When applied to investing, the Pareto Principle (also known as the 80-20 rule) suggests that 20% of the stocks in a portfolio will generate 80% of the returns. That makes sense. After buying a stock, the worst outcome is a loss of 100%, but there is no limit on the upside. Given enough time, a stock could grow tenfold, 50-fold, or even 100-fold in value. That's one reason a long-term outlook is so important.
With that in mind, I think Lemonade (LMND -0.46%) could generate 100x returns in the next 15 to 20 years. The past few quarters have been difficult for the business, as high inflation and potential interest rate hikes have compounded the fallout of a somewhat disappointing financial performance. For that reason, Lemonade stock has fallen 85% from its high. But with investor sentiment circling the drain, now could be a smart time to buy a few shares.
Here's what you should know.
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A disruptive business model
Lemonade is an insurance company that leans on artificial intelligence to make its business more efficient and customer-friendly. For instance, its digital-first platform does away with agents and paperwork. Instead, consumers interact with intelligent chatbots to purchase insurance and file claims, which keeps Lemonade's payroll expenses low. In fact, management believes its customer acquisition costs are tenfold lower than a traditional insurance company.
Better yet, Lemonade's digital platform is built to capture a volume and variety of data that legacy systems can't match. The company collects about 100 times more data points per customer, which should (eventually) allow Lemonade to quantify risk more precisely, meaning its loss ratio (i.e., claims payments as a percent of premiums) should be lower than the industry average. In turn, by paying less in claims (and spending less on payroll), the company should be able to undercut its competitors on price.
A disappointing financial performance
Unfortunately, Lemonade posted a loss ratio of 90% last year, which compares poorly to the industry average of approximately 70% through the first half of 2021. However, the company posted a loss ratio of 71% in 2020, and management attributes the recent spike to strong growth in newer product offerings -- like homeowners and pet insurance -- which have a higher loss ratio than the company's more mature renters insurance business.
However, losses in the homeowners and pet insurance verticals are decreasing, and management expects all lines of business to eventually achieve a loss ratio below 75%. Shareholders should be encouraged by that news.
Additionally, Lemonade's focus on a frictionless user experience helped it reach 1.4 million customers in 2021, up 43% from the prior year. And the average customer spent 25% more, as more people added additional policies (e.g., pet insurance) or graduated to more expensive coverage (e.g., upgraded from renters to homeowners coverage).
To that end, gross profit grew 26% to $31.2 million, though Lemonade remains unprofitable on a GAAP basis, and the company generated negative free cash flow of $154 million over the past year.
A chance for 100x returns
Looking ahead, Lemonade's recently launched auto insurance product could be a significant catalyst, as it brings its addressable market to over $400 billion in the U.S. alone. More importantly, the company's current clientele already spends $1 billion on auto insurance each year, meaning the cross-sell opportunity is significant.
To accelerate its entrance into the space, Lemonade plans to acquire AI-powered car insurance provider Metromile for $500 million in stock. Once complete, that move would allow Lemonade to incorporate Metromile's proprietary driving data into its own AI models.
Here's the big picture: Lemonade is a small-cap company with a big market opportunity and a differentiated business model. Currently, the stock has a price-to-book ratio of 1.1, meaning it's cheaper than rivals like Allstate and Progressive, which trade at 1.5 times book and 3.5 times book, respectively. But if Lemonade can continue to win customers and grow its top line while bringing its loss ratio down, I think this disruptive company -- which is currently worth just over $1 billion -- could grow 100-fold in value over the next 15 to 20 years.
