‘Growth’ investing, correctly done, could be very rewarding over the next decade
The technology bubble that so spectacularly burst a decade ago following the merger between AOL and Time Warner has given ‘growth’ investing a bad name. As a result, many UK investors currently appear more interested in ‘recovery’ and ‘income’ as investment styles – as evidenced by the huge growth in assets under management at some of the leading funds at M&G and Invesco Perpetual.
Resurgence of old economy
Many would argue this resurgence of ‘old economy’ companies over the past decade is to be applauded, with investors now focused on the generation of cash and balance sheet strength rather than blue-sky valuations based on projections of future revenues. However, it is also obvious that many of the largest and heavily held companies in the FTSE 100 Index (such as Vodafone and Royal Dutch Shell) are large and mature, if not in gentle decline. This is potentially a major issue, as in previous decades (such as the 1950s and the 1990s) we have had long periods when companies which have demonstrated sustained growth have performed well and, ultimately, have been valued highly by the market. I believe the scene is set for this to occur again over the next decade.
Jam tomorrow
Before I explain the reasons behind my optimism, it may be worth explaining what my interpretation of ‘growth’ investing is. Clearly a company’s growth is due to some form of competitive advantage in providing services or products that enables it to expand the market or increase market share. However, in order for a business to generate long-term value for shareholders, it has to demonstrate two key favourable financial characteristics:
It must continue to generate returns on capital employed which are higher than an investor, on average, can obtain elsewhere.
Its reported profits must be converted into free cashflow, so that only a limited amount of incremental capital should be invested to generate growth.
Indeed, many so-called ‘growth’ companies are let down by the fact they do not generate sufficiently high returns on capital (preferring to promise ‘jam tomorrow’) and consume cash as they grow – something not often picked up by simple price earnings to growth (PEG) ratio analysis.
Identifying value
The other key tenet of ‘growth’ investing, although this may seem a contradiction in terms, is identifying where there is also good ‘value’. Many investors have been undone by paying too much for growth stocks. The way I overcome this is to calculate an appraisal value for each company I analyse based on my projections of their future returns and growth in invested capital. This best estimate of the actual value of the company is then compared to the market price, and an investment is only made if there is significant upside.
There are a number of reasons why I believe ‘growth’ investing is starting to look very attractive. Firstly, the flood of capital we had into the technology area in the 1990s is now more correctly allocated and, focused on business models that work. For example, Imagination Technologies – which designs graphic and audio electronic components – developed the graphics microchip that helped Apple turn the mobile handset into a highly productive device.
This technology, as well as benefiting the technology companies themselves, is allowing other companies (especially at the smaller end) to benefit from better creativity, productivity and competitiveness.
There are two very good examples from my own sector; financial services: Fidessa supplies revolutionary technology that dramatically reduces the cost base of brokers and fund managers.
Hargreaves Lansdown, the independent investment management and financial services provider, is combining a strong brand with an online platform resulting in minimal cost to incremental growth.
Secondly, a long-standing driver of growth has been the power of brands and this remains in place. Some of the most long-lived and successful companies globally have been built around brands such as Coca-Cola, which has been going since 1886 and Colgate-Palmolive, which can trace its roots back to 1806. The added factor coming into play now is the emergence of a vast new potential customer base through developing economies such as China and Brazil.
Customers in these developing countries, if anything, rely more on brands than their Western counterparts due to the poor historic experience of local products. Thankfully, the UK equity market has its fair share of brand giants; most successfully led in recent years by Reckitt Benckiser, closely followed by a resurgent Unilever.
Thirdly, the UK has its fair share of world-class management teams who have taken over at good, but poorly run, companies. Management teams at Compass, Reed Elsevier and the Centrica, just to name a few, have excellent track records and are starting to deliver in their new roles.
A fourth ingredient is reduced levels of competition. A sharp recession like the one we have just experienced puts pressure on many companies with weak business models or too much debt. As a consequence, we have seen a lot of competition coming out of the banking sector – favouring the remaining stronger players. For example, Standard Chartered has benefited from the travails of Citibank and Royal Bank of Scotland, leaving the former in a far stronger position in core areas such as trade finance.
Finally, there are attractive valuations. As investors have been focused on defensive businesses which pay dividends and those with earnings recovery in the recent ‘dash to trash’, many faster growing, higher quality companies have received less attention, and therefore trade at lower valuations than they otherwise might. Applying our appraisal value methodology, we can currently identify plenty of opportunities where such companies are trading well below our estimate of their actual value. Added on to this from an investor’s perspective is the much more favourable tax treatment of capital gains compared to income.
It would therefore appear that, after 10 years where investors have been more concerned with capital conservation, there are now some very good reasons for believing that equity investment will revert to its long-standing role of growing that capital as well. I firmly believe that ‘growth’ investing, if properly done, currently offers significant value for investors.
Michael Crawford, manager of the UK Growth Fund at LV= Asset Management
