15 September 2022

Trey chats with Brian Feroldi to discuss stock picks like Alphabet, FIGS, and AXON. They also explored some thoughts around valuation and how some of the best investors of all time have evolved their strategies and thinking.

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  • How and when to apply metrics like P/E, P/GM, and P/S depending on a company’s stage in its lifecycle
  • Brian’s most important attribute when valuing a company
  • The difference between real moats and fake moats
  • When to emphasize valuation and when not to
  • Brian’s assessments of Alphabet, FIGS & AXON
  • And a whole lot more!


Disclaimer: The transcript that follows has been generated using artificial intelligence. We strive to be as accurate as possible, but minor errors and slightly off timestamps may be present due to platform differences.

Trey Lockerbie (00:03):
Today, we welcome back our friend Brian Feroldi to discuss a few stock picks like Alphabet, FIGS, and AXON. Before we dig into the discussion, we explore some thoughts around valuation and how some of the best investors of all time have evolved their strategies and thinking. In this episode, you will learn how and when to apply metrics like price to earnings, price to gross margin, and price to sales, depending on a company’s stage in its life cycle. Brian’s most important attribute when valuing a company, the difference between real moats and fake moats, when to emphasize valuation and when not to. Brian’s thorough assessments of Alphabet, FIGS and AXON, and a whole lot more.

Trey Lockerbie (00:40):
Brian is always such a fun guest to speak with, and I always walk away feeling smarter. So without further ado, I hope you enjoy this conversation with Brian Feroldi.

Intro (00:53):
You are listening to The Investor’s Podcast, where we study the financial markets and read the books that influence self-made billionaires the most. We keep you informed and prepared for the unexpected.

Trey Lockerbie (01:12):
Welcome to The Investor’s Podcast. I’m your host, Trey Lockerbie, and today I’m so excited because we have our good friend back on the show, Mr. Brian Feroldi. Brian, welcome back.

Brian Feroldi (01:22):
Trey, awesome to be here. Thanks so much for having me again.

Trey Lockerbie (01:26):
I brought you back because I’ve been spending all this time in the macro world recently, and I thought it’d be fun to kind of dive back into the micro a little bit. I want to talk a little bit about valuation, a couple of things around metrics, but then also some stock picks. I just thought it’d be good to kind of see what the market’s offering up nowadays. There’s a few interesting picks out there that you’ve done a bunch of research on that I wanted to dig into. So I’m excited to have you on the show.

Trey Lockerbie (01:53):
And one of the things I learned from you very early on is the idea that the price-to-earnings ratio may not be all it’s hyped up to be, or should I say that it’s only relevant some of the time. That’s really stuck with me. I’ve been putting that into practice ever since we first spoke about it. But I’d like to provide the audience an opportunity here to learn exactly about what you mean about the price-to-earnings ratio and actually maybe the first time you realized it wasn’t maybe your primary focus.

Brian Feroldi (02:22):
The P/E ratio is one of my favorite valuation metrics to use. The unfortunate thing about the P/E ratio is that there are many, many, many cases when the P/E ratio is just absolutely useless as a tool for figuring out what a company is worth. The first time I really realized this was in the early part of the 2010s. Because I vividly remember the year was 2006, and at the time, the company that I was working for had just switched our software to this amazing new cloud-based tool called Salesforce.com. As an employee, I got access to this software and I immediately was like, “Wow, this is so much better than what we had before.” I mean, I was just instantaneously blown away with how this software worked.

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Brian Feroldi (03:14):
So at the time, I was new to investing, and I went to see, hey, I wonder if this company’s publicly traded? Lo and behold, it was. And I was like, “I love the software.” Our company would literally shut down if this software stopped working. It’s that important. And I was like, “I wonder what the company’s trading at?” Well, I looked up and I knew enough about valuation to know that a very high P/E ratio was just an automatic don’t buy. And at the time, this was 2006, Salesforce.com’s P/E ratio was 160. And I was like, “Isn’t the market 15 or 20? So is this company really eight times the value of the market in general?”

Brian Feroldi (03:54):
So it was the first time when I looked at a company, knew the P/E ratio, and just instantaneously passed, right? Way too expensive, can’t buy this thing. And if you followed Salesforce.com at all, you probably know that this has been a tremendous winner. In fact, from that 160 P/E ratio that I passed at, the stock is currently up 2250%. So I am currently, I’ve missed out on a 20X return on this company that I had insights into very early on as a customer but I passed on simply because the P/E ratio was too high. And that’s not the only stock that this has happened to me on. This is one that stings the most because the P/E ratio really led me astray.

Trey Lockerbie (04:37):
Well, you are not alone. Let me just assure you there, because I’ve definitely made that exact same mistake. And I know our good friend Morgan Housel has done a lot of cool research around this. He’s actually provided this chart where he showed exactly the P/E ratio you would’ve bought a company at to get the market return of around 8%. And some of the stocks on there at the time were listed pretty highly, maybe over 20, but you would actually have bought it at 40 just to get a market return. It’s just really interesting. So not to say it’s not relevant. Like I said earlier, there are times where it makes sense. So what are the phases of a company’s growth in which maybe it’s less relevant and then where it becomes relevant?

Brian Feroldi (05:17):
Yeah, Trey, that table that you’re referring to blew me away the first time that I saw it. And for those that are listening, what this chart showed was the actual P/E ratio of the Dow components in 1995, and then the P/E ratio that a willing investor should have been willing to pay in 1995 to earn a market-matching return.

Brian Feroldi (05:40):
And some of the ones that stick out during this time period is a company such as Home Depot. In 1995, Home Depot was trading at 36 times earnings. In no world would you call that P/E ratio cheap. And yet, even though it was trading at 36 times earnings, it smashed the market’s return. So much so that investor could have been willing to pay 77 times earnings for Home Depot in 1995 and they still would’ve earned a market-matching return.

