CLAUDE WALKER | A Rich Life
CLAUDE WALKER | A Rich Life
We all know and love the high-growth companies that have (hopefully) helped to contribute to our market returns, but how can you run the tape measure over them? What kind of numbers can help you to value companies that are growing fast but are not yet maximizing profit margins? According to Claude Walker, the magic number is 40
Claude Walker is the founder of A Rich Life where he writes the Ethical Equities column. He loves his ASX tech stocks and investing in smaller unloved and ignored microcaps where the market is much less efficient.
In this episode we chatted about The Rule of 40. He was inspired by the announcement from new CEO of Xero (ASX:XRO) Sukhinder Singh Cassidy. She has struck a completely different tone than the old CEO. She says that the company will now be “more balanced and look to Rule of 40 as a useful performance evaluation measure in managing the balance of growth and profitability.”
Generally speaking the rule of 40 is a way of comparing different companies where you're looking at their growth rate and their profitability or cash flow positivity and it's scoring companies on both of these things. So that's very important because right now what we're seeing is the companies that are just cash flow negative are getting absolutely smashed and some of them will eventually just go bankrupt.
And then companies, even companies that are cash flow positive or profitable, a lot of them are coming down a long way as well as multiples contract. But the point is, for most of them, as long as they can maintain that situation or even grow their profits or cashflow, they're gonna be fine. They're not gonna go bankrupt.
Claude has more on The Rule of 40 here:
TRANSCRIPT FOLLOWS AFTER THIS BRIEF MESSAGE
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It's a very easy quantitative measure for the everyday investor can use just to compare the quality of the growth stocks in their portfolio. So it's really simple, really like, you know, if it's achieving a higher growth rate and a higher free cashflow margin, it's a stronger business and it probably almost certainly deserves a higher PE ratio than one that has a lower one. and it gives you, you know, a way to measure it. Ah, there, these ones are close or these ones are far apart. And then you can go and crosscheck and say, are there PE ratios closer or are they fire apart?
G'day and welcome back to Shares for Beginners. I'm m Phil Muscatello. We all know and love the high-growth companies that have hopefully helped to contribute to our market returns, but how can you run the tape measure over them? What kind of numbers can help you to value companies that are growing fast but are not yet maximizing profit margins? According to my guest today, the magic number is 40 G'day Claude. Good
Claude (1m 4s):
Day Phil Great to be here.
Phil (1m 5s):
Claude Walker is the founder of A Rich Life where he writes the Ethical Equities column. He loves his ASX tech stocks and investing in smaller unloved and ignored microcaps where the market is much less efficient. So I just wanted to preface this episode and warn listeners that we're gonna go a little bit into the weeds, aren't we? Claude
Claude (1m 25s):
Warning, I, my podcast episode gets a warning. Oh dear. Trigger warning. I'm sorry everyone. Ah, yeah, no, we definitely get into the weeds, but I think, you know, on a, on a more general zoomed out level, part of the reason for that is I'm a big believer in the Pygmalion effect. If you have high expectations of something, even unreasonably high expectations, you know, it could come true. And the really interesting thing is that some scientists sort of started testing this, you know, quite a long time ago now, and they initially I think tested it on rats and, and told the rats that they were intelligent or, or treated them in some way that they had this high expectation of the rats.
Claude (2m 5s):
And, and for some reason over time these ones that had high expectations performed better, whatever challenge it was, then they, you know, they did it in humans as well. And again, it was just like the teachers were told that some of the students had actually scored higher on a test. So the teachers were tricked into truly believing that they either had the gifted class or they had the less gifted CLA class that was struggling a little more. And then, you know, o over time as they measured the performance of, you know, the, the two groups over time, the kids that had teachers that expected them to score well on tests and expected them to understand more difficult concepts, those kids actually did better. And I think this is a really interesting thing when it comes to, obviously, you know, I'm, I'm 10 years into a, a content creation journey in, in terms of stocks.
Claude (2m 52s):
I think it's really interesting because the marketing side of this kind of business is says it's make things as simple as possible. You know, three, like literally if you're doing continuing professional education for financial advisors, they're telling you explicitly the way to communicate with people is very, very simple. you know, three dot points, no more than five dot points. That's, you know, if, if you say six, then they'll have forgotten the first one by the time that you say six. But what you lose the flip side of that approach is you lose the Pygmalion effect, which is where if you actually challenge people to extend themselves and expect that they can follow it, then some of them do.
