“We try to own every one of them. Every single one. And if I had my druthers, I wouldn't own any other stocks in the year 2000. Because these are the only ones worth owning right now in this extremely difficult, extremely narrow stock market. They are the only ones that are going higher consistently in good days and bad. I love every one of them, just as I loathe the rest of the stock universe.”[1]
- Jim Cramer, February 2000
Many times you will hear talking heads discussing the “must-have” stocks to own in your portfolio. They are usually the largest and fast-growing companies (Google, Facebook) or the providers of a hot product or service (Tesla, Cloudera). For instance, the Liberty Portfolio (”providing financial freedom for conservative investors”) has “3 Must-Own Stocks”[2] while Kiplinger has “10 Stocks Every Retiree Should Own”[3].
But I tend to look at the concept of “must-have” a little differently than most. I look for stocks in companies that have products or services deeply embedded in their customers’ strategy and operations. They play such a vital role that customers perceive their products or services as “must-have” in their business operations. This is a very different way of looking at must-haves.
In a time of expanding markets and a booming business cycle, it’s easy to forget that – as Lincoln said – these times shall also pass. During these inevitable down turns, shareholders find out – sometimes in the most spectacular ways – that their portfolio holding was a shiny toy for a customer but not all that important to their success. Think of it as a corporate pet rock. Management might ogle or fondle it, whisper their deepest secrets to it, but in the end it will have no impact on free cash flow growth or corporate earnings.
Identifying must-have holdings
Over the years I’ve developed a set of questions I apply to test the demand for a company’s product or service in both good and bad economic conditions. In the course of answering these questions, I’ve found there are three major buckets of must-have companies.
Provide mission-critical informatics
Some companies find ways to collect, aggregate and report data that are essential to their customers’ long-term success. Assuming the quality remains high, it becomes extraordinarily difficult for a customer to switch vendors or backtrack to legacy systems.
An example of this in some of my portfolios is Veeva (VEEV, Financial). The company has created platform that runs most biopharmaceuticals’ entire customer relationship systems. Every transaction related to its sales, marketing and promotional campaigns is integrated into other data such as supply chain, regulatory filings and clinical development activity. The Biopharmaceutical industry’s ability to convince doctors to prescribe their medicines would be crippled without Veeva’s informatics solutions.
Create a platform for success
Some companies create platforms that are indispensable for their customers’ success. For the customers, it becomes impossible to shut down, remove or replace the platform without unacceptable losses.
An example of this in some of my portfolios is Guidewire Software (GWRE, Financial). Guidewire has assisted the entire P&C (property and casualty) insurance industry that was wholly paper-based and moved it into the digitized world. Guidewire Software’s platform has replaced these legacy systems with a full-feature core application suite that manages claims, billings and the entire policy life cycle. Guidewire’s platform accelerates processes, cleans up billing and assists in managing the company’s relationship with each policy holder in a timely and robust manner.
As an aside, informatics is defined as the use of data – retrieved from internal and external sources – to make more timely, accurate and predictive decisions. A platform is a singular or collective set of applications that allows complex systems to operate.
Make operational and strategic success possible
Many companies achieve their long-term success by outperforming their competitors through seemingly insignificant and incremental changes. The ability to increase accuracy while cutting a part for a new car headlight without sacrificing a thousandth of a second might not seem like much, but in the final analysis could add tens of millions of dollars to the bottom line.
Companies that empower such change aren’t frequently seen on television accompanied with the shrieks of “Buy! Buy! Buy!”. They keep their nose to the grindstone and constantly find ways to improve quality and add value to their customers’ operations. One such company held in many of my portfolios is Cognex (CGNX, Financial). Cognex provides its customers with the ability to see details and key measurements more sharply than a human eye could. This allows customers to improve manufacturing quality and speed to a remarkable degree.
Measuring your success
During an inevitable downturn in the business cycle, it’s important to know how critical your portfolio holdings goods and services are to their customers. The difference between a “must-have” and “nice-to-have” can be the line between success and failure as an investment manager. During a downturn there are several key measurements that can tell you whether your portfolio holding company has an essential product or service.
The most obvious sign is a company where revenue, margins and returns remain steady even though market dynamics have turned against them. The ability to keep selling products and services at non-discounted prices can tell you a lot about the customers' perception of value and demand.
Second, I like to see free cash flow remain positive. A collapse in cash flow could imply the company will need to tap the markets for cash through stock sales or debt. Going to the markets for either can be incredibly costly during a market downturn.
Last, I like to see management continue spending on research and development or capital projects required for sustainable growth. Real long-term value can be generated by spending on projects when others are forced to cease.
Conclusions
The inversion of the concept of must-have stocks in your portfolio to must-have products and services offered by your investment holdings can make a huge difference in your returns. One makes you the life of the party, while the other (hopefully) makes you wealthy. As our current business cycle gets long in the tooth, now is the time to see how critical your portfolio holdings are to their customers.
As always, I look forward to your thoughts and comments.
DISCLOSURE: Veeva, Guidewire and Cognex are holdings in portfolios the writer manages at Dorfman Value Investments LLC.
[1] This article went on to site market pundit Jim Cramer’s top 10 “must have” stocks. These were: 724 Solutions, Ariba, Digital Island, Exodus, InfoSpace.com, Inktomi, Mercury Interactive, Sonera , VeriSign, and Veritas Software. This was a case of “must-have” in your portfolio without the companies providing a “must-have” product to their customers.
[2] https://finance.yahoo.com/news/3-must-own-stocks-buy-152113903.html#
