“How do you keep the vitality of Day One, even inside a large organisation?”
Jeff Bezos 2016 Letter to Amazon.com Shareholders
Like most investors, TDM has a structured framework for evaluating new investment opportunities. The benefits of having this shared framework, particularly as a team, are threefold:
- A way to reduce and simplify an unbounded and complex question (“Is this company a good investment?”) to a far more bounded and solvable one (“Does this company have any identifiable competitive advantages?”)
- A common language that enables a more robust and effective team debate. For TDM this is becoming increasingly important as the team has grown and the diversity of background and experience has broadened.
- Enabling more effective comparison of investment opportunities. This is most notable when comparing investments between vastly different industries and business models, such as between a mining company and a software business. Given our unrestricted investment universe, comparisons like these are not uncommon at TDM.
The most recent addition to our investment framework is ‘Vitality.’ Whilst a concept that we have always implicitly discussed, until more recently we had not created the explicit shared language that make it a more robust and debatable component of our framework.
The aim of this memo is to define Vitality, share our perspectives on identifying high-Vitality companies, and demonstrate why it is often essential to great growth investments and can be the key driver of outsized returns.
For context, Vitality fits within the ‘Growth Opportunity’ pillar of our broader Four Pillars Investing Framework. Sitting alongside Total Addressable Market (TAM), Experience Market Fit (EMF) and Friction of Adoption (FOA). All four growth elements are important and interdependent, though our experience has shown Vitality, when present, to be the most value accretive.
An important contributor to our understanding of Vitality, and the original source of the term, was work done by BCG. I recommend reading their research which I have referenced below.
Defining Vitality
We define Vitality as “A company’s ability to successfully expand their total addressable market (‘TAM’) over time by developing new products and/or services.”
Unsurprisingly, the key word in our definition is successfully. There would be many examples of companies that have destroyed value by unsuccessfully expanding into new products or services. So, what leads to successful TAM expansion? Our experience has shown a distinguishing feature is that the company is providing incremental value to existing customers often in relation to existing products and/or services.
Another way of framing it is the company’s “right to provide more value” – i.e. what part of the customer relationship or technology capability means they can provide adjacent value to their existing customers? Whatever the answer, it should leverage a core competitive advantage of the company and/or their unique culture, giving them a right to expand into these new areas from a customer’s perspective. An example which we’ll come back to in more detail is Hubspot. By providing a Customer Relationship Management (CRM) tool to customers for free, they gained the customer relationship (managing their customers’ customer data) and the technology capability (expertise in front-office software) as leverage to provide a much broader set of tools over time. Each of these new software products that Hubspot provided added incremental value to customers on a stand-alone basis, but also made the existing products more valuable through a unified customer data layer.
If we invert the approach, we would not be interested in a business just because management said they were providing a new service which expanded the TAM, if they had no real right or advantage in providing that service. Almost any large conglomerate would be a relevant example here. In many ways being viewed as a conglomerate is symptomatic of failure to achieve Vitality. There is very little or no benefits to existing customers from the launch or acquisition of new products or services in this case.
Identifying Vitality
In our experience high-Vitality companies typically share some of the following characteristics:
- Test and learn culture. A culture tolerant of risktaking and a willingness to challenge incumbent beliefs and strategy. Sometimes expressed by the company as a variation of, “what got us here might not get us there.” They are persistent but not stubborn.
- Management focus. Management that balances the need between managing the performance of the existing business with the importance of future bets for enabling sustained growth. Management will often discuss a risk-based approach to new opportunities, and/or the importance of new opportunities for durable growth.
- History of successful new product execution. Somewhat obviously, a history of successful expansion into business units beyond, most often adjacent to, their core business is the best indicator. This is evident in a sustained and higher durable growth than peers and the industry.
When analysing the Vitality prospects of an investment, we’re evaluating each of these factors. An important distinction is that as with analysis of competitive advantage, a company’s Vitality in relation to peers and the industry is the key measure. For some industries a high level of Vitality might only result in staying in the same place, if peers are also evolving just as quickly. See the Red Queen Effect.
Our experience has been that high Vitality businesses can be found in any industry. Interestingly, we have found that high Vitality businesses outside of technology can often be the greatest investments given the sustained growth is least expected by the market. A selection from various industries that we’ve come across are outlined in the table below.
Importance of Vitality to Investors
Vitality is only one of several factors in our assessment of a company’s growth prospects, but more than any other it separates the good investments from the great, multi-decade compounders. Our experience has shown that Vitality is often the key driver of long-duration growth and that growth is the primary driver of superior long-term investment returns.
Growth = Rate + Duration
Analysis from Morgan Stanley and BCG showed that in the short run (<12 months) multiples drive share price performance, accounting for 46% of movement. Conversely, over the longer term (>10 years) revenue growth accounts for 74% of share price performance. This demonstrates how important superior sustained growth is for long-term share price performance.
This demonstrates that sales growth is the key driver of long-term stock performance.
The nagging fear that all investors, particularly growth investors, are afraid of is a company ‘hitting the wall.’ A sudden deceleration in growth, not always explainable and often unexpected by both investors and management teams, typically resulting in a painful re-rate downwards. There can often be a multitude of causes. However, our experience has been that it is often related to some kind of TAM constraint that the company is nudging up against. The company may be executing well, but even the best management team can’t out-execute the constraints of a limited TAM. This is why Vitality, a company’s ability to successfully expand their total addressable market (‘TAM’) over time by developing new products and/or services, is so important. It extends the TAM and thus the potential for higher sustained growth.
