A year ago, Morningstar’s vice president of research John Rekenthaler wrote an extremely engaging post about growth and value investing in a tongue-in-cheek fashion. I reproduce his description of the enthusiastic growth investor here.
For growth-stock investors, every day is a new beginning. There are always fresh industries to be invented, monopolies to be created, record profits to be earned. The growth-stock buyer is the child on Christmas morning, bounding down the stairs, wondering just what delights lie under the tree. Or the puppy, tail wagging, ready to step outside that door and explore what the world offers.
Paul Black of WCM Investment Management, who describes himself as psychologically inclined to be a growth investor, would identify with the above exemplifications. He believes that to be a growth investor one must be optimistic about the future because it is the optimists who rule the world.
His investment credo is to bet on great growth companies with superior cultures whose competitive advantage keeps getting stronger. Here he gives a few pointers on how to ensure that the rapidly growing companies you bet on don't turn out to be massive destroyers of capital.
Based on his interviews and presentations, one can decipher his thoughts as to what makes a great company. We produce them below.
1. Moat typologies.
Most money managers attempt to buy high quality businesses with strong competitive advantages selling at a discount to intrinsic value. It sounds completely rational, but extremely difficult to generate alpha if everybody treads the same path and all approach the market from the identical perspective.
People talk about moats in a variety of ways; brands, disruptors, low-cost providers. All that is good, but we also look at moat typologies where we consider certain companies in different industries and classify them in ways that don’t make them specific to an industry.
Core Laboratories measures core samples in gas wells and oil wells. Its services are outsourced to various drillers and integrated oil companies. Chr. Hansen is a global bioscience company that creates enzymes and probiotics for use in yogurt and cheese.
An analyst looking at the material sector will find Hansen richly priced. Ditto for one looking at the energy sector in relation to Core Labs. But we position both these companies as outsourced R&D players and compare them with others in different industries. And we believe that companies in these types of businesses deserve higher multiples because they climb the value chain and add services very effectively, and margins grow substantially.
2. Direction of the competitive advantage.
It is easy to find yourself in a value trap if you are only scouting for high quality, wide moat businesses selling cheaply.
Nokia elucidates this effortlessly. In 2007, if you had visited 25 different analysts on Wall Street that covered the Nokia, and asked them if it is a high quality, wide moat business selling at a discount to intrinsic value, they would be unanimous in their approval. All had a buy recommendation in 2007.
Honestly, what was not to like? With a 53% market share, the company was the undisputed monarch in the cell phone market. The brand was iconic and ranked amongst the world’s most valuable. No debt. Return on Capital (ROC) of 30% for the prior 5 years. And, selling at 60 cents to the dollar.
So what did the analysts miss?
It was a wide economic moat but that moat was clearly deteriorating. The company failed to acknowledge the dramatic shift in the industry. It was clearly losing its edge and being disrupted by the iOS from Apple and the Android operating system that brought in a whole lot of phone manufacturers.
Every organization is either getting stronger against its competitors or weaker. So you must be able to make the case that the company you are looking to invest in has a strong likelihood of growing its competitive advantage over the next 5 to 10 years.
Apple is a terrific company. We owned it in the past. The reason we offloaded our holdings was because we believed that despite a significantly wide economic moat and a very strong competitive advantage, we found it difficult to make the case that their competitive advantage has been getting stronger vis-à-vis others in the industry. While they have made incremental changes and improvements to their products, there has been no great innovation over the past 5 years.
Stay focused on the direction of the competitive advantage. If you get that right, then any valuation work you come up with will look ludicrously cheap 5 and 10 years out.
3. Company Culture.
This goes beyond shareholder family management teams and good capital allocators. We want to understand the DNA of the business and what the core values are. Then take it a notch higher and attempt to comprehend how those core values relate to the competitive advantage.
Retail is a good example. Running a successful retail operation is all about people: employees, customers, and the interactions between them. You want your employees to be taken care of and happy so that others get a great experience. All this bodes well for the long term cultural success of the firm. Look at Walmart. It was the culture created by Sam Walton that turned Walmart into a powerful and insurmountable competitive advantage. He believed that company culture was not built in a boardroom but by bringing your employees along, keeping them happy, making them excited about work. He convinced thousands of employees to help him compete against big successful department stores like J.C. Penney, Sears and Mervyn to eventually dominate the market.
The distinguishing characteristic in any investment is determining what the core values are and what animates that culture and aligns it with the company’s moat.
How do you assess a company’s culture?
If I wanted to assess a company’s culture, I would not just talk to the CEO or CFO or others in management. There are questions to ask to tease out indications about the company’s culture: What three things would you tell a friend about how to be successful in your company? What is really hard for new hires to get used to in this firm? I would also speak to the firm’s ex-employees, their suppliers and vendors. I would ask the competition whether or not they respect them and why.
People don’t pursue such information because it cannot be quantified or put in a box or scored; cannot come up with a scale or number ranking. Philip Fisher’s Common Stocks and Uncommon Profits provides a checklist on how to analyse a company. A very significant number of them are qualitative elements, which is reverse to what most people on Wall Street do. Most analysts spend 95% of their time crunching numbers and running DCF models. But as Lou Gerstner, former CEO of IBM states, “culture isn’t just one aspect of the game, it is the game. In the end, our organization is nothing more than the collective capacity of its people to create value.”
We build a mosaic when we go after culture. The strongest companies are the ones where the cultures and values are aligned with the competitive advantage. Such companies are few and far between, but when found, they can be held for a long time - at least a decade.
4. Return on Invested Capital.
There are lots of different ways to measure a company's competitive advantage. Historically, money managers look for some level of return on ROIC; say 10% hurdle on ROIC over the prior 5 years.
What we find more valuable is not just the level of the ROIC but the direction. There is a 1:1 correlation between the direction of the ROIC over 5-year period of time and stock performance.
We would prefer companies that 5 years ago had a 4% ROIC grow into 5%, 6%, 7%, 8%. That is a much better investment than a company that is at 12% ROIC that might be stagnant over that same period of time.
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