There’s no doubt growth is much harder to come by these days. While Australia, along with the rest of the world, is experiencing some growth, it’s not the strong numbers of the past decade. Australia’s GDP for 2019-20, for example, is expected to be just under 3 per cent while the global growth outlook has been revised downwards.
As a result, the long run of high market returns may be a thing of the past as the world adjusts to this ‘new normal’. But not all industries are tied to the economic cycle: there are other factors that drive earnings.
We recently sat down with two bottom-up fundamental stock pickers – Liam Donohue of Lennox Capital Partners and Natalie Tam of Aberdeen Standard Investments – to discuss how to measure growth these days and which companies are showing the best growth prospects. They believe if you’re seeking growth, then you need to go for quality and to be careful about paying too much.
Image: Liam Donohoe and James Dougherty from Lennox Capital
In today’s climate, what is good growth?
With current growth much lower than what investors have been experiencing, expectations about what numbers can be achieved have to be managed. Tam says she looks for a broad range from the companies in her portfolio.
“We've got companies that are growing at mid to high single digits – which are our more mature or defensive holdings – and then we've got those that are growing at a top-line growth rate of 20% to 30% plus, which is more what we'd expect from our tech holdings,” she says.
Tam adds in today’s climate, rather than fixating on an absolute level of growth, investors should think about where the market is pitching its expectations for growth relative to their own expectations, as that's where you can identify mispricings in the market.
How should you measure growth?
A common measure used to identify growth companies is the price-to-earnings ratio [the price of a share divided by its current year’s earnings]. Another measure is discounted cash flow or DCF, which estimates the value of an investment based on its future cash flow. The DCF is a useful measure for companies that may take longer to reach profitability.
Tam says if you’re looking at a tech stock, such as online accounting firm Xero, you might want to consider the LTV to CAC ratio (the ratio of lifetime value to customer acquisition costs). “With Xero, it is about six so for every dollar Xero is investing to acquire a customer, the amount of value that it’s getting is about $6,” she says.
“From that point of view, we’re not as concerned with looking at bottom-line earnings growth, but rather that their top-line earnings growth is still coming through at an appropriate rate.”
Donohue adds one thing he absolutely wants to see, particularly from high-growth stocks is if they're not profitable, is a path to profitability.
“We're happy in the short run to use metrics that assess revenue growth or sales growth as the key metric, but over the medium term, we want to see a path to profitability when we’re assessing the value of that business.”
Key differentiators between cyclical drivers and structural growth
Australia has a large number of cyclical stocks that align themselves to what’s happening in the economy and in the current market, these companies are benefiting from macro tailwinds largely outside the control of the business. Donohue says these factors tend to typically be shorter-run phenomenon.
“The structural growth story is of far higher quality mainly because the company has the fate of its earnings in its own hands,” he says.
“We tend to value and pay a higher value for structural growth stories but there's a place for both within the portfolio at certain times.”
Tam agrees and cites Appen as one stock she would pay high multiples for as it is currently exposed to the structural tailwinds of the explosion in AI applications.
“It is quite difficult to pick the precise moment when a cycle peaks and when it troughs,” Tam says. “Because it is difficult to predict, there is the potential for outsized returns and this is why it is worth looking at cyclical plays.”
Opportunities in housing
The shape of a recovery can be just as important as picking the peaks and troughs of a cycle. One example is what’s happening with the housing market, which has reached a turning point. Tam says housing may experience a V-shaped recovery or an elongated one, which slowly grinds its way up. “Having an opinion on the shape of the recovery is as important as picking those turning points because there is the opportunity for outsized returns if you can pick a cycle accurately.”
Tam believes house prices can overshoot consensus expectations. “We're quite constructive on the outlook for housing although a lot of housing-exposed stocks have run pretty hard of late so you need to analyse what the market is pricing in versus where your expectations sit. But we do still see a lot of opportunities in that space.”
Where are the growth prospects?
While the tech sector is again looking appealing after having been sold off, Donohue says the Chinese consumption thematic is delivering several strong growth stories such as IDP Education and A2M.
“Rather than a sector-level investment, we typically look for a bottom-up individual stock story, take into account the specific risks associated with that investment and then make an investment on that basis,” he says.
Tam sees opportunities in tech as well as the retail sector. “It's been a bumpy ride for retail and some names have been sold off so we see selective opportunities there, but they are selective,” she says. “Some companies have been executing well and hitting strong like-for-like sales figures but this may have been at the cost of margins. I think ultimately we will see consumption growth coming back, but it will be a slow grind.”
Tune in to Buy Hold Sell this week as Liam and Natalie discuss growth at a reasonable price. (VIEW LINK)