This article discusses a framework for capital allocation, focusing on how to evaluate and choose between investment opportunities, particularly in the context of volatile growth stocks. The key is understanding the underlying value creation process and maintaining conviction based on fundamental analysis, even amidst market fluctuations.
Understanding the Value Creation Process
The core principle is to break down a company's value creation process into its fundamental components and thoroughly assess your understanding of each component. This understanding should ideally be near 100%.
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Stock prices, particularly for growth stocks, are often volatile in the short term.
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Over the long term, prices tend to correlate with free cash flow per share.
Duolingo Example: Users, Engagement, and AI
Let's use Duolingo as an example to illustrate this. Duolingo's free cash flow per share is primarily driven by:
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Number of users
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User engagement
A platform-based business model provides operating leverage, which improves free cash flow per share if the management team is shareholder-friendly. AI is a major dynamic that can further increase user engagement by creating more compelling content. Duolingo has a proprietary data advantage due to its position as a top-of-funnel platform in the education industry. This advantage is similar to other successful web 2.0 platforms like Uber, Netflix, and Spotify.
The Importance of a Data Advantage
Companies with a significant data advantage are better positioned to withstand disruption. The market continually seeks to disrupt established operations.
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Companies like Lemonade are making progress, but it's crucial to assess whether they possess the same level of data advantage.
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Social media platforms, like YouTube and Instagram, have a substantial data advantage in some sectors due to their extensive user data.
Managing Emotional Volatility and FOMO
The market's volatility and the fear of missing out (FOMO) can lead to poor investment decisions. Remaining focused on the fundamentals is crucial.
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Duolingo's potential lies in its ability to increase users and engagement, with AI as a tailwind.
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Duolingo's dominant position and proprietary data make it challenging for competitors to replicate its success.
Iron and the Data Center Blueprint
Iron presents a compelling case with its ability to efficiently produce data centers.
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This is critical because compute capacity is scarce, and demand is high.
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Iron's success hinges on its operational excellence and data center blueprint.
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However, a key aspect of Iron's business model is tied to Bitcoin mining, and that might not be a point of total conviction.
Palantir's Digital Twin Platform
Palantir is another example of a company rapidly creating value via rapid data flywheel for clients.
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Companies that want to leverage AI require digital twins. Palantir can generate them very efficiently.
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With new tools, the time-to-value has collapsed, creating new data for them to learn from.
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As a result, Palantir can better deploy digital twins for various industries and individual functions.
The Importance of Long-Term Vision
Focusing on long-term growth and free cash flow per share is vital.
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Don't get caught up in trying to time the market by buying at the bottom or avoiding the top.
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Cycles are not real, especially when considering long-term investments in exceptional companies.
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The key to making money (outside of index funds) lies in free cash flow per share rising exponentially over the long term.
Hims & GLP-1s
Hims demonstrates this point effectively.
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Even with the risk of lawsuits (common in the pharmaceutical sector), the focus should remain on the company's ability to consistently increase free cash flow per share.
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Hims deploys a growing volume of verticals that solves a growing volume of acute customer pains.
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As long as lawsuits are not an existential threat, they should not be the primary concern.
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The future includes testosterone, menopause, and possibly peptides approved by the FDA.
Continued Learning and Adaptation
Constant learning and adaptation are essential in a dynamic market.
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The pace of innovation is accelerating, creating new opportunities and disruptions.
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Social media amplifies market volatility and noise, making it even more critical to stay grounded in fundamentals.
By studying businesses, creating content, and being held accountable for your opinions, you can significantly accelerate your learning and improve your investment decisions.