William ‘Slick Willie’ Sutton was a prolific, if not always very successful, bank robber. When asked by a reporter why he robbed banks, he allegedly replied “because that’s where the money is”. This became known as Sutton’s Law, even though he denied saying it! We would have the same answer if asked why we focus on quality growth equities.
But this is not yet another ‘growth versus value’ article; my focus here is much more on ‘quality growth versus any old growth’. Corporate history is littered with examples of fast-growing companies sucking in investors who were afraid of missing out despite opaque accounting, difficult to follow cash flows, or hard to understand business models.
From Polly Peck to Parmalat and Enron to Worldcom, and now Wirecard, many of these companies seemed to have followed the mantra, ‘Live fast, die young’. Not all die, of course; some end up being rescued at the expense of equity holders.
No more FOMO
As growth investors, we are acutely aware of these risks. If you can’t see how the company makes money, can’t trace the cash flow, then should you really be investing in the company? Common sense, but the fear of missing out can be a very powerful temptation and discipline is needed.
A quality company will in our view have a positive spread of returns on capital over cost of capital, will typically be cash generative, and will have a clear mission that is being implemented by a strong management team. A quality growth company will have these attributes plus a clear growth profile, often supported by an understandable trend, such as ageing demographics, urbanisation, de-carbonisation, and so on.
At the portfolio level, our growth strategies tend to have higher returns on equity than the market as a whole, but also higher expected revenue growth and much higher than expected earnings growth. Naturally this comes at a higher cost and valuations are generally higher than those of the broader market, although valuation-to-growth ratios are usually more attractive than the market averages.
We believe higher valuations are justified by the expectation of higher returns over an extended period of time. Why is this valuation premium higher now than in the past? In a word, scarcity.
In the late 1990s, high-growth companies (with revenue growth of 8% or more per annum) and low-growth companies (revenue growth of 4% or less per annum) accounted for about 30% of the European equity market each, according to the Goldman Sachs research.
Into the tech bubble, the proportion of the market that was high growth rose to about 45%. Since that bubble burst, high-growth companies have fallen steadily and now account for 10% or less of the market, while low-growth companies now account for about 55% of the market. Moreover, quality growth is a subset of that 10%, making it even scarcer and deserving an elevated premium.
High valuations do come with a higher element of risk in periods of market reversion. But we believe a sound understanding of how the companies make money, generate cash and invest that cash; a clear vision of what the companies are aiming to achieve; and a high degree of confidence in the management teams to deliver can give us confidence that over time these equities will deliver above-average returns.
As Jerry Maguire was forced to shout repeatedly, “Show me the money!”