As many of you are aware, I have not published for a few days. Believe me, I have 4 drafts of content I put together. It varied from inflation, to macro, to stock analysis and it wasn’t until this one that I felt was most appropriate. I mean, what the hell am I supposed to say when the NASDAQ is nearly down 40% from its high (yes, it’s been that much) and no end in sight. It’s not easy to navigate, you’re not alone and everybody is getting torn up unless you’re in cash. But, being in cash is not where the opportunity is.
This market is hard and my short term paper losses are real as most investors are. Every day we have to watch businesses that we own go down for no reason/fault of their own. We watch our wealth vanish in days/weeks/months because of…. The Fed? Believe me, I know and understand the Fed, liquidity and why it’s important to economic/market function. But at some point the Fed begins to over shadow what’s going on with the individual businesses. The micro environment is equally as important as macro.
Let that sink in for a moment were we simplify exactly what this is. “This” being the business we are in. The purpose of the stock market is to buy and sell corporate equity based on the prospects of the business, to generate wealth and let someone else work for us. Yes, it’s that simple. Or, at least, that’s what it was supposed to be.
That was until somebody wanted to “beat the market”, preserve wealth and prevent the major draw downs. Truthfully, most younger investors when the first get started out perform the markets if they just buy good businesses. I recall back in 2021 basically everyone was out performing the market only to give it all back because reality hit. Returns come at a price…. Volatility.
Volatility is extremely difficult to deal with. Like I mentioned above, we watch our wealth VANISH over night and come Monday morning it’s like we know we are going to see red on our screen, bad news and ALL CAPS TWEETS BECAUSE THE WORLD IS ENDING. None of this is fun and it makes it worse when everyone is screaming, “sell, sell, sell, raise cash, sell!” Meanwhile, I am criticized on a daily basis for holding my stocks and buying businesses I believe in. Unfortunately I have never had a desire to participate in the Wall Street crowd. After all, why would I follow that crowd?
Outperformance is hard because it requires you to do what that 80% is NOT willing to do. Buy. The. Dip. On. Great. Businesses. And. Wait.
It sounds like a no brainer but for every reason I listed above, it makes it extremely hard. If you’re wondering if long term investing works or not, please read my friend Eric’s SubStack. Eric is a self made multi-millionaire made through participating in the market. He has invested through the 2000 dot com bust, 2008 GFC, 2020 COVID crash and the monetary/fiscal policy flop of 2022. I follow guys like Eric because they show people their account, their positions and the wealth they have. I don’t know any multi-millionaire traders, none. I value his experience because I am younger, 31, and was 8 when he began investing.
The ones I do know that trade… The ones that are still around from 2021, are quick to criticize but never show their real results. ever. Or their real wealth. Usually they sell expensive courses that teach you what a $15 book (how to make money in stocks) teaches you.
So, Today, The Most Appropriate Thing to Do is Go Over How to Analyze a Business and How You Can Tell if it’s Good or Not
I post a lot about macro but I do that because I am usually trying to get a pulse on where the market is going. Sometimes I am right, sometimes I am wrong but the core foundation of who I am is a stock picker and investor. Nothing more, nothing less. I love picking excellent businesses, developing a thesis and following along with the story to ensure I made a good investment. After all this will generate more wealth over time.
Let’s analyze a crowd favorite today, why I have zero problem buying more, and then we will go over my portfolio. Let me know what you think about the change of pace here:
DataDog
There is a lot that goes into stock selection and understanding a business but at the core of everything, there is only one reason and one reason alone why a stock goes up over time.
They generate a return on investment
This means that if you put $100 into a stock, you expect some sort of return on that $100, right? Whether that’s in the form of a stock jiggle up or down, or over time, you need a real capital return. So today, we are going to focus primarily on DataDog’s financials because that is the most important part of stock selection. We will cover the business model at a later date.
Financial Statement Analysis
There are three financial statements:
Income statement
Balance Sheet
Cash flow statement
Each one of them work together and in DataDog’s case, it gives me the conviction to buy more even when the stock goes goes. The financial statements are “reports” of a business function. These reports give you insight about the health of the company, where cash is going and its ability to survive as well as keep growing. From there, we obviously would need to access the business model and competitive environment but we’ll stay on track with the financials.
If we think about today’s macro economic risks, what should we be concerned about?
Inflation (obviously)
Fed raising rates
Economic slow down
Global conflict
High energy prices
Perhaps the most important of this is raising interest rates because it impacts a businesses balance sheet. So in the case of DataDog, we are going to examine their financials to see if the macroeconomic picture actually impacts them or presents a risk.