Brian Feroldi (06:12):
Conversely, in 1995, Alcoa was trading at 10 times earnings, a cheap number, a low number in absolute terms, and yet to earn an 8% return in 1995 on Alcoa, you would’ve had to bought the company at three times earnings. So in other words, Alcoa at 10 times earnings in 1995 was incredibly overvalued and Home Depot at 36 times earnings 1995 was incredibly undervalued.

Brian Feroldi (06:41):
And the table just really hammers home the point about how valuation is really, really important in the short term, but what truly matters in the long term is, did you buy a great company or not?

Trey Lockerbie (06:52):
There’s actually some considerable research around this, primarily from Morgan Stanley. So why don’t you walk us through this chart. And for those listening, you can just hear the percentages that Brian will show up, but this will really, I think, help provide a great example of what we’re talking about here.

Brian Feroldi (07:06):
Yeah. So over a 20-year period, from 1990 to 2009, Morgan Stanley and BCG Analysis did some research about what is the factor that leads to stock market performance? What is the factor that drives the stock higher over various periods of time? And they actually quantified the results. What their analysis showed that was over a one-year period, the number one driver of returns of a stock was the multiple, valuation, the P/E ratio. In other words, if you want to outperform in the short term, you better buy at the right valuation, right? You buy a low valuation that expands, you’re up. You do the reverse, you’re down.

Brian Feroldi (07:45):
However, what this same study showed is that the longer you’re holding period, the less and less and less important that valuation becomes. In fact, the biggest, the number one driver of stock returns over a 10-year period by far is revenue growth. Revenue growth accounted for 74% of the outperformance of a stock over a 10-year period. And over that same period, the changes in the multiple, the changes in valuation only accounted for 5% of that growth.

Brian Feroldi (08:15):
And what that really hammers home to me is in the short term valuation is everything, but in the long term it’s really the quality of the business that shines through.

Trey Lockerbie (08:24):
Essentially saying that the stock price is tied to its earnings over time. And it goes back to that Ben Graham quote about the stock market being a voting machine in the short term, but a weighing machine in the long term. And I think this is exactly what he was intuitively talking about back then in the 40s.

Trey Lockerbie (08:40):
So just to tie the knot on that point, there are phases of when we should focus on valuation in a company’s growth cycle, right? So maybe give a couple of examples of companies either today or in your experience where it’s been less relevant and then become more relevant when you’re assessing the stock.

Brian Feroldi (08:57):
Yeah. So this depends on the company that you’re talking about. But by and large, I created a chart that basically walks through the various phases that a very successful growth company goes through on its way from being founding all the way to making its way into the S&P 500 and then falling out and fading away into obscurity.

Brian Feroldi (09:18):
So when a company is founded, there are no financial statements to look at, right? There’s no revenue. There’s no sales. There’s no margins. There’s no anything. All you have is an idea. At that point, what is the company’s price-to-earnings ratio? It’s infinite. There are no earnings to measure. But was it a good idea to invest in Apple and Google, and Microsoft and Intel, et cetera at their founding? You bet it was. So the P/E ratio is useless when a company is founded.

Brian Feroldi (09:41):
After a company gets started, it’s very common for those companies to be in very fast growth mode, right? They’ve clearly nailed and demonstrated product market fit, and all of the company’s energy and resources are devoted to growing the top line higher, adding customers, capturing market share, executing on the opportunity that they see at them. It’s very common for companies that are in this stage to be running off of venture capital or investor funds and to be outspending their own sales growth because their focus is capturing market share. So it’s very common in companies that are in the launch and hypergrowth stage to be losing money. Now, is the P/E ratio useful in this stage? Well, no, there’s no earnings. There’s no E, so the P/E ratio is absolutely useless in this stage.

Brian Feroldi (10:27):
Eventually, as the company grows and the company scales, there becomes a tipping point when it goes from losing money to reaching break even and starting to make a little bit of money. At this point, the company goes from not having earnings to having earnings. And when you’re looking at a company in its hypergrowth stage, when again, the top line is still the focus, it’s very common for the earnings power of the company, the true earnings power of the company to be severely understated. Again, because all the company’s resources are devoted to the top line growth. So companies in this stage do have a P/E ratio. However, that P/E ratio is often 1,000 or 500 or 100 because the earnings power of the business is so depressed because it’s not the focus.

Brian Feroldi (11:11):
However, eventually a company realizes all of the gains of scale and does start to focus on bottom line profitability, starts to generate bottom line earnings. It’s only when a company reaches true operating scale and is fully optimized for profits that the earnings power of the business shines through. And this is finally the stage when the P/E ratio becomes meaningful.

Brian Feroldi (11:38):
The trouble that investors get into and the mistake that I made on Salesforce.com all those years ago was I was using the P/E ratio, which is a great ratio for judging mature companies, to judge a hypergrowth company. This is why for the last 20 years people have been screaming about the P/E ratios of, fill in the blank, growth stock, right? Amazon, Tesla, Netflix, et cetera. All of them have had sky-high P/E ratios because their true earnings power has not been demonstrated in the financial statements.

Brian Feroldi (12:08):
So it’s just a mistake, a common mistake that a lot of investors make when they only look at the P/E ratio is they’re using this metric that isn’t yet meaningful at the wrong time.

Trey Lockerbie (12:17):
When we are assessing a company earlier in its life cycle, what are some of your go-to metrics that you do like to focus on if it’s not the P/E ratio?

Brian Feroldi (12:27):
So it depends on the stage that the company is in. And there are, in some cases there are no good answers. However, I like to think of it through the way that the income statement works. So the income statement starts with revenue and it flows all the way down to net income, right? So net income, earnings is the bottom line. And when a company is fully optimized up and down the income statement, that’s when the P/E ratio becomes useful. However, if that number is not currently useful, you’re kind of forced to go higher up the income statement along the way to account for those factors.

