Growth investing for skeptics – Investors’ Chronicle

I don’t really like value-for-growth nicknames and consider myself to belong in neither camp. And I think the terms are often unnecessary – I remember a 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 criticizing had an average price-to-earnings ratio 60% above the market average.

At a recent Quality-Growth Investor conference in London, a series of managers specializing in the growth genre took the floor, describing what they thought constituted a growth stock.

I studied about 15 presentations from these fund managers and extracted some of the buzzwords from their PowerPoint presentations. But before going through them, it should be noted that few of them discussed evaluation. A few managers highlighted this as a criterion in their process and one reported using cash flow metrics. But how you value companies is a key differentiator for professional managers, and managers may have spent more time on it in the presentations themselves.

On the positive side, I really liked a slide from Lindsell Train that presented their investment hypothesis: “Investors are undervaluing sustainable cash-generating business franchises.”

It was clear, understandable and helped explain his philosophy in one sentence. Why more managers aren’t doing this is a mystery.

Anyway, on the buzzwords, which I’ve collected under four headings:

• Financial solidity
• Management
• Growth
• Quality

Financial solidity

Three managers highlighting this as one of their criteria.

I think we can take that for granted because without enough cash, a growing business won’t last long. We want to invest in companies that have strong balance sheets. Indeed, as we enter an economic downturn of unknown magnitude and duration, this should be considered an even higher priority.

Don’t own anything that has a lot of debt – or needs refinancing a fair amount of debt – because there’s a reasonable chance that financing won’t be available on acceptable terms, let alone at recent rates.

Management

This was cited by four members of the group, who spoke of “trust management” (this was a Chinese company), “management”, “good management” and capital allocation. Of course, you must invest with managers who are honest stewards of the capital you entrust to them. I discuss this in more detail in my book. (I also explain there why I liked investing with scammers: their actions are considered untouchable and the share price can often do well because they are rehabilitated. But I am not suggesting that you try this to the House.)

Yet, what is interesting with management is that it is difficult to pass judgement.

S&P 500 CEOs are not shy, retired people. They know how to sell, so I have some sympathy for the view – shared by people as diverse as James Montier at GMO and Terry Smith at Fundsmith – that you shouldn’t meet them. Personally, I would always take the risk of being charmed on the basis that I might also discover something. Again, let’s leave the question of management aside, because it’s not controversial and it stands to reason that it should be part of the research process.

Growth

This, of course, was a popular term – “growth”, “growth track”, “secular growth” and the like – given the focus on these managers. I didn’t see much emphasis on the cost of growth – there was no mention in the slides of the cost of customer acquisition, the capital required for growth, or even the dreaded churn. Despite this, technology stocks figured prominently in the portfolios. And in this type of industry, the cost of growth should be a priority for investors.

The subject of capital discipline should also be at the center of the concerns of these investors.

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

The only relevant slide I saw was on semiconductor equipment companies, which showed an expected cash flow return on investment (CFROI) for the industry of 27-28%, and an implied yield of 22 % in 2026, after the huge capital investment. This industry has seen zero or negative returns three times in the past 20 years, but is apparently less cyclical today.

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

Quality

The most repeated quality factor across all 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 decide whether a company has real or sustainable competitive advantage (the term sustainable was used by two of the presenters).

Maybe it’s part of the secret sauce they don’t want to reveal, or maybe it’s just a hard thing to explain. These funds invested in a very wide range, from health care to soft drinks, but with a concentration in the technology sector. The qualities that confer a competitive advantage vary widely from company to company.

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

• Pricing power
• High gross margins
• High and growing Ebit margins
• Revenue growth above industry 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. But it’s much harder to define, and a sustainable advantage is even more difficult to reliably identify.

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 graphics. Holt is a great system but it is expensive and I plan to cover returns in a future post. There are a lot of misunderstandings here.

Other quality factors cited were:

• Economies of scale
• Cash flow predictability
• Pricing power
• Risk of disruption
• Macro Sensitivity
• Recurring revenue

Nothing wrong with any of these. I think true economies of scale that provide real and lasting advantage are quite rare – Amazon (AMZN) and Walmart (WMT) are examples where their scale is on a different level than competitors, but I can’t think of many more.

Cash flow predictability is a hallmark of a stable business – a utility or a consumer good. Pricing power is a major differentiator for businesses today, especially in an inflationary environment (although it is just as useful in times of deflation).

Macro sensitivity and disruption risk are notable risk factors, and I was surprised that more presenters did not identify what disqualifies a company from qualifying as investment grade. I often find it easier to think about what should be excluded.

Finally, recurring revenue is highly valued by the stock market and subscription businesses saw significant revaluation prior to this year, particularly in the technology sector. The good news here is that there are warning signs in financial statements if trouble is brewing here, which I’ll cover in my next forensic accounting course.