Saul Rosenthal’s Knowledgebase compilation

This is a compilation of Saul Rosenthal’s insights, interviews and his own investing style approach.

(not final)

The main topics in this Knowledgebase are divided into:

My Historical Results

My General Approach and Philosophy

Evaluating a Company

Portfolio Management

Adjusted vs GAAP Earnings

What is My Buying Policy?

What is My Selling Policy?

Calculating Portfolio Returns

Dips and Downturns

On Insider Trading

Thoughts on IPOs and Secondaries

Investing Ethically

Graphing

Professionally Managed Money

Teaching Investing to Kids

Investment Primer

How to Post in Italics, Bold, and Make Tables

## My Historical Results

I started keeping track of my results yearly in 1989 because my wife and I had a baby and I wanted to retire in about 7 years (I did). My wife panicked (“You can’t retire! We have a new baby!”) so I decided I had to get serious about investing. In Jan 1993, I increased my record keeping and started keeping track of my results weekly, and not just annually, as I had done before.

You should know that my wife and I and my family have been living off what I make in the stock market since I retired in mid-1996. That’s 23 years! I have no pension or other source of income except Social Security.

From 1989 to 2007 inclusive I averaged about 32% per year compounded. This produced a rather amazing overall multiplication of my total portfolio, In fact, if you sit down with your calculator and multiply 1 by 1.32 (since I averaged a 32% gain) 19 times, you’ll be amazed too. (It’s the power of compounding). You’ll note that this was not a large multi-bagger on one stock, but on my entire portfolio, the whole works!

I lived through the Internet bubble of 1999–2000. I sold out of Amazon, Yahoo, and AOL one day in January or February of 2000, after Yahoo, as I remember, had gone up something like $30 to $50 per day for three days in a row. I said to my wife, “They may keep going up, but this is insane. I’ll let someone else have the rest of the ride.” The bubble broke about 3 weeks later. Sometimes selling can be the most important thing you can do. I didn’t get out of the market. I just bought non-internet stocks and was up 19% for the year. Sure I could have held through the decline, and 10 years later Amazon came back, even if Yahoo and AOL never did, but why???

I got killed in 2008 like everyone else. Probably worse than someone who was in defensive stocks. It was my first negative year after 19 positive years in a row. I stayed 100% in stocks, selling anything which hadn’t gone down much to buy more of the ones that were down the most.

Finally, I was down so much that even I got scared and started to think of selling out and going into cash. All the talking heads were saying, “Sell! Sell! Sell! Get out! Get 100% in cash!”

I said to my wife, “If everyone is shouting ‘Sell!’ and even I am scared enough to be thinking about selling, there’s no one else left to sell… This must be the bottom.” And it was (Nov 2008).

In 2008, in the big meltdown, I dropped 62.5%, which was pretty terrifying. In 2009 I was up 110.7%. The way percentages work though, after dropping 62.5%, gaining even 110.7% doesn’t get you back to where you started, but I sure felt better.

My Annual Results since 1993:

You’ll note that 32% a year compounded doesn’t mean you make roughly 32% every year. Below you’ll find a list of the gains of my entire portfolio starting in 1993. Numbers are percent gain. In other words, 21.4% means every $100 turned into $121.40, and 115.5% means every $100 turned into $215.50.

Two enormous years in 1999 (Internet Bubble) and 2003, when my portfolio was still fairly small, sure helped out.

**1993:   21.4%
**1994:   15.4%
**1995:   43.4%
**1996:   29.4%
**1997:   17.4%
**1998:    4.9%
**1999:  115.5%
**2000:   19.4%
**2001:   46.9%
**2002:   19.7%
**2003:  124.5%
**2004:   16.7%
**2005:   15.6%
**2006:    8.6%
**2007:   22.5%
**2008:  –62.5%
**2009:  110.7%
**2010:    0.3%

At this point I have a little reminiscence: I remember in 2010 there was a lot of talk in the media about the “Lost Decade” for the stock market, which apparently had finished roughly unchanged after 10 years. I was up 570% in those same 10 years of market stagnation, in spite of 2008, so I was wondering what they were talking about.

**2011:  –14.5%
**2012:   23.0%
**2013:   51.0% 
**2014:   –9.8% 
**2015:   16.0%
**2016:    2.5%
**2017:   84.2%
**2018:   71.4%
**2019:	  28.4% 
**2020:  233.3%
**2021    39.6%
**2022   -68.4%

We are talking 34 years from 1989 to 2022 inclusive, and that’s a lot of time for compounding to accumulate. As of the end of 2022, I had a 1745-bagger on my entire portfolio (even after subtracting the horrible 2022 losses).

A number of people were very skeptical when I first said I had made 30% per year in ordinary markets. Some even implied that I must be lying, that even Warren Buffet couldn’t do it. (But he was investing billions of dollars, like piloting a battleship instead of a speedboat. He had to buy whole companies, for God’s sake!).

Well, 2018, for example, was a slightly down market. The S&P was down 6.6%, and the Russell 2000 Small Cap Index was down 12.5%, but my portfolio was up 71.4%. Others on this board, following the principles that we discuss, were up even more. And it wasn’t magic. I’ve been transparent and given all my positions and their relative size each month, and basically told exactly what I was doing. You’ve followed along with me. It’s real. It takes some work, but you can do it too. I know there will be pullbacks and I will end other years with more or less gains than this year, but it can be done!

Stock picking does work (obviously). Especially if you are lucky, as I must have been. Some people say you can’t beat the market in the long run. They are wrong.

Please note: I wrote in the 2015 edition of the KB that it’s a lot harder to make great returns as the amount you are managing gets larger. I explained that I can no longer get in and out of a stock position on a dime as I could when my portfolio was a tiny fraction of the size it is now. I just can’t be as nimble as I was, and I said that I’ll be very happy now if I can average 22% growth per year instead of 32%.

Well, in the seven years of 2016 through 2022 inclusive, since I wrote that, I grew to 611% of what I started with. I compounded at just under 30% even with the horrible 2022. Again, I really don’t think that is a realistic expectation going forward.

## My General Approach and Philosophy

Most of my stocks start with a recommendation and write-up by someone I have a lot of confidence in. This could be someone on the board, Bert, The Motley Fool, or more rarely a write-up by someone else on Seeking Alpha.

I want rapid revenue growth. My ideas about that have become inflated in the last couple of years and where I once might have looked for 20% to 25% as very fast growth, I’m now looking for 40% growth, and sometimes more.

I look for a stock in a special niche, with something special about it. I guess this could be considered a moat. It also could be considered a potentially big future. I want a company that does something special, a rule breaker, not a company that just makes a commodity product well.

I look for recurrent revenue. I want my company to have last year’s revenue repeating this year and building from there, and not a company that has to go out and grow by selling the whole thing over again. God, this is important! It usually means software and a SaaS model, and NOT selling things. You just can’t keep growing at 40% selling things. And when an economic slowdown hits, people will put off buying a new car, or a new house, but companies won’t tear out the software that keeps their company going. The software also usually means not capital intensive, and it also means high gross margins.

I really want high gross margins.

I look for rapidly improving metrics like rapidly dropping losses as a percent of revenue or increasing profits if they are already profitable, increasing gross margins, rapid customer acquisition, improving cash flow, dropping operating expenses as a percent of revenue, etc. If some metrics aren’t improving (S&M as a proportion of revenue, etc), because management says they are taking advantage of a greenfield opportunity to gobble up all the recurring revenue customers they can while the getting is good, I generally approve but want to see those revenues really growing.

I want a dollar-based retention rate of over 110%. I look for one over 120%, and I’m impressed by one over 130%. A high Net Promoter Score is nice too, but there’s no easy way to get that information.

I look for positive and growing Free Cash Flow (FCF). If the company isn’t there yet I’d want to see progress in that direction.

It’s been a long time since I’ve been in a company that didn’t have a lot of cash and little or no debt.

Almost all of my companies are founder-led, but I think that’s mostly because they haven’t been around for generations. I look for substantial insider ownership. I want the company executives to have the same interest as I do in the stock price rising.

I don’t want the company to have huge customer concentrations (top three companies making up 30%-40% of revenue). But I don’t seem to have to look for those features, they just come with the territory.

I constantly monitor these factors and I exit if they seem to have changed for the worse, or if I think I made a mistake in the first place, or if I’ve lost confidence, or if there are new facts.

I don’t sell out of a stock because the stock price has gone up. Ever. That’s not a sufficient reason to me, no matter what it does to the EV/S. If my position has become too big I’ll trim my position around the edges…

When I first started out I didn’t mind concentrating your investments in four or five companies. However, when you are retired, and you are investing for a livelihood, and you don’t have any other income to replace potential losses, it’s safer not to let any position get too big. You should rarely, if ever, let a position grow bigger than about 15%, and even that is usually way too much. I’ve been breaking that rule lately and letting positions grow to 20% or 21%.

I usually start with a small position and let it grow. Sometimes, I add to a position while it’s growing. I almost never start with an oversized position. I usually don’t buy a full position all at once, or sell all at once, but I taper in and taper out, unless I have a good reason to get out in a hurry. (Although when I had a smaller portfolio I sometimes would buy or sell an entire position at one time).

You can’t really keep track of more than 20 or so stocks, and that’s an absolute outer limit. I greatly prefer a much smaller number of stocks, as they are easier to keep track of. You need to read all the quarterly reports, and the transcripts of all the quarterly conference calls, which gives you a busy earning season. They often say a lot more on the conference calls than in the earnings press release. Reading the transcripts works much better than listening to recordings as it takes a quarter of the time, and you can skip the forward-looking statements messages, etc. Look at investor presentations too. And get a news-feed from your broker on each of your stocks.

You can beat any mutual fund over the long run. You can’t tell much from a mutual fund’s results because you are always buying last year’s results. For example, if it’s a oil company fund, and last year oil stocks were in, it will show great results, but this year it could do terribly. Also, you are always buying the results the fund had when it was much smaller and nimbler than it is now, because those good results they had when they were tiny made people pour money in.

I pay no attention to 2-baggers, 5-baggers, 10-baggers, etc, in individual stocks, nor do I count them in considering investments. This is relevant because this way it never crosses my mind to think anything like “This stock is slowing down, but it’s a 9-bagger. Maybe I should hold it for another year to try for another 10-bagger.” Going from a 9-bagger to a 10-bagger is only an 11% gain. If I’m no longer in love with the stock, I should be able to put the money into a new stock that will be up 30% in a year, and it will never even cross my mind that I missed having a 10-bagger. Here’s another way to think about it: If you have an 80-bagger on a stock that grows to an 85-bagger it sounds exciting, but it’s only a 6% gain on your money. If you take the same money and put it into a new stock where you just get a tiny little 2-bagger, you’ve made a 100% gain on the same money. Which is why I don’t pay attention to trying to get multiple baggers. If they happen, fine, but it’s not my focus.

If you were to put a small amount of money in every stock listed on the market, you would eventually pick up every 10-bagger, even every 100-bagger, that occurred. You’d be able to brag “I have fifty 10-baggers now, and three 100-baggers!” But so what? You’d just be doing as well as the markets as a whole, by definition, as you’d be investing in the whole market. My goal, and my entire focus, is increasing the value of my entire portfolio. As I pointed out above, having a multi bagger on my whole portfolio is what counts, not on individual stocks.

Not accepting that an investment could be a mistake as it continues to go down is a dangerous error, and could be very expensive. A big problem investors have is getting attached to their previous decisions and not being willing to consider that they may have made a mistake. Some of the most angry I’ve seen people get on these boards is if you criticize a stock that they’ve fallen in love with.

I try to always pay attention to criticism of a stock, to reevaluate my investments, and to get out if it turns out that I’ve made a mistake, or if the situation has changed. Which is why I rarely end up holding stocks for 5 or 10 years.

Sometimes changing your mind in the face of new evidence, and selling when necessary, is the most important thing you can do. If you are wrong, you can always buy back in. I think that being willing to change my mind in the face of new evidence is one of the most important skills I have. And learning that it’s okay to change your mind when appropriate is one of the most important things I try to teach on this board. Let me remind you that I sometimes make mistakes getting into a company (big mistakes, on occasion), but that I am willing to consider the possibility that I was wrong, and change my mind when I see that I actually was wrong. And that that is very important. Although I realize that I make mistakes, I don’t regret my decisions. I figure I did the best I could at the time. And sometimes I make mistakes getting out too. So what! I can’t be right all the time.

I buy no bonds of any type.

I don’t invest in options. They are too much distraction for too little gain. Also they are a “zero-sum game”. That means if you sell an option, whatever you gain, the person who bought the option loses. Exactly the same amount. And vice versa. There is no total value creation. And you are competing against professionals!