Market Expectations
The other important dynamic for investors is the positive relationship between Vitality and market expectations. The sell-side, most notably, is constrained with their ability to incorporate more prospective future growth opportunities. As a result, they either heavily discount or totally exclude new growth opportunities from forecasts or valuation. For high Vitality companies, this creates a dynamic of expectation outperformance as the new opportunities are incremental to how the sell-side (and broader market) evaluates and values the company. This dynamic is clear in high Vitality businesses where consensus expectations are continually revised upwards over time. Stating the obvious, this is typically correlated with positive share price movements.
Vitality Case Study – Hubspot
We decided to incorporate Vitality as a distinct component in our investment framework as a result of one company: Hubspot.
Some brief context for those less familiar with the business. Hubspot is a provider of software for marketing, sales, and customer service for small and medium businesses. The company listed in October 2014 at $25 and now trades at $500, a 20x return and 35% CAGR. Over that same period revenue has grown from $115m to $2.5bn, a 17x increase and 32% CAGR.
Originally, the company begaun as a marketing automation product (or ‘Hub’ in Hubspot’s terminology). Over the last ten years they have expanded the product suite to include a Sales Hub, Service Hub, CMS Hub, Operations Hub and CRM. Given the company breaks out the financials for each Hub, we can quantify the Vitality of the organisation. Since 2015, 40% of all incremental ARR has come from products outside the core Marketing Hub. Over the same period, the new Hubs have added a 10% increase on the growth CAGR over the same period.
Identifying Vitality at Hubspot
Test and learn culture. Hubspot is famous for its corporate culture. The widely shared ‘Culture Code‘ presentation has over three millions views on SlideShare and is a top reason candidates say they want to work at Hubspot. I highly recommend reading it. The company is clear they are creating two products, one for their customers, and the second for their employees. As they say, “culture is the product we build for ourselves.” Without going into all the detail, the values and the culture of the organisation are highly conducive to experimentation and innovation. Values include, “We solve for the customer” and “We favour autonomy and accountability.” The culture is the foundation of Vitality within the organisation.
Management focus. Like most software companies, Hubspot is incredibly focused on the quality of its tech stack. What separates Hubspot from its peers are the difficult decisions management have made over the years to maintain the quality. In 2019 the company made a firm-wide decision to slow development of new products to focus on rebuilding the tech infrastructure. This is a very difficult decision to make as a public company. This investment has underpinned their ability to build a product, and ultimately platform, that customers love. It has also enabled them to launch new products and rapidly iterate, expanding the products and services that Hubspot offers. You can read about Project Mainsail and Hubspot’s engineering and product philosophy here and here.
Hubspot has also been clear about the need to experiment with future growth opportunities. In communication with investors, they were upfront that growth opportunities might not always be successful and will require time, capital and management attention without an immediate ROI or benefit. In Hubspot’s case, they analogise this to “sowing seeds.” In their most recent Analyst Day they discussed the ‘seeds’ they are planting with the new commerce module.
History of successful new product execution. Hubspot has been explicit about the opportunity in adjacent products over time and how that is key to expanding their TAM. Below is a slide from an Analyst Day presentation. Not only was the company expanding into new ‘Hubs’ such as Sales and Service, but they also expanded the product’s suitability for both larger and smaller customers. This dramatically expanded their TAM over time, whilst also creating a much stickier (and more valuable) customer base.
In our view, the key strategic decision which unlocked everything else was the decision to provide the CRM for free in 2014. This gave them the right to offer all other solutions as a bundle to customers given there was a now a benefit from unified data for customers. Hubspot arguably had no strategic right to offer Sales / Support / Ops when it was just a marketing tool, but once they had the common data asset of the free CRM, it became an obvious opportunity to expand the product set over time to effectively anything that touched the customer.
Importance of Vitality to Shareholder Returns at Hubspot
Even when the product expansion strategy was clearly articulated by the company, the market (and us!) continually underestimated the continued benefit to growth. This resulted in a multi-year cycle of strong share price performance.
The chart below shows the rolling three-year revisions to revenue from consensus to actual result. Focusing on 2018, we can see that over the period from 2015 to 2018, revenue forecasts were revised up 50%. Over the same period the share price compounded at a 48% CAGR.
Clearly some of this performance was driven by an attractive operating and investment environment for horizontal software. However, when looking at individual broker commentary over that period there is constant revision as a result of either new products launching or greater traction of those products. A broker noted in 2018, “we see HubSpot’s large $28B TAM providing a long runway of growth with potential upside from new product offerings.” However, these new product offerings were not incorporated into forecasts by the same broker! As Hubspot executed on the upside from new product offerings, it created an attractive stock dynamic with continually upwards revised estimates and a share price that followed suit.
We would greatly value any suggestions on high-vitality companies, particularly outside of the core software domain. We have found these to be some of the best investment opportunities!
For a detailed overview of TDM’s full investment framework, what we call the ‘Four Pillars,’ Hamish has outlined it in detail in this article here.
Best,
Harrison
Footnotes:
2 TSR calculated from IPO, $25.00 at October 2014
3 TSR calculated from IPO, $9.00 at November 2015
References
BCG: The Global Landscape of Corporate Vitality
BCG: Achieving Vitality in Turbulent Times
BCG: Measuring Managing Corporate Vitality
BCG Henderson Institute: In Search of Vital Companies
BCG: How Vital Companies Think Act Thrive
Software Stack Investing: The Invisible Hand of Product Agility and TAM Expansion
HBR: Building a Culture of Experimentation
