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What does it take to have long term success?
Thursday 21 Sep 2017 Author: Steven Frazer

WHAT IS A GROWTH STOCK?

Growth, or the perception of it, is arguably the biggest driver of share prices.

The Organisation for Economic Co-operation and Development (OECD) defines a growth business as a company of 10 or more employees that grows revenues by an average of more than 20% per year for three consecutive years.

‘That sounds like a good enough definition,’ says Lorne Daniel, an analyst at broker FinnCap.

‘We like to see a strong track record as it is an indication of quality,’ adds Mark Slater, founder of asset manager Slater Investments and primary manager of the Slater Growth Fund (GB00B7T0G907).

But like any investor, Slater has his eyes firmly fixed on future potential rather than historic performance.

‘A business with a great track record that has come to an end is of no interest,’ the fund manager says. ‘20% growth rates are much rarer now than 10 or 20 years ago but our favourite companies are able to sustain growth rates in that ballpark.’

Pharma firm Hutchison China Meditech (HCM:AIM), big data analytics company First Derivatives (FDP:AIM) and veterinary practice operator CVS (CVSG:AIM) are currently Slater’s three biggest stakes.

Growth companies come in all shapes and sizes but the dynamic inevitably favours smaller companies. A business with £100m of revenue is far more likely to put up 20% annual growth rates over a three year period than one with £5bn sales.

That is described by what is called the ‘law of large numbers’, where boosting revenue becomes increasingly difficult when sales are much bigger.

However, technology titans like Google’s parent compay Alphabet and online retail giant Amazon have been pulling off this trick for years despite being among the world’s five largest companies by market value (more on Amazon later). The big Chinese internet companies including Alibaba and Tencent are doing likewise.

‘I find it extraordinary,’ says Ali Unwin, manager of the Neptune Global Technology Fund (GB00BYXZ5N79). Unwin was a fan of the Chinese internet boom long before he helped launch his Neptune fund in December 2015, and his fund has held stakes in both Alibaba and Tencent during the 21 months or so since launch.

Mark Slater says the impressive thing about some of the big US tech names in recent years has been that very large companies (Alphabet, Facebook et al) have been able to sustain very high growth rates with low levels of capital employed. ‘This is extremely unusual,’ he adds.

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Top line driver

Rapidly expanding revenue is most relevant to investors as a way of driving the share price higher, which arguably makes that the true arbiter of a growth stock.

One excellent example is Blue Prism (PRSM:AIM), the robotic process automation technology designer that Shares has followed since its initial public offering (IPO) in March 2016.

For the year to 31 October 2016 the company posted revenue growth in excess of 200% and it’s on track to more than double sales again this year, with consensus forecasts predicting £21.5m (up more than 120%).

Other important growth metrics – recurring licence run-rate and recurring revenues, for example – have been soaring similarly.

‘Price is also important,’ says Slater. ‘Great growth companies priced to the sky are of no interest to us. We seek the optimum combination of dynamic growth and a reasonable price, along with a raft of other protective criteria to limit our downside,’ he explains.

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Profit matters

In the spirit of that old stock market saying; ‘revenue is vanity, profit sanity, cash flow is reality,’ many investors will judge a growth company’s ability to turn its fast-growing sales into, hopefully, even faster expanding profit and cash.

‘Profit is a very different issue from growth,’ says FinnCap’s Daniel. ‘I’m sure people hope growth leads to profit but that’s been shown as not always the case,’ he says.

Also the higher the rating, the more the future growth is already reflected in the share price, says fund manager Slater.

This can all combine to colour an investor’s view of a growth stock’s risk/reward balance.

‘It’s the first question I ask a potential investee company – does it make a profit?’ says Paul Mumford, fund manager of Cavendish Opportunities (GB0032212283), Cavendish AIM (GB00B0JX3X39) and Cavendish UK Select (GB00B55L4S87).

Eyes on the long-term prize

Growth investors tend towards the optimistic and are quite capable of chasing share prices to astonishing levels on the assumption of future profit performance. Often profit may be years down the line.

AIM-quoted Blue Prism is, again, a good example. The company joined the junior market at 78p per share and the stock has since soared to astonishing heights of more than £10.00. This stock performance came despite Blue Prism never having made a profit and chewing its way through millions of pounds of investment funding.

New technology is sparking a paradigm shift in business and society that creates opportunities and threats to established organisations. It is also spawning legions of new businesses which are shaking up existing operating models and creating entirely new markets.

Growth stock classics

Fast growing companies which are now household names include Uber, Airbnb, Netflix and Tesla. These relatively new businesses are transforming the way we behave and are blazing new trails for us to travel.

Yet while most of those companies aren’t profitable, investors haven’t allowed that to get in the way of the story or the share price in the case of Netflix and Telsa (Uber and Airbnb remain privately-owned, for now).

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‘I think Amazon will come to dominate retail, media, cloud storage and other areas in future,’ says Lorne Daniel of FinnCap. ‘I increasingly buy a load of stuff on Amazon that I’d otherwise have gone to the shops for; it’s so much quicker and easier and you get what you’re looking for.’

How much money does Amazon make?

In the 20 years to 2016 Amazon generated a staggering $652bn worth of revenue, according to numbers crunched by Russ Mould, investment director at AJ Bell.

Yet its operating profit of $11.9bn earned over the same time frame is surprisingly miniscule, in relative terms. The company has thrown off just $10.6bn of operating free cash flow.