I’m usually nearly 100% in stocks, and only rarely and briefly as much as 3% in cash. I have a couple of small accounts in which I can buy on margin, but my amount of margin is rarely as much as 2% or 3% of my total portfolio.

I don’t invest in futures. I tried them when I was younger and saw a bunch of money disappear overnight. They are also zero-sum games and you are again competing against experts.

Dividends aren’t a big part of my investing. In general, I treat dividends, if I get them, as just fungible dollars. They just get mixed in with whatever cash I have in the account and I don’t think of them as “income,” as opposed to “capital gains.” If I’m withdrawing some cash to live on, I don’t in any way separate out the dollars that came from dividends. This is just the way I do it, and it seems the simplest to me.

Trading in and out is self-destructive. You remember the trades where you made a few dollars and it encourages you, but you forget the losses. Never take a position to make a few percent. You should be investing in stocks that you can see at least tripling.

I always buy with the idea of holding indefinitely, never with the idea of a short holding period, but in practice I guess my average holding period is six months to three years. I sell when I’ve fallen out of love with the company or I think the story has changed, or I think that the price has gotten way out of line.

Never miss getting into a stock because you are waiting to buy it a few cents cheaper. The decision is whether you want to invest in it or not. Once you decide, take a starter position, at least. Don’t wait around for a slightly better price. When it’s at $110, I can guarantee that you won’t remember or care whether you paid $20.10 or $20.30, but you’ll be kicking yourself if you didn’t get in. The issue is: Do you want to buy the stock? If the answer is yes, don’t fool around trying to buy it a bit cheaper. You are buying with a long-term perspective.

**I assume that any good stock I might want to buy probably traded at a lower price some time before I found out about it…**Duh… But so what? I can’t go back and buy it in the past. What I care about is whether the stock is a good buy now. I see too many people who are “waiting” for a price to go back to where it had been, for a lower price, a better buy in point, or whatever. They may get it and save a $1 or $2, or they may miss getting in, and miss a $50 eventual rise in the stock. Don’t try to wait for the price to go down before getting into a stock. Geez, you are getting into it in the first place because you think the price will go up, not down. If you like it and are convinced, at least take a starter position now.

I definitely don’t sell winners just because they have risen in price (not as a policy, anyway). I only sell if I have a specific reason.

Sometimes you have to sell. You can adopt the MF mantra that if you just hold on it will come back in time, and maybe it will. But I hope to employ that money in much more profitable ways than watching a stock go down and then hoping it will start to come back. It you sell it five years later because it never came back (as they occasionally do), you not only suffered the loss, but you suffered the opportunity loss as well. That money could have been making a profit for you in another company’s stock during those five years.

I’m in no way a trader. I never, ever, ever, EVER, buy a stock thinking I’ll try to sell it in a week or a few days for a small profit. I always buy for the long term, but sometimes decide I’ve made a mistake, and just sell it. And I don’t worry about whether I made an error in selling. I worry about what I’m going to buy with the money. (I sometimes even buy back something I’ve previously sold. I’ve bought a stock that was an error both times, and I got out both times).

I usually pay little attention to what the indexes are doing as my goal is to average between 20% and 30% per year, and it’s an internal goal. If the market was down 15%, I wouldn’t feel I did well because I was “only” down 10% and I “beat the market”. It’s not a game. I need to make money at this as my family and I live off what I make. Because the MF compares to the S&P, I’ve also compared my results to the S&P for comparison since I started this board, and more recently added four additional indexes to give a more complete view of the market.

You can beat any index over the long run, in spite of what you may hear.

You don’t have to be right about the stocks you sell, just the ones you hold in your portfolio. It simply doesn’t matter what happens to a stock after you sell it. The only thing that matters is what happens to the stocks that you are holding. Think about that!

If you sell 10 stocks over time because you have legitimate questions about them, and you were “wrong” about some of them (they eventually do all right and move up), so what? As long as you put the money in stocks that you are happy with, that’s what counts!

There’s no such thing as “I was so far down I couldn’t sell”. The stock price has no memory of the price you bought it at. It’s at the price it’s at. That’s the reality of now. The question about any stock is “What decision should I make about it now, at its current price and its current prospects?” Not, “What price did I pay for it?” unless you are planning for tax losses or gains. Price anchoring is a big mistake.

Forget the price you bought something at. It’s at the price it’s at now. If you think you should sell it, say to yourself “I’m fed up with this stock and I no longer like its prospects. Where else can I put the same money where it will do better?” That takes a lot of the emotion out of the decision.

In making a decision to sell, it doesn’t matter now what price you bought it at. What matters is what you think it will do from here! If you suspect that it may be down for several years, or even down for good, don’t focus on what you paid for it. You can’t make it go back in time to where you bought it. I’d suggest you put the money into something better.

It’s not logic, it’s common sense. For example: I originally bought some ABC as high as $21 and $22 (as well as some around $17 and $18), but when I decided to get out and put my money elsewhere because it wasn’t panning out, it never even occurred to me, and I mean that honestly, it never even occurred to me, to wait until it got back to $22 so I could break even on those shares. I sold at an average price of about $17.50 by the way. (It was at $14.48 when I wrote this entry to the Knowledgebase).

Another example that I’ve used before: Early in the 3D printing craze I bought some DEF at about $15.30 I think. That was the price it was selling at. I never considered trying to wait to get it 25 cents cheaper or even a dollar cheaper. Later that same year it got to $190 for about a 12-bagger in less than a year. Do you think I remembered, or cared, whether I spent $15.10 or $15.40 per share?

I added to my GHI even though it had run up considerably from my initial purchases. I had initially bought at $27, but I added a lot more at $47. Should I have hesitated because it had been cheaper a few months ago? Should I have berated myself because I didn’t buy more then? And maybe decided to wait and see if it would sell off so I could get some cheap? No way! I bought it at the price it was available at. I eventually sold out two years later at $144.

When I first bought JKL at $38 and $40, it had been as low as $25 just seven months before. So what could I do about that??? I wasn’t even aware the company existed seven months before! I bought it when I found out about it because I thought it was a buy then. Now, none of that is “logic.” It’s just common sense as I see it.

The MF has a lot of propaganda about how you should almost never sell. However, if you make a well thought-out decision to sell several stocks for what you perceive to be good reasons, and then make an equally well thought-out decision to buy several replacement stocks for what you also perceive to be good reasons, it’s simply not plausible, and it’s even silly, to assert that you will not end up better off. It would imply that your judgment in picking stocks is just terrible. If you look at two stocks and say to yourself “This one is a Sell and that one is a Buy,” don’t you think that on average the ones you think are buys will do better? I’d bet a bundle that, on average, the ones you figure are buys will do better than the ones you figure are sells! If not, why are you bothering to evaluate stocks at all?

Why hold on to your failed positions? They have little going for them except that you are already in them. I doubt you would dream of buying most of them now if you didn’t already have a position in them. I just don’t think you should hold on to a poorly functioning company on the basis that it might transform itself into something successful some years from now.

I’m not saying my replacement stocks always do better than the stocks that I’ve sold. What I’m saying is that I do my best and use my judgment, and over time I expect that companies I think are going to do well will, on average, do better than companies I think will do poorly. (If not, I should just put it all in an index fund.) If I sell a particular stock and it then outperforms my replacement stock over the next quarter, so what? I’m not perfect. I’m just trying to do a good job. That’s how I think about it anyway.

To simplify, the Gardners’ point of view is that if you buy the same amount of 19 stocks and 18 do terribly but one is a 20-bagger, the one that is a 20-bagger will make up for all the losses. Therefore you should never sell your losers. That works in theory, and on paper, but in the real world, if it’s a portfolio with your money in it, it doesn’t work at all. That’s a pretty radical thing to say, so I’ll make clear why it is so.

First of all, if you don’t sell any of the successful stock on its way to becoming a 20-bagger, it soon becomes 70% or 80% or 90% of your entire portfolio, as the losers shrink. Now you have a portfolio with 19 stocks but one is 70% or more of the entire portfolio. You are not going to sleep nights with one stock at 70% or more of your portfolio. Not with your real money in the portfolio. Remember, this stock doesn’t have a sign on it saying it will end up as a 20-bagger. It’s just a stock and all you know about it is that it’s 70% of your portfolio and bouncing up and down. You will probably sell some of it at varying points all the way up, keeping it at a maximum of 20% or 25% of your portfolio, or maybe less. And the rising stock will thus never balance all the losers.

Add this to the fact that the ones that go down keep sopping up more and more percent of the total investment as you “double down,” “reduce my average cost,” “buy at better value points,” and generally put in more and more money in at lower and lower prices. For example, on the WPRT board, which used to be a MF favorite, when the price dropped from $32 to $25 lots of people felt it was a bargain, and bought more, and at $20 “doubled down”, and “doubled down” a second time at $15, etc. It’s hard for people to see a stock they believe in go down to what they think are ridiculous levels without buying more (it’s at $2.60 as I write in Jan 2020), especially if it’s misleadingly still labeled a “Buy.” People see this “Buy” that is down to half what they paid for it. Of course they will sell some of a winner that is making them nervous to buy more of the “bargain” stock.

Unfortunately, if you had 18 stocks that went to zero and one that was a 20-bagger, you probably would have ended up putting much more into each of the ones going down than into the one that went up, AND you would have sold a lot of the one going up on the way. It’s natural. I’ve done it myself but try hard not to do it any more. Which is why the MF hypothesis doesn’t work in real life. It’s the difference between a series of recommendations and a real-life, real-money portfolio.

If the market was efficient no stock would ever go up or down 30% in a week (it would have been already accounted for), and you’d never be able to make a 10-bagger. Fortunately for us, the market is often very wrong about a stock (either too high or too low at times).

On the Estimates Game. I exaggerate a little for the clarity of the message, but what I am saying is essentially all true. I hope you find these ideas useful:

The earnings and revenues estimate game that the analysts play has put the company CFO’s, who give the outlooks, in a no-win situation. Here’s how it has come to work over time: It doesn’t seem to make any difference how good or bad the actual results are, whether they are up 3%, or 30%, or 70%, or more. The only thing that the headlines pick up is whether the earnings beat or missed analysts’ estimates. (Who cares???)

For example, a company whose earnings are up just 3%, but beats estimates by a nickel, will get screaming headlines. The headlines won’t say “ABC earnings only up 3%!” No, the headlines will say “ABC beats estimates!” The price will undoubtedly rise.

On the other hand, a company whose earnings are up 70%, but misses estimates by three cents, will get equally screaming headlines, not saying “DEF earnings up an amazing 70%”, but saying “DEF misses estimates!!!” The price will undoubtedly fall.

The whole estimates game is only about whether the earnings and revenue beat or miss a number that some analysts have picked. It totally ignores the question of how well the company is actually doing, and how good (or bad) the revenues and earnings really are.

However, the companies aren’t stupid. They have figured this out. And they have started to give lower and lower estimates for their next quarter, picking numbers that they are almost certain to beat (by a lot). They don’t want the bad publicity of missing analyst estimates. (Again, who cares!!!)

So what happens? The companies give low estimates and the analysts say “Good earnings, but disappointing estimates for the next quarter. We’re downgrading them from a buy to a hold.”

Thus the companies are screwed whatever they do. If they estimate high, where they think they will be, and miss, they get the “missed estimates” headlines, and if they estimate low, to let themselves beat estimates handily, they get the “disappointing estimates” headline. They lose either way.

How do we as investors deal with this puzzle? Think “How is this company doing? How much are earnings and revenues actually up?” What matters to me is that the company is growing revenue at 50%, and if the company sells off because of a “revenue miss” (which is a ridiculous term for a company increasing revenue by 50% if you think about it), I might take advantage of it by adding to my position.

I base my purchase decisions on how well the company is doing, and my evaluation of how it will do in the future, and how well its price matches its prospects, rather than whether the company came in two cents above, or two cents below, what the analysts predicted.

Evaluating company results against consensus analyst estimates can produce perverse and peculiar results. Consider this hypothetical: A small stock with three analysts following it has an average estimate of 50 cents for the quarter. Another “analyst” representing a firm that is secretly short the stock, puts in an estimate of 82 cents. This raises the “average estimate” to 58 cents. By raising the estimate he sets the company up to “miss” estimates. After all, it doesn’t matter what the actual results are, just whether they met expectations. Right???

Sure enough, if the company makes 53 cents, what would have been a nice beat becomes a 5 cent miss. The stock sells off for a few days, until people figure out that 53 cents was a very good result, and meanwhile, the firm closes out its short at a profit. Pretty ridiculous, isn’t it. But this hypothetical scenario could, and probably does, play out in the current market.

