It’s no secret that when economic conditions are favourable, most businesses are able to do well. Even portfolios containing average and low-quality firms may see strong performance in the short-term; as the saying goes, a rising tide lifts all ships.
Over the long-term however, the picture can look quite different as markets are subjected to the gyrations of upturns and downturns in economic cycles. Prior to the GFC, many below average businesses steadily grew their earnings, often assisted by financial leverage.
On face value, many of these companies might have looked attractive but their earnings and associated share price appreciation, produced in such buoyant economic conditions, were illusionary and unsustainable over the longer-term and in more modest conditions.
Over the past few weeks, global markets have shed approximately 30% from all-time highs in a dramatic drop sparked by COVID-19 fears – and just as a rising tide lifts all ships, it also drags everything down with it when it goes back out.
Apart from a few outliers, we have seen many companies dropping lower in this current market sell off – but some more than others – and this is an indication of strength.
Why growth investing?
The simple fact is this; in economic downturns, portfolios containing average and low-quality businesses suffer more; this is one of the key reasons why we favour growth investing.
At its most basic level, growth investing is the approach of investing into companies which exhibit above average growth relative to peers. Unlike value investing which seeks to identify companies trading at a discount to their perceived market value, growth companies are characterised by their strong revenues and profits, allowing them to grow at rates well above the overall benchmark. This is especially true in economic downturns and weaker periods.
For successful and profitable businesses to remain so during weaker periods, the need for structural tailwinds like a strong value proposition, a large and growing addressable market and a talented and committed management team with a long-term outlook and ‘skin in the game’ are all required. It is also equally important for a business to have a creative organisational culture that effectively harnesses technology and invests in R&D. These are the sorts of factors we consider, among other things, when assessing a company’s competitive advantages in the market.
Our proprietary investment processes are designed to weed out average and low-quality businesses, allowing the investment team to focus their research efforts on high-quality businesses that are positioned to grow earnings, even in harsh economic climates. For example, Hyperion’s portfolios have been stress-tested and significantly outperformed through difficult economic conditions such as the GFC and European debt crisis.
Over the past few weeks we have seen huge market volatility with indices selling down heavily and volatility rising to levels not seen since the GFC. We believe there are various structural headwinds which threaten a global economic recovery once the dust settles. These include high debt levels, declining population growth rates, ageing populations, rising wealth inequality, automation and other forms of technological disruption and natural resource constraints and disruptions including climate change. While we think COVID-19 will be a short-term issue, we expect these sorts of structural inhibitors to be persistent and threaten a strong and sustained economic recovery. In an environment of economic stagnation, most (but not all) companies will experience lower earnings.
The world is turning Japanese both in terms of the structural transition to very low economic growth rates for most countries around the world but also in terms of Governments’ and Central banks’ reaction to low rates of economic growth. Governments and Central banks around the world are copying the Japanese Fiscal and Monetary blueprint from the past three decades of large budget deficits, high and growing Government debt levels, very low official interest rates and quantitative easing.
So, if the economic pie is not growing, companies will need to take market share from their competitors to grow earnings.
Many old-world companies will be faced with an ongoing decline in earnings and in this sort of environment, growth companies with their competitive advantages will be well placed to thrive.
Free cashflow more important than disruption
Over the last decade, growth stocks have performed remarkably well. Two household names which we have held for a long time are Facebook and Amazon. We purchased Facebook in the $US30s and Amazon in the $US300s; they are now trading at $153.03 and $1,877 respectively (at the time of writing).
Despite seeing huge price increases over time, we still like both companies because of the way they continue to disrupt the traditional means of commerce and communication. For digital platforms specifically, the network effect plays a crucial role in propelling the growth trajectory of these companies as the bigger they grow, the faster their rate of growth.
In other words, size is not providing the normal handicap on growth which it might do in other sectors. This is due to various reasons including the low capital intensity of their business models and because the barriers to entry for competitors are relatively high.
There is also a large and growing global addressable market for these companies to operate within. These factors position companies like Facebook and Amazon well for future earnings growth, no matter the economic backdrop.
It’s not all about disruption, however. There is no substitute for a positive free cash flow, which is why a company like Netflix, which is growing rapidly, but producing massive negative cash flows, is not on our radar. Amazon’s Jeff Bezos, on the other hand, has always focused on maintaining and growing free cash flow, and this has proved massively value enhancing for investors.
This investment approach is what has allowed us to deliver strong performance and returns to our investors, but that isn’t to say that all companies we invest in using our proprietary model have played out as expected.
