Growth investing: how to find good companies and avoid bad ones
The appeal of a growth company is easy to understand – when we put our money into a business which we expect to grow rapidly we can imagine the worth of our investment growing fast too.
Many of today’s largest companies were once small or medium-sized operations which have expanded their business by targeting a buoyant market or identifying a particularly profitable niche.
And growth as an investment style or strategy has dominated for the last decade or more, putting other investment styles like value firmly in the shade.
This makes sense when you consider that growth proved scarce in the wake of the financial crisis and therefore those businesses which could deliver it have been highly prized. The same applies now, with companies able to keep growing through the pandemic being rewarded with a higher share price.
A growth stock is a company whose earnings are expected to grow at an above-average rate either for its industry or the overall market.
A growth investor will often invest in such a business even if it appears to be expensive based on metrics such as the price to earnings (PE) ratio. A growth business is less likely to pay a generous dividend as it may prefer to reinvest cash flow into its business in hope of achieving even bigger growth.
Covid-19 has super-charged growth stocks, particularly in the tech space, as it accelerates trends which were already in motion – in particular, driving more of our daily activities online.
In previous economic cycles, growth stocks have performed well in the middle and latter stages when genuine growth is harder to come by. It is currently difficult to judge where we are in the cycle given the unprecedented impact of coronavirus and the continuing support and stimulus on offer from governments and central banks.
But, as we discussed in our recent article on value investing, there is a case for value to make a comeback and looking for cheap stocks (assuming they have robust enough balance sheets) can be a successful approach when we emerge from a big downturn as they could bounce back from a lower base.
A SOLID LONG-TERM STRATEGY
If you are a genuine long-term investor, then looking for businesses which can deliver consistent growth is likely to prove a solid strategy in fair economic weather and foul.
As the late Philip Fisher, often tagged as the first technology investor, wrote in the 1950s: ‘The greatest investment reward comes to those who by good luck or good sense find the occasional company that over the years can grow in sales and profits far more than industry as a whole.
‘It further shows that when we believe we have found such a company we had better stick with it for a long period of time.
‘It gives us a strong hint that such companies need not necessarily be young and small. Instead, regardless of size, what really counts is management having both a determination to attain further important growth and an ability to bring its plans to completion.’
In this article we will discuss what constitutes growth and where and how you can find it. We also offer a selection of growth-related investment ideas across stocks and funds.
DIFFERENT TYPES OF GROWTH
Growth stocks come in different flavours. At the higher risk end of the spectrum is blue sky growth. This might be a small pharmaceutical firm working on a new drug, a spin-out from a university with an untested technology or a resources firm exploring for metals, oil or gas.
While these types of investment can in theory generate strong returns in a short space of time, examples of them doing so are few and far between, and you need accept the risk of loss is high.
At the other end of the spectrum are the steady growers – with these businesses you need to accept the rate of growth will not necessarily be that high, maybe not much more than 5% or 6%, but it will be consistent and predictable. Perhaps because the company operates in a market which is driven by regulation, making its returns less likely to fluctuate in line with the economy.
To cater to different risk appetites, our investment ideas later in this article fall into four different categories: steady growth, small cap growth, growth at a reasonable price and blue-sky growth.
IDENTIFYING TRUE GROWTH
There are some key questions to ask when considering investing in any growth company:
Is the growth real?
Measures such as earnings per share can be flattered so in a lot of cases it will make more sense to look at the level of cash flow a firm is generating and whether this is growing.
It is somewhat of an extreme example but look at what happened with insurance business Quindell (now a very different animal called Watchstone (WTG:AIM)). Between 2011 and 2014 its pre-tax profit apparently increased from £4.1 million to £107 million while its operating cash flow fell from £4.4 million to £3.2 million. Profit and cash moving in different directions was a major red flag.
The shares rocketed from 2012 to 2014 and hit an all-time high valuation of £2.7 billion but in 2015 controversial founder Rob Terry was booted out and the accounts from 2011 onwards were restated. Watchstone now has a market cap of just £30 million.
Cash cannot be manipulated and is the lifeblood of any business. A firm which generates lots of cash should also be able to invest for future growth, such as building a new factory to sell more of its product in different markets.
Where is the growth coming from?
A business could grow rapidly by loading up on debt and buying lots of different businesses but, while it might end up bigger at the end of it, it won’t necessarily be better. Such a strategy is not really one that can be sustained in the long run and is unlikely to yield growth in profit and cash flow.
Large acquisitions destroy value more often than they create it so a business whose growth is reliant on buying other businesses could hit a wall eventually as business cultures clash, savings are overestimated and integration costs are underestimated.