Phil (3m 28s):
Yeah. Augmented expectations. And we're approaching this episode because I've been saying a lot lately that this, even though this podcast is called Shares for Beginners, it's not Shares for simpletons and really the stock market is not a simple place. Yeah, right.
Claude (3m 42s):
Well it's a learning journey and you know, I was speaking to a fellow investor just yesterday and you know, reminiscing about, I guess the one makes an error sometimes of, of seeing a company and, and you see how well it's performing and it's outperforming the share price is going up and it's doing really well. But you think, oh, you always end up thinking, oh this is a bit too expensive. you know, 50 times earnings that's crazy or 30 times earnings for this kind of business that's too high or 20 times earnings, you know, whatever it is, you can always kind of convince yourself, oh yeah, if only I'd bought it 20% cheaper or whatever then then I'd buy it now. But it's, I've missed it. It's interesting because investing is a psychological game.
Claude (4m 23s):
There are certain tools you can try and use to hone the craft, but you'll al it's a completely moving target all the time. There are some periods where people will be more on the ball and more having a better read on what's going on because it's a two-pronged approach. It's, it's one, you need to be able to form your own opinion of a stock, but then you also need the market to have a different opinion. So like, you know, it's a buy when the market's underestimating it and, and it perhaps it's a sell when the market's overestimating it.
Phil (4m 50s):
Before we get into it, and I refer to your preference to work in the smaller end of the market, fund managers often can't play in this sector. Is this like, would they be like whales trying to swim in the kiddies pool?
Claude (5m 3s):
Well for some of them it would be Phil certainly for the big ones. But there are some great small cap fund managers and micro cap fund managers on the ASX. And I think like any small cap investor really the name of the game for most is, well there are different strategies, but one of the more repeatable strategies of small cap investing is basically to try to find the smaller companies that are getting bigger and that they're gradually going to graduate into the ASX All Ords and then one day into the ASX 200. And then once they're at that level, not only do active managers of larger funds start getting interested but also so passive funds that are just index trackers obliged to buy these companies.
Claude (5m 48s):
So the, the holy grail of a a small cap success is basically when you buy something that's unloved smaller company and considered riskier and perhaps rightly so. And then it gets bigger and it sort of starts getting rerated as a larger company. And essentially once it gets put in the ASX 200, you have a whole bunch of forced buying and it's not uncommon to see stocks prices increase either before, just before or around the time that they're entering into the, into the indexes or indices I should say.
Phil (6m 24s):
Yeah. So that happens every quarter, doesn't it, where the ASX 200 gets rerated or reweighted, whatever the correct word is, there is trading and an arbitrage opportunities about that, but not easily easy to come by. Yeah,
Claude (6m 38s):
I'm not sure how easy it is. I've never tried to actually just purely arbitrage like and invest purely in a company, just purely because I think it's about to get into the index. But I guess the multi-year thesis is that if you think you can, you know, sometime in the next few years a company is gonna get in the index. I've definitely played that and I definitely do believe that sometimes a good time to take profits is once they actually get into those bigger indices.
Phil (7m 3s):
Are there any fund managers that do actually play in this space?
Claude (7m 6s):
Oh yeah, absolutely. I don't wanna start talking my book cuz I invest with a, a few of the small cap fund managers, but there's like a, there's quite a lot of good small cap managers. They often don't have such big marketing. I guess some of the best funds actually close quite quickly. So one of the tricks of small cap investing is you can't do it with a lot of money. So all of the best small cap funds will close their fund once they reach a certain amount and you can really actually, you can really judge a small cap fund or a micro cap fund by how much money it takes on. And it's not uncommon to see a fund perform well when it has a smaller amount of money, say for example 10 million.
Claude (7m 48s):
But then if it got successful and then suddenly raised a lot of money and was suddenly dealing with a hundred million, the opportunity set would be so much worse for that fund. And mind you, there are some good small cap investing funds at around a hundred million. Cuz when you think about it, if they're gonna have, you know, 5% position sizes and they need to be able to buy 5 million worth of stock, and I guess that means if, if there's a company that's 15 million market cap, they'd need to accumulate like 10% of that company to, to have a normal position size. So around a hundred million I think it starts getting quite, you know, the, the size of the companies that they can invest in starts getting, you know, a lot bigger and, and then you sometimes see, you know, a small cap fund that has 500 million under management.