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Operating profit margins have been growing since 2014 after several years of shrinkage, yet 2016’s 3.1% is piddling when drawn against other established organisations. That hasn’t bothered investors as Amazon’s share price has tripled in five years to the current $990.38.

Clearly Amazon has many fans. ‘It is an extraordinary business and a bit of a one off,’ believes Mark Slater.

‘Amazon’s model (dominating every market with a view to maximising profit later) is very unusual, or at least it is unusual in that the prospect of them being able to monetise their market dominance is highly credible.’

But Slater puts forward caveats. ‘Amazon doesn’t work for us as we like the margin of safety afforded by a reasonable near-term rating combined with strong cash flows and dynamic earnings growth.

‘For most businesses, forecast profits many years in the future are highly suspect and extremely difficult to get right,’ he adds. ‘We like to start with ratings in the normal range as we then benefit from profit growth and an upwards status change in the multiple; a very powerful double whammy.’

Ways for UK investors to access growth stocks

There are plenty of growth companies available on the UK stock market. Examples of ones we like include attractions and ticketing software designer Accesso (ACSO:AIM), health, safety and regulations kit maker Halma (HLMA) and cyber security specialist Sophos (SOPH).

We also favour property website Rightmove (RMV), IT consultant and experts supplier FDM (FDM) and Alfa Financial (ALFA), the asset financing software expert.

Allianz Technology Trust (ATT) and Polar Technology Trust (PCT) are specific technology investment collectives which provide exposure to lots of growth companies.


THREE GROWTH STOCKS ON THE UK STOCK MARKET

We now take a closer look at three familiar growth stories and explain the individual pros and cons of each company. They are insurer Admiral (ADM), online retailer ASOS (ASC:AIM) and property portal ZPG (ZPG), best known as the owner of Zoopla.

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Admiral (ADM) £17.72

Cardiff-based Admiral has been a superb growth stock over the years in terms of revenue, profit and dividends as it increased its position in the UK insurance industry.

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Unfortunately market share growth could now be harder to achieve, according to investment bank Berenberg. That in turn could cause investors to reconsider how the shares are rated. They currently trade on 16.7 times forward earnings. A slower growth business may only command a rating in the region of 14 to 15 times, in our opinion.

Admiral’s share of the UK motor insurance market has gone from around 8% in 2010 to 13% today. Management have referred to the company’s optimal market share as being 12% to 14%, says Berenberg.

The investment bank reckons Admiral is close to becoming the market leader yet is worried that rivals are eating away at its competitive advantage.

For example, it believes Hastings (HSTG) is now at least as good as Admiral operationally and has also enjoyed rapid market share gains. Berenberg also believes Admiral’s overseas businesses aren’t that great apart from its operation in Italy.

Fundamentally we believe Admiral is still a fantastic investment to have in your portfolio. The caveat is that you should now consider this to purely be an income stock rather than one which will also reward every year with strong capital gains. It currently yields 6%.


ASOS (ASC:AIM) £56.44

Online fashion and beauty retailer ASOS (ASC:AIM) is perhaps the ultimate AIM growth stock. Its market value has rocketed from £12.3m at IPO in 2001 to £4.76bn today.

The cutting-edge fashion seller, originally dubbed AsSeenOnScreen and selling fashion items copied from celebrities, has proved a major beneficiary of the structural spending shift to the internet, sales surging from a mere £1.7m in 2001 to around £2bn today.

The question is; can ASOS sustain this stellar sales momentum into the future? We believe the answer is yes, driven by investments in price and proposition and ASOS’ immense overseas growth scope.

Underscoring its outstanding growth momentum, a trading update (13 Jul) for the four months to June revealed 32% total top line growth to £675.8m, helped by rising average order value and order frequency and surging mobile penetration.

Chief executive Nick Beighton also reiterated his medium
term sales growth guidance of 20-25% per year.

Investors have to pay a premium price to access ASOS’ growing sales, profit and cash flows. Ahead of results (17 Oct) for the year to August 2017, Shore Capital forecasts adjusted pre-tax profit of £80m (2016: £63.7m) for earnings of 76.7p, placing ASOS on a 74 times price to earnings multiple.

Profit is expected to power higher to £101.4m in the current financial year, ahead of £127.4m in fiscal 2019, with free cash flow rising from £23m this year to £54.6m next year.

Potential risks to the stock’s high rating include the potential for weaker spend in key markets and expansion by competitors.


ZPG (ZPG) 367.9p

Zoopla’s parent company ZPG (ZPG) has enjoyed strong growth since being spun out of Daily Mail & General Trust (DMGT) in 2014. Revenue has increased from £26.8m to £197.7m over the past five financial years thanks to a mixture of acquisitions and organic expansion.

This sales boost has help drive up its share price by two thirds on the 220p price at which it joined the stock market.

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The revenue growth is expected to continue with a further advance to £238.6m in the current financial year to 30 September. Full year results are reported on 29 November.

Founder and chief executive Alex Chesterman has steered the company away from a pure focus on online property listings to offer comparison and data services.

Most recently (7 Sep), it agreed to acquire financial services comparison site Money.co.uk for £140m. With ZPG’s shares trading on a forward price to earnings ratio of 21.4 times, prospective investors need to decide if the cross-selling opportunities created by this ‘one-stop shop’ approach can sustain the company’s growth.

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Earlier this year investment bank Liberum suggested the company was sitting on a £3bn revenue opportunity across its suite of businesses. The competitive threat posed by agent-led proposition OnTheMarket, soon to float on AIM, also needs to be considered along with the vagaries of the housing market.

 

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