The best approach is for a company to build a strong competitive position from which it can deliver sustainable long-term growth. Though that doesn’t mean modest-sized acquisitions can’t be used to augment this organic growth.
Is the growth sustainable?
This involves making a judgement on the future. For example, does the company operate in a market prone to being disrupted by technology, shifting societal or consumer trends or regulation?
For example Carphone Warehouse was valued at £1.6 billion 20 years ago and eventually hit a market value several times that number before completing a multi-billion merger with Dixons in 2014 to create Dixons Carphone (DC.).
However, Carphone Warehouse’s business model was built on people frequently upgrading their phones and that trend has dissipated as the market has matured. In March this year Dixons announced the closure of all its standalone Carphone Warehouse stores.
Combining growth and value
Growth investors don’t necessarily throw valuation out of the window entirely. Some will actively talk about growth at a reasonable price or GARP.
Popularised by the late investor Jim Slater, GARP typically involves employing the price to earnings to growth ratio, which divides the price to earnings metric by the level of annual earnings per share growth.
Slater looked to find smaller, growth companies which were undervalued relative to their growth potential. He also looked for a track record of growth and strong cash generation alongside other factors.
SCREENING FOR GROWTH STOCKS
Leaning on several different measures is a good starting point if you are looking to screen the market for growth opportunities.
As an illustration Shares employed data from Stockopedia and SharePad to identify stocks which had generated a compound annual growth rate of at least 15% in free cash flow over a five-year timeframe, thereby avoiding situations where earnings had been inflated by creative accounting.
We also looked for businesses which had delivered the growth consistently with unbroken earnings per share (EPS) growth over at least five years.
As these are both backward-looking measures we added an additional filter by examining forecast EPS growth for the current and next financial year. Given the unprecedented nature of Covid-19, ignoring stocks which might see growth interrupted in the short term would risk missing out on some interesting opportunities which might subsequently resume their growth trajectory.
We therefore identified businesses where forecasts suggested that over the two financial years earnings would either be higher overall or only marginally lower.
While such screening exercises are useful, they are only a starting point. You also need to take a closer look underneath the bonnet of a company to truly understand its growth potential – something we have done with the four picks which follow.
FOUR GROWTH STOCKS TO BUY
Buy for steady growth:
Health, safety and environmental electronics equipment designer Halma (HLMA) has an exceptional track record of consistent growth.
Up until Covid-19 struck the company would almost certainly have delivered an 18th consecutive year of growth in revenue and profit, not to mention the business has also delivered 40 years of dividend growth.
Against the backdrop of the pandemic, an expected 8% fall in pre-tax profit for the current financial year to 31 March 2021 is certainly worth keeping in perspective and for us represents growth interrupted rather than a sign the company’s long-term story of expansion is running on empty.
The company’s strategy has proved stunningly effective over time. It has exposure to trends around health and safety regulation and demand for healthcare and life-critical resources.
It makes and sells worldwide everything from hazard detectors to environmental protection kits and sensors.
Regulatory drivers make its growth highly resilient as its products aren’t simply nice to have; businesses need them to meet safety standards. Robust organic growth is supplemented by bolt-on acquisitions.
The company’s objective is simple. It aims to double its earnings every five years while still generating strong returns.
You need to pay up for this growth. It trades 40 times expected earnings for the current financial, falling to a PE in the high 30s times the year after. We think this is justified by the track record and continuing growth potential.
Buy for small cap growth:
Farnham-based biotechnology company Bioventix (BVXP:AIM) packs a big punch for a small business and leads the field in the creation and production of high infinity sheep monoclonal antibodies. Its customers incorporate the antibodies into test packs for use on automated blood testing machines.
Sheep monoclonal antibodies can bind themselves to their target around 100 times stronger than traditional rodent antibodies. The £214 million company supplies antibodies to almost all the global multinational immunodiagnostics companies. It’s the quality and effectiveness of the product which differentiates the business and gives it an edge.
The company has an in-built economic moat protecting high returns due to long lead times and loyal customers. It can take up to a year to develop a new antibody while the customers can spend two to four years making an assay or testing pack and getting the product approved.
The company has a strong track record, having achieved compound annual growth rates in revenues and operating profits of 21% and 25% respectively over the last five years. Returns on equity (the company has no debts) have averaged 50%, reflecting the high-quality nature of the business.
The shares aren’t cheap on 30 times forecast earnings for the current financial year. However, we think they are still worth buying given the quality characteristics and the fact it has a strong pipeline of new products which supports the continuation of strong growth for years to come.
Buy for growth at a reasonable price:
Cloud IT hosting and managed services company Iomart (IOM:AIM) has been helping smaller and medium-sized enterprises (SMEs) for more than 20 years and has produced consistent growth throughout, far in excess of the UK market.
