Qualitative Checklist Part 2 of 3
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Welcome back to Part 2 of our qualitative checklist series. Let’s get right into it!
6. Large and growing addressable market
High returns on capital coupled with a big reinvestment runway and a deep moat is the key to compounding. There are certainly riches in niches but if the company saturates its market, it can’t really grow. The best companies even constantly expand their market size as they venture into other areas. Amazon is the best example of this as it started as a book reseller but from early on, Bezos knew they would expand into other categories. And then, of course, AWS was completely unexpected. However, a large market alone is not a good enough reason to make an investment. The classic “if we only get 0.1% of the market, we’ll be a great company” pitch isn’t really convincing. Big markets also mean more competition. So there are upsides and downsides. However, a big market with tailwinds offsets some of the effects of competition. That’s why this criterion (fancy word, huh?) is a large and growing market. If the market is shrinking, those headwinds will be hard to overcome as competitors want to grow but the pie is getting smaller.
7. Recurring revenue
Companies with recurring revenue have multiple advantages. For one, they can predict demand more easily. This enables them to hire efficiently rather than overhire when demand peaks while also investing wisely for growth. Two, customer acquisition costs are typically much lower in these businesses. Retaining a customer is so much cheaper than getting a new one. Now, this doesn’t have to mean a software/subscription business. I would say that Starbucks has a certain degree of recurring revenue and maybe even Chipotle. Or a company like Pool Corp that distributes chemicals and pool equipment to maintain pools, of which 80% is recurring. And the same goes for Bill.com. 80% of its transactions are recurring as businesses pay bills to their regular suppliers. The point is that there are varying degrees of recurring. A true SaaS company with 98% gross retention has much more “true” recurring revenue than Starbucks. And therefore, the multiples should be different. Thinking through just how recurring revenue actually is and how many customer interactions the company has is important. If a customer orders a fridge from Samsung, they may not need to interface with Samsung for another 15 years. However, for a SaaS company that every employee uses daily, the number of customer interactions builds loyalty if the company does a good job.