Growth investing for sceptics

I don’t really like the value versus growth monikers and consider myself to be in neither camp. And I think that the terms are often unhelpful – I recall one specialist hedge fund manager being accused of “just being a value investor” by a client. In response, he pointed out that the portfolio the client was criticising had an average price/earnings ratio that was 60 per cent above the market average.

At a Quality-Growth Investor Conference in London this year, a range of managers who specialise in the growth genre spoke, outlining what they thought constituted a growth stock. 

I studied around 15 or so presentations by these fund managers and extracted some of the buzzwords from their PowerPoint presentations. But before I go through them, it’s worth noting how few of them discussed valuation. A couple of managers highlighted it as a criterion in their process and one flagged that they used cash flow valuation measures. But how you value businesses is a prime differentiator for professional managers, and it may be the managers spent more time on this in the presentations themselves.

On the positive side, I really liked a slide from Lindsell Train that featured its investing hypothesis: “investors undervalue durable cash generative business franchises”.

This was clear, understandable and helped explain its philosophy in a sentence. Why more managers don’t do this is a mystery.

Anyway, onto the buzzwords, which I have collected under four headings:

• Financial Strength
• Management
• Growth
• Quality

Financial strength

Three managers highlighting this as one of their criteria.

I think we can take this as a given because without enough cash, a growth company won’t last long. We want to invest in companies that have strong balance sheets. Indeed, as we go into an economic downturn of unknown steepness and duration, balance sheet strength should be considered an even higher priority. Don’t own anything that has a lot of debt – or that needs to refinance a decent slug of debt – as there is a reasonable probability that financing will not be available at acceptable terms, let alone at recent rates. 

Management

This was cited by four of the group, who spoke about “trusted management“ (this was a Chinese company), “management”, “good management” and capital allocation. Of course, you need to invest with managers who are honest stewards of the capital you entrust them with. I go into more detail on this in my book. (I also explain there why I have enjoyed investing with crooks: their stocks are considered untouchable and the stock price can often do well as they are rehabilitated. But I don’t suggest you try that at home.)

Yet the interesting thing about management is that it’s difficult to form a judgment.

S&P 500 chief executives are not shy and retiring people. They know how to sell, so I have some sympathy with the view – held by people as diverse as James Montier at GMO and Terry Smith of Fundsmith – that you should not meet them. Personally, I would always take the chance that I would be charmed on the basis that I might also find something out. Again, let’s park the issue of management, as it is uncontroversial and it’s a given that it should form a part of the research process.

Growth

This, of course, was a popular term – “growth”, “runway for growth”, “secular growth” and similar – given the prevailing focus on these managers. I didn’t see much emphasis on the cost of growth – there was not one mention in the slides of customer acquisition cost, of capital required for growth, or even the dreaded churn. Despite this, tech stocks featured heavily in the portfolios. And in that type of industry, the cost of growth should be a prime focus for investors.

The topic of capital discipline should also be uppermost in these investors’ minds.

I am no expert in semiconductors, but I know it’s a highly cyclical industry. It’s certainly a growth industry and was probably over-represented in these investors’ portfolios; but the capital being deployed in this industry is huge – hundreds of billions of dollars over the next five or so years. But we have recently emerged from the Covid period, in which everyone who needed to buy a new laptop/phone/device surely did so, and we are entering an economic slowdown where such purchases may be a lower priority.

The only relevant slide I saw looked at semiconductor equipment companies, which presented forecast cash flow return on investment (CFROI) for the sector of 27-28 per cent, and an implied return of 22 per cent in 2026, post the enormous capital investment. This industry has seen zero or negative returns three times in the last 20 years, but apparently it’s less cyclical today.

The bottom line for me is that growth investing has significant downside risk and the cost of growth is something I would pay close attention to, as is the capital cycle. The latter is underrated.

Quality

The single most repeated quality factor in all the presentations was competitive advantage.

One investor called this “competitive positioning” and about half cited it as a key factor in their process. None explained how they decided whether a company had a real or sustainable competitive advantage (the sustainable qualifier was used by two of the presenters).

Perhaps this is part of the secret sauce which they don’t want to give away, or maybe it’s just a difficult thing to explain. These funds were investing across a really broad spectrum, from healthcare to soft drinks, albeit with a concentration in the tech sector. The qualities that convey competitive advantage would vary widely from company to company.

In my view, the characteristics of a company with competitive advantage are

• Pricing power
• High gross margins
• High and growing Ebit margins
• Revenue growth superior to the sector average
• High, possibly increasing and potentially stable returns on capital

Competitive advantage is an easy factor to cite in an investor presentation as everyone understands it. But it’s much harder to define, and a sustainable advantage is even more difficult to identify reliably.

The only quantitative quality factor cited by the managers was high returns, but predictably none of the investors defined it – although one used the Holt measure of CFROI in its charts. Holt is a great system but it is expensive and I intend to cover the issue of returns in a future article. There is a lot of misunderstanding here.

Other quality factors cited were:

• Economies of scale
• Cash flow predictability
• Pricing power
• Risk of disruption
• Macro sensitivity
• Repeat revenues

Nothing wrong with any of these. I think true economies of scale which confer a real and sustainable advantage are quite rare – Amazon (AMZN) and Walmart (WMT) are examples where their scale is at a different level from competitors, but I struggle to think of many more.

Cash flow predictability is a characteristic of a stable business – a utility or consumer staple. Pricing power is a major differentiator for companies now, especially in an inflationary environment (although it is equally helpful in deflationary times).

Macro sensitivity and risk of disruption are notable risk factors, and I was surprised that more presenters did not identify what excluded a business from qualification as a quality investment. I often find it easier to think of what should be excluded.

Finally, repeat revenues are highly valued by the stock market and subscription businesses have seen a significant rerating prior to this year, especially in the tech sector. The good news here is that there are warning signals in the financial statements if trouble is brewing here.