Claude (8m 31s):
But you know, really they're going for the mid companies at that point because if you've got 500 million under management, then even if you manage to accumulate 10% of a 50 million company, it's only 1% of your fund. So it's very hard for that to move the dial. Hmm.
Phil (8m 44s):
But it, it can move the dial in terms of the, the share price of a company. If someone goes in and just starts buying that one, they, they just can't do that because would affect their, their actual
Claude (8m 54s):
Position. Yeah, definitely. But you know, by the time the, the company itself like naturally ma makes it way up to 200 million and then starts really getting on their radar again, that's why you can get this with this share price re-rate. Now at the moment we're not really seeing too much of that in small cap tech and, and that kind of stuff. It's actually had a terrible run after, you know, many years of performing well, especially at the end like into the covid boom, the tech stocks for all the rage, you know, some of them have come down a really long way and many of them have haled and we've seen, you know, mining companies for example go into the index plus, you know, I guess a s a couple of speculative AI story story stocks. But you know, I remember there was, you know, there was one index inclusion day when it's like, you know, most of it was lithium miners or whatever.
Claude (9m 40s):
So there will be this sort of shuffling in and out depending on like what's hot and what's, what's not at any given time.
Phil (9m 46s):
So it's very hard for investors to find these companies. Where would you suggest is a good place to start looking just to find out what's, what's on the menu there?
Claude (9m 54s):
Well actually one of the reasons why I was keen to talk to you about the rule of Thor 40 and discuss, you know, what is the rule of 40 is because I actually think it is a, a, a reasonable way for people to invest in growth stocks. And one of the reasons I think it's reasonable is it balances, I guess cash flow generation or profitability with growth. It's not highly spec, well they can be quite speculative depending on how they're priced. But generally speaking the rule of 40 is a way of comparing different companies where you're looking at their growth rate and their profitability or cash flow positivity and it's scoring companies on both of these things. So that's very important because right now what we're seeing is the companies that are just cash flow, you know, negative are getting absolutely smashed and some of them will eventually just go bankrupt.
Claude (10m 40s):
And then companies, even companies that are cash flow positive or profitable, they, a lot of them are coming down a long way as well as multiples contract. But the point is with them, for most of them, as long as they can maintain that situation or even grow their profits or cashflow, they're gonna be fine. They're not gonna go bankrupt. They may have their ups and downs, it doesn't mean they'll be a success just cause the company's profitable but the, the chances of them going bankrupt whilst they continue to be profitable is much, much lower. and it would usually be just something, you know, outta left field thing would have to happen.
Phil (11m 9s):
So is the rule of 40, does it apply just only to particular ki kinds of companies like tech companies, software companies, software as a service companies?
Claude (11m 17s):
I think that it originally sort of became a way of comparing software companies and I think it has, you know, it could be used to look at any really growth at a reasonable price style companies, a lot of companies basically that are growing fast and are not maximizing profit, they often are software or tech companies because there's this balance basically between them wanting to invest in what they perceive as their competitive advantage. Now for some of them it truly is a competitive advantage and for others that's probably just keeping up with the competition. But they wanna keep investing in that and then they need to keep investing to grow. So they wanna keep a good growth rate. But at the same time there's one mind view which is like don't worry, just run the losses and grow, grow, grow.
Claude (11m 60s):
And then the rule of thought is really more useful for companies that are actually like, well we're at least cashflow positive, we're at least sustainable. And sort of, I think originally when it was used for software companies, certainly how I first came across it was a combination of revenue growth and free cash flow margin. So the way you might define that would be the revenue growth is the year on year revenue growth. So if you look at as an example, a company I want to use that I don't own, but I really like and have previously owned shares in which is Xero Xero kind of really started talking about the rule of 40 in its most recent results because it was transitioning from a situation where under the previous CEO they had run pretty weak free cash flow and or or in fact negative free cash flow but supposedly justified it because you know, they, they had good revenue growth and the market wasn't really loving that in the, in more recent times like the the profit going backwards, the the free cashflow being minimal at best and wanted to, you know, basically Xero to to show its business qu quality a little more and the new CEOs come on and she's saying look, we're gonna start measuring ourselves by the rule of 40, which Xero itself is defining by their normalized free cash flow number, which in the most recent results is I think quite reasonable.