Brian Feroldi (12:58):
So prior to the P/E ratio becoming useful, sometimes you have to go to price to EBITDA, which is not a metric that I like, even though a lot of management teams tout that number like crazy, but that’s because everything below the E-B-I-T-D-A is hiding the true earnings power of the business. Prior to that, even if a company isn’t optimized for EBITDA, sometimes you have to go one step higher, and the number higher than there is called gross profit. So it’s revenue minus cost of good sold.

Brian Feroldi (13:25):
And a metric that I often look at is called the price-to-gross profit ratio. If a company’s gross margin is optimized, I actually think the price-to-gross profit ratio oftentimes is more useful than the more commonly known price-to-sales ratio. But if a company isn’t optimized for gross profit, you’d have to go one step higher and you have to look at the price-to-sales ratio.

Brian Feroldi (13:47):
In general, the earlier the company is in its growth phase, the higher you have to go on its income statement to judge the valuation of a company. So that is one way to think about how to value companies depending on the growth stage that they’re in.

Trey Lockerbie (14:00):
In your opinion, what do you think is the number one most important attribute to be focused on when you’re determining to invest in a company or not, maybe irregardless of its life cycle stage?

Brian Feroldi (14:14):
Well, I think the Buffet quote says it best. And I’m going to butcher it, but I know that it’s there. And it says, “When the key to assessing a business isn’t how fast it’s going to grow, the key to think about is the company’s competitive advantage, and above all the durability of that advantage.”

Brian Feroldi (14:31):
To me, I won’t invest in a company unless I think that it has a moat or a competitive advantage, some factor that’s going to keep its profits protected from the inevitable forces of competition. If a company is out there and they have a hit product of some kind and they’re making money, you can be sure that eventually competitors will crop up that says, “Hey, I want a piece of that.” They’ll offer the same product or service, sometimes for less in order to capture market share. And in order to compete and to maintain your market share, companies often lower prices to maintain their customers. Doing so is hugely detrimental to the profitability of a business.

Brian Feroldi (15:12):
So to me, I won’t invest in a company unless I believe that it A, has a moat, or it B, is actively building out a moat for itself.

Trey Lockerbie (15:22):
When people think about moats, there’s a lot of things that come to mind, management, great product, you name it. What are some things, in your opinion, you would categorize as somewhat of a fake moat, meaning it’s perceived as a moat, but over time maybe it loses its relevance?

Brian Feroldi (15:36):
Yeah, a few of them come to mind. One of the more popular fake moats that I’ve seen in the past is a popular product. So a product is the latest, shiniest thing of the day and demand for that product seems to be going nowhere but up over a short period of time. And these are actually really, really tricky to spot in real time because if you’re just looking at the financial statements, oftentimes they look awesome. They look really great. Revenues heading in the right direction, margins are good, profits are growing up. However, if that product is just temporarily popular, not permanently popular, that can be a fake moat.

Brian Feroldi (16:13):
In recent history. I would say a couple good examples of that would be products like GoPro. I remember when GoPro came public a few years ago, their growth looked outstanding. But then they quickly saturated their market and they were forced to slash prices at retailers in order to drive product sales. So that, I think, was a fake moat.

Brian Feroldi (16:31):
Another one was Fitbit, or perhaps more recently you could say Peloton has a fake moat given the enormous demand they saw in 2019 and 2020 that immediately evaporated once people had that. Or even in the fashion industry. I remember a couple years ago a company called Michael Kors became public. And at the time, that brand was red hot, everything was going well for that business. But slowly that brand faded away, lost its relevance and profits and revenue did too.

Brian Feroldi (16:59):
So just because a product is popular doesn’t automatically mean that a moat is being built.

Trey Lockerbie (17:05):
One thing I really love about your style is you have a very clear investing regiment. You follow a checklist and you do a number of things that set you up for success, which ultimately leads to having this investing thesis, which I think a lot of people just don’t actually have when they go into stock. So the reason why that’s so important is that you have to know when your thesis is busted.

Trey Lockerbie (17:25):
And I’m just going to use this example, because I don’t know if you’re invested in this or if you’ve even got a thesis around it, but Shopify, for example. Fast-growing company and we saw this huge ramp up in their stock price and their business just when COVID hit because e-commerce, the demand got kind of pulled forward quite a bit. And during that time, you can’t really blame the management for this, but they went really big, right? I think they put $100 million or so into R&D. And they went from a positive earnings to a negative earnings over the last quarter that just came out. So I’m curious, when you see stuff like that, is that a thesis buster or is that just sort of par for the course in the long roadmap of a positive company?

Brian Feroldi (18:03):
Yeah, what we’ve seen over the last couple of years has been extraordinary. In 2020, companies like Shopify had more business and more demand than they knew what to do with. They just foresaw this huge bolus of people ordering online like never before. And those management teams at companies like Shopify, companies like Etsy, companies like Amazon saw that demand and bet big immediately to fulfill that demand. So we saw many of those companies just invest hugely in their own capital expenditures to fulfill the extreme demand that they’ve seen. The bet that they were making was that that will be the new rate of demand for e-commerce products indefinitely.

Brian Feroldi (18:47):
Unfortunately, what we’ve seen over the last six months or so is that all of those shoppers that were forced to go online have since returned in a large way to shopping back in stores. And the growth rate of many of those e-commerce companies have come plunging down. And now those companies essentially over bet, they overbuilt. They have way too much capacity. When you have too much capacity and that demand that you’re betting on doesn’t come through, that does awful things to your income statement in the short term. And those businesses are being forced to right size their businesses in order to fulfill the actual demand, not the demand that they thought. So companies like Amazon, companies like Shopify clearly overbuilt and overhired, and now we’re seeing the reverse of that where they’re actually laying off people in light of the small demand.