Income Statement
In an economic slow down or a period of increased risk, we need a business to actually be making money. In this situation, we have to assess if DataDog is actually making but double check to see if they are “purposefully” showing unprofitability by using the cash flow statement at the same time as the income statement. So, let’s take a peak here using a free tool for everyone Yahoo Finance.
I broke these up to into three sections. We can quickly get in the weeds when looking at these financial statements but I am going to break down exactly what each part means in a concise way while applying it to today, while thinking of today’s macroeconomic risks.
Since we have a risky environment, we want to ensure our businesses are controlling their spend and even growing in struggling economic environment. Here, we can see exactly how much money they are making as well as what they are spending their money on. Let’s break these sections down:
Revenue and Gross Profit: Growing revenue at a strong pace while maintaining a strong gross margin is essential, and usually number 1, in any good business. If we find businesses that can still grow in an economic recession, that’s HUGE! That tells us so much. It will tell us:
They have a durable competitive advantage
The demand for their product(s) are strong
In B2B businesses, it tells us they have a mission critical product
There are secular forces behind their product rather than cyclical
The Gross Profit the business keeps is essentially to any strong business performance. Basically this can also be considered as Revenue - COGS (cost of goods sold). Think of it like this; it’s what a business keeps from the initial sale. A real world example is if I sold you a car. That car costs money to produce. The gross profit would be what I keep from the price I sold the car to you for subtracted from the production price.
In the case of DataDog, their gross margin is very strong (about 80%) and their revenue is Subscription based while maintaining high growth. Why is this important?
Subscription businesses have sticky products and usually have their product embedded in their customers business processes
High gross margin allows DataDog the flexibility to adjust bottom line spend to ensure health of the business
DataDog’s growth tell us that they are positioned to be a massive, long term, winner because they are still maintaining high growth in a turbulent economy. There is a secular need for their products, not cyclical.
Operating Expenses and Operating Profit: This is a difficult area for most investors to grasp because it does require you to benchmark these results against the cash flow statement (which is often the most confusing). The goal we should be looking for here is “are they operating profitably?” or, “if they are not operating profitably, why?” When analyzing DataDog’s income statement, let’s take a look at their line items:
Operating expenses totaling $327.3m
Sales, General and Administrative expense is $149.6m
Marketing expense $115m
R&D expense is $177m
Operating income is slightly negative at -$3m
The spot where most value investors get it wrong is that they automatically say, “Ope, DataDog is unprofitable. PASS!” But this isn’t true. Remember like I mentioned that we should be looking at why they are not profitable. This is when it’s helpful to take a look at the cash flow statement.
The cash flow statement can be a whole other newsletter but we are focusing on the income statement and how to use the cash flow statement to supplement the income statement. In this case, I highlighted the 3 areas to look:
In the first part (1) you can see that they actually had POSITIVE CASH FLOW from operations. But, if we looked at the income statement, remember that it said we had a -$3m operating income? How is this possible?
Stock based compensation (2) is an expense that can be written off under GAAP principles. That means that under general accepted accounting principles, businesses can “write off” SBC to NOT PAY TAXES. Basically, businesses are incentivized to not show an operating profit and they will usually do this by offering stock incentive plans and rewards.
Free cash flow (3) is arguably one of the most important pieces to the cash flow statement. This shows us the net change in cash on their balance sheet. DataDog made $60m of untaxed income. This means they are actually increasing the cash on their balance sheet while not necessarily showing “GAAP profitability”, while they are actually increasing the strength of their balance sheet and business.
Let’s Bring DataDog’s Income Statement Full Circle and Apply it to Today’s Macro Risks
The most important thing, when looking at an income statement, is to see if they are:
Growing during a slowing economy
Operating profitably
An ability to cut expenses, if need be, to prevent any bankruptcy
DataDog checks all these box’s. Since they are growing, with continued strong growth, during an economic recession they are likely to emerge as a long term winner and be one of the first stocks to recover when the market decides to not be emotional anymore.
This is just one piece of the puzzle I look at to ensure that I feel safe “buying the dip” on my businesses. To see more of what I look for, consider subscribing and let me know your thoughts/questions:
Dillon’s Positions
Perhaps, this is one of the biggest reasons why I have been hesitant to release anything because I am trying to figure out exactly how to position my portfolio. I am asking myself:
Where are my convictions?
Does long term investing work?
What is my strategy?
Why is the Fed so stupid?
What house do I burn down? (just kidding)
It has taken me time to readjust after the damn NASDAQ dropped 21%+ in 6 weeks (this is a massive move). After much deliberation, I am sticking to my strategy.
Fiscal Year 2022, Year of Accumulation
Here are the moves I have made:
Keep reading with a 7-day free trial
Subscribe to BluSuit to keep reading this post and get 7 days of free access to the full post archives.