On trading in and out: No one knows how long a stock price can keep climbing. If you sell now at $135 it could keep going up to $200 before it takes a rest. When it was up $15 from where you sold, would you buy back in or just watch it go? And if you timed it right and sold now, and it dropped $15 would you get back in, or would you wait for down $20? And then if it got to down $19 and started back up, would you panic at down $12 and buy back in? And then, what if it goes down $5 from there? Do you buy, sell or hold? In other words, trying to time the market in these stocks will drive you crazy. If you don’t have a good reason to sell just stay with it and enjoy the ride.

On staying fully invested: You’d be much better off staying nearly 100% in the market and just deciding WHICH stocks you want to invest in, instead of complicating it with deciding WHEN you want to buy, and trying to time the market. For example, you don’t want to buy now because the market is up, but I suspect you didn’t want to buy at the bottom either, because then everyone was saying that the market was going lower. And if these stocks go up 10% from here you certainly won’t want to buy, but if they go down 10% from here, you’ll wait for down 20%, and then if they start back up you’ll wait for them to get back to down 10% again, which may never happen. Just think, if you stay fully invested you can forget about all those crazy-making decisions, and just concentrate on which stocks you want to own for the long term.

About being Number One: A poster on our board seemed concerned that I’d feel bad because his totals were higher than mine. But that’s not what this is all about. It’s not a game where there is just one winner. We can all be winners. The goal is not to have the best record. Not even to beat a benchmark like the S&P. The goal is to be successful, to make enough money at investing to support your family eventually and be able to purchase the goods and services that you need in life. I have never dreamed that I’d be the best investor in the world, or the most successful. Worrying about that will make you crazy. I just want to be a good, successful, investor.

You can think of possessions the same way. There will always be someone with more money, a bigger and better house, a nicer wedding ring, a more exciting vacation, whatever. Don’t sweat it. It doesn’t matter. Happiness isn’t getting what you think you want. Happiness is being content with what you have — on the way to possibly getting what you think you want. It’s today you want to be happy, not in the future. The future never gets here. It’s always today.

## Why and How My Investing Criteria Have Evolved

I used to feel that my most important criteria was investing in companies who were making a profit and growing their earnings and who had a reasonable PE ratio. In the last few year my way of choosing stocks has changed and evolved. Here are the questions I get asked:

Why have I “abandoned” PE as my most important criteria, and Why am I willing to invest in companies that are losing money.

Those are good and valid questions and they deserve a response. Please take into account in reading my response that I’m not a techie and some of my details may not be accurate. And above all, remember that this is just my opinion, the opinion of a non-techie.

After some reflection, it isn’t so much that I have changed, but that the world has changed, and that the business models of the companies I invest in have changed. Companies like the ones I am currently investing in simply didn’t exist before. They have only emerged in the past few years.

There has been a revolution in the world of business, and especially in the world of software. As recently as four or five years ago, with the exception of perhaps one or two companies, a company selling software would sell a customer a perpetual license to use it. Then they’d charge for updates that the customer might have to install, and they’d charge for service, and they’d try to sell the customer a new updated version of the software in two or three or four years. The customer might decide to skip the next version and just wait for the one after if he’s happy with the current one. Think Microsoft and all those Microsoft Office and Word versions you had to buy. It was the same for big companies with their software.

This procedure was bad for both of them. It was terribly inconvenient for the software customer. For example, if there was an update or a patch to the software they had to have their IT people go install it on all 2,134 computers in the company. And there was no visibility into the future for the company selling the software.

There was little if any recurring revenue. For an investor, encountering a growth company that had even a small percentage of its revenue recurring was a major find. The only companies that had most of their revenue recurring were slow or no-growth utility type companies. Think: the electric company!

There was little or no recurring revenue because the customer who bought a perpetual license for a version of the software this year might not buy an updated version for 4 or 5 years. All you had that was recurring were service contracts, and not every customer took a service contract.

It was the same with dollar-based net retention rate. There was simply no such thing. You were essentially making a one-time sale with the hope of making another sale in a few years.

As an investor, PE and profit was all you had to go on (besides hope). Finding a company that was growing revenue at 20% per year was great. NO companies had revenue growth of 40% to 60% on a regular basis. It was unheard of. It was something you couldn’t even imagine, except perhaps for a tiny company growing off a very small base, or as a one-time occurrence.

But then an incredible new world came along in which data, and Internet usage, and Cloud usage, and software usage, have all hit an inflection point and taken off, literally exploded. What these software companies are selling is actually currently needed by every company in every field, whether it’s a bank, a grocery chain, an insurance company or an auto manufacturer. It’s not going to go away. Every company now needs software, needs the internet, needs a website, needs ecommerce of some sort, needs security against hacking, needs to be able to analyze and visualize data, to analyze customer patterns, needs… well you get the idea.

And something amazing called SaaS was developed. It stands for Software as a Service: Instead of selling the software on a perpetual license, you, the software company, lease the customer your software, and the customer makes monthly payments “forever.” You have visibility for the first time in your company’s life, and your customer doesn’t have the large upfront outlay of cash. These monthly payments you are getting are recurring revenue.

You can update your software monthly, weekly, or even daily using the Internet, which keeps your customer very happy and very hooked, and keeps him renewing his lease contract every three or so years. Your software becomes an integral and essential part of your customer’s business. You can sell the customer additional programs, with new bells and whistles that your R&D department just perfected, or sell to additional departments in the same customer company, and your revenue from this customer will be higher next year than it was this year (dollar-based net expansion rate). This is referred to as land and expand.

Because of increasing spend by existing customers, and because of increasingly high demand for what you are selling from new customers, you may see revenue grow by 40%, 50%, or 60%, or even more, each year. This means that your revenue will quadruple or even quintuple in four years, or five at most.

Your margins rise with time because your monthly S&M charges for the recurring part of your revenue are miniscule compared to what you paid for the initial sale. You could make all your updates in the Cloud and it would be even cheaper, and cheaper for the customer too, as the customer doesn’t need to buy all that computer hardware.

This is still early innings. All companies out there need what you are selling but most of them don’t have it yet. You want to go all out to sign up as many of these companies as possible before credible competitors emerge on the scene. This means increasing S&M expense now. You know that while a dollar of S&M expense spent today is mostly expensed against your current earnings, it will bring in (expanding) revenue almost forever in the future. This incredible opportunity also means spending on R&D so you continue to have the best products to sell. But this is all new and greenfield, and the imperative is to sign up as many customers as you can, as rapidly as you reasonably can while still providing good service, and not worry about current profits.

Think about this for a minute. Every good-sized company now uses more and more software every year. They all want to be part of the cloud, they all need what our companies are selling, and most of them don’t have it yet. The opportunities are enormous, and once the software is incorporated in the customer’s business it becomes harder and harder to change providers… really a pain for the customer and a risk of all kinds of disruptions to their business if they tear it out, so they will need a really, really, good reason to change.

So our software companies have mostly recurring revenue, and not only recurring, but expanding recurring revenue as the old customers increase their spend (dollar-based net retention rate), and new customers sign on. This means that each year our software companies add lots of new recurring revenue. And they are growing at rates that will quadruple their revenue in four years. (Actually 50% compounded for four years will quintuple their revenue in four years, but I’m being conservative!

And that’s why I buy SaaS companies, that are growing revenue at rates I couldn’t have imagined a few years ago, and it’s why I don’t worry about them not making a profit now. My other criteria are still there: rapid revenue growth, recurring revenue, lack of debt, insider ownership, a moat, not capital intensive, not hardware, doing something really special, etc, etc, but I’m taking advantage of this new world.

## More Thoughts about Evaluating a Company

I look for companies that are easy to follow. A lot of my companies are recommended by the MF. I invest largely in MF recommended stocks because it helps me to be an informed investor. Other services recommend a stock because “two analysts have raised estimates this month” or “they’ve beaten estimates two quarters in a row” or some such nonsense, where I don’t think the person doing the recommendation even knows what the company does. There is little or no follow-up and, most importantly, no place to discuss the stock. When there is a recommendation from MF, someone has already screened the company and written a full recommendation. That’s very important to me. Besides which there are the boards for discussion, which I feel is a very valuable service. I will get important ideas pro and con, and I won’t miss important news.

Do I need to understand the technology or the industry to buy a company? Someone commented “but I can’t imagine following them because I don’t feel that I understand the industry.” Well I almost never understand the industry or the technology. I don’t know anything about banking but I have invested in SBNY and INBK in the past. I don’t know anything about microchips but I have invested in SWKS and NVDA… I don’t know anything about the shoe business but I have invested in SKX, etc. And I don’t know anything about SaaS but I’m investing in mostly SaaS companies right now. My investments are not based on knowledge about the industry, but on the fundamentals and progress of the company itself.

Wow, if I thought I had to understand the industry, I doubt I could find any stocks at all I could invest in. To think of it simplistically: If you are considering buying stock in Apple, do you need to understand how to build an iPhone, or do you need to know how successful the company is?

Wanting to be an informed investor means that I generally avoid foreign companies. And I won’t touch ANY Chinese company. Not even Baidu. This is due my experience in 2010 or so with 13 little companies (most recommended by MF Global Gains, since closed down), of which fully 11 turned out to be fraudulent in one way or another (The MF was fooled just like I was). You simply can’t tell what’s going on in a Chinese company. Consider that Yahoo is a major company and owned 40% of Alibaba, and the Chinese CEO blithely gave himself the fastest growing subsidiary as a present without telling Yahoo. If it can happen to a big company like Yahoo, what chance do I have? That’s not even touching on the political risk and the government interference risk. I probably wouldn’t invest in companies in other emerging markets either.

Get the information yourself. I suggest that you don’t get information that’s important to you, off Yahoo, or eTrade, etc, but get earnings off the company’s earnings press releases, which you can always find on their Investor Relations website. You just don’t know what Yahoo’s computer is grabbing.

I look for a company that has a long way to grow. A company that I can hope will at least triple or quadruple. I’d never buy a stock at $45 hoping it will get to $55. I wouldn’t buy a stock at $45 unless I though it could get to $150. That means a company that has a long runway. One that ideally can grow almost forever. What I mean is a company where the addressable market is so big that their share of it allows them to keep growing for the foreseeable future. That’s no guarantee that they will, but it’s better than a company that already has 40% of it’s total addressable market, for instance, and can only double once.)

How do you know when a company is too big? Let me try off the top of my head: Can you imagine Nike doubling and doubling again? It’s impossible. They already have most of the market.

Now to generalize that thought: If a company owns just 5% of a market, it has a lot of room to double and keep on doubling, especially if the market is growing too. If the company already has 80% of the market, all that it can grab is the other 20% of the market (which is unlikely, anyway). If a company has most of the market because it just invented the market and the market is hardly penetrated, that’s fine, it has plenty of room to grow (think Apple and the first iPod/iPhone). If it’s an old market and is saturated, that’s a different story.

Finally, there is the problem of big numbers. If you have a chain of 200 stores and you can add 50 a year, the first year you add 25%, but the same 50 stores only adds 20% the second year and 16.6% the third year, etc. To maintain the same 25% growth rate, you have to add a larger number of stores each year, and you run out of places to put them.

If you have another kind of firm, with $100 million in sales, and double it, the next year you will need to add $200 million to maintain the same rate of growth, and $400 million the next year, and it soon becomes impossible, except in rare cases.

I avoid mining and drilling and natural resources stocks, which tend to go in cycles from boom to bust.

I usually don’t usually buy restaurant chains. They seem inherently limited. How many outlets can you build without getting to a point of diminishing returns? I know the Fool has done well with some of them but it’s usually not my thing.

I want management to be interested in making a profit. That’s why I sold out of Amazon some time ago, even though I loved the company. Making a profit just didn’t seem to be on Bezo’s radar screen. He never even mentioned it. Amazon just kept going up without me, but that’s okay. The stocks I put the money in went up too.

## What to Do?

Go to the company website and find out what they do. To get there, google, for example, “Alteryx investor relations” and you’ll get the Alteryx investor relations website.

Read the text part, at least, of their last quarterly report. “Analyzing the financials” sounds intimidating, and probably isn’t necessary. They usually tell you what is going on in words.

Read the transcript of the conference call. You should be able to find it on Seeking Alpha “Alteryx Q1 2019 Transcript” should get it. (Yep, I put it in on Seeking Alpha and it came right up.)

