proved willing to make enemies left right and center, and priced itself in a way to ruin the goodwill of its drivers.
Uber now may need to raise prices twice: first to move to profitability, and second to lift their drivers’ earnings. Good CEOs constantly talk about the customer. Uber has squandered much of that initial customer love.
Why do such ‘quality’ companies outperform?
In short, we believe the fundamental challenge of every business is finding customers and generating revenue. If the customers are there, everything else, from finance to operations, can follow.
The factors driving equity returns lie largely in the future. The enthusiasm of users, customers and clients today is the best guide to what the company might look like in a few years time.
For our next investments, we’re going to be looking for the kind of company that customers love so much they’re willing to camp on a street. Every investment we make is going to offer convincing numerical proof of a positive answer to this question: Do customers truly love the product? If so, we love the company.