In search of tomorrow's winning stocks
Before the coronavirus pandemic hit, investor anxiety already was mounting, even as the U.S. economy continued in its longest expansion ever. The stock market was at record highs, global trade tensions between the U.S. and China were moving beyond a simmer and we were entering a highly contentious election season.
Covid-19 ended all speculation on the market’s direction, unleashing a swift, extreme reaction with the S&P 500 falling into a bear market at its fastest rate in history, dropping 34% in just 23 trading days off Feb. 19’s record high. In its wake came difficult questions: how long can this economic paralysis last? How low can gross domestic product fall in a quarter—10%? 20%? More? Where is the opportunity in the midst of an unprecedented crisis?
With this uncertainty as a backdrop, it may be useful to reiterate the criteria our growth investment team considers in all environments:
- Industry composition The Federated Hermes Kaufmann team seeks to avoid cyclicality and focus on where the trends can transcend market and economic cycles. Investing in “the new economy” sounds simple but finding companies that can grow in any type of economy is about finding unique drivers behind the momentum in their business. Secular growth companies by nature are innovators that have invested in areas such as e-commerce, telemedicine and data analysis. These are the services and systems that can continue their growth in virtually any economic environment.Consider that small business e-commerce currently accounts for less than 5% of total e-commerce (non-Amazon related) and that e-commerce remains less than 15% of total retail sales. E-commerce is a megatrend poised to accelerate significantly regardless of the economic cycle. Identifying industries and, critically, finding the dominant participants in those categories have strongly benefitted investors over time.
- Ability to identify the added value The value a company provides for its customers and how customers perceive that value are especially critical during downturns. When discretionary spending drops off and essential needs become the priority, every dollar has a greater value when spent. For example, services provided by certain software companies such as relationship management support, cost-benefit analysis and regulatory analytics have gone from “nice to have” to essential for clients. The perception of value is evolving as software becomes an integral piece of many companies’ day-to-day operations, needed to survive this downturn and thrive well beyond it.
- A healthy balance sheet When customers aren’t paying for a product or service, a company must rely on internal capital—its balance sheet—to keep the business going until the worst is over. Borrowing money in a time of need can be a useful tool to help pay the bills and continue operating, so having access to the capital markets for funding is key. But even more important is how a company managed its balance sheet and capital markets access prior to a slowdown. This is typically reflected in a company’s equity valuation during an economic shock. An example particularly relevant today applies to certain companies in the medical device space that had utilized the debt markets for years to finance growth. In the midst of this pandemic, their prior prudent use of the capital markets for debt or additional equity can now serve as an opportunity. Such companies are able to deploy the additional funds to remain fully operational and even ramp up production as the need arises.
- An adaptable, scalable business model Most businesses are built with growth in mind, but the profitability and sustainability of that growth varies tremendously. When companies grow they typically need to increase spending to fund sales, expertise, equipment and expanding operations. Some companies are more easily scalable and require less investment to grow, driving higher profits from sales. How defensive a business model is can be observed during dramatic slowdowns. The proverbial competitive moat is challenged whenever rival companies attempt to replicate a thriving business model. Within biotechnology, for example, many companies have aspirational goals to cure or effectively manage previously untreatable diseases, but can they provide a unique process that can’t be copied or bested by competitors and reach the goal faster? This capability separates good from great companies over the long term. Companies that can differentiate and efficiently scale their businesses have a distinct edge when it comes to adapting to negative circumstances, warding off competitive threats and resuming outsized profitability when business conditions improve.
Just as every company is unique, so various investment managers employ an approach that is uniquely suited to their strategy’s objectives. Whether there are headwinds or tailwinds, the Federated Hermes Kaufmann growth team relies on a research-intensive stock-picking process to evaluate companies. At a time when economic and market clarity is at a minimum, asking the hard questions about every aspect of a business’s operations, how it interacts with customers and understanding what is driving growth in its industry may never be more important.