Claude (13m 13s):
It excludes things like acquisitions. You can also argue about whether it's fair to exclude acquisitions because if you're making an acquisition that then also contributes to revenue growth, then you should include the cost of that acquisition in calculating the free cash flow. Arguably, but either way Xero is defines it has this sort of their normalized free cash flow number, which is, which is pretty reasonable. And they had revenue in FY2023 of 1.4 billion and the revenue growth was 28% and the free cash flow, their number is 102.3 million. So what you can do is to get the, the cash flow margin is just divide the free cash flow by the revenue.
Claude (13m 55s):
Now this like works for companies where revenue and and cash receipts sort of are reasonable or proxies for each other. There you, there could be an argument, this is not such a good way to do it depending on the actual company in question, but that gives you a free cashflow margin of 7.3% and then you add that to the revenue growth number of 28%, which gives you 35.3. So by Xero's zone measure that they're sort of making their self there, they're basically saying well we're trying to get that to 40 so when the CEO says we're gonna measure ourselves by the rule of 40, the rule of 40 says, you know, you want that to be at least 40 essentially. So what she's saying and probably why since these most recent results came out, the the reason that the Xero share price is up is because what she's saying is we're gonna either increase the revenue growth or increase the free cash flow margin and given re you know, Xero is reasonably mature in its biggest markets, I think it would be hard for people to imagine a scenario where they really increase their revenue growth rate from here.
Claude (14m 51s):
Really it it was probably more more like, you know, how much does it fall by in a way you could interpret the CEO's comments as saying we're gonna start really making some free cash flow happen now we're gonna increase that free cash flow margin now. you know, cause it has 1.4 billion in in revenue as that free cash flow margin increases from you know, 7.3% to, you know, who knows is it gonna get to 15%? It's really gonna, you know, the company's gonna start accumulating a lot of cash and showing its power there. So I think that's why the market's getting sort of excited about that but has also got a lot of people interested in understanding the nuances of the rule of 40 and this and the different ways. Is
Phil (15m 27s):
This the first time in Australia that it's been used? No,
Claude (15m 30s):
I wouldn't say that like analysts and, and investors have been using it in Australia for sure. This is, I'd say the most prominent time, you know a company that's a a software, the service or a software company, a tech stock in Australia has said we are explicitly like aiming for this and that sort of like set the agenda and a little bit because you know, Xero is a a leading tech stock and then we sort of saw, you know, an AFR article about you know, some other company iRESS which is like a much more old school sort of tech company or software company.
Phil (15m 60s):
We're gonna do it
Claude (16m 0s):
Too. Yeah, exactly. And Ashley, that's what kind of got, you know, piqued my interest a little bit about what do readers think because I noticed in the two AFR articles the article about Xero, you know, defined rule of 40 as as Xero does it, which is revenue growth in the free clash flow margin being 40 or more. Whereas another, the other article about iRESS talked about the company's revenue growth plus EBITDA margin should having to add up to 40 or more. And this to me was a little bit Claude.
Phil (16m 30s):
Sorry let before we get lost in the weeds here because I, I just want to get back to the basic definition of what the rule of 40 is. Yeah, you've given us the example Yeah that because we're talking about free cash flow and then now we're talking about EBITDA. Yeah. Okay, so just break it down. So
Claude (16m 49s):
The basic definition, essentially the problem is there are two definitions. One definition, which is the one that I prefer is the free cash flow margin plus the revenue growth rate has to equal 40 or more. Right? And, and and that's the, funnily enough there are two management consultant companies that take, take a different view of this. So McKinsey basically adopts that definition whereas their competitors Bain, they say analysts have differed in which measure of profitability use most use EBITDA they say, but some have proposed free cash flow ebot or net income as alternatives. We use a bit a publicly available profitability metric that excludes the effects of taxes and accounting policies.
Phil (17m 30s):
So that's earnings before interest tax depreciation and amortization. And it's not something that you really need to get into the weeds on a about understanding every bit.