TripAdvisor was a company that we were attracted to due to its popular website where hundreds of millions of people go to research their next holiday. Several years ago, TripAdvisor attempted to add a booking engine to its website which failed to gain traction, upsetting its main advertising partners such as Expedia and Booking.com. We sold the stock at a loss once it became obvious that the booking product was adversely affecting TripAdvisor’s overall business. The stock is still trading at prices well below the price we ended up selling for several years ago.
The long-term view
We take a long-term view when it comes to generating alpha for our clients. Our process systematically compares current share prices that are heavily influenced by short-term, non-fundamental volatility, to relatively stable but structurally growing long-term intrinsic value estimates.
Adopting a long-term investment mindset like that of a business owner, rather than a share trader, is an important factor in achieving attractive compounding returns. It requires the portfolio manager to focus solely on generating long-term alpha rather than trying to string together a series of unrelated short-term alpha generating trades – and we think the vast majority of market participants are focused on short-term alpha and share price-based returns.
To maximise short-term alpha, share traders try to predict short-term share price movements by buying stocks they think will outperform in the short term and selling stocks that they think will underperform over a similar time period. In essence, these traders are trying to predict the short-term direction of share prices, which requires them to constantly reassess their short-term directional thesis.
Our view is that this is very difficult to do consistently, because share prices are highly unpredictable in the short term.
In addition, when investors have a short-term mindset, the focus is less on the long-term fundamentals of the stock, and more on news flow and meeting or beating short-term consensus expectations as the dominant reasons for going long or short a stock.
Hyperion’s portfolio construction system tends to be contrarian in nature and provides liquidity to the market. We tend to be buying when individual share prices are weak and selling when they are strong. This is the opposite to most short-term alpha seeking investors who are sucking liquidity out of the market because they are trying to buy positive momentum stocks and sell negative momentum stocks.
Fact vs Fiction: The biggest myths about growth investing
Growth companies don’t usually come cheap but investing in them doesn’t necessarily mean overpaying.
The concept of ‘growth at a reasonable price’ is something which is often overlooked by investors but is something which we apply to our rigorous investment process. Renowned value investor Benjamin Graham once famously said that in the short-term, the market is a voting machine but in the long-term it is a weighing machine. As long-term investors ourselves, we aren’t focused on short-termism or market noise. We look to identify quality companies and invest in them for the long-term, but that doesn’t mean we don’t exploit market gyrations. When share prices drop substantially, we definitely take an interest.
Our team constantly looks to top and tail its portfolio when a specific stock moves away from its intrinsic value. On short-term bad news we might add to our positions on a stock and on good news, we might take some profit as price overheats. Approximately 50 per cent of the long-term alpha Hyperion generates comes from this tactic.
Growth investing is often associated with famous American investor Thomas Rowe Price, known for his rigour in interviewing company executives prior to investing in them. Importantly, Price stressed the need for companies to be in growing industries and for investors to take a long-term approach, both of which align with our investment philosophy.
Another renowned growth investor was Philip Arthur Fisher, who like Price, also stressed the importance of having a long-term investment outlook. He advocated for a concentrated portfolio of companies and believed that companies with low or no dividends would be the most likely to generate above average profits.
Our firm’s funds contain 15 to 25 stocks, with one or two stocks added and removed each year so our investment philosophy is also very aligned with Fisher’s approach.
It’s not too late to get on board
The current COVID-19 crisis is unsettling and is wreaking havoc on the markets, but it is also creating opportunities to purchase quality companies at attractive prices.
As we mentioned before, we think there are various long-term structural inhibitors to economic growth which is why we believe the market today is increasingly becoming a ‘winner takes all’ environment.
This means that beaten down companies will continue to be beaten down by higher quality companies in the absence of strong and sustained overall economic growth. In this environment, technology disrupters like Amazon, Facebook and Google will likely continue to outperform the market.
There are also plenty of other companies which aren’t household names which we believe will outperform. We like modern businesses that invest in R&D, but these businesses are hard to find in Australia.
Looking ahead, we think investors should focus on businesses and investment styles that are not reliant for success on high levels of economic growth and low levels of competition.
Instead, investors should look for businesses which can compete in a disrupted world – where technology has changed the way we work, interact with each other and pay for goods and services.
Old-world profit drivers simply don’t work anymore – and the companies which are set to dominate, as we have said, are those with structural tailwinds, a sustainable competitive advantage, low levels of debt and run by a management team with a long-term focus and skin in the game.
The bottom line is that value investing, which relies heavily on investing in average businesses which are themselves reliant on a strong economy to succeed, will not work in a global economy which is no longer growing. In fact, since the GFC, the so-called ‘value anomaly’ has disappeared, and growth investing, which includes qualitative as well as quantitative analysis is becoming increasingly important – and more likely to produce results.
Mark Arnold and Jason Orthman