SSTI - Holding My ShotSpotter Stake

Summary

• The company has reported excellent financial results in 2022 so far, and I expect more of the same on the eve of annual results.
• The valuation is not objectively cheap, though, so I'll not add to my stake here.
• I think position size is of critical importance when running a portfolio of stocks, and not enough people write about it.

Between November 21 of 2021 and March 3rd 2022, I switched from an " avoid " to a " buy " stance on ShotSpotter, Inc. ( SSTI ). Since I put out the "Avoid" piece, the shares are down about .9% against a loss of about 12.7% for the S&P 500. Since I put out the bullish piece, the shares are up about 32% against a loss of about 6.25% for the S&P 500. I am very pleased by that 38% plus outperformance. A wiser, more mature, stronger man would never dream of bragging about this. I am neither wise, nor mature, nor particularly strong, though, so I'm going to take this opportunity to try to take focus off of my many failings by bragging about this performance.

In this article, I want to review what changed for me in the 102 days between my cautious and bullish take on the stock. Also, since I'm more interested in the future than I am in the past, I'm going to work out whether or not it makes sense to buy more, hold, or take my winnings and go home. I'll make that determination by looking at the latest financial results, and by looking at the valuation of the stock. After all, a stock trading at $36 is a much more risky investment than the same stock when it's trading at $27.35.

The first thought I think when I wake up in the morning, and the last thought I have before my head hits the pillow is "how can I make the lives of my readers a little bit better?" One of the ways that I indulge this obsession is by offering up a thesis statement paragraph in each of my articles. These offer the "gist" of my thinking in a nutshell, so you can get in, read what I'm thinking in a few pithy sentences, and then get out before you're exposed to too much of my tiresome bragging. You're welcome. Although the capital structure has deteriorated here, it remains very strong. Additionally, this is a growth company that trades at a "value" company price, which is why I'm remaining long here. By some measure, though, the shares are expensive, and so I won't add at the moment. I would rather preserve my capital, so I'm limiting my position size here. If the market continues to reward the growth here with a higher valuation, great. If the shares fall in price in a general market meltdown, less great, but I will at least maintain a small ownership stake in a fast growing enterprise. I like this company a great deal, but I run a portfolio, can spend only so many units of risk, and will spend no more on this name at current levels. This approach may not be profit maximizing, but I'm comfortable with that, because I think "risk minimizing" is an even more relevant strategy at all times.

Financial Snapshot

The most recent financial performance has been very good in my view. Relative to the same period in 2021, the first nine months of 2022 revenue was up by 35.8%. Additionally, net income has switched from a loss of ~$1.12 million last year to a positive $7.4 million this year. Each of the expense categories were up massively on a percentage basis, for example R&D expenses in 2022 were 47% higher than they were in 2021, but the $15.8 million uptick in revenue swamped all of that, so that the company was nicely profitable. The same dynamic applies when we compare the most recent period to the same period in 2019. For example, revenue and net income for the first nine months of 2022 were higher by 101% and 1477% (!) than 2019 respectively. This is obviously a "growth" company, as evidenced by the spectacular financial results reported on the income statement. To fully drive home the point to the point of tedium, between 2015 and 2021, revenue grew at a CAGR of about 25.6%, and revenue was up in 2022 by an additional 35.8%. Sales are booming.

It's not all gumdrops and lollipops over at Shot Spotter, though. Specifically, the capital structure has deteriorated since I last commented on it. Back in February of 2022, the company had total liabilities of about $26 million, and cash of about $28.7 million. Today, total liabilities have exploded to $53.4 million and cash is down to $9.6 million. This is still quite strong, but it's moved in the wrong direction in my view. I'll certainly keep an eye on the capital structure here.

There's also been a problem of dilution, with shares outstanding up about 4.8% over the past year. This is typical of growth companies, but I think it's worth noting that people who buy today are picking up a smaller slice of this enterprise than they would have done last year.

Given the above, I'd be happy to buy more of this growth machine at the right price.

The Stock

My regular readers know that I consider the company and the stock to be very different things. If you're new here, it's time to let you in on this idea, too. I consider the stock and the company to be very different things. The company takes a number of inputs, adds value to them, and sells security solutions for a profit. The stock, on the other hand, is a traded instrument that reflects the crowd's long-term views about the strength of the business. Additionally, the stock is affected by a number of variables that have little to do with the business, including changing interest rates, the crowd's desire to own "stocks" as an asset class etc. In my experience, the only way to profit trading stocks is to spot discrepancies between the crowd's views and subsequent reality. If the crowd is too pessimistic, for instance, it makes sense to buy and then ride the price higher as new information is eventually digested. If the crowd is too optimistic about a company's future, it's best to avoid the name in my view. The level of optimism or pessimism in a stock is reflected in the valuation. If the crowd is optimistic, the shares are not cheap and are likely not a great investment in my view. If the crowd is pessimistic, the stock is likely an excellent investment. I absolutely hate to remind you of my performance here, but it's exactly this approach that helped me eschew these shares when they were going to drop in price, and then buy when they were about to rise in price.

I measure the cheapness (or not) of a stock in a few ways, ranging from the simple to the more complex. On the simple side, I look at the ratio of market price to some measure of economic value, like earnings, sales, and the like. I want to see the shares trading at a discount to both the overall market, and their own history. In case you don't remember, I got pretty excited about these shares when they dropped to a price to sales ratio of about 5.3 times. I eschewed the shares, in spite of the obvious growth here, when the shares were trading at a price to sales ratio of about 7.5 times. At the beginning of this article, I wrote that I'm going to explore what changed for me in the 102 days between my "avoid" and my "buy" stance. That's it. I became compelled by the valuation. At the moment, the shares are neither that cheap, nor that expensive, per the following:

My regulars know that I think ratios can be instructive, but I also want to try to work out what the market is "thinking" about a given investment. If you read my stuff regularly, you know that the way I do this is by turning to the work of Professor Stephen Penman and his book "Accounting for Value." In this book, Penman walks investors through how they can apply some pretty basic math to a standard finance formula in order to work out what the market is "thinking" about a given company's future growth. This involves isolating the "g" (growth) variable in this formula. In case you find Penman's writing a bit opaque, you might want to try "Expectations Investing" by Mauboussin and Rappaport. These two have also introduced the idea of using the stock price itself as a source of information, and we can infer what the market is currently "expecting" about the future. Applying this approach to ShotSpotter at the moment suggests the market is assuming that this company will grow earnings at a rate of ~10.5% in perpetuity. I consider that to be a very optimistic forecast for any company, even one with a recent growth profile like this. I'm now on the horns of a dilemma. On the one hand, the shares of this high growth company are reasonably priced. On the other hand, in some ways they're very expensive. Given that, I'll neither add to, nor take from my position here. I'm going to stay long, but I'm not going to add.

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