The stock has produced annualised total returns of 18.5% over the past decade (share price gains plus dividends reinvested), versus a 4.9% annualised total return for the FTSE 100, according to Morningstar data.
Highly acquisitive, Iomart has completed something like 20 bolt-on deals to supplement its typically mid-to-high single-digit organic growth. The Glasgow-based business now has eight UK data centres and employing around 400 staff domestically and in the US.
The imminent retirement of founder and long-run chief executive Angus MacSween may trigger some soul searching for Iomart around its next moves.
Last year saw some hefty investment in sales and marketing which should hopefully bring rewards in the future.
In June, the company reported its twelfth consecutive year of growth since the transition of the business to cloud services in 2008 with the acquisition of our first data centres.
Analysts forecast a slight dip in profit in the current year to March 2021 with Iomart recently flagged uncertainty over the timing of new projects due to Covid-19. However, analysts see pre-tax profit growing by approximately 10% in both 2022 and 2023.
The shares trade on 20 times earnings for 2021 which seems fair for a company of its stature, meaning investors can certainly buy growth at a reasonable price.
We wouldn’t be surprised to see Iomart targeted as part of intense sector consolidation, having knocked back a private equity takeover at 340p per share in 2014, the same price at which the shares are trading today.
Buy for blue sky growth:
BLUE PRISM £13.62
We have previously pondered the idea that Blue Prism (PRSM:AIM) may be the UK’s most exciting growth company yet it continues to split opinion.
Sceptics argue the technology is unproven, its business model is yet to generate a profit and the shares trade at eye-watering valuations.
But fans believe the business is a virtual workforce disruptor which uses robotic process automation (RPA) technology to run manual back-office administration.
This is a new digital way of automating labour-intensive and mundane tasks, cutting costs for clients, freeing the human workforce to do more value-adding and less boring stuff. It also improves customer service and speed and reduces the need to invest in new IT systems, all via a compliance-friendly platform.
There is no doubt that the RPA industry is in its infancy and growing rapidly, and perhaps sceptics can’t quite get the heads around the idea that a Warrington-based start-up has led the world in an area we might normally expect Silicon Valley or the Far East to dominate.
Yes, there is intense competition, not least from UiPath and Automation Anywhere, the private equity-backed US specialists, but this is also a market that could be worth billions in the future.
For the year to 31 October 2020 Blue Prism is forecast to generate £142 million revenue, soaring to £242 million in 2022. Cash break-even is targeted for next year, and if the company meet these ambitions, profits could come fast and meaningfully, justifying its 6.6-times enterprise value to sales ratio, based on next year’s figures.
TWO GROWTH FUNDS TO BUY
MARTIN CURRIE GLOBAL PORTFOLIO
TRUST (MNP) 338.2p
An investment trust with a ‘quality growth’ remit, Martin Currie Global (MNP) has thrived since fund manager Zehrid Osmani took the helm in October 2018.
The portfolio provides exposure to global growth businesses without having too much exposure to names like Amazon which have already been pushed to very high valuations. Research house Edison notes: ‘It has performed well despite a lack of exposure to the high-profile, large-cap US technology stocks that have led the market.’
This is a highly concentrated portfolio with just 30 holdings. While well-known names like Microsoft, Visa and China’s Tencent are present and correct, the top holding is lesser-known US medical technology play Masimo.
The strategy is to focus on areas of long-term growth including telecoms infrastructure, healthcare, robotics and automation, and cyber security.
The investment process starts by looking at a total universe of some 2,800 stocks. This is screened down to 500 with a pipeline of 90 stocks warranting further research thanks to their combination of quality, sustainable growth. The team behind the trust then run a systematic risk assessment looking at areas like governance and the risk of disruption.
The trust has a 0.63% ongoing charge.
SLATER GROWTH FUND
Portfolio builders seeking a fund focused on growth stocks selling at a reasonable price should look at Slater Growth (B7T0G90), the unit trust managed by respected stock picker Mark Slater which has generated benchmark beating 10-year annualised returns of 13.2%.
Son of the late Jim Slater, a famous financier and author of best-selling investment book The Zulu Principle, Mark Slater puts money to work with attractively priced companies exhibiting superior, sustainable growth potential and has a methodology to find growth companies using value filters.
Slater employs the ‘PEG’ valuation metric, which compares the price-to-earnings ratio with a company’s earnings growth, as a starting point to find inexpensive shares with a proven record of earnings growth.
Once the PEG screen has pared back the investable universe, other measures are then overlaid such as cash flow screens.
Slater also looks for companies with a competitive advantage such as a large market share. He also prefers positive signs in recent trading updates as well as directors buying shares.