Five essential traits of growth stocks
Traits of companies that are truly growing is what investors need to be aware of to benefit from sustained earnings growth, Nick Griffin writes.
Overall, the macroeconomic picture is looking brighter than it has for some time (despite the political landscape), with both emerging markets and Europe looking stronger. Against this backdrop, central bankers have made moves to turn off the quantitative easing programs that have stimulated economies and allowed sharemarkets to recover since the global financial crisis.
Despite this, we still see a number of forces that will keep interest rates low and growth below previously experienced levels. Primarily we would point to large fiscal deficits in developed economies and a growing savings glut as likely to crimp growth and keep a cap on interest rates.
Elsewhere, technological change is holding inflation back, providing little incentive for central banks to meaningfully raise interest rates back to previously accepted normal levels.
Regardless of the macro environment, we have always felt that when buying equities, investors are ultimately buying earnings growth over the long-term. It is not a stock market, but a market of stocks and there will always be companies that are growing faster than their peers.
It is our job to find them at the right price.
With 24,000 companies in the global equities universe, we have a wide universe from which to choose and, while most of these companies will claim they are growing, in many cases this is due to gross domestic product (GDP) growth rather than structural growth.
From our point of view, there’s no value-add in forecasting GDP, or whether China is slowing, or what’s going to happen to the UK as a result of Brexit.
The key is to find companies that can grow regardless of the economic cycle, through structural growth, and have sustainable earnings growth not adequately recognised by the market.
As a result of many years of research, we have identified five essential traits of great growth companies and find these traits consistently in many of the best investments we have made over the years.
Top line growth
Firstly, gross sales or revenue must be growing faster than GDP. This usually means the total available market is growing. A good example is Apple and the smartphone.
When Apple first launched the iPhone, five per cent of the market had a smartphone; now it is more than fifty per cent. The total market has grown, and so has Apple’s share of it.
Economic leverage
A growth company must have earnings growing faster than revenue, indicating an increase in efficiency within the company and how it produces its goods or services. Good earnings growth means more profit for investors.
Sustainability
Any growth must be sustainable over a three to five-year period. Short-term growth over a period of several months may look impressive, but if it can’t be sustained over a longer period then this isn’t a good sign for investors.
Controlling shareholder
Perhaps surprisingly, having a controlling shareholder is a positive for a growth company. Of course, the controlling shareholder must be an asset not a liability to the company, but we have found that someone who can drive the vision of the company and maintain the focus of its people, is a very powerful thing. Apple and Steve Jobs is again a good example here.
Customer perception
A product can only grow sustainably if it has great customer perception – that is, the customer’s impression or awareness of the product is very strong. One of the advantages of measuring this is that it gives us an idea of what is going to happen with a product or a company, before it appears in the numbers. Investment managers aren’t always very good at seeing what is going to be the ‘next big thing’.
With the iPhone, for example, it was obvious that it was going to be bigger than a niche product, right from the start; however it took a long time for consensus earnings forecasts to reflect this. As we now all know, it ultimately became the most successful consumer product ever and made Apple the biggest company in the world.
Apple is a good example of a company that has displayed all five of these ‘growth traits’. Another example, which is perhaps particularly pertinent at the moment, is Amazon.
Amazon is dominating the e-commerce world and has built a lead on its competitors – including traditional retailers – that now looks insurmountable.
Running through the five traits described above:
Growth – Amazon’s global retail e-commerce sales are expected to grow at approximately 20 per cent a year.
Economic leverage – Amazon margins are currently very low, below five per cent, and likely to expand as the network effects from their increasing sales kick in.
Sustainability – With continued technology growth and ease of delivery, e-commerce is set to continue to grow and, as the dominant player, Amazon can continue to capture market share.
Control – Chief executive Jeff Bezos controls almost 20 per cent of the company’s shares.
Customer perception – Amazon Prime, a membership service for Amazon shipping and streaming, is growing at 35 per cent a year.
In total, Amazon makes up a staggering two thirds of all new e-commerce growth in the US market.
Any attempt to challenge Amazon’s dominance will be difficult from here considering the network of over 160 distribution centres Amazon has already built, and even being number two in the market is unlikely to reap the same rewards, due to what we call “network effects”.
Network effects have a very strong impact on digital businesses. It is when people – consumers – congregate on one platform and create a virtuous cycle of demand and supply. So, for example, everyone uses Google to search the internet because all the information is on
Google, so everyone puts information on Google so everyone searches there so everything goes on there so everyone searches there so everything on goes there, and so on.
As a result, we essentially now have one search engine where once there was 11.
The same effect applies to a business such as realestate.com.au – everyone searches there so everyone advertises their properties there, so everyone searches there so everyone advertises their property there, etc.
It is very hard, if not impossible, to upset these network effects. And being number two in this environment is often not a strong position. Google has a market cap of $550 billion. The world’s number two search engine is Yahoo and it was sold in June this year for just under $5 billion. That’s a significant difference between the number one and the number two companies.
This kind of differentiation doesn’t occur in the non-digital world, for example between Woolworths and Coles or between Coke and Pepsi.
From an investor’s point of view, this can limit the investment universe. While it might make sense to hold both Coles and Woolworths in a portfolio, there might not be as much value in holding both Google and Yahoo.
Likewise, Facebook can monetise each of its 1.7 billion users at about $17 a user; Twitter and Snapchat, which each have around 200 million users, can monetise them at less than $1 each.
Over the medium-to-long-term, regardless of macroeconomic changes, these trends are likely to continue and investors will need to be increasingly aware of the traits of companies that are truly growing in order to continue benefiting from sustained earnings growth.
Nick Griffin is chief investment officer at Munro Partners.
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