I know you are all value investors now, but remember 2021?
Growth was in vogue, as was quality. Unfortunately, I missed the inaugural Quality-Growth Investor Conference in London, organised by the same group as the Value Investor Conference. The presenters all pay to speak and the audience pay to attend, which must make it a lucrative venture. It also means that the managers are in sales mode, which can help you learn about their process.
I previously looked at quality from a quantitative perspective, trying to understand what constitutes a quality business. So, I thought it would be interesting to see what the fund managers who specialise in the genre say about it.
Regular readers will be aware that I don’t really like the value vs growth monikers and consider myself 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 p/e of 60% above the market average.
So what factors do these specialist fund managers consider constitute a quality growth stock?
I went through 15 or so presentations and extracted some of the buzzwords from the fancy powerpoint schematics. 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 surely how you value businesses is a prime differentiator for professional managers (although to be fair, perhaps they spent more time on this in the presentations themselves).
On the positive side, I really liked this slide from Lindsell Train with their investing hypothesis:
“investors undervalue durable cash generative business franchises”
This was clear, understandable and helped explain their 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
I’ll start here, as I was slightly surprised to see 3 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, this 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.
This was cited by four of the group who talked 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. Please check out my book where I go into more detail. (I also explain there why I have enjoyed investing with crooks as 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).
But the interesting thing about management is that it’s difficult to form a judgment.
S&P500 CEOs 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’s uncontroversial and it’s a given that it should form a part of the research process. (Joseph who works with me thinks we should publish our content on assessing management as a separate course – would you be interested? Let me know by replying.)
This, of course was a popular term – “growth”, “runway for growth”, “secular growth” and similar – as these people were all quite growthy. 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, which I will cover in the section for paying subscribers. 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 – several $100bn over the next 5 or so years. Meanwhile, we have recently emerged from the Covid period, in which everyone who needed to surely bought a new laptop/phone/device, and we are entering an economic slowdown where such purchases may be a lower priority.
The only relevant slide I saw looked at semi equipment companies, which presented forecast CFROI for the sector of 27-28% and an implied return of 22% 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 under-rated and you can learn more in my podcast with Russell Napier and Jeremy Hosking and in this article.
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, with a concentration in the tech sector. The qualities which 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 Holt 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
- Cashflow 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 and WalMart 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 especially in the tech sector. The good news here is that there are warning signals in the financial statements if trouble is brewing here, something I shall cover in my upcoming Forensic Accounting Course. (Email firstname.lastname@example.org to get on the waiting list and be notified of launch).