Go back through at least two years of quarterly reports and pull off at least adjusted earnings and revenue. Make a table for each. Let’s look at made up stock ABC. Here’s what their Revenues looked like:

2018: 18 24 25 33 = 100
2019: 32 39 51 56 = 178
2020: 56

You see what a good visual image this gives you. You can see both sequential change and year-over-year change at a glance. And that 78% increase in revenue from 2019 to 2019. And other patterns jump out to the eye as well. For example, you notice that revenue doesn’t rise between the fourth quarter and the first quarter of the next year (it’s called seasonality), and then it does rise in the second and subsequent quarters. When that happens in the future it won’t bother you because you’ll say “Oh yeah, their first quarter’s usually flat with the quarter before.” I do the same with Earnings, and Free Cash Flow, and other metrics that I’m interested in.

Then I do a running 12-month trailing earnings:

12 2012: 22
03 2013: 28
06 2013: 34
09 2013: 48
12 2013: 59
03 2014: 70

This gives you a picture of where they are going and how fast. You should graph this on a piece of log paper. (On log paper a move from 10 cents to 20 cents is the same length as a move from 50 cents to a dollar (100%)).

I remember that the COMPANY may do well, but the STOCK may do poorly, if the stock price has too much growth already factored in.

I’m not sure I can come up with a single calculation that will give you all the information that goes into my thinking about a stock. Often the CEO’s explanations in the conference calls play a considerable role, along with the rate of growth, the company’s competitive position, the PE, how much is recurring income, and other factors I’ve already discussed.

## Portfolio Management

The number of stocks in my portfolio waxes and wanes according to a number of things, but probably never is less than 8, or more than say 15. Okay, so what makes the difference?

If I have stocks that I have strong convictions about I will tend to add additional funds to them instead of looking for new stocks, and I end up with a more concentrated portfolio.

If I have less conviction, or if some positions have become too large, I will try out a lot of smaller positions in order to decide which ones I should add to and make into ongoing positions.

Consider, for instance, if something were to happen and I were to have to exit my largest position now. That would be a big part of my total portfolio. I wouldn’t put that much into any one or two new stocks, nor would I add that much to existing positions. I’d probably have to reallocate the money to five or six smaller (3% to 4%) positions, and maybe one or two “put it on the radar” (1% to 2%) positions.

When the market tanks irrationally, I tend to reduce or eliminate the stalwart stable stocks that haven’t declined much and thus won’t have much of a bounce, and reinvest the money in the great, fast growing stocks, which have declined a bunch with little or no reason except that the market is falling. This also tends to concentrate my portfolio. I might buy some of a new stock that has fallen in one of these panics, but it’s difficult emotionally to put money in an unfamiliar stock when there’s panic all around.

When I think my main stocks have gone up irrationally, are over-extended, and the positions have gotten too large, I tend to trim them and put some of the funds back in the stable stalwarts and some in new “try-out” stocks. This increases my number of stocks. (This is similar to B.)

I really like it better when I have fewer, but high conviction stocks. I’m more comfortable, and I can probably make much higher percentage gain for my portfolio with 8 positions than with 24. Fewer are easier to follow, and the chances of finding 8 that will average 50% gain is MUCH better than the chances of finding 24 that will average 50% gain, and HUGELY better than your chances of finding 100 that will average even 40% gain.

When do I sell?

I tend to sell a piece if my position has gotten too big for me to be comfortable with. However, I have let rare positions get very big if I was in love with the company.

I tend to sell a little piece if I feel the price has shot up wildly. On the other hand, a stock might go up steadily, but if my position isn’t too big, the rise isn’t too fast, if their metrics are improving nicely, I may add multiple times along the way instead of selling. In other words I don’t sell just because something is going up.

I tend to sell a piece if I feel the story has changed.

There really are some times when it makes sense to sell a stock. Saying that “it would be better if I held” because at some time in the future the price may go back up up is not valid (it’s silly, even). Just think of a stock that you sold at $200. It dropped to $50. It gradually came back and now, 5 years later, it’s at $220. Would you say it would have been better to have held because it’s now up 10% in 5 years!!! That really is silly. You could have thrown the money at a dartboard of MF recommendations and beat that result by 500%. And could have done lots better than that by intelligent picking.

There’s a big opportunity cost to leaving your money in a stock which keeps going down, and then stays down, as well as whatever paper loss you have.

If I need cash for an attractive opportunity, I:

(1) sell a little of stable, slower-moving companies that I have confidence in, but which haven’t fallen hardly at all and which aren’t going to run away from me when the growth stocks start back up.

(2) sell a little of high flying stocks with growth that doesn’t warrant their high valuation, and which therefore seem vulnerable.

(3) sell my little experimental positions in stocks which may turn out well in the future, but where I have surer places to put my money.

Since I’m almost always nearly 100% invested unless I’ve recently sold out of a big position, I often don’t have the money to take a full position all at once. If it’s something I absolutely fall in love with, I’ll jump into it right away with whatever money I have available, and will likely trim some other large positions to fill out a full position. If I’m not sure, I’ll take a small position to put it on my radar. I then may start adding more as money becomes available, often building to a “full” position, which for me is an average-sized position, not an oversize position. Or as I get more familiar with the stock that I’ve taken a starter position in, I may say to myself, “This is stupid, it’s not my kind of stock”, and sell out of my starter position. That does happen.

I usually keep enough for a couple of years worth of living expenses in cash that I don’t consider part of my investing account, or part of my portfolio. I keep it firmly in cash.

We all tend to get worried or elated over moves of our stocks with no news attached. This is usually random noise. For a trivial example, say your stock dropped from $58.70 to $58.30 from Thursday to Friday. Did anything happen that caused it to be worth 40 cents less on Friday? Of course not. The message in all this is to keep your eye on the company, and how it’s doing, and not as much on the stock price.

## Adjusted (Non-GAAP) vs. GAAP Earnings

I use adjusted results because they tell you what the real company is doing. I pay no attention to GAAP earnings and only look at non-GAAP or adjusted earnings. I know this bothers some people, but it’s what I do. I feel that GAAP earnings ridiculously distort the picture. (Consider company X that has a big tax benefit this quarter and reports huge GAAP earnings, and then next year they pay normal taxes and looking at GAAP it appears as if their earnings have tanked, just for a trivial example. Or company Y that has outstanding warrants. If their stock price goes down, GAAP rules makes their apparent GAAP earnings go up due to repricing of warrants. Just nonsense. I especially remove stock-based compensation as an expense).

I ignore the stock-based compensation because it is already accounted for in diluted shares. More shares reduces earnings per share. Taking it also as a non-cash expense double counts it, which is why almost every company that I know of subtracts out the stock based compensation non-cash expense insisted on by GAAP when they figure adjusted earnings or “real earnings.”

I don’t like excessive stock compensation either, but you have to remember that at most small technology companies, that is most of executive compensation, as the companies don’t have much money. It also allies the insider’s interests with ours if they have options that are only valuable if the price goes up.

In the earnings press releases, management almost always gives a reconciliation between adjusted and GAAP figures. You can see exactly what they leave in and take out so you aren’t taking it on blind trust. If I have confidence in management, I just use the adjusted earnings they give. This perhaps sounds overly trusting, but what I’m aiming for is seeing how the company has been functioning over time, and management is trying to evaluate the same thing. If I don’t have confidence in management, I shouldn’t be in the company in the first place.

It’s important that you realize just how insane some GAAP rules are. Let’s consider company ABC, which makes engines, and has some outstanding warrants. What would happen if some terrible news came out during the next quarter? For example, if a big new engine had a bunch of defects, or a new competing product showed up which was taking lots of their customers. Their revenue would drop like a rock, and their stock price would crash (for good reason!).

GAAP rules for repricing the warrants would mean that because the stock price plummeted, the company would show huge (imaginary) INCREASES in GAAP earnings for the quarter!!! And this is from a system that is supposed to be giving the public a clearer idea about what is really happening at the company!

(For those who wonder what their rational is, it’s: stock price down, means potential obligation from warrants is reduced, and thus more GAAP “profit”)

By the way, analyst earning estimates are almost always adjusted earnings too, as far as I can tell. Also the companies’ disclaimers almost always specify that management uses adjusted earnings for their own internal evaluations of how the company is doing. They always give GAAP results as a formality, and then usually base their entire discussion of results on adjusted results.

For those who think that GAAP are the only valid earnings, and that Non-GAAP are just “cheating,” these were the latest PSIX results, at the time I wrote this back in 2015:

GAAP earnings: 68 cents
Adjusted earnings: 39 cents

WHOA! Adjusted just about half of GAAP? It’s supposed to be the other way around! How can that be? Because, as usual, GAAP has a lot of nonsense in it: GAAP was up because the stock price was down so they had to reevaluate the “liability” of the warrants downward due to the lower stock price. This gave more GAAP “earnings”. (Note that if the stock price had been up, repricing of the warrants for more liability would give lower earnings. If you think that makes sense, well…)

In addition, GAAP income included a non-cash gain resulting from a decrease in the estimated fair value of the “contingent consideration liability” recorded in connection with an acquisition. This also gave more GAAP earnings.

Now if you think GAAP gives a better idea of how the actual business did in the quarter, be my guest. As I said, it’s nonsense to me.

## What is my Buying Policy?

What is my buying policy? I actually don’t have a fixed buying policy. That means you can rule out cost-averaging over a predetermined time. I never do that.

You can also rule out: “I am tempted to just wait a bit longer until the right opportunity arrives.” If I like a stock enough to take a position, I will always take at least a starter position, and figure on adding later. I never wait for the “right opportunity” to take a starting position. I do add to a stock when it goes down for no reason on an opportunistic basis, but you can’t take that as a rule, for some of my most profitable stocks ever I kept adding on the way up, instead of on the way down. (If I start buying at $25, adding at $28 or $31 might seem expensive, but when it gets to $75 or $120 the difference between $25 and $28 will seem negligible. Also if it’s at $25 and I wait for $22, to buy at a “cheaper price,” I’ll really kick myself when it’s at $120 and I never got in because of waiting for a cheaper price.)

As you can see, there’s no clear rule, but I was able to rule out two approaches (buying thirds at predetermined times and waiting for a cheaper price to add).

Remember you’re not locked in. Not infrequently I decide my initial purchase was a mistake, I don’t really have faith in this stock, and I sell out at a small profit or loss.

On the other hand, if I’m really excited about a stock I’ll take a substantial position right from the start. I’m more likely to do that with a MF recommendation or a company being actively discussed on our board than with a little stock I found myself. But I occasionally change my mind on those too.

Never miss getting into a stock because you are waiting to buy it cheaper. The decision is whether you want to invest in it or not. Once you decide, take a starter position, at least. Don’t wait around for a slightly better price.

Price anchoring is a BIG mistake. Treat a company as if you had just encountered it, and then decide, based on its current metrics and story, whether you want to buy it now. Where the stock price was in the past is irrelevant. You can’t go back and buy it at that cheaper price where it was two months ago.

When the whole market is falling, putting more money into your high confidence stocks usually works out very well in the end. On the other hand, when one stock is falling off a cliff in a rising market, it usually means that something is very wrong. Putting more and more money into it on the way down is usually very dangerous, and a way to lose a lot of money.

If the stock is going up, it generally means the hypothesis upon which you bought the stock is working out the way you hoped. The business is doing well, revenue, earnings, cash flow, and all the rest are going up. I’m glad to add to an idea that is working out. If it’s going up wildly on just hype I won’t add.

There are others who like to “average down,” which sounds good, but it often means adding to an idea that isn’t working out (watering the weeds, making excuses for bad news). Oh, sure, if my original purchase was at $73, and a week later it’s at $71 because the market is down a little, I might add a little. That’s just random noise. But if they come out with really bad news or a bad report and the price is dropping like a rock, I’m not one to say, “Oh, they’ll get it figured out. I’ll buy at this cheaper value. It’s a bargain.”

I saw the following question on a MF board and thought it typified what I wouldn’t do. Here’s the question: “With the disappointing XYZ results, is XYZ a buying opportunity?”

I didn’t know anything about XYZ, nor did I read their results, but the general idea of buying more of a company because it had bad results and the price fell, and thinking you are getting a bargain seems foolish to me.

There are exceptions: If a stock, after reporting excellent earnings, falls off a cliff because it didn’t meet estimates, or some such nonsense, but I know what the news was, I have read the conference call, and I know there is nothing wrong, at least that I could see, I don’t hesitate to add. (Maybe some hedge fund got a margin call on another stock and had to raise cash in a hurry and so had to liquidate my stock at whatever price they could get. Who knows? Irrational things happen.)

You can’t buy all the great stocks! (unless you run a big index fund yourself). Some stocks you pass on will go up. It’s guaranteed! Personally I don’t even think about them. I just care about how the ones I bought are doing. (THIS IS A KEY POINT, READ IT CAREFULLY!)

Where do I get my stock ideas? Many of my stocks were MF picks (mostly RB, actually), although I had invested in several of them before they were picked by MF. As I indicated above, I really prefer to invest in MF picks because the discussion boards and continuing coverage is incredibly important to me.

