Since the start of 2023, shares of app-based education company Duolingo (DUOL 3.64%) have nearly doubled in value, increasing 97% year to date as of this writing. And anytime investors see big gains over small time periods, they're often tempted to lock in trading profits by selling.
Prematurely selling winners can actually be extremely detrimental to your long-term success as an investor. And it's why I believe Duolingo shareholders need to be very careful right now.
Why investors should hold winners
When it comes to picking stocks, many investors aspire to do as well as investing great Warren Buffett -- a lofty goal. But what does that mean practically?
Image source: Getty Images.
According to Buffett, he's not a great stock picker -- a shocking confession. Indeed in his 2022 letter to Berkshire Hathaway shareholders, he explained his success by saying, "Our satisfactory results have been the product of about a dozen truly good decisions – that would be about one every five years."
In a given year, Buffett buys and sells dozens of stocks. And yet, he says only about one decision every five years is "truly good."
As it turns out, your bad investments aren't as consequential as your good investments over the long term. Buffett went on to say: "The lesson for investors: The weeds wither away in significance as the flowers bloom. Over time, it takes just a few winners to work wonders."
This is why part of the Motley Fool investment philosophy is "Let your portfolio's winners keep winning." Like Buffett counsels, it's bad to sell winners too soon. That would leave investors with a weedy garden devoid of flowers.
Therefore, selling Duolingo stock just to lock in strong year-to-date gains isn't a good reason to sell. If this company is truly a winner, it behooves investors to keep it firmly planted in the flowerbed.
Is Duolingo truly a winner in the making?
The gain for Duolingo stock has been steady in 2023. But it made a punctuated move higher after reporting financial results for 2022, showing really important progress.
For context, Duolingo needs to entice people to pay for a subscription even though its apps are available for free with ads. This will likely be the biggest contributing factor to its long-term success. After all, the difference between these two revenue streams -- subscriptions and advertising -- is extreme.
Duolingo ended 2022 with 60.7 million monthly active users (MAUs), but only 4.2 million were paying subscribers. However, the company generated $274 million in revenue from subscriptions compared to a paltry $45 million from advertising. Therefore, it's abundantly clear the key to success is growing and retaining paying subscribers.
If this is the key to success, then Duolingo is succeeding. The growth rate for MAUs has accelerated in six straight quarters. And this has led to a progressively higher number of net new paying subscribers as well, as shown below.
| Quarter | MAUs | YoY Growth | Paying subscribers | Net new additions sequentially |
|---|---|---|---|---|
| Q3 2021 | 41.7 million | +13% | 2.2 million | +300,000 |
| Q4 2021 | 42.4 million | +15% | 2.5 million | +300,000 |
| Q1 2022 | 49.2 million | +23% | 2.9 million | +400,000 |
| Q2 2022 | 49.5 million | +31% | 3.3 million | +400,000 |
| Q3 2022 | 56.5 million | +35% | 3.7 million | +400,000 |
| Q4 2022 | 60.7 million | +43% | 4.2 million | +500,000 |
Source: Duolingo's filings. YoY = year over year. Chart by author.
I don't believe Duolingo's success is accidental at this point. In its filings, management writes, "We utilize the latest in artificial intelligence, machine learning and data analytics, along with a relentless focus on A/B testing, to fuel our differentiated learning experience." Of course, all companies talk about their products in glowing fashion. But when you see consistent execution with the business, it's highly suggestive that management's approach is working. And I believe that's likely the case with Duolingo.
Duolingo also has a possible competitive advantage that could make it a winner: brand recognition. In its most recent letter to shareholders, management said, "90% of our user growth has been organic," as happy users spread the word for free. As a result, Duolingo spends relatively little on sales and marketing. It spent 18% of revenue on this line item in 2022, down from 24% in 2021.
As a final cautionary word, Duolingo's 97% year-to-date gain is largely the result of a higher valuation, illustrated below.
Trading at a price-to-sales (P/S) ratio of about 14, Duolingo stock isn't cheap for those looking to buy today. Therefore, making small, periodic buys, or waiting for a more attractive price could be appropriate.
However, for Duolingo shareholders, the business is performing very well, and its opportunity remains large. This isn't a stock to sell, in my opinion. Rather, I'd let this flower continue to bloom.
