My favourite guests when I hosted the Market Call shows on BNN stood out because they thought differently. Jason Donville was one of them.

The President & CEO of Donville Kent Asset Management takes concentrated positions in companies and has a laser-like focus on return on equity, or ROE. Nothing less than 20 per cent will do.

That strategy works. Since inception in 2008, the DKAM Capital Ideas Fund LP has returned 17.64 per cent annually, net of fees.

Donville and his team produce the quarterly ROE Reporter newsletter.

Here, Donville and his Senior VP & Portfolio Manager, Jesse Gamble, explain why fast-growing technology companies can appear to not be profitable – and why that’s okay.


The Long-Term Case for Technology

Technological evolutions typically stretch over long timeframes, but catastrophic events such as recessions, wars, natural disasters, and pandemics can suddenly drive a sharp acceleration of these advancements.

We have observed this phenomenon firsthand as society’s continued digitization ramped up dramatically over the past year, triggering a major transformation in how society functions.

These changes will have significant, lasting implications for investors for years to come.

How to Invest in Technology?

Traditionally, we have strived to invest in high return on equity (ROE) stocks, using ROE as the primary measure of value creation, and the price-to-cash earnings ratio (P/CE) as the primary valuation method.

(ROE is net income divided by shareholders equity, which is assets minus debt. ROE is the return on assets i.e. a $20 return on $100 in assets is a 20% ROE.)

How does a high ROE investor reconcile this approach with the high revenue growth, low profit model emerging in the technology industry?

Is this the right framework to look at technology stocks? The answer is yes, but slight adjustments to the framework need to be made.

First, let’s take a look at the ROE element of stock investing. Historically, we have invested in companies that earn an ROE of at least 20%.

For example, in the past we would have been drawn to a trucking company with $200 million of revenues that could generate a profit of $20 million on an equity base of $100 million, therefore achieving an ROE of 20%.

At year end, the company would invest its $20 million of profits in additional trucks.

Presumably, this expanded fleet would enable the company to push sales to $240 million in the next year, generating a profit of $24 million on an equity base of $120 million, and so on. This illustrates the magic of compounding.

Next, let’s examine a hypothetical software-as-a-service (SaaS) company.

Assume it has the exact same financial performance as the trucking company: revenues of $200 million and a profit of $20 million on an equity base of $100 million.

However, unlike the trucking company, the SaaS company does not have to purchase any additional hard assets at year end in order to boost sales because SaaS companies scale extremely efficiently.

The adage in the software sector is that SaaS companies build only once and sell it a million times.

These businesses derive most of their economics from attracting and retaining new customers, who will typically remain customers for many years (referred to as lifetime value).

As such, the cost of acquiring that client will be paid back handsomely in subsequent years if the cost of servicing that customer is minimal.

If the technology company can acquire new customers through marketing efforts at attractive economics (i.e. the lifetime value of a customer is multiples higher than the cost to acquire a customer), the company would be motivated to increase its marketing budget by $20 million as opposed to spending $20 million on hard assets like the trucking company.

However, from an accounting perspective:

  • The entire $20 million marketing expense will flow through the income statement in the year it is incurred, reducing the company’s profit to zero.
  • In contrast, the trucking company’s investment in additional trucks will flow through the income statement and the balance sheet, ultimately being treated as a capital expenditure.

The $20 million trucks purchase will be expensed over time during the trucks’ 10-year life as a depreciation expense on the income statement.

Both companies are making rational capital allocation decisions to further grow their businesses, but in terms of their respective financial statements, the companies look quite different from each other.

Setting aside valuations, both companies are extremely promising, but the key differentiator is that the trucking company seems to be quite profitable whereas the technology company appears to be barely breaking even.

In today’s digital economy, many technology companies are doing exactly what we described in the example above.

Value-creating technology companies show evidence of their value creation solely through the income statement whereas the traditional ROE model implies that evidence of capital allocation and value creation are found in a combination of the income statement and the balance sheet.

Editor’s note: In our next post based on Jason Donville’s writing, we’ll examine the Rule of 40, and how to find high-growth technology stocks at reasonable valuations.

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