Claude (17m 38s):
In fact I would actually argue that probably for most investors, certainly for Beginners, EBITDA is a very dangerous figure and one that you should probably try to ignore cuz the what what that doesn't tell
Phil (17m 52s):
Accountants. The accountants are massaging that figure aren't
Claude (17m 54s):
They? Well it's funny that Bain says that, that this one excludes differences in accounting details cuz it, it most certainly doesn't. And that that was actually one of the key points that I wanted to make is that it really does matter whether you use EBITDA or the free cash flow. So if you see a company itself having calculated the rule of 40 or you see somebody that you've read a journalist saying such and such satisfies the rule of 40, you really need to ask what's the definition? What definition are you using? Cuz EBITDA and free cash flow are not the same things a company can sort of have some discretion about how it classifies its spend on software developers.
Claude (18m 36s):
you know, Xero's got a bunch of software, we've got a lot of people working on it. Some of that work is like maintenance or fixing things or just updating them and it's not creating a new asset. Some of that work they can classify as like r&D that's like a capitalized new thing that it developing and they say, oh well when we've spent this money on the developers they saying it's not actually an expense because we've actually just been investing in an asset there. So what they'll do is they'll capitalize that expenditure, that cash flow, it'll come out of the investing cash flow sure enough, but it'll go onto the balance sheet as a, as a intangible asset and won't go through the profit and loss as an expense In subsequent years it will go through the profit and loss as an expense being amortization, if a company did a bit expenditure one year on on r and d then that would affect their free cash flow margin right away and their free cash flow margin would go down but the effect on their EBITDA margin would, would be delayed over the number of years that it amortizes that expense.
Claude (19m 38s):
So in the case of Xero, if you used the free cash flow the way that Xero does, which is the example I just talked you through, they reach under the rule of 30, you know the combined percentages are 33.5%, but if we use statutory EBITDA for Xero, that number is bigger than their free cash flow, it's 158.2 million and it would be even more different if you used adjusted EBITDA . But even in just using statutory EBITDA you get an EBITDA margin of 10.8% compared to a free clash show margin of 7.3%. So add that to the 28% revenue growth you get 38.8%, which is like almost achieving the rule of 40. So you can see it'll be much easier for a company to achieve the rule of 40 based on or at least much easier for Xero to achieve the rule of 40 based on EBITDA than it would be on cash flow.
Claude (20m 25s):
And then as I alluded to beforehand, you can also say, well I don't accept Xero that you've, you know, spent money on acquisitions and you're gonna exclude this, that or the other from your normalized free cash flow. I'm actually gonna just take the absolute operating cash flow and then subtract the investing cash outflow, all of it, whatever it's for. And also on top of that I'll subtract the repayment of leases cuz that's like an ongoing cost which now runs through the financing cash flow line and, and if you did all that with Xero, you'd get 60, about 69.1 million as your sort of very strict free cash flow. And then so that means the, again, margin would be lower and to calculate the rule of 40, you'd get only 32.9% then.
Claude (21m 9s):
So there, that's just three examples with one company of how you would calculate it. So that's why, you know, I definitely remind investors that you know, Charlie Munger, you know once said like every time you hear EBITDA a bitta just substitute the phrase bullshit earnings. And that's something that I do when I, when I read about, you know, a bit based rule of 40 i, I definitely put more credence in the way, for example, even if it's normalized free cash flow, that's actually genu, that's actually a measure of genuine cash coming into the business. And the basic rule of thumb is even though sometimes in very fraudulent cases cash flow statements lie, you know the old saying is cash is king.
Claude (21m 50s):
It's much harder to manipulate what's happening in the business when you are actually measuring the cold hard cash and whose account it's in.
Phil (22m 3s):
So just to find free cash flow for us, what, what is it and where do you find it on a, in a company report?
Claude (22m 9s):
Yeah. Right, so a company like Xero, it's pretty easy to find in a company report and I definitely recommend anyone who owns Xero Shares to to keep an eye on that metric because they calculate it for it and they, and so you can just, you know, control F in the presentation and you'll find the free cash flow. The only thing that you've gotta remember is that they do that. If someone's calculating something for you then you know it's prudent to actually figure out how they're calculating that just to make sure you agree with all of those changes. Now most of the time, like so for example with Xero it's like they're excluding the deferred consideration of a past acquisition or something like that, which probably is quite fair to do. So I'm not saying that you know, you should be suspicious of all adjustments, but I do think that at the end of the day it can also be useful to have a strict definition which is just the same for every company.