Brian Feroldi (19:33):
So the question that I try and ask myself when I see something like that is, okay, is the thesis for owning this stock busted or did the expectations for the company seem to get out of hand? When I look at Shopify’s recent results, the bottom line losses, and I’m saying layoffs are coming, are not pleasant to see. But I also see that Shopify grew its revenue 16% in its awful, god awful, terrible quarter. 16% growth on top of extreme hypergrowth in the prior year. In fact, their three-year revenue growth rate is 53%. So when I see the company is still growing its revenue at a double-digit rate today off of those extremely high comparisons from the year ago period, I don’t think that the thesis is busted for Shopify. I think that the management team overbuilt out, has admitted its error, and is now pulling back.

Brian Feroldi (20:23):
Conversely, when I see the demand destruction at a company like Peloton, Peloton is really saying canceling orders. And that company is seeing its revenue declining, margins are hugely under pressure, and they’re trying to do all kinds of things. With a company like Peloton, if you bought a Peloton two or three years ago, why do you need to buy another one? Right? So they actually need new consumers to come in to buy their expensive devices to use them in-house when the demand for that product in general is evaporating.

Brian Feroldi (20:51):
So when I look at the differences between Peloton and Shopify, Shopify I still think the thesis is on track, although I could be proven wrong in time, but a company like Peloton, I would be much more willing to say I was wrong and sell and learn a lesson.

Trey Lockerbie (21:05):
Is there any period of grace you give these companies that you’ve determined in advance that two consecutive quarters in a row, do you give them some forgiveness and then let them come back and prove it? Or what’s your take on when it is time to say, “Okay, this thesis is busted?”

Brian Feroldi (21:20):
So the thesis for Shopify all along for many, many years has been growth and e-commerce generally. Shopify makes it super easy to set up a site, and importantly, a lot of small businesses are going to prefer to own their own distribution through a company like Shopify as opposed to renting it on places like Amazon. And I think it’s been well publicized that Amazon, for all the great things that it does, sees products that are working well, says, yes, please, I’ll take that, and they effectively compete against their own customers. By contrast, Shopify does not do any of that.

Brian Feroldi (21:54):
So if I was a small business, I would be reluctant to list on Amazon and I would really try and use Shopify. That difference in positioning I think actually gives Shopify a durable competitive advantage over the likes of Amazon. So that is the large thesis for this, that Shopify is a diversified way to play the broad-based growth in the internet around the world.

Brian Feroldi (22:16):
As far as I can tell, the thesis for that is still firmly on track. So I expect the next year or so to probably be pretty rough for Shopify. But I don’t invest over short-term periods of time. The thesis is where is Shopify going to be in 2030? I still think the answer is much bigger than it is today.

Trey Lockerbie (22:33):
And it does look like they’re chasing the heels of Amazon a little bit by building out more and more of their distribution so they can deliver to customers and not have to rely on third parties as much. There’s been some recent deals around that.

Trey Lockerbie (22:44):
To that point though, as someone who does sell product on Amazon and Shopify, I can tell you that there’s an interesting dynamic playing out here where a lot of customers, although they might not buy on Amazon, they still use it as a search engine of sorts. Say they’re in the grocery store, they see a product for the first time, they’ll search for it on Amazon just to check the reviews because there’s a ton of reviews, the star ratings, the comments. And I wonder how Shopify will compete with something like that in the long term. It’s just kind of interesting maybe on the sales side, but it’s still driving a lot of traffic just to Amazon for that one reason.

Brian Feroldi (23:18):
Well, in the longer term, I’ve actually seen some recent studies, or at least people producing content that say the number one way that whatever the youngest generation is called, I don’t even know, Gen Z, Gen whatever it is, do you know how they’re searching for things nowadays? TikTok. That is becoming their go-to search engine where they go to TikTok first to get reviews and stuff on there. I’m pretty sure that Shopify has an agreement with TikTok to do cross-promotion. So that is something that if that trend holds and persists might actually benefit Shopify secondarily.

Trey Lockerbie (23:51):
That’s very interesting. A little bit more on valuation here. I know that you started out just like me, and by reading all of the classic investing books, researching Buffet and Munger and many others. And there’s this line that Buffet told our recent guest Brent Beshore a while back when he was having dinner with him. And Brent was pressing him on his diligence process. And he kind of put his fists on the table and said, “Price is my due diligence.” And that really stuck with me because it kind of resonated with what I had learned from Buffet, which was to buy a dollar for 50 cents. Right?

Trey Lockerbie (24:22):
But interestingly enough, Buffet didn’t make any investments at the lows of the 2020 COVID correction and instead has been buying billions of dollars of stock worth in the last six months here, sometimes near these decade highs. So sometimes you have to watch what Buffet does more than what he says. And given his long time horizon for his investments, perhaps he is more knowledgeable given those studies we mentioned earlier and perhaps he’s even de-emphasizing valuation over time. What are your thoughts on perhaps he’s even taking your lead, Brian?

Brian Feroldi (24:54):
So Buffet is a master. I have learned absolutely so much from Buffet and he has so much to teach. But I have learned that there are actually many different mindsets you can take when it comes to valuation to invest successfully. Buffet is the one that’s often thrown up, but I actually think that valuation and the mindset for valuation is really a spectrum.

Brian Feroldi (25:19):
So on one side of the spectrum, think about pure value investors. That mindset is what Buffet said, “Price is my due diligence.” I don’t care. The mindset is I don’t care what I’m buying as long as I’m buying the thing cheaply enough, as long as the expectations are so low that I can make money if the price is right. On the exact opposite side of the spectrum is the way that venture capitalists invest. So people like Marc Andreessen. Marc Andreessen, valuation isn’t even on his radar in many cases. The only thing venture capitalists like Mark Andreessen care about, what is the upside if I’m right and what are the chances that I’ll be right? It doesn’t matter to him if he overpays or overvalues the next Google, what matters to him is he buys the next Google.

Brian Feroldi (26:06):
So I think that a lot of investors are somewhere between those two extremes. And you can learn lessons from people that practice both sides of the extreme. I myself started out far more on the left-hand side, on the side that was valuation-focused. And slowly, over time, I’ve shifted more to the right and have become less valuation-focused, in part because some of the research and the findings that we saw previously.