People on our board have introduced me to a large number of stocks with their posts. I’ve also more rarely gotten ideas from news articles and from random posts on other MF boards.

I’ve gotten some stocks from random Seeking Alpha articles. Note that most investing newsletters have no discussion boards and no real ongoing support, such as you find on MF.

## What is my Selling Policy?

I tend to sell a piece if my position has gotten too big for me to be comfortable with. Usually, that means more than 12% to 15% of my portfolio. However, sometimes I have let rare positions get to 20% if I was madly in love with the company.

I tend to sell a little piece if I feel the price has shot up wildly.

When I’m thinking of selling I seem to sell a little first while I’m evaluating, then decide for sure what to do. I might even decide to buy back the little piece I’ve sold if I reconsider.

One problem investors have is getting attached to their previous decisions and not willing to consider that they may have made a mistake. Not accepting that an investment could be a mistake is a dangerous error. I try to always reevaluate my investments and get out if I’ve made a mistake, or if information changes. Which is why I don’t hold stocks generally for 5 or 10 years.

I always buy with the idea of holding indefinitely, never with the idea of a short holding period, but in practice I guess my average holding period is six months to three years.

If a stock seems overly extended, I won’t sell out completely, but I’ll trim my position a little. Then if it goes up even further, I’ll trim a little more. If it drops back substantially, I might buy back some or all of what I’ve trimmed. I will never sell totally out of a position I’m very happy with just on the basis of valuation. I definitely don’t sell winners that have had a run-up as a policy. I only sell if I have a specific reason.

We all often worry when stocks we have sold go up. I try to ignore them and figure that once they are sold they don’t matter any more. Here’s a great quote from Huddaman: “I don’t really need to be right for the stocks I sell, I just need to right about the stocks I own.” Boy! Doesn’t that really say it all! It simply doesn’t matter what happens to a stock after you sell it. You can’t hold all the stocks in the market. Some stocks you don’t hold are going to go up. A lot! So what!!! The only thing that matters is what the stocks you are holding do!

Selling out at the bottom, when everyone is panicking, is not a good outcome. The time to have sold the wildly over-extended stocks, was when everything was booming. On the other hand, when the market is down, selling low-beta stocks that haven’t fallen much, and thus have less to rebound, can be a good source of cash to buy stuff that has fallen a lot.

There’s no such thing as “I was so far down I couldn’t sell”. The stock price has no memory of the price you bought it at. It’s at the price it’s at. That’s the reality of now. The question about any stock is “Where is it going from here? What decision should I make about it now, at its current price and its current prospects?” Not: “What price did I pay for it?” unless you are planning for tax losses or gains.

How to handle the emotions. I don’t even think about the price I bought the stock. I promise you, I don’t consider it at all probably 95% of the time (especially since most of my portfolio is in IRA’s). I think about a position that I’m considering selling simply as a part of my portfolio.

For example, a hypothetical thought process: My portfolio value is now at $xxx. AAA makes up 3.7% of my portfolio. It’s at a price of $yy. (That’s the price it’s at right now, and there is nothing I can do about it). Its fundamentals and its stock price are both deteriorating seriously, and there is nothing on the horizon that I can see that will magically turn that around anytime soon. Where can I put that 3.7% of my portfolio where it will have a better chance to grow?

As you see, there’s no consideration at all of the price I bought it at. In that thought process, the price I bought it at would be irrelevant.

You need to think of money as fungible, interchangeable. It’s only money. It’s not a share of AAA that you bought at $94, so you have to wait until it gets back to $94 before you sell it even if it takes five years. (Perhaps to make you feel better, so you won’t feel like you made a mistake when you bought it?) It’s just 3.7% of your portfolio, which as a whole is doing fine. Is there somewhere better you can put that money, that 3.7% of your assets, with a clearer path to a long-term good profit? That’s the question.

Do I wait for long-term capital gains? My results are for my entire portfolio, which includes various accounts, some taxable, some not.

Most positions I’d exit short-term would be losses or small gains. If a stock was really doing well I’d be more likely to add to it. If, for some reason, like a major change in the fortunes of a company, I had to get out of a position with a significant gain, I would do it in all my accounts, taxable or not.

Normally, to get to be a big gain it would mean I’ve held it for a year at least. It would be rare that I would be selling out of a stock with a significant short-term gain. So let’s say I do sell $120 worth of stock on which I have a $20 short-term profit. The key is that the tax is not on the whole $120, it’s just on the $20 profit. The difference in the short-term tax on that $20 profit and the long-term tax might be about $4.00. Should I risk the entire $120, keeping it in a stock I’m worried about, because I’m worried about $4 in taxes? When the stock could easily drop more than that $4 in a few days? When I could redeploy the money in something I prefer? I don’t think so.

## Calculating Portfolio Returns

I retired in July 1996, so I’ve actually been taking out money to live on for the last 20 years, instead of adding money.

Here’s how to calculate your overall returns ignoring cash flow in or out. Say you start the year with $14,000. You want to equate that with 100% and calculate gains and losses from there. So you ask yourself “What number (factor) would I multiply $14,000 by to get 100?”

By simple arithmetic we have 14000 x F = 100

And thus F = 100/14000 = .0071428

Sure enough 14,000 x .0071428 = 100

Now say three weeks later you have $14,740 and you want to see how you are doing, you multiply that number by .0071428 and you get 105.3 (so you are up 5.3%). If you don’t add or subtract money, that factor will work for the whole year.

Now say you add $2300 of fresh money, but you don’t want that to screw up your estimate of how well you are doing.

You add the $2300 to the $14,740 and get $17,040 which is your new balance that you are investing with. That’s your new starting point. It doesn’t affect how you’ve done up to here. You haven’t suddenly done better because you added money. You can’t still multiply by .0071428 because you’d get 121.7 and it would look as if you were up 21.7%, when you are really only up 5.3%.

So you need to change your factor to make it smaller so it will still reflect just the 5.3% gain you’ve made so far. You figure: “What would I multiply my new balance ($17,040) by to get 105.3, to reflect my 5.3% gain so far this year?”

F x 17,040 = 105.3

F = 105.3/17,040 = .0061795

And that’s your new factor. If you multiply it by 17,040, sure enough you get 105.3. Now you continue to see how you will do for the rest of the year.

If a little later you are at $18,000, you multiply 18,000 by .0061795 and you get 111.2, so you know that your investing is now up 11.2% for the year.

Same, if you take money out. You don’t want it to look as if you lost money. You calculate a new factor so you start from the same percentage where you were.

On January 1st of the next year, you write down how you did for the year to keep a record, and start over at 100 for the next year.

## Dips and Downturns

When the market is in euphoric phase, companies can report poor or mediocre results, but the analysts and investors will find some positive slant to bid the stock up. This will last until it reverses, and then no news is good enough. Whatever it is, the analysts and investors will find some negative way of looking at it, and the stock will go down. So don’t panic at irrational sell-offs. If it’s one stock, then you have to make sure there’s not something wrong with that particular company. When it’s all your stocks and the pundits are all saying the big crash is coming, relax. It’s just something that they say now and then.

Sometimes you can feel shell-shocked from the pounding you get from the market. All your well-functioning, rapidly growing companies, who have had no bad news at all, have sold off sharply for no reason. If the market is down, it will recover. It always does. If anyone says “This time is different, it won’t recover,” you should greet what he says with suspicion. Just hope that the recovery is sooner rather than later.

Remember how scared everyone was at the end of 2008. One financial expert, when asked what positions he’d be in, said “Cash, and the fetal position!” That’s how scared people were. — Well, I was up 110.7% the next year, in 2009. The market has now been up for 11 years since 2008. If I had listened to the doom-and-gloomers at the end of 2008, I’d have been in cash and missed it all.

I wrote this one day in 2014: “Just two weeks ago, people were writing in on the board to ask whether they should sell out of everything and go into cash, long term growth newsletters were taking on “short” ETF’s to protect themselves from a falling market, and someone on this board was suggesting maybe it was the start of a Bear Market. By coincidence, they all occurred on the bottom day for the market. It’s worth keeping that in the back of your mind the next time the market takes a little breather and you get unreasonably scared. If you’re scared, almost everyone is likely to be scared, and we probably don’t have much further to fall.” That was in 2014 and the economy has been up every year since. Don’t believe the gloom and doomers. Eventually we’ll have a recession and they’ll say “I was right all along!” but they were WRONG all along, beause they missed most of this 11 year bull-market

My preparations for the next market drop. That’s easy. I don’t try to time the market and I stay fully invested. I try to pick good, really excellent companies, who will do reasonably well even if the economy turns bad. In other words, companies that have a lot of recurring revenue growth, high gross margins, and little or no debt…

Why don’t I try to time the market? Because the experts can’t do it, so why should I think I can do it. There are people saying “Watch out for a market crash this year!” The only trouble is that they said that last year too, and in 2014, 2013, 2012, and 2011. And in 2010 they were warning about a “Double Dip Recession,” which didn’t happen either. Eventually they will be right, or partially right. Even a stopped clock is right twice a day.

Given all that, and that no one can forecast the market, here is my attempt to do so. Sure this has been a long Bull market. But this isn’t a euphoric market that charged out of the Great Recession. It has inched its way up slowly, climbing a wall of worry all the way. And it had, and could still have, a long way to go. Does this feel like a frothy market top? Do you hear any euphoria? Have you heard anyone calling for a massive market rise, anyone at all? Does everyone seem worried about one thing or another? And the market keeps inching up. The economy is growing, unemployment is falling, employment is rising, there’s no inflation, NO inflation, and no wage inflation. The market usually continues to rise for two years after the Fed starts raising rates, and they’ve just made one token little step. Give me a break! Relax and have fun investing. Sure, a correction will come along sometime, but we’ll all live through it. — I wrote that paragraph for the 2015 version of the KnowledgeBase and boy was I right. It still makes sense. Here is a wonderful compilation of all these guys who predict a stock market crash every year (often using the exact same words even, from year to year). It’s worth clicking through on it: https://pbs.twimg.com/media/CGVzK7_VIAAyCSH.jpg:large 12

Right now (Jan 2020) we are in a growing economy, with low unemployment, low inflation, low interest rates, growing GDP, growing corporate earnings, and corporations are loaded with cash. This is a great environment for stocks, no matter what the bear market worriers say.

## On Insider Trading

I don’t give any guarantees, but insiders sell for all kinds of reasons, and undoubtedly have plenty of stock options that haven’t vested yet. I wouldn’t make any decisions based primarily on insider sales, without some confirmatory evidence. Just look up insider sales for Amazon, and you’ll see that there have been dozens of insider sales per month, all the way from when it was $5 (split adjusted) to its current $1900 per share. Why are the insiders selling some of their stock? Because it’s most of their portfolio, and they want to diversify, or buy a house, or send their kids to college, or buy a Tesla. You get the idea.

Heavy insider buying is something else again. It’s much rarer, and much more indicative.

## Thoughts on IPO’s and Secondaries

Little companies that are doing IPO’s or secondary distributions get ripped off by the underwriter investment bank. It’s not that investment banks are evil. You might as well call a wolf evil because he eats rabbits. It’s the nature of things.

Here’s why: Sure the investment bank gets a fee for sponsoring the IPO and arranging to sell all the shares. But it still has to get rid of all those shares, which normally it sells to its own clients. Now if it’s a big popular company like FB that is having the IPO, everyone wants shares, and all the investment banks compete for the prestige of taking part in the IPO. That gives the company having the IPO a lot of negotiating power.

However, if it’s a little company that no one has ever heard of that is having the IPO, how is the investment bank going get rid of millions of shares? The answer is to pressure the little company to sell its shares as cheaply as possible. Well below what they are worth. What matters to the investment bank is how its own clients who get the shares will do, not how the company who is having the IPO will do. And it’s not only worried about its clients! The underwriter will take some of the shares itself, for its own book, if the price is low enough.

The IPO company is a one-time customer. However, the favorite clients will hopefully be there indefinitely and the investment bank wants to keep them happy so that they will take IPO stock in the future too. That insures that they, the investment bank, can keep getting those IPO fees, etc. In addition, if the favored customers can make instant money on the IPO, that gives them a good reason to keep their banking and investing relationships at the investment bank.

So that’s why you’ll hear of stocks going up 30%, 40% or more on the day of the IPO. The underwriter (think Goldman Sachs, Morgan Stanley, etc.), succeeded in getting a great deal for its clients by pricing the stock very low. Remember that the underwriter’s customers don’t know anything about the company. They just know they are getting a stock cheap and that they will be able to sell it at a profit almost immediately. Pretty good deal for them, isn’t it?