Claude (22m 58s):
And then that allows you to compare companies with each other on a more fair basis. And when I use a strict definition, I would use what I described it for. So that's just in an Australian company report, if you turn to the cash flow statement, you're gonna see there are sort of a few sections of the cash flow statement and those sections are the operating cashflow part, the investing cashflow part and the financing cashflow part. And so what you do is you just take the subtotal that's at the bottom of the operating cashflow, which I hope for any kind of profitable company you would generally experience on a yearly basis. If the company's profitable then that's almost always gonna be a positive number. And then you subtract the total of the investing cashflow, which is again almost always gonna be a negative number.
Claude (23m 41s):
There might be things you want to remove from that. For example, there could be a situation where companies redeemed a term deposit for example and that might run through the investing cash flow statement. So you have to watch out for something like that. You might wanna exclude, but as a general rule you just can take the investing cash outflow and so you take the operating cash flow and then subtract the investing cash outflow that will give you a number. And then in order to account for the fact that companies spend varying amounts on their, you know, on their like leases for their offices and that and their premises, you also wanna look at the financing cash flow section and you'll find something that is called repayment of lease liabilities usually or something like that or payment of release liabilities.
Claude (24m 25s):
And then you might wanna subtract and that'll be a negative number so you can wanna subtract that as well and that will give you a sort of strict free cashflow number that you can then use that to calculate the free cashflow margin of any of the gross stocks you're looking at. And then you have a like for like measure if you define it the same way for everybody and that is I think the power of the real power of the rule of 40. It doesn't actually matter whether you use EBITDA or free cash flow, but as long as you're using a what is hopefully a statutory like for like calculation and it that is gives you a basis on which to compare the companies.
Phil (25m 2s):
So I guess the point is not to actually believe that journalist that you referred to before who says okay this is, this company's got the,
Claude (25m 9s):
Well, it's not about not believing, it's not about not believing them because like they, first of all taking,
Phil (25m 13s):
Taking the numbers on your own terms rather than on terms that are determined it's important for
Claude (25m 17s):
You, it's just important when you're comparing different companies, you're using the same measure. So that article I mentioned before like that dud did do that by the way. It took a bunch of different companies and used the same measure for all of them. So that's totally valid. The point I was making is that if somebody cross referenced the two articles that used a different mechanism or you know they hear me talking about it and I'm using free cash flow and then they read the same read an article by a different author and that's using EBITDA . I'm not really saying that the EBITDA one's wrong. I'm basically saying that you just have to, you can't cross reference people that are using different measures of the rule of 40. That's the thing. So the thing that I was more trying to flag was like the company itself might say hey this is our rule of 40 score, you know, how have they measured it?
Claude (25m 58s):
And for that reason basically I was just saying you've gotta be aware of it. I wouldn't, I definitely wouldn't say doing it with a bit is wrong. I think that actually as long as you're using the standard thing across different companies, there's like a legitimate value to that.
Phil (26m 11s):
So what are the other companies you wanted to look at in this interview? Well there's, yeah
Claude (26m 16s):
And so this is true
Phil (26m 17s):
And Promedicus, yeah, yeah this
Claude (26m 19s):
Is true for quite, almost everyone will get a a better number if they used the EBITDA number versus the free cash flow number because by definition these companies are spending usually on r and d and capitalizing some of that. But one company that's interesting because it doesn't really capitalize its r and d and, and one that I own Shares in is Objective Corp, which has come down a fair bit lately sort of in line with tech stocks but also by the way, cuz it missed its guidance or downgraded its guidance. And so they do software for like government and and large corporates like the governance of information. So there are documents in public service that a council wants to know who has access to what kind of records and you know, they, they don't want necessarily everyone that works for council accessing somebody's building development or whatever it is.
Claude (27m 5s):
But there's also like a workflow association with it associated with a development application. So one of Objective Corp's areas of operation is to provide software that that helps with building approval processes. So you can see like the attraction for me is obviously it's like very ingrained into like, first of all a lot of government, big corporate customers, they're gonna keep paying no matter what. They're like they're not gonna go bankrupt. And then second of all, you know, it's, it's really in the work in the workflow of core functions for society, you can totally imagine, you know, automation having more and more of a role in these processes and, and as that happens these guys are sort of well suited to, to benefit but you know, they don't look as good on the rule rule of 40 as Xero for example.