Brian Feroldi (26:33):
But I think that everyone kind of exists somewhere on this spectrum and great investors exist on both sides. You have Benjamin Graham, Warren Buffet on one side, and you have people like Mark Andreessen and David Gardner on the other, and then in the middle somewhere are some other investors like Peter Lynch and Mohnish Pabrai and Charlie Munger, et cetera. So I don’t think there’s any one mindset that is “correct” when it comes to valuation, I think it really depends on the investor.

Trey Lockerbie (27:00):
I wanted to highlight an example that might surprise a lot of people about Ben Graham. And Ben Graham, everyone knows Ben Graham as the godfather of value investing as you just kind of highlighted there. He had an average investment performance around 20% annualized from about 1936 to 1956, and the overall market performance around that time was 12.2 annualized, so almost double the market average. In 1948, 12 years after GEICO was founded, he bought 50% of the company for about $712,000, which is about $8.5 million today. Let’s talk about the valuation around GEICO at that time. And how did this play out for Mr. Graham?

Brian Feroldi (27:43):
Yeah, it’s funny, when Ben Graham, I’ve also seen analysis of his returns over time. And from what I understand is that while he is the father of value investing, he was an extremely disciplined investor. And he actually broke a whole bunch of his own rules when he chose to make an investment in GEICO. So yeah, he bought 50% of GEICO in 1948 for $712,000. At the time, that was 25% of his partnerships total assets. And I think he did get a decent deal on GEICO, but it wasn’t a Ben Graham cigar butt, pay the cheapest price possible deal.

Brian Feroldi (28:24):
And the interesting thing about that single move is that he bought it in 1948 and by 1972 that position was a 500 bagger for him. So $712,000 turned into $400 million for Graham and Dodd’s portfolio. In fact, he made more money off of GEICO than he did off of every other investment that his investment firm made up until then. And he had this great quote that I just love. He said, “In 1948, we made our GEICO investment, and from then on we seemed to be very brilliant people.” So even he admitted that a huge amount of his return and his performance was owned to essentially a single company.

Brian Feroldi (29:06):
And the thing that I like to point out is think back to that decision. Was GEICO a phenomenal investment because he paid a low valuation for it? No. GEICO was a phenomenal investment because it was a phenomenal company that went on to grow like crazy. The thing that Graham got right about GEICO was he bought a great company and he didn’t sell it. So if you actually make the valuation that he paid far worse, if you 10Xed the valuation that he paid at the time to acquire GEICO, if he way overpaid for GEICO at the time and he still held it, he still would’ve done incredibly well because GEICO went up so much.

Brian Feroldi (29:47):
So I love that example because he is the quintessential value investor, the literal inventor of value investing, and yet he owes a huge amount of his success as an investor to a growth stock.

Trey Lockerbie (29:58):
Maybe Buffet’s first experience of a wonderful company at a fair price, sitting next to Graham later on. So on that point, perhaps Warren’s first example of a wonderful company at a fair price, given that he was under the tutelage of Ben Graham back then. You brought up Mark Andreessen. And I thought this was kind of interesting because a lot of people think venture capital is a lot different than traditional investing because, hey, they’re taking sort of a shotgun approach and they just need one bet to outperform everything else, to kind of 10X, to kind of make money for the entire portfolio, and they can let the other 90% fall away.

Trey Lockerbie (30:33):
But what people might not realize is that traditional investing is very much the same kind of thing. And there’s some research that you’ve brought up here about exactly this. So why don’t we talk through how the average stock tends to underperform the index. How is that possible?

Brian Feroldi (30:52):
Yeah, one of my favorite studies that’s ever been done was done by FactSet and J.P. Morgan. It’s this wonderful study. It’s called the Agony and the Ecstasy, and it’s a 30-plus, 35-year study of the stocks in the Russell 3000, which essentially covers like 99% of the market cap of the U.S. stock market. And what they did in this study was they studied the returns of each individual stock and they found the broad distribution of the stocks versus the index.

Brian Feroldi (31:20):
One of the most eye-opening things about this study… I would’ve assumed at the start, if you just said what percent of the stocks beat the market and what percent lose the market, I would’ve assumed the answer was 50/50. That just intuitively makes sense to me. What this study actually found was that 66% of companies underperform the index over time, and I think the number is 40% of companies actually suffer a “catastrophic loss,” which is 70% or more, and never recover. So if you’re going to be picking stocks, you have to know that two-thirds of the time, the average stock, if you’re just picking blindly, is going to underperform the index.

Brian Feroldi (32:00):
Conversely, what that same study found was that 36% of the companies outperform the index, but the most important thing there is that 7% of the companies, only 7% of the companies that are out there generate such huge returns for investors, are such massive winners for investors that they literally drag the entire index higher. So this is very much the Pareto principle at work, the 80/20 principle, except for it’s even more extreme than that, where only a teeny minority of companies, 7% of companies literally account for the vast majority of the gains of the index.

Brian Feroldi (32:40):
And I think that one reason that index investing works so well is this chaos is completely hidden from view. When you’re investing in the S&P 500, the total stock market index, 40% of the things that you’re buying are declining in value 70% and never recovering. However, since you’re also guaranteed to get in all of the extreme winners, that is a thing that drives the stock market higher over time. So if you’re investing in individual stocks and you feel like you’re picking a whole bunch of stocks that have gone down, know that that’s normal.

Trey Lockerbie (33:12):
I think this is a perfect segue into some stock picks here because I can’t think of a single stock, maybe a couple in the FANG category, but a single stock that pulls the market higher in a asymmetric way more than Alphabet, or I might just call it Google because it’s a habit, but Alphabet. Let’s talk a little bit about Alphabet. It was recently around 20% off its all-time highs, and the P/E ratio is looking pretty tempting. So walk us through your current assessment of Google.