How about secondaries? Why does the price often go down the day before the secondary? Well, the underwriters’ clients, who are promised cheap shares, don’t know beans about the company and don’t care. Joe Blow, who is promised 20,000 shares tomorrow at $4.00, sees a price of $4.60, or $4.50, or whatever, and sells his promised 20,000 shares short at that price, knowing that he’ll cover his short tomorrow with the shares he gets at $4.00. So he makes a fast profit of 50 or 60 cents in one day. Probably nearly EVERY ONE of the underwriters’ clients is doing that. Pretty good deal for them!

## Investing Ethically

I have occasionally not felt comfortable in investing in a company that everyone else liked. For example, I was uncomfortable with ZLTQ because it’s a weight-loss company, with all those before and after ads you are familiar with.

Then there’s HZNP, a little pharmaceutical company whose meds are combinations of cheap non-steroidal anti-inflammatories like ibuprofen, combined with cheap over-the-counter stomach-protectors like ranitidine and omeprazole, all generics. Then they charge huge amounts for the combination medicine (which people could easily take as two cheap generic over-the-counter meds). Their investor stuff is all about how good their marketing is, and how they are convincing doctors to prescribe these overpriced meds, not about how effective their medicines are. With a whole universe of great companies out there, is this really where I want to put my money?

I had the same problem with GILD, a company that a lot of people on this board, loved. Is it right to charge $80,000 for pills that cost maybe $1.00 to make, using the justification, basically, that they work? They should work. That’s the whole idea of a medicine. And they cure a chronic and potentially fatal disease. Does that mean that the company that makes an antibiotic that cures your pneumonia, which was going to kill you a lot quicker than hepatitis C, should therefore charge you $200,000 or $300,000 for the antibiotic? Or that the surgeon who removes your infected appendix (which was going to cause a very painful and miserable death) should charge $1,000,000, because he’s got you by the unmentionables? Is that the kind of world you want to live in? Is that the kind of company I want to invest in? Nope! It’s probably irrational, but those are just my feelings.

Graphing

If you have the time, do a weekly graph on your stock, on old fashioned large graph paper. It helps you keep things in perspective. A drop from $51 to $49 doesn’t look so bad if you look back and see that it’s been between $52 and $48 for the past six weeks, or if you see that your stock rose from $40 to $51 in the previous two weeks and the “drop” to $49 is meaningless. (The problem with graphs that your computer makes is that a move from $10.00 to $10.05 will fill the whole space if that’s the whole move for the day or week. There’s no fixed scale.)

Graphing adds to my piece of mind. For example, when the price of ABCD hit $69.50 and finished the week at $66.50, I could look back and see that the week before the price had risen from $61.70 to $68.80, so this was just catching its breath and nothing to worry about.

It also gives me a quick visual look at where I’ve made recent purchases, as for every X dollars of purchase I put a little B, and a little S for the same amount of dollars of sales. So if I’m considering adding to a position I can quickly look at my graph and see that I just added 3X’s worth two weeks ago, and the price I bought them at. That may or may not influence my decision. (I do prefer to buy stocks that are going up rather than down, but if a stock is going down for absolutely no reason, I may add cautiously as well.)

I can also look at the graph and see immediately what the stock’s price action has been in the past several weeks or months.

## Professionally Managed Money

You can beat any mutual fund over the long run. Since they are investing many millions, if not billions of dollars, they can only invest in very large established companies, and hope to find a pricing anomaly.

I don’t know of any fund manager or hedge manager with a run like mine. It went through a number of recessions and lasted 19 years until I finally had a down year in 2008. But again, if a fund manager does real well for a year or two, not only does his fund get larger because of capital gains, his fund get flooded, swamped, with inflows of dollars and he can’t duplicate what he did when the fund was small.

Also they have lots of people looking over their shoulders for quarterly results (are they equaling their benchmark each quarter?). It makes it hard to get good results, I’m sure.

The average hedge fund gained 6.5% in 2013, when the S&P 500 gained 29.6%, and the best hedge fund manager was congratulated because he gained 25%. It shows how hard it is when you are investing billions of dollars, and how we can beat any mutual or hedge fund on a consistent basis. They are too big to invest in most of our type stocks. Also hedge funds invest in futures and currencies, which are zero sum games. When one wins, another loses and the sum comes to zero.

Money managers: A friend in his mid 70’s but in good health and still working part time) asked me for help. He had put all his assets to be managed for him by a broker or asset management company, and they had accomplished all of 3% for him in 2013, one of the best years for the market in recent memory. They invested 75% of his money in bonds (which paid almost nothing due to low interest rates, and then decreased in value in the latter part of the year when rates went up). The 25% they invested in dividend paying stocks made a net return of only 15%, giving him a total return of 3%.

My friend wants to take a quarter of the money and invest it himself. I said investing for himself was only going to work if he put time and energy into it, and if it was fun for him. If it’s an onerous chore, it’s better to let someone else do it. I suggested the Motley Fool to him, but since he was interested in income producing stocks I suggested Income Investor, and Stock Advisor once he got more comfortable. I also mentioned that MF has mutual funds and an asset management service if he decided he didn’t want to do it himself.

What I want to discuss was how asset managers could put anyone 75% in bonds? (Whatever his age was!) How can they ask to be paid for getting results that were one tenth of what the markets produced? I think that they must be covering themselves by investing super “conservatively.” No one can ever come back and sue them, no matter how bad their results, if they could say they invested “conservatively.”

And this was profoundly stupid! Interest rates were at epochal lows, so bond prices were at maximum high prices, and could only go lower when the Fed turned down the stimulation and interest rates started to rise. It had to happen. The handwriting was on the wall. But this didn’t stop them from putting my friend 75% in bonds, following some formula or something.

Lest you think that this was just because of my friend’s age, a couple of years ago a young guy in his thirties wrote in on the SA Investing Philosophy board to say that his asset managers put him 80%(!) in bonds… a guy in his 30’s!!! That’s malpractice it seems to me.

## Teaching Investing to Kids

You want to make it fun for the kids. I would consider first explaining what a stock is, and then presenting the stock market as the biggest and best game there is. Then I’d tell them what you look for in a company you invest in. I’d explain compounding growth by letting them multiply $100 by 1.2 or 1.3 ten times on a calculator, and then twenty times to see what that $100 would grow to in a company that could keep growing at 20% or 30%. I’d try to pick (and let them pick) companies that they are interested in, or could be interested in, even if they aren’t your first picks. You might consider making a competition between them for a year, say (with a small amount of real money), or for each of them to see how they do compared to the S&P, but warn them that growth stocks will go down more than the S&P in a down market. I’d say that one stock was too risky (you don’t want them to get in bad habits, even with limited funds). Probably 3–4 stocks each. I’d pay the commissions for them at first since they have small amounts of money and the commissions would take out too big of a chunk.

## Investment Primer:

We have members of this board with all different levels of investing experience, and from some recent questions, we have some members who are just starting out, and some with more experience. I prepared this primer for my wife, but you are all welcome to read it.

Difference between Stocks and Bonds

Bonds: If you “buy” a bond, it means you actually lend money to the company. You receive interest payments for the term of the bond and then get your money back at the end of the loan.

For example, if you buy a thousand dollar, 5.6%, 20-year bond from GM, that means GM owes you a thousand dollars which they will pay back in twenty years from the issue date, and will pay 5.6% per year interest in the meanwhile ($56 per year).

Bonds trade on exchanges on Wall Street, just like stocks, so if you want to sell the bond and get your cash before the due date you can sell it just like a stock. The price will vary though and won’t always be exactly $1000.

For example if interest rates are very low (like now), and all you can get from the savings bank is 1% or less, that 5.6% can look very good to someone who is interested in income.

She might say to herself “I’d be willing to pay $1040, $1050, or even $1080 for that bond. It still has 18 years to run, and I’ll get $56 per year in interest. That’s $46 per year more than I’ll get from the bank. I know that I’ll only get $1000 back in 18 years when the bond matures, but even if I pay $1080 I’ll more than make the difference back within the first two years.”

On the other hand, if interest rates are high, at 7% or 8% for a fully guaranteed treasury bond, for example, the same person might say, “I’m not willing to pay $1000 for a GM bond paying 5.6% when I can get a better rate from the Treasury. I’m only willing to pay $920 for it. That way the $56 per year I get will actually be 6.1% on the money I’ve invested. It’s less than I’d get on a 7% bond, but when the bond matures, I’ll get a full $1000 back and make $80 profit.”

Also if there is any question that the company may fail, the value of their bonds will fall in value, because they may not be able to pay you back that $1000.

Note that if it’s closer to the maturity date, the price that people will pay will be closer to $1000, because they are about to get $1000 for the bond.

A new company starting out, or one whose finances are shaky, in order to interest people in lending them the money, will have to offer their bonds paying a higher rate of interest, than say a company like General Electric, for example. The question is “Is this company sure to be able to pay back the $1000 in 20 years?”

I personally never buy bonds. You have no chance of profiting in the success of the company, but all the risk if the company fails or goes out of business. In twenty years the company’s stock could be worth 50 times what it is now, but the bond is just a loan, and you’ll just get back what you loaned them — which will be worth only a small fraction of what you actually loaned them due to inflation.

My father called bonds “guaranteed confiscation,” because the money was guaranteed to lose value over time.

Stocks: about which we will talk at length, are ownership of a piece of the company. If the company has a million shares and you own one hundred shares, you own one ten thousandth of the company. If the company is successful and increases in value, your shares will go up proportionally.

If a company has 1 million shares of stock and each share happens to be trading today for $80, the company is valued by the market at $80 times 1 million, or $80 million. This is called the Market Cap, which is short for market capitalization.

Since the market sets the price of the stock, the price, and thus the Market Cap, can be more, or it can be less, than what you think it’s worth. It varies from day to day with the stock price, and can go up or down depending on how people estimate the company’s chances for success, or just for irrelevant reasons such as a big mutual fund deciding to buy the stock or sell it, or even because a large holder of the stock decides to buy an apartment in New York, and thus sells $1.5 million worth of shares.

Several factors go into how the public values a stock. One is growth, another is profit, a third is how much publicity a company gets, and a fourth is how much the company is in the public eye. Let me touch on these:

Growth is very important and people will almost always pay more for a company that is growing rapidly, even, usually, if it isn’t yet making money. (That is, they’ll value the fast growing company higher for a given amount of sales and earnings than they will another company with identical sales and earnings but which is not growing. They value the first company higher because they figure it will be worth more next year).

Profitability. In the past I generally wouldn’t buy a company until it’s profitable, but now I make exceptions for super-rapidly growing companies with recurring revenue. Note that a company can be quite profitable, but can be making the same nice amount of money each year, or be growing very slowly. In this case it won’t be valued as highly as a rapidly growing company. Its P/E ratio — how high its stock is priced relative to its earnings or profits — will be lots lower. (More on P/E ratios later)

Publicity is important because people have to hear about a stock before they can buy it. The stock is like a product that needs advertising. For example, if a newsletter recommends a stock, or if a brokerage house like Morgan Stanley recommends a stock, the price will go up because more people will be bidding for the same supply of stocks after the recommendation. There are even newsletters which make paid recommendations (recommendations for a fee)!

Public Eye. Everybody knows Google, for instance, and Amazon, so they will sell for higher multiples than a company, for instance, which automates the mortgage origination business. Everyone in the mortgage origination business may know about it, but that is a tiny fraction of the number of people who are familiar with Google or Amazon.

Size of the company. In general, smaller companies can grow faster and therefore often sell for higher valuations in relation to the size of their sales and earnings. In other words, they often sell at higher PE ratios. Part of the reason is “The Law of Large Numbers.” A little company, say with $20 million in sales, which is doubling each year but controls only a 1% share of its potential market, can double again next year, and the year after, and the year after that, and still have only an 8% share of its potential market. Maybe even less, if the potential market has grown in the meanwhile.

On the other hand, a big company with $20 billion in sales, which controls, say, a 40% share of its market, will have a very difficult time doubling its sales even once. (It’s hard to find $20 billion in new sales, and it’s almost impossible to go from a 40% share of the market to an 80% share).

Note that you can easily find a small company that has no room to grow. If it sells widgets and has $20 million in sales, but there are only $30 million in worldwide sales of widgets, where’s it going to go? Or if it has nothing special about its widgets, how is it going to get more sales, etc.

Similarly, a larger company with $5 billion in sales, may be facing a $200 billion worldwide opportunity, and thus have plenty of growing room. Rules about size are not hard and fast.

Quarterly Reports:

Each company in their quarterly report gives a rundown of its quarterly results, and usually compares them to the same quarter a year ago.

This starts off with their Revenues, or Sales (the money they brought in from selling things).