Claude (27m 48s):
I think we got to 35 and a little bit under Xero's definition of free cash flow objective court comes in at about 33 by my calculations. And but one of the interesting facts about these, so,
Phil (27m 58s):
So they're not quite at 40
Claude (27m 59s):
Yet? No. And their revenue grosses is slower. So they earn their 12% revenue growth using the FY 22 results and it's gonna be I think probably worse in FY 2023 based on the first half. And they do have luckily a strong free cash flow margin. So they have high free cash flow margin than Xero, they had 21.3%. And that gives you an idea of the kind of potential Xero has because this is just, you know, a slower growing software company that is getting to a roughly the same score on the rule of 40 but through a different way in, in objectives case it's slower revenue growth but high free cashflow margin. And I think, you know, it shows the kind of potential Xero has at maturity to at least, you know, potentially double its free cash flow margins from here and and even I mean who knows how high beyond that.
Claude (28m 46s):
So that one I was just interested to do the do it for some of the tech stocks I do own so do with Objective Corp got 33.30 that seems pretty decent but not great but it fails the rule of 40. And then the one that did really well of it is, is the one that I also own Shares in and have, it's like my longest holding now, which is Promedicus and that had anyone
Phil (29m 4s):
Who follows you on Twitter Claude knows about Promedicus.
Claude (29m 7s):
Yeah, yeah. So I would invite anyone to calculate the rule of 40 for Promedicus because you know, I don't even want to say how high I got when I calculated that rule of 40 based on the fi 2022 results cause I'm scared that it'll be that it's a mistake cuz it looks so much higher than objective Core or Xero. But that's the homework for anybody that's out there. If nothing else, you know the rule of 40 and it does give you a way to compare these tech stocks. So Objective corp that's on a p ratio of like 60, so it's still pretty high and Promedicus is on a P ratio of like 120 or maybe a hundred or something, almost twice the PE ratio. And funnily enough I get about almost twice or around twice the, the score in the rule of 40 for a Promedicus as well.
Claude (29m 52s):
So you could argue that, you know, to a degree, and I'm not saying this is justified by the way, not at all, but to a degree you could argue the rule of 40 is useful because it is gonna give you a good gu not a good guide, but a useful directional guide as to what PE ratio or stock might trade on after it reaches a certain point of profitability. And that's why I'd say it's useful because I think it's a very easy quantitative measure for the everyday investor can use just to compare the quality of the growth stocks in their portfolio. So it's really simple, really like, you know, if it's achieving a higher growth rate and a higher free cashflow margin, it's a stronger business and it probably almost certainly deserves a higher PE ratio than one that has a lower one and it gives you, you know, a way to measure it.
Claude (30m 37s):
Oh the these ones are close or these ones are far apart and then you can go and crosscheck and say, are there PE ratios close or are they far apart? So no me, no single measure is ever perfect and you know, rule of thumb stuff on the edges, it always has like quirks where it, it doesn't really work like, you know, for an example, like it's easy for one year's results just to not, you know, a company could have a free cash flow margins of between 7% and, and 10% for like five years and then just like fluke at one year and it gets higher for some random reason because it, for example, sold something or had some cash come in. So there's lots of different ways it, it can go wrong and I hope that, you know, in our discussion I've given listeners some way to actually think about how well does the rule of 40 test hold for this company.
Claude (31m 26s):
Watch for some of the ways that the integrity of the test can be impacted. What, you know, you can use a picture if you want, but you might wanna crosscheck to see the free cash flows like in the same vicinity as as EBITDA . And because if one com you know, and, and again with free cash flow, you can get an outlier result really easily with free cash flow as well for whatever reason it could be really bad cause they paid for a, you know, they might've paid for an acquisition in say June and received none of the revenue for that acquisition, but they did a massive cash outflow for it in that case, you know, the, the cash flow would look really bad. So there's lots of like, I guess the devil's always in the detail, but this gives you a way to actually measure the growth stocks in your portfolio and just to see how well they're doing in a way that cross checks both their profitability or their cashflow generation, which is what you ultimately want out of a company, but also measuring that against the growth.