Brian Feroldi (33:42):
So Google has been a core holding of mine for I think 14 years now, and I’ve never sold it and it’s one of my top positions today. Everyone knows what Google does. Google is a big ad company that owns some of the most valuable real estate in the world on the internet, and it’s essentially become like a toll booth for accessing the internet. That still remains true to its day.

Brian Feroldi (34:06):
To your point, Google is at the stage when it is hyper optimized for profit. So this is a company that the P/E ratio is useful except for, there’s a big caveat that needs to be thrown in there, and that is Google has investments in other companies. It’s made bets on other companies. A recent change to the accounting standards now make it so when those investments go up in value, Google has to mark up its net income during that time period. And conversely, when those companies go down in value, if their stocks decline in value, Google has to mark down its earnings over this time period. This isn’t something that only affects Google. This affects all companies that make investments in other businesses.

Brian Feroldi (34:50):
For that reason, the earnings power of Google, the underlying business isn’t fully reflected in the earnings of the company. So you have to keep that in mind when you’re judging this company’s P/E ratio is that that E has some wonkiness to it that’s causing it to be understated and overstated depending on the recent movement of stock prices.

Brian Feroldi (35:08):
However, when I think about Google the company, I still think that hundreds of billions of dollars in ad spending is still done offline and that spending is going to gradually come online. Google has so many amazing properties in its fold. To me, the crown jewel is YouTube. In fact, in my household, if you ask any member of my household, we could only have one streaming service what would we keep? In every single case, it would be YouTube. We all watch and love YouTube more than any other streaming platform. And I know that many of my kids friends feel the same way. So I think that YouTube still has tremendous upside ahead of it.

Brian Feroldi (35:44):
And then you have to mix in all of Google’s other bets, all the moonshot projects, none of which have really paid off yet, none. But the company, it’s just a matter of time that one of them does start to move the needle for the business. But even still, the company’s core business is still growing at a double-digit rate, what are we 25 years later? So I still think that the future for Google is bright and it will just get even brighter if one of the company’s other bets pay off.

Trey Lockerbie (36:11):
Yeah, the trailing 12 months going back to 2020 is 37% for Google 25 years later, as you just mentioned. This is astronomical growth for such a massive company, a $1.5 trillion company. This is really insane. And to your point about the other bets, there’s a lot in there. There’s Nest, there’s DeepMind, which in my opinion is probably the most promising bet just sneakily in their portfolio there. But they also have Waymo, there’s a lot of promise there, and many other things. The stickiness with Google we’ve talked about on the show before, but it’s almost unlike anything else I’ve ever seen.

Trey Lockerbie (36:47):
Walk us through a couple of the qualitative things you look at because I found this really fascinating as well. Things like employee ratings, insider ownership, management. What’s the scorecard you look at on a qualitative basis?

Brian Feroldi (37:03):
There’s a number of factors when you’re investing that you have to keep in mind, or at least I like to think about. It’s not just looking at the financials. To me, the financials are like a company’s wake. It’s the trailing things of what they’ve done. I want to see rapidly improving financials. I want to see profits. I want to see free cash flow. But that’s not the thing that tells you what’s going to happen next.

Brian Feroldi (37:23):
When it comes to what’s going to happen next, that’s when things like, do I think the company has moat matters? Does the company have optionality? In other words, is it actively developing new products and new services that could in the future open up new revenue opportunities? Does it have low customer acquisition costs? Meaning it doesn’t have to spend a lot on sales and marketing to bring in new customers. Who’s in charge? Have they been at the company for a long time? Are they a recently hired gun? How much stock does the company’s insiders hold? What do the employees think of the company?

Brian Feroldi (37:55):
Many of those things I just said don’t matter at all if you’re trying to buy Google for the next three months. All right? They literally don’t matter at all to the company making or missing its next quarterly report. However, all those factors that I have just mentioned, I believe do really matter in the long term to trading a sustainable company that consistently grows and delivers for shareholders. So there’s a couple of the attributes that I look for to determine whether or not a company’s worth investing in.

Trey Lockerbie (38:22):
Another promising part of Google is its cloud business. And that’s been burgeoning and expanding rapidly as well. And we saw this with Amazon just dominating. I mean, half of the internet kind of flows through Amazon, AWS now. So talk to us about what to watch. To your point about the rear-view versus the dashboard here, what are some things you’re watching just to make sure this thesis stays on track?

Brian Feroldi (38:46):
Yeah, I want to see… I mean, despite the fact that cloud and YouTube and many of the companies other bets are very promising and growing very quickly, there’s no doubt that still the lion’s share of this company’s revenue comes from its core search and advertising business. So that is still the lion’s share of growth today. However, I think that the search market that the company has is mature, although it is still growing. And the other services, namely YouTube, and to your point, Google Cloud are growing fast enough and are starting to reach enough scale to actually move the needle for the company.

Brian Feroldi (39:18):
So last quarter, for example, Google recorded $69 billion in total revenue, and of that just $6 billion, “just $6 billion” was from the company’s Google Cloud division. That’s actually one of the company’s fastest-growing divisions, growing over 40% during the quarter. And YouTube is also growing pretty quickly too. So over time, my expectation is that the core search market continues to grow, albeit at a slower rate. But the other of the businesses that have more growth to them, YouTube and Google Cloud and the other bets that we mentioned before, are going to pick up the slack to ensure that this company can continue to grow its top line at an acceptable rate.

Trey Lockerbie (39:55):
A couple other things to note about Google is that its balance sheet is just pristine. This is obviously maybe the best business model that’s ever existed, and it just shows in the balance sheet. You can look at it right now. But there’s $164 billion of cash sitting on Google’s balance sheet, only about $13 billion of debt. Just proving that it’s got a lot of ammunition should things turn south and there are some opportunities for more acquisitions and to just keep building out that portfolio that should be creating the next few decades of Google’s growth.