This is followed by the Cost of Sales, which is how much it cost to make and ship whatever they are selling. What is left is their Gross Profit or Gross Margin. Then the Gross Margin Percent is what percent their Gross Profit made up of total revenue.

In other words, if they had $80 million in sales and their cost of sales was $30 million, their gross profit was $50 million, and their gross profit margin percent was 50/80 or 5/8 or 62.5%. It’s usually listed as a percent.

Then they list Operating Expenses, which are the cost of running the business, and are usually listed in categories like:

R&D — which stands for Research and Development and means pretty much what it says: the cost of research and of developing new products or improving the old ones.

SG&A — Which stands for Sales, General and Administrative, and includes everything from salesmen’s commissions to electric bills, legal and accounting expenses, and right through to the CEO’s salary.

Depreciation and Amortization — This is an accounting thing: If they bought or built a factory five years ago, they may be depreciating the cost over twenty years. That means they didn’t count (“write down”) all the expense in the year they built it (which would drop earnings that year enormously and not give a true picture of the business). Instead, they take 5% of the cost each year for 20 years for accounting purposes. This would be considered the “useful life” of the factory.

Other — This is miscellaneous. For example they sued someone for infringing on one of their patents and they received a payment. Or someone sued them, etc. Or they paid interest, or made interest on money the company had in the bank or had invested. It really is “other” and it’s usually minor.

Note that a lot of this is considered “fixed costs.” That is to say that doubling sales usually won’t require a doubling of salary expenses, or legal expenses, or accounting fees, or electricity in the home office. It won’t change depreciation or amortization, and probably the company will just increase research expenses marginally. That means that an increase in revenues can often increase profits by a larger percentage, once fixed costs are covered.

What’s left after you subtract operating expenses is Operating Profit, or Operating Income. The importance of this number is that one year the company could have a tax loss carryover and have lower taxes and higher profits, and another year pay full taxes and have lower profit. But, operating profit gives the amount that the company actually makes in running the business. It’s sometimes referred to as profit before taxes.

The percent that operating profit is of total revenue is Operating Margin percentage. (In other words, operating profit divided by total revenue and expressed as a percentage. For example, if they had $80 million in revenues and $20 million in operating profit, their operating margin was 25%).

Another useful side-figure that is often referred to is EBITDA. (That stands for: Earnings Before Interest, Taxes, Depreciation and Amortization). It’s useful because it tells you how much money the actual business is making, and year-to-year comparisons can add to your understanding of the company’s business.

If you subtract taxes from Operating Income, you get Net Income, which is what’s left at the end. This is a very important figure. Net income divided by the number of shares gives you Earnings Per Share, or EPS.

The above covers the majority of the basic terms you need to understand. I’ll talk about two other terms, adjusted earnings and diluted EPS below, but they are just modifications of the basics.

For example: Basic EPS is Net Income divided by the total number of shares outstanding. However there may be additional potential shares that are not currently outstanding.

For instance, consider if employees have been granted options to buy an additional 100,000 shares, and the company sold someone else warrants to buy 50,000 shares more, you have to add that additional 150,000 shares to your outstanding share count to get the number of Fully Diluted Shares.

Then Diluted EPS is the net income divided by the fully diluted share count. Diluted EPS is usually a smaller number than basic EPS because the earning are divided among more potential shares.

The company will always list Basic EPS and Diluted EPS (as well as basic shares outstanding and fully diluted shares), but when people refer to Earnings per Share, they are almost always referring to Diluted EPS.

Adjusted earnings are another important term. The accountants preparing the quarterly reports have to follow what are called GAAP rules, which stands for “generally accepted accounting principles.” The problem is that some of the rules distort the true picture of how the company is doing, and others are just stupid.

Therefore, many, many companies give non-GAAP or “adjusted” results alongside the GAAP results. If the company had a large one-time expense or windfall, a legal expense or suit settlement, for example, they would remove these from the calculations to get adjusted results.

Also stock-based compensation, or option grants must be counted as an expense by GAAP rules, although there is no cash expense, and in spite of the fact that they are already counted by an increase in the diluted shares. Almost all companies remove this double counting expense in figuring adjusted earnings.

I ignore GAAP results almost entirely, and almost always use adjusted results, which usually make more sense and are more useful.

Now lets talk about the price to earnings ratio, or PE. (The terms “PE” and “PE ratio” are used interchangeably). The PE tells you how highly the market is valuing the company for the amount of earnings that they have. Simply, it tells you how many times the price of the stock (the price of one share of stock) is of the EPS (the earnings for that one share of stock).

You get the PE ratio by dividing the price of the stock that day, by the earnings per share over a full year. If you base it on the previous four quarters (which is a common method), it’s called the trailing PE. On the other hand, if you base it on what you think it will be this year, or the next four quarters, it’s called the forward PE.

For example, if the stock is selling today at $80 per share, and the company made $4.00 per share last year, their trailing PE is 80/4 = a PE of 20.

Note that I specified that it’s the price today, because the PE changes from day to day according to the price of the stock. If tomorrow or next week the price of the stock has gone up to $88, the PE will be 88/4 = 22. Thus higher PE’s mean the stock is more expensive per dollar of earnings.

Let’s go back to that stock with earnings of $4.00, a price of $80, and a trailing PE of 20. If you think that next year their earnings will be up 25% to $5.00, you can say that their forward PE is $80/5 = 16, which is quite reasonable for a stock growing at 25%.

A company’s PE can be quite different for the same earnings, depending on what the expectations are for the company and how fast it’s growing and what industry it’s in. For example a high-flying Internet stock making $4 per share, that people expect to be increasing its earnings by 50% per year for the next five years, could have a PE of 50 instead of 20, and be selling at $200 per share instead of $80 per share. And a stodgy company that makes electric lawn mowers and makes about the same $4 every year, with maybe 5% growth, might be selling at $40 per share, which gives it a PE of 10.

Companies with very high PE ratios (like 100 or more, because people have very high expectations for them) often don’t turn out well as investments, although the company itself may do well. That’s because it takes a long while for the company to grow into its stock price. These are often called “story stocks” because they have a great exciting story, which makes investors bid up the price of their shares.

Some companies keep growing like that though and end up making a lot of money for investors. The trick is to know which ones.

I would advise you that if you are going to invest in stocks you really, REALLY, should read EACH of the earnings reports of the companies you invest in.

The earnings reports are actually made up four things:

The Press Release (also called “the Earnings Report”). This is the press release the company puts out in which they give the outline of what they did in the quarter, their revenues, earnings, adjusted earnings, progress during the quarter and financial tables. The basics are important, but there is often stuff that I skim.

Then most companies have a Conference Call in which they give more color on what the quarter was like, and then answer questions from analysts. This is VERY useful. You can tell a lot from the tone and from the questions and answers. You can listen to this live, or go back and listen to it recorded. You can find it on Yahoo Finance or on the company’s investor relation website.

The problem with the recording is that, while you can hear the voices, which sometimes is wonderful, if it was an hour conference, it takes an hour to listen to. Thus Seeking Alpha does a transcript of each call. It only takes 15 minutes to READ an hour conference. You can find the transcript on Yahoo Finance, or on Seeking Alpha (but not usually on the company’s investor relation website.

Finally there’s a government filing of the results, which if you’ve paid attention to the other three, you can probably skip unless you have serious questions. It’s available on the company’s website.

What do all those letters stand for?

To help you out, if you are a relative beginner, I thought I’d give some definitions. Let’s begin:

TTM or ttm (sometimes it’s in caps, sometimes in small letters). This means “trailing twelve months” and refers to the previous four quarters that have been reported. If the reference is to TTM earnings and the last quarter reported was Dec 2018, that’s easy. It refers to the sum of the March, June, Sept, and Dec 2018 earnings. But what if they have already reported Mar 2019 earnings? Then you use the sum of June, Sept, and Dec 2018, and Mar 2019, earnings, but you drop off Mar 2018 (which would be a fifth quarter).

FCF stands for Free Cash Flow. The actual cash the company has made at the end of the year.

SaaS is software as a service. You don’t sell the software outright or lease it outright, you keep it on the Cloud and manage it for them.

ARR is Annual Recurring Revenue, and means what it says.

S&M is Sales and Marketing expense.

R&D is Research and Development expense.

G&A is General and Administrative Expense (telephone, electricity, CEO’s salary, etc.

Operating Expense, the sum of the above three.

GAAP is short for Generally Accepted Accounting Principles and refers to a set of fixed required accounting rules. These were created to avoid cheating on quarterly reports, but for all the good intentions, they unfortunately sometimes give bizarre and nonsensical results. For this reason, in addition to the GAAP results, which they are forced to give, most companies give:

Adjusted or non-GAAP results, which they feel (and I agree) give more consistent and more helpful results in allowing you to see how the company is doing from quarter to quarter. They are usually obtained by removing various non-cash expenses or gains, or extraordinary one-time gains or losses that don’t reflect how the underlying business is doing. (These can also be abused, but in my opinion are almost always preferable to GAAP).

YoY or yoy is short for Year-over-Year. Okay, but what does that mean? Well, for example, if you say March quarter results were up by 12% year-over-year, that means compared to March results a year ago. This is contrasted to sequentially.

Sequentially, which refers to the quarter just before. Thus, if you say March quarter results were up by 5% sequentially, that means compared to the December quarter results, the quarter just before. Investors like to see earnings and revenues going up sequentially as well as you, but sometimes it isn’t possible because you also have to take seasonality into account.

Seasonality? What the heck is seasonality? Think Christmas. If you are a major retail store a large part of your years results will come during the December quarter. But if you are a manufacturer, your big quarter is likely to come in the quarter before, the September quarter, when you are shipping out to the stores who are stocking up for Christmas. And some businesses renew a lot of contracts in December and get a lot of business then, or get orders when other companies are closing their books for the year in December. Companies that do business in China are light in the first quarter because of the Chinese New Year. Those who do business in Europe may be light in the Sept quarter because every one is on vacation in August in Europe. Outdoor construction companies will do less business in the middle of winter, etc, etc.

The PE ratio or PE. This is the Price of the Stock divided by the earnings over the past year (These are the trailing-twelve-month earnings, or TTM earnings). It tells you how many times bigger the price is than the earnings. Lower is better. For example, company ABC has a price of $91.70 and adjusted earnings of $3.52, so it’s PE is 91.70 divided by 3.52, which gives a PE of 26. That means the price is 26 times the earnings, or that the earnings are just about 4% of the price. Generally a faster growing company will get a higher PE because the price is bid up by investors anticipating future higher earnings. Also, a company with a lot of hype will often get a higher PE, again because investors bid the price up based on dreams. (For example, last time I looked, company DEF had a PE of about 90 or so, which is huge, although it was growing at a quarter of the pace of ABC, but DEF had a lot of hype and TV ads, etc).

PEG ratio. This is an attempt to see if the PE is appropriate by comparing it to the rate of growth, (PE divided by the estimated rate of yearly growth of earnings over the next five years). It’s a noble effort, except that guessing the rate of growth of earnings over the next five years has no more accuracy than estimating how many angels can dance on the head of a pin. To avoid this problem, I suggested the 1YPEG.

1YPEG, or One Year PEG. This is the PEG looking back over the past year: the PE divided by the rate of growth of earnings over the most recent twelve months. It has the major disadvantage of looking backward, but has the advantage of using a real number, not a guess, for the growth rate. And the rate of growth over the next year will probably approximate the rate of growth over the past year, more than some five-year guess. The 1YPEG is just a screen though, to tell you if the price is in a reasonable range, and not the end-all and be-all.

TTM Rate of Growth of Earnings is calculated by taking the earnings of the last four reported quarters, and seeing how much they have risen over the four quarters previous. For example, you’d get it by taking the sum of June, Sept, and Dec 2014, and Mar 2015, earnings, and divide it by the sum of the sum of June, Sept, and Dec 2013, and Mar 2014, earnings.

How I pick a company to invest in

I start with P/S together with the 1 year revenue growth rate. This is just the start. I also consider GM, customer growth, cashflow, and other factors which are more intangible like competitive advantage. There are a lot of considerations when I decide whether I like company A compared to company B. And which company I prefer can change as their relative stock prices change. I often make adjustments to my allocations based on valuation, remembering that P/S is a factor that needs to be adjusted for things like growth rate, GM, and several other factors.

Hi Chris, You inspired me to think about how I pick a company to invest in. I simply don’t start with P/S.

First, most of my stocks start with a recommendation and write-up by someone I have a lot of confidence in. This could be someone on the board, Bert, Motley Fool, or more rarely a write-up by someone else on Seeking Alpha.

