Going for Growth
Hunting Opportunities in a Slow Growth Economy
Given the choice, what company wouldn’t prefer the advantage of operating in a strong, stable economy? Yet even during times of slow growth and uncertainty, there are companies that prevail. What gives them their edge? Are there sectors today that are more conducive to growth? Is the IPO market mostly hype or a boon for growth seekers? This report explores what’s behind strong growth opportunities and, more importantly for investors, what it takes to find them.
An abundance of economic instability and market volatility over the past few years has tested the approaches of managers who rely on fundamentals-based analysis when picking stocks—not to mention the fortitude of investors seeking even a modest stretch of stability. Combine Europe’s sovereign debt and structural dilemma with our own fiscal challenges, divisive politics and high unemployment, and it’s not surprising that the fear trade that began in late 2008 has continued to dominate the market.
Nonetheless, in the midst of this persistent uncertainty, growth managers are continuing to uncover opportunities in both the tried and true manner—tracking down great companies with compelling business models that also offer good value from a stock price standpoint—and by scouring the initial public offering (IPO) market for solid, long-term prospects. And while views may differ on the degree to which big-picture economic factors such as interest rates, employment and gross domestic product data matter when it comes to growth investing, even die-hard stock pickers would acknowledge the potential influence of these factors on a given company or sector.
Despite talk of a new normal, the reality is difficult, protracted market and economic conditions have existed throughout history, well before the Great Depression, and extending to other deep recessions from the 1960s through today. All involved some combination of high unemployment, currency impacts, commodity shortages and imploding bubbles. And during each of those downturns, highly successful companies were launched or expanded. Charles Revson founded the Revlon cosmetics empire in 1933, introducing color-coordinated nail polish and lipstick. With a strong belief that women were looking for an affordable luxury, the company charged fifty cents for its nail polish all through the Great Depression when competitors were selling theirs for a dime and one dollar for the unique coordinating lipstick. FedEx made its start in the delivery business in the midst of the 1970s gas shortage. It was during the 1980s recession when Microsoft launched its initial public offering. And tech-based companies like EBay, Amazon and Cisco all came out of the first tech bubble collapse.
“There are companies that will grow despite macro circumstances and headwinds,” said Aash Shah, Federated portfolio manager. On a longer-term basis, stock prices follow companies’ sales, earnings and free cash flow growth as well as steady to increasing profit margins. Helping to drive all of that is a unique and compelling business proposition, excellent management and a durable, sustainable advantage such as better technology, better pricing, and/or a superior ability to reach customers.
A high barrier to entry is another quality that many strong growth companies possess. It’s hard to create an iconic brand like Starbucks, Coca Cola or McDonalds from scratch. And, according to Shah, when it comes to tech or health care, it’s important to have the inside track on what’s going on in the top labs because these larger players have the research dollars, infrastructure and distribution channels to overtake similar efforts coming out of startups. “Particularly when you’re looking at growth from the small company perspective, there’s great value in knowing what the big companies are already doing in their respective spaces,” he said.
How Macro Conditions Influence Growth
Although the trajectories of exceptional companies may appear to be immune to larger economic and market influences, growth managers know how these influences can affect companies and investor mindsets. Such awareness at the macro level can complement intensive fundamental analysis. For example, the state of the economy determines the size of the consumer’s spending “pie.” Secular growth companies like Apple—because of their superior products, brand or “cool factor”—are able to capture a healthy share of that consumer spending pie even in a downturn. At the other end of the spectrum, consumer spending for soap or paper products will stay fairly steady regardless of what the economy is doing. So, those great secular companies as well as the steady-as-she-goes stable growers tend to be in favor even when the economy stumbles.
Because so many larger companies have global operations and reach, what is viewed as a stable grower in developed markets can morph into a secular growth opportunity given an entirely new level of demand by a rapidly expanding middle class.
By contrast, cyclical growers—such as industrial and manufacturing companies—are directly affected by the state of the economy and, as a result, are often viewed as value stocks. The distinction can be vague, however, and many cyclical companies have proven to be capable growers. For example, when the economy starts to heat up, certain cyclical companies—carmakers, for example—may go from negative or flat growth to 15-20% growth. From a growth investor perspective, it’s important to verify that there is some secular issue within a company that can deliver growth over a longer period and withstand the inevitable economic downturns.
Another factor contributing to growth is the rapidly expanding global middle class. Because so many—particularly larger—companies have global operations and reach, what is viewed as a stable grower in developed markets can morph into a secular growth opportunity given an entirely new level of demand by a rapidly expanding middle class. In fact, in China alone, McKinsey has estimated that incremental growth in urban consumption between 2008 and 2025 will amount to the creation of a new market the size of the German market in 2007. Consider Proctor & Gamble, a company that can be expected to grow here at a slow but steady 1-2% per year. In the emerging markets, personal care products like soap and toothpaste are becoming a new category as those with rising income levels—and an appetite for foreign brands—spend more for these products. The same is true for fast food franchises. Here in the United States, for example, KFC is a stable grower; in China it has been a secular growth story as the company employs a strategy focused on expanding quickly throughout the country.