Claude (32m 17s):
So for that reason I think that, you know, if you go and perform the rule of 40 tests on a few of your holdings, you're only gonna get a better as an, as an investor if you do that and, and learn more about the companies you, you hold Shares on. I wouldn't make a decision based purely on this one thing, but it's just an, it's a us useful data point to monitor.
Phil (32m 36s):
And you've kindly written an article about this, which this episode's gonna be embedded in and where listeners can find out more about the, the rule of 40, haven't you?
Claude (32m 44s):
Yeah, that's right. That's if you wanna do your homework and then you need a reminder of how to calculate on this, you, you should be able to find it by googling, you know, how to calculate the rule of 40 and and my name. But, you know, I think finally, you know, it, it wanted to lead into another point of like why I chose this subject today, which is that I genuinely think for beginner investors, if you make the, the upside from doing the rule of 40 test on your companies is that it's gonna keep you in companies that are profitable basically, or free cash flow generative. Like there's nothing wrong with doing a totally speculative thing on something that's not making money, but just remember that it's like gambling and I'd never put more than you afford to lose in even for growth stocks, obviously they can go hugely up and hugely down.
Claude (33m 27s):
They're generally more volatile. So it's still gonna be like a risky, a riskier investment. Any investment that you're evaluating like this is, it's gotta be in like the growth part of your investment pyramid. you know, hopefully you've got a lot more in much more conservative assets. But yeah, also it's gonna keep you focused on like quality and sustainability of a company overall and basically saying, you know, if you're not a really profitable or free cash degenerative company, then you need to compensate with high growth and, and it's gonna set your standards better basically. And you'll, you'll, if you do it on all the companies in ASX for sure, you'll end up spending time learning about companies that are more likely to be multi-year compounders.
Claude (34m 7s):
Because going back to the beginning of episode, really if you are investing in small cap growth stocks, the whole, for me, the main thing like this by the way, there's other strategies, small cap value, unforgettable, you're gonna get a capital turn, big dividends, whatever, it could be multiple ways to win. I'm just talking about one pure strategy, which is trying to find a smaller growing company that's one day gonna be a bigger growing company and then benefiting from both a combination of the growing earnings and even as unbelievable as it sounds like, you know, earnings multiple uplift as well, given that essentially there are small cap companies that are, that have got some kind of problem with them or they're just like on the verge of profitability, like, you know, Xero is or whatever, and you can hold them for a few years and they will eventually make it and then they become a, you know, one of the ones that are considered super high quality like Promedicus or technology one that we talked about earlier that have long histories of earnings growth and blah blah blah.
Claude (35m 4s):
And then you do have all the big fundies in it because they're like, this is the growth stock, this is the quality growth stock and it grows its earnings every year and they, that's the thing they're looking for and there's always gonna be some money chasing that. And I still, I'm not saying sell then either by the way, but that's, I don't see as much upside then put it that way. Like after that's happened I fe I say, well who's the next guy after that? That's gonna be the enthusiastic buyer off the, off those people and it's harder to point to someone there.
Phil (35m 32s):
Yeah, and I think the lesson that I've picked up from this and that I've picked up from many other guests in on other episodes is that it's too easy to just get taken in by the story of a stock without actually even doing the, the most basic accounting due diligence. And if anyone has got something to take away from this episode, it's, it's not easy. But this is the kind of work that you gotta do if you are going to invest in individual stocks,
Claude (35m 55s):
I know it sound like a complete nerd, but I'm gonna hammer it one last time. All you need is the revenue and then you need to get the free cash flow or EBITDA , try and just get, calculate the free cash flow yourself. That's gonna be the best learning experience. Worst case scenario, just look for the statutory, not in, not underlying EBITDA the statutory EBITDA and then calculate the margin by dividing the cash flow or the bit to buy the revenue. Also get the revenue growth based on the year before, which the company will almost always tell you, make sure you're looking at a full year results just cuz it's added level of complexity. If you're trying to look at the half year results and do this same exercise, look at the full year results, they'll tell you the revenue growth rate, add 'em together, do it for a bunch of your holdings and that's gonna give you a way to monitor 'em, write 'em down and then you can do it a year later and that that way you have to measure each company against each other and it against itself over time.
Phil (36m 47s):
Claude Walker, thanks very much for joining me today. Thanks
Claude (36m 49s):
Very much for having me and having an investing nerd session. Thanks for listening everybody. I love
Phil (36m 54s):
Chloe (36m 55s):
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