Second, I would want rapid revenue growth. My ideas about that have become inflated in the last couple of years and where I once might have looked for 20% to 25% as very fast growth, I’m now looking for 35% growth, and usually more.

Third, I look for a stock in a special niche, with something special about it. I guess this could be considered a moat. It also could be considered a potential big future.

Tied for Third, I look for recurrent revenue. I want my company to have last year’s revenue repeating this year and building from there, and not a company that has to go out and grow by selling the whole thing over again. God, this is important! It usually means software, and a SaaS model, and NOT selling things. You just can’t keep growing at 40% selling things. And when an economic slowdown hits, people will put off buying a new car, or a new house, but companies won’t tear out the software that keeps their company going. Software also usually means not capital intensive, and it also means high gross margins.

Fifth, I look for rapidly improving metrics like rapidly dropping losses as a percent of revenue, or increasing profits if there are some already, increasing gross margins, customer acquisitions, improving cash flow, dropping operating expenses as a percent of revenue, etc. If some metrics aren’t improving (S&M as a proportion of revenue, etc), because management says they are taking advantage of a greenfield opportunity to gobble up all the recurring revenue customers they can while the getting is good, I generally approve, but want to see those revenues really growing.

Sixth, I’d demand a dollar-based retention rate over 100%. I look for one over 120%, and I’m impressed by one over 130%. A high Net Promoter score is nice too, but there’s no easy way to get that information.

Seventh, It’s been a long time since I’ve been in a company that didn’t have a lot of cash and had a lot of debt. Almost all of my companies are founder led, but I think that’s mostly because they haven’t been around for generations. They also don’t have huge customer concentrations (top three companies making up 30%-40% of revenue). But I don’t seem to have to look for those features, they just come with the territory.

I, like you, constantly monitor these factors and I exit if they seem to have changed for the worse, or if I think I made a mistake in the first place, or if I’ve lost confidence, or if there are new facts. But somehow, EV/S never enters into my consideration.

Perhaps that’s because I don’t sell out of a stock because the stock price has gone up. Ever. That’s not a sufficient reason to me, no matter what it does to the EV/S. If my position has become too big I’ll trim my position around the edges. Again, consider Shopify. The stock price is about six times what it was when I bought it two years ago at $27, up 500%. I’ve trimmed it innumerable times, but it is still one of my largest positions (4th) at 11.5%. If I was watching EV/S, I would have sold out when the stock price went from $27 to $47 in a few months. That’s just not my way of investing. I added in the $40’s. (It’s now $161).

Again, let me reiterate, I do know that a recession is likely to hit us. They always do. No expansion goes forever. I keep cash segregated so that I and my family can get through it comfortably without having to sell stocks at the bottom for cash. I carry no margin, and use no leverage. But I don’t know when the recession will arrive, and I won’t try to guess. I think that the recent chorus of voices saying that a recession is just around the corner possibly means that it is not right around the corner, but what do I really know about that? Nothing.

Why my investing criteria have changed and evolved

A number of you have commented that my criteria for choosing stocks have changed and evolved over the years. This seems to have caused some perplexity and confusion. The questions you have especially asked are:

Why have I “abandoned” PE as my most important indicator of desirability for a stock, and
Why am I willing to invest in companies that are losing money.

Those are good and valid questions and they deserve a response. Please take into account in reading my response that I’m not a techie and some of my details may not be accurate. And above all, remember that this is just my opinion, the opinion of a non-techie.

After some reflection, I think I’d say that it isn’t so much that I have changed, but that the world has changed, and that the business models of the companies I invest in have changed. Companies like the ones I am currently investing in simply didn’t exist before. They have only emerged in the past few years.

There has been a revolution in the world of business, and especially in the world of software. As recently as four or five years ago, with the exception of perhaps one or two companies, a company selling software would sell a customer a perpetual license to use it. Then they’d charge for updates that the customer might have to install, and they’d charge for service, and they’d try to sell the customer a new updated version of the software in two or three or four years. The customer might decide to skip the next version and just wait for the one after if he’s happy with the current one. Think Microsoft and all those Microsoft Office and Word versions you had to buy. It was the same for big companies with their software.

This procedure was bad for both of them. It was terribly inconvenient for the software customer, and there was no visibility into the future for the company selling the software.

There was little if any recurring revenue. For an investor, encountering a growth company that had even a small percentage of its revenue recurring was a major find. The only companies that had most of their revenue recurring were slow or no-growth utility type companies. Think: the electric company!

There was little or no recurring revenue because the customer who bought a perpetual license for a version of the software this year might not buy an updated version for 4 or 5 years. All you had that was recurring revenue were service contracts, and not every customer took a service contract.

It was the same with dollar-based net retention rate. There was simply no such thing. You were essentially making a one-time sale with the hope of making another sale in a few years.

As an investor, PE and profit was all you had to go on (besides hope).

Finding a company that was growing revenue at 20% per year was great. NO companies had revenue growth of 40% to 60% on a regular basis. It was unheard of. It was something you couldn’t even imagine, except perhaps for a tiny company growing off a very small base, or as a one-time occurrence.

But then an incredible new world came along in which data, and Internet usage, and Cloud usage, and software usage, have all hit an inflection point and taken off, literally exploded in their usage. What these software companies are selling is actually needed by every company currently, in every field, whether it’s a bank, a grocery chain, an insurance company or an auto manufacturer. It’s not going to go away. Every company needs software now, needs the internet, needs a website, needs ecommerce of some sort, needs security against hacking, needs to be able to analyze and visualize data, to analyze customer patterns, needs… well you get the idea.

And something amazing called SaaS was developed. It stands for Software as a Service: Instead of selling the software on a perpetual license, you, the software company, lease the customer your software, and the customer makes monthly payments “forever.” You have visibility for the first time in your company’s life, and your customer doesn’t have the large upfront outlay of cash. These monthly payments you are getting are recurring revenue.

You can update your software monthly, weekly, or even daily using the Internet, which keeps your customer very happy and very hooked, and keeps him renewing his lease contract every three or so years. Your software becomes an integral and essential part of your customer’s business. You can sell the customer additional programs, with new bells and whistles that your R&D department just perfected, or sell to additional departments in the same customer company, and your revenue from this customer will be higher next year than it was this year (dollar-based net expansion rate). This is referred to as land and expand.

Because of increasing spend by existing customers, and because of increasingly high demand for what you are selling from new customers, you may see revenue grow by 40%, 50%, or 60% each year. This means that your revenue will quadruple or even quintuple in four years, or five at most.

Your margins rise with time because your monthly S&M charges for the recurring part of your revenue are miniscule compared to what you paid for the initial sale. You could make all your updates in the Cloud and it would be even cheaper, and cheaper for the customer too, as the customer doesn’t need to buy all that computer hardware.

This is still early innings. All companies out there need what you are selling but most of them don’t have what you are selling yet. You want to go all out and sign up as many of these companies as possible before credible competitors emerge on the scene. This means increasing S&M expense now. You know that while a dollar of S&M expense spent today is mostly expensed against your current earnings, it will bring in (expanding) revenue almost forever in the future. This incredible opportunity also means spending on R&D so you continue to have the best products to sell. But this is all new and greenfield, and the imperative is to sign up as many customers as you can, as rapidly as you reasonably can while still providing good service, and not worry about current profits.

Just think about this revolution for a minute. Every good-sized company now uses more and more software every year. They all want to be part of the cloud, they all need what our companies are selling, and most of them don’t have it yet. The opportunities are enormous, and once the software is incorporated in the customers business it becomes harder and harder to change providers… really a pain for the customer and a risk of all kinds of disruptions to their business if they tear it out, so they will need a really, really, good reason to change.

So our software companies have mostly recurring revenue, and not only recurring, but expanding recurring revenue as the old customers increase their spend (dollar-based net retention rate), and new customers sign on. This means that each year our software companies add lots of new recurring revenue. And they are growing at rates that will quadruple their revenue in four years. (Actually 50% compounded for four years will quintuple their revenue in four years, but I’m being conservative

And that’s why I buy SaaS companies, that are growing revenue at rates I couldn’t have imagined a few years ago, and it’s why I don’t worry about them not making a profit now. My other criteria are still there: rapid revenue growth, recurring revenue, lack of debt, insider ownership, a moat, not capital intensive, not hardware, doing something really special, etc, etc, but I’m taking advantage of this new world.

People who are looking for conventional companies with PE’s of 15 or 20, and with 10% or 20% growth, are investing in the S&P and growing their portfolios at perhaps 12% per year, while we are growing at….

…Well, I’m up 57.8% by the 13th of July this year.

I hope this helps.

My thoughts about the valuation of our companies

I was curious about what your thoughts were to the maximum limits of your valuation stock price being irrelevant. Using SHOP at 19.9 p/s, many people say this is an extremely high valuation, including myself. Does this valuation give you any hesitation when building out a position? If not at what level would you begin to hesitate due to valuation of this type of growth company, or do you use different valuation metrics entirely?

Maraj asked a good question here. I know I’ve answered it before, but I’ll take another few swings at it.

First: A shameful admission. I don’t really look at P/S ratios and couldn’t tell you the P/S ratio’s of any of my companies. Why? Consider a supermarket company that has a maybe 3% margin and a software company that has a 95% margin. That means $100 million in sales is worth $3 million to the supermarket company and $95 million to the software company. How do you compare bare P/S ratios in any meaningful way?

Second: Growth matters. Our companies are growing VERY fast. A company compounding sales growth of 60% for just three years (hard to do, I grant), would have over four times current sales and cut that P/S by a factor of four. In other words that $100 million in revenue we were talking about would grow to $410 million in just three years at that pace.

While it’s hard to do it can be done. For example, Shopify compounded 100% growth for four years, and then this last year it “slowed down” to 73%. That was $24 million, $50 million, $105 million, $205 million, $389 million, $673 million. Take a good look at those numbers! Revenue has grown 28 times in five years. That’s not 28%, or 280%! It’s 28 TIMES, a 28-bagger (that’s the power of compounding), in just five years.

Third: Our new SaaS companies are a new breed, and the accounting and evaluation metrics haven’t caught up with them yet. Look, if your company manufactures cell phones, washing machines, dishwashers, refrigerators, railroad engines, or microchips, you sell one this year and next year you have go out and sell a new one, with no great guarantee that you will, or that your customer will need a new one. If you have $100 million in revenue this year, who knows what your revenue will be next year? On the other hand, when our SaaS company signs up a new customer, for all practical purposes, it’s forever! We only see one quarter’s revenue, but the customer is leasing a program that becomes so intertwined with their business that it becomes more and more difficult to extract it and switch to another provider.

Fourth: In fact, most customers will sign up for new services next year, so most of our SaaS companies have dollar based retention rates of 120% to 130%. That means that that $100 revenue becomes $120 or $130 million next year, just from existing clients, before they even sign up any new clients. That’s a 20% to 30% growth rate “guaranteed,” before the first new client signs up!

Fifth: Then there is deferred revenue. This is money paid for a year (or two years) in advance, but which can only be recognized quarter by quarter. It doesn’t mean any additional revenue in the long run, but having the money in the bank, and resultant positive cash flow, means the SaaS company won’t have to go out and raise more money unless it wants to. It also means that those customers really are signed up forever if they are willing to pay in advance to get a slightly reduced lease rate.

Sixth: Let’s look at sales and marketing expense. If you sell a refrigerator, a bicycle, a railroad car, an oil drilling rig, your sales and marketing expense, with its salaries and commissions, goes into more or less the same quarter where you recognize your sales revenue, and it makes total sense. That enables you to see how well your company is doing.

But you remember that I said, when talking about SaaS companies, that the accounting and evaluation metrics haven’t caught up with them yet. As I understand it, when a SaaS company makes a sale, the sales and marketing expense, with its salaries and commissions, goes into the quarter when the sale is made, but only one-fortieth of the revenue that will come from that sale over the next 10 years with very little further S&M expense, is recognized in that quarter. (One quarter’s worth out of forty quarters).

Probably a lot less than one-fortieth actually, as the customers usually spend more each year (see dollar based retention rates above), maybe one-one hundredth, but we can be conservative and think of it as one-fortieth.

Seven: So guess what? Duh…! The S&M expenses dwarf the revenue at first, and the SaaS companies show big “losses” according to current accounting. How could they not if all the sales expenses are counted, but only 1% to 2% of the total revenue from the sale is counted.

As opposed to the companies selling bicycles or oil rigs, current accounting does NOT give you an idea of how well your company is doing. As I’ve heard more than one SaaS company CEO say something like, “We’d be crazy not to spend every penny we can of S&M to sign up new customers now, before anyone else signs them up, because they will be our customers forever.”

So when people make snarky remarks about our “loss-making” companies, remember that they may not entirely understand what is going on.