Trey Lockerbie (40:27):
And one interesting fact about Google is that since it’s IPO, it’s gone up 4500%, 4560% at the time of this recording. So I thought that was pretty good, right? I thought, hey, you did really well with that investment. And it wasn’t until I came across AXON and discovered this business and it’s growth since it’s IPO that I said, “Wow, my goodness, what an amazing company.” So let’s go over now to Axon and talk about this company that I believe that was surprising to me and may be surprising to some of our listeners.

Brian Feroldi (41:04):
Axon. The ticker symbol there is AXON. This is a smaller-cap company trading at around $10 billion today. You probably aren’t familiar with the name Axon, but I guarantee you’ve heard of the company’s core product, which is called the TASER. So this company used to be called TASER International, and it is by and large a company that provides tools and products that are making the bullet obsolete. So the company’s core TASER product is used to get unruly citizens to get them down without having to shoot them. And then the company has also made a big move into the body camera market. So we’ve seen that police officers around the United States and around the world are now being required to wear body cameras on them that record what’s happening. Axon is the number one provider of that hardware.

Brian Feroldi (41:52):
But the thing to me that is so interesting about Axon, I generally don’t like hardware companies, companies that make their money by selling products that have a physical component to them because many cases those products can be obsoleted or they’re fashionable. However, one thing that I really like about Axon is that it’s taking an Apple-like approach to its market.

Brian Feroldi (42:12):
What I mean by that is it’s building out these products to be connected to each other and to work together, and it ties all them together with software. So Axon has been investing in its own recordkeeping tool and its own software as a service product, which it broadly calls Axon Cloud. And as police officers move to this cloud, suddenly the company’s TASER products and the company’s body camera products now work seamlessly with each other. And all of those products help to reinforce the other products, which makes this company’s moat even stronger over time.

Brian Feroldi (42:46):
And this company has been growing its top line at a very robust rate over the last five years. And if you believe that these products are going to become more and more important moving forward, and you believe that Axon has the ability to create even newer products in the next couple years that we can’t even imagine today, this is one company, an under-the-radar company that I think has a very bright future.

Trey Lockerbie (43:08):
Yeah. Going back to 2017 to 2021, the TASER, as you put it, is growing at 17% on average. And the software business, which is, to your point, the most exciting part of this business, has gone up 44%. So we’re seeing really healthy growth there.

Trey Lockerbie (43:23):
And let’s just talk about the stickiness of this software because what’s so fascinating to me is this idea that you’re training all these police forces to have these cameras on their body. That is collecting valuable evidence, maybe invaluable evidence in some cases, and that lives on this cloud and switching to anything else would result in losing that evidence perhaps and reteaching all of these police forces to use something different. So the stickiness factor is extremely high. But let’s talk about how they’re using that to even broaden out into other markets.

Brian Feroldi (43:57):
Yeah. And it gets even better than that. For example, one thing that they’re doing is they’re tying their camera into a police officer’s holster. So if a police officer pulls its gun, the camera automatically turns on and starts recording. Moreover, they can use their camera to get interviews from eyewitnesses around them so that way they don’t have to take physical note-taking. So they’re really trying to minimize the recordkeeping burden on police officers, which I know is a massive thing.

Brian Feroldi (44:26):
And to go even one step further, as police departments around the United States start to adopt the system, using Axon Cloud they can securely share evidence with each other. So I think that the cloud software, as you mentioned, is the fastest growing, is the kind of sneaky, a secret sauce that keeps the rest of the company’s products top of mind.

Brian Feroldi (44:46):
But this is a company that is incredibly impressive, growing very, very fast. Very few other companies are doing what it’s doing. And when you think about the nature of selling to police forces, you have to go through a very high bar just to even be considered out there. So I really think that this company can be viewed as the Apple of police forces, and it’s actively moving into different markets too.

Trey Lockerbie (45:09):
And similar to Google, amazing balance sheet. $558 million of cash and zero debt, which you always love to see. So I mentioned that it had an impressive performance since its IPO. Axon is up 21480% from its IPO, and it was in fact a micro cap, I believe, when it was first debuting. Brian, what was the market valuation at the time of its IPO?

Brian Feroldi (45:36):
Yeah, this is a company that many, many years ago when it came public, which was 2001, back then companies used to come public way earlier than they did today. So this was a company that had a market cap of about $16 million back in 2001. So good luck finding this company back then, right? It was just so small. This would’ve been nowhere close to anybody’s radar. But that is a big reason why the returns of this business have been so massive is that it came public at such a small market cap when compared to the size of companies when they come public today.

Trey Lockerbie (46:09):
All right, let’s jump over to one more stock here. And this one is also super exciting. This is very interesting because it’s the first company to IPO with two female founders, which is just an interesting fact that it’s taken this long to get a stat like that. But it’s exciting to see. And this company I especially love personally. So let’s talk about FIGS.

Brian Feroldi (46:32):
FIGS is a fascinating business because I remember the first time I heard that this company was coming public, my immediate thought was pass, way too niche. But the more I’ve dug into it, the more impressed I’ve become with this company.

Brian Feroldi (46:44):
So for those that don’t know, FIGS is a company that makes clothing and gear aimed at healthcare workers. So it actually makes scrubs that are very high quality and they really seem to be catching on within its core market. One way to kind of think about this company is it’s essentially the Lululemon of healthcare. So the company has a number of products that it makes, but it’s core scrub products are just more comfortable, more durable, and better made than traditional scrubs can be made.

Brian Feroldi (47:15):
And what’s really fascinating about this company is when you learn about the scrubs market, there isn’t brand loyalty to any of the scrub makers. They’re really all just generic scrubs that are out there, and they’re typically provided by hospitals or in some case by specialty retail stores. What’s fascinating about FIGS is it’s actually done a fabulous job about building a direct relationship with each of its customers. So the company actually brings customers to its products through its own app or on its own website, so much so that 98% of this company’s sales are direct to consumer. So it’s essentially bypassing the distribution model altogether.