The IPO Market
Complementing a stock-picking approach, the global initial public offering (IPO) market offers an abundant source of new growth ideas. Because IPOs are issued either by new companies or by existing firms seeking to raise capital in order to build new plants, expand geographically, make acquisitions or launch new product lines, they are a natural habitat for growth. Although the IPO market retreated somewhat in 2012, primary due to the credit crisis in Europe and an economic slowdown in China, reduced stock market volatility, a strengthening U.S. economy, assertive action from central banks and brighter economic prospects point to an accelerating IPO market, particularly in the second half of 2013.1
Some growth managers enter into IPOs with an approach far different from stock flippers who, seeking quick profits, subscribe to an issue only to sell it when that issue starts trading—and, they hope, instantly increasing in price. “IPOs require the same level of research as any company because the goal is strong multi-year growth potential,” said Shah, “It’s particularly important to do as much as you can to get the valuations right.” Having a strong rationale for a company’s value is important because it’s not unusual for a stock price to fall after an IPO. Such was the case when Cetip, Brazil’s largest securities clearinghouse, held its IPO in 2009. The company became public at $13 a share, fell below its IPO price for a time but then proceeded to more than double in price over the next two years. “Falling prices after a launch shouldn’t concern investors who went into the issue with a strong investment thesis. In fact, if you’ve done your homework and are confident in your research, falling prices in the early stages of an IPO present a great opportunity to add to your position,” said Shah.
In terms of global IPO activity, North America, and particularly the United States, remains a significant market, but in terms of number of IPOs launched annually, the Asia-Pacific region has taken the lead. The Hong Kong-issued IPO of luxury brand Prada illustrates the reason why. On a square foot basis, Prada is now selling more luxury goods in China than they are in the United States or U.K. “In the next three years, Prada plans to build at least 50 stores as part of their expansion plan for China, a country with an increasing appetite for luxury in everything from cars to technology to fashion,” Shah explained.
Another recent Hong Kong IPO launch was established luggage maker Samsonite. Over the past five years, the Chinese government has built more than 20 new airports in their fast-emerging “Tier 2” cities, such as regional hubs Sichuan, Chengdu and Hunan. In China, a Tier 2 city has a population of around eight million—similar to New York City. This is in addition to new and expanding airports in the major metropolitan Tier I cities of Beijing and Shanghai, each populated with some 20 million or more inhabitants. China’s growing middle class is eager to put these airports to use for vacations and family visits within and outside the country. And this fast-growing propensity to travel is resulting in a surging demand for luggage. While many Americans have accumulated several suitcases in their closets or attics, owning luggage is a new concept for many in China and other emerging markets.
“Within the consumer sector, brand strength is more important than ever,” said Federated portfolio manager Barbara Miller. “Changeable economic conditions enable those in stronger financial and strategic positions to gain market share, while growth in spending power among emerging market consumers fuel the ability for brands with authority—like Samsonite or Starbucks—to grow around the world,” she said. This is a secular growth story about companies prepared to meet growing overseas demand.
Favorable Valuations Benefit Growth Investors
What about today? Although continuing uncertainty on the global fiscal and political front isn’t giving growth-oriented stock pickers an easy ride, overall conditions have improved to the point where companies are again able to differentiate themselves based on those qualities that have historically defined growth opportunities. In addition, valuations are favorable. Since 2008, investors have experienced the Great Recession, continuing effects of the European debt dilemma and uncertainty regarding potential tax and austerity measures in the future. This wall of worry has caused large numbers of investors to move out of equities and into U.S. Treasuries and other perceived havens. The result of this broad equity pullback is that starting valuations of growth stocks, a major driver of future returns, look attractive. Historically, growth stocks have had higher Price-to-Earnings Ratios (P/Es) than the broader market.
In recent years, however, P/Es for growth stocks have declined, along with spreads between growth stocks and the broader market as represented by the S&P 500 Index. As a result, investors can now buy growth stocks for less of a premium, even as the fundamentals—cash flows, balance sheets and return on equity—have improved. “We’re seeing a number of global, U.S.-based companies that are generating free cash flow yields that we haven’t seen in a generation and that are in position to keep growing through near-term uncertainties,” said Shah. “This includes companies such as Microsoft, IBM and Intel, which have been through this cycle before.”
Paying close attention to valuation is an essential risk control measure because even the best company with better-thanexpected expected business results and earnings growth can cause investors to lose money if they’ve overpaid for its stock. Because growth stocks tend to behave more aggressively, identifying reasonably priced companies that are likely to exceed expectations and avoid potential threats over time requires more than homing in on companies that everyone is talking about. “Successful growth investing involves a mosaic approach, gathering pieces of information from a number of areas” said Shah. “It combines quantitative research to ensure a company is delivering on all the fundamentals—that’s the ‘what.’ But we also need to be clearabout the ‘why’—what is it about a company that enables it to achieve strong results and, importantly, how likely are they to continue doing so.” Typically, the answers to those questions require a combination of intensive research and judgment based on years of experience. According to Shah, investors should have a good understanding of dominant trends within a given industry or sector and the ability of a given company to benefit from those trends over time. They also should know how firmly the company is positioned in the global marketplace, the solidity of the company’s revenue stream, its capacity to innovate, and if there are significant products or services in its pipeline poised to launch. “At any time, but particularly in a difficult market, superior intelligence is a great asset because buying perceived weakness and selling strength can give you a distinct edge,” said Shah.
The challenges that have unfolded since 2008 have emphasized the importance of managing risk, requiring a constant review of the investment rationale for every holding, using price momentum to confirm fundamental views and revisiting the macro, industry and company data to ensure that any risks are in line with an investor’s confidence about each stock’s potential. By staying true to that process, growth investors have a solid basis for generating consistent, above-market returns.
- The current low-growth environment tends to favor stocks with strong secular trends that can thrive in almost any economic environment.
- Success at IPO investing requires the ability to research companies without the benefit of readily available information, particularly when it comes to identifying whether a company is under or overpriced.
- The impact of increasing numbers of middle class and high-end consumers in emerging economies is substantial. Companies with products and services that appeal to these burgeoning populations are experiencing new and, in some cases, recharged growth potential.
- Since 2008, widespread uncertainty over global economic conditions has caused investors to favor U.S. Treasuries and other perceived havens over equities. The benefit for growth stocks is more favorable valuations, a key driver of returns.