Brian Feroldi (47:56):
And that does really interesting things to this company’s financials. For example, the company’s margins are much stronger than you would expect them to be. Their gross margin is over 70%, which is higher than companies like Nike, for example, or Under Armour. So I really like that this company is going after the market by establishing a direct relationship with its customers. That’s really hard to do, but this company is really doing that well.

Trey Lockerbie (48:21):
Yeah. And I first discovered this company through their COVID masks because they’re just very comfortable and effective. And that just kind of provides an example of the optionality that’s built into this company. To your point about starting in healthcare, but there’s a lot of ways to define healthcare. What are some other ways you might define healthcare? What are some other categories that this might spill over into?

Brian Feroldi (48:41):
Yeah, this company started by going after hospital workers in particularly, but they have their eyes on basically every other category of service providers that provide a uniform. One area that I know that they’re starting to move into in a big way is the dental industry. The dental industry is another massive market. At my dentist, I know for a fact that they wear scrubs whenever I’m there. So the fact that they’re going to be making products specifically for that industry does bode well for this company’s future.

Brian Feroldi (49:10):
And they’re also doing things like potentially getting into footwear. To your point, they have masks. But they do a really good job about listening to their customer, which they can do so because they have that direct relationship with them, creating new products for their customers and then selling them directly.

Brian Feroldi (49:25):
Another interesting thing that’s worth noting about this company is up until now this has been basically a North American story. 95% of their sales are in North America. Only 5% are international. So the company has done such a good job in America that I think this brand can translate overseas. And if that’s the case, this company should have a very long growth runway ahead of it.

Trey Lockerbie (49:47):
And yet another example of a company with a really strong balance sheet, 170 million in cash, zero debt, which we always love to see. You know, I noticed that your quality score on this was lower than some of the others. I’m kind of curious with this one what might be dragging down the thesis for you to make it not as high a quality of business as you would rate some of these other companies we’ve talked about?

Brian Feroldi (50:10):
The thing that I’m still kind of pondering with FIGS is the strength and durability of the company’s moat. By and large, this company’s moat is largely its brand name. And brand I think can be a powerful moat when built up over time. But of the moats that I typically look for, I would vastly prefer its protected by a network effect or high-switching costs or some kind of durable cost advantage, or some patents or trade secrets, et cetera.

Brian Feroldi (50:37):
So moat, a brand I think can be a moat and I think that this company does have it. But on my scoring system, that’s one of the weakest moats that you can possibly have. Now, we’ve seen companies like Nike and Lululemon, for example, to be home run, grand slam investments for investors largely built on the strength of their brand. But that is one reason why I wasn’t as high on this company initially. But there’s room for improvement, of course.

Trey Lockerbie (51:02):
In going to some of the metrics here, the price to sales at the time of this recording was pretty low. It’s about 4.7, whereas the P/E ratio was incredibly high. I mean, 75 or almost 76, which to your point is never a cheap metric there at that level. But it’s this high-growth stage we talked about earlier. So how much are you emphasizing valuation on a company like this?

Brian Feroldi (51:26):
Given the range of outcomes here, and this is a company that actually is making a physical good and shipping it. So it’s not one that’s going to have infinite operating leverage, and it doesn’t have zero marginal cost of replication. Right? So there is a cost for this company to set up in new markets. And for that reason, it’s growth rate isn’t going to be the same nutty growth rate that we see for software as a service company, for example.

Brian Feroldi (51:47):
So with a company like this, because of its relatively lower quality score on my checklist, this is one that I am going to be more valuation-focused than I would be for other companies. But I think given FIGS size today, this is a relatively small company, trading at just a $2 billion market cap. For comparison, Lululemon today is a $42 billion company. So when I see that huge disparity, and that tells me that this company could have 10-bagger potential from today’s size if it can execute. So that’s why I’m interested in FIGS today. It’s a combination of I think it’s a quality business with a long growth runway and it’s market cup is small enough to multiply.

Trey Lockerbie (52:26):
Yeah, I love the point there about brand and even product really, because you’re comparing it to Lululemon. What’s to stop Lululemon from just going into the healthcare business and creating these things? I mean, it’s hard to say. There’s this established connection with the customer, as you mentioned, which could get them pretty far. But going to that moat, it’s really important to understand the competition because this does seem like a little bit of a weaker moat than some of the other businesses we talked about. So it’s a great highlight there.

Trey Lockerbie (52:51):
All right, Brian, you have been so fantastic in providing all this research and this analysis on a few amazing stocks that I know our audience is going to sink their teeth into. So thank you so much for being such a great guest and always providing such value for our audience. Before I let you go, I want to give you the opportunity here to hand off to our audience where they can learn more about you, follow along on your YouTube channel or anywhere else you want them to find you.

Brian Feroldi (53:15):
Yeah, I can be found on all the social channels. I’m most active on Twitter and YouTube. That’s just under my name, Brian Feroldi. I also have a free weekly newsletter that people can sign up to if they’re interested and you can find that at mindset.brianferoldi.com.

Trey Lockerbie (53:29):
Brian, thanks again.

Brian Feroldi (53:30):
Awesome, Trey. Great to be here. Thanks for having me.

Trey Lockerbie (53:33):
All right, everybody, that’s all we had for you this week. If you’re loving the show, don’t forget to follow us on your favorite podcast app. And if you’d be so kind, please leave us a review. It really helps the show. If you want to reach out directly, you can find me on Twitter @TreyLockerbie. And don’t forget to check out all of the amazing resources we’ve built for you at theinvestorspodcast.com. You can also simply Google TIP Finance and it should pop right up. And with that, we’ll see you again next time.

Outro (53:56):
Thank you for listening to TIP. Make sure to subscribe to Millennial Investing by The Investor’s Podcast Network and learn how to achieve financial independence. To access our show notes, transcripts, or courses, go to theinvestorspodcast.com. This show is for entertainment purposes only. Before making any decision, consult a professional. This show is copyrighted by The Investor’s Podcast Network. Written permission must be granted before syndication or rebroadcasting.


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