Session 21 (of 42): Growth Investing - Against the tide of history!

0:00 Hi, welcome back to this my final session on growth investing. Let's review where we are. We started with an introductory session where we looked at small cap investing as one strand of growth investing. We then turned to IPOs, initial public offerings and then to screening for young growth companies and in the last session activist growth investing in the form of venture capitalists. This one I' I'd like to pull all the strands together and talk about growth investing in the aggregate because in many ways growth investing it looks like you're going against the tide of history. And in a minute I'll show you a graph that illustrates what I'm talking about and it looks like you're winning against the odds. So let's set the table by looking at why so many investors call themselves value investors rather than growth investors.

0:49 You can trace it back to this one chart. What is this chart? It looks at returns on an annual basis for stocks classified based on PE ratios from lowest to highest. And if you remember, we used to back up value investing that the lowest PE stocks earn much higher returns than the highest PE stocks. And that this has been true for a century. That's the legend of value investing. In many ways, when you pick growth investing, people's response is, why would you do that? the highest P stocks which tend to often have the highest growth rates have underperformed.

1:24 There are four ways you can push back if you are an advocate for growth investing. The first is while it is true that over this entire time period outperform growth investing at least in its most generic form low PE stocks beat high PE stocks. If you look on a year-to-year basis, you see that there are periods of time, sometimes extended periods, where high PE stocks outperformed low PE stocks. So, basically what you have in this graph is a difference in growth in value over time. And it's a function of earnings growth. During periods where earnings growth is low, it turns out that growth stocks do much better. That might strike you as contradictory, but here's the rationale. When earnings growth in the aggregate is low, growth becomes a scarce resource. So you are willing to pay a higher price for growth stocks. So the first thing that seems to drive this yearto-year shift is what the actual growth rate is. In periods when growth is high in the aggregate, value investing outperforms. In periods where people are struggling to grow overall aggregate growth is low, growth investing wins out. The second thing that seems to affect growth investing is what the yield curve is doing. The yield curve of course captures the difference between the short-term rates and long-term rates. In most time periods, long-term rates are higher than short-term rates. The yield curve is upward sloping. But when the yield curve is flat, short-term rates are similar to long-term rates or downward sloping. It turns out that growth investing outperforms value investing which actually described because when the yield curve is flat or downward sloping you're looking at recessions negative growth.

3:09 So the key variable that seems to drive growth investing is can you time the economy and the overall know patterns of growth in the economy. There's a component of market timing that seems to kick in with growth investing. And finally, if you are a growth investor, you can also point to recent history. This table goes only through 2018, but I did in a previous session look at the table all the way through 2024. The payoff to growth investing, at least in terms of low PE versus high PE stocks, seems to become more in growth investing's favor in this century. This century, high PE stocks have actually matched up to or even outperform low PE stocks. So let's summarize what your case might be for growth investing. One is when earnings growth is low, growth investing seems to win. So maybe that's the time you go into growth investing.

4:02 Second, when the yield curve is flat or downward sloping periods where you're heading into recession or low economic growth, growth investing seems to win. Again, a potential winner. And the third is there's this timing issue. As over time, as you've gone through, you know, you see that the payoff to buying high PE stocks has become better. You think that's three, you said four. Here's the fourth one. Ultimately, when we talked about active investing, we're not just buying low PE stocks or high PE stocks. Were picking individual stocks. And there is evidence, though it's it's contested that the payoff to active investing.

4:37 Picking stocks is greater if you're a growth investor than a value investor. Very old study. Bert Malcio, you know, illustrated this by by by doing a very clever exercise. He took the average actively managed value fund and the average actively managed growth fund. And the average actively managed value fund outperformed the average actively managed growth fund by.16%. You're saying that means value funds are better, right? But wait, he showed that if you bought a value index fund, which is basically low P stocks in the aggregate and and a growth index fund, that the value index fund outperformed the growth index fund by 47%. You're saying where is this going? If you think about the difference between those two numbers, which is 31 basis points or 31%, you could argue that that's the payoff that active growth managers get relative to value managers. Because remember, remember if they both pick stocks the same way. The difference between the two should be 47% in both the index fund and with the active investors. But you don't get that. There is some evidence that stock picking has a much bigger payoff when you're a growth investor than a value investor.

5:50 Now, if you ask me why that might be, there are three things that I think explain the phenomenon. First is the kinds of companies that growth investors scrutinize tend to be smaller. They're less followed. You could argue that the payoff to doing research is greater with small companies and less followed companies with large mature companies. Second, small companies know or growth companies are more difficult to value than mature companies. As somebody who teaches valuation, I know this for a fact. You think that must mean the payoff is great at the value mature companies, right? No. Because if mature companies are easy to value, they're easy to value not just to you, but to everybody else. The payation is greater when you have difficult to value companies. You can argue that growth companies are more difficult to value. more estimates to make, more judgments to make, less trust on historical data. And finally, there's an argument to be made that with small growth companies, there is a payoff to knowing the business they're in. If you truly understand medicine and drugs and pharmaceuticals, you might have an advantage with a small biotech company that you will not have with a large steel company. So active growth investing seems to do better in the numbers and there is a rationale for why it works better and of course you got to walk in with open eyes. There are pitfalls in growth investing and there are three big ones. One is what I call the scaling problem. Many companies when you invest in them as growth companies are small and young and if you're right they will become larger. You're saying so what as you scale up it turns out that it becomes much more difficult to grow. Second, growth by itself is not a good thing and you can pay too much for growth. So you got to answer the question not just how much the growth is but how valuable is it and how sustainable is it. And third there is a component of momentum in growth investing. You saw that with the cycles.

7:49 It becomes critical that you get in at the right time and get out at the right time. There is a momentum trading component to growth investing that might lead investors to earn higher returns. So, let's take each of these factors. Let's start with the scaling factor. To back up my scaling argument, I'm going to look back at a study of IPOs. And what the study looked at was companies that are going public. And it looked at the revenue growth rate of these companies a year after they went public and then two years after, three years.

8:19 So, you're creating a portfolio of companies that go public and you track their growth rates relative to the revenue growth rates of the sector. Let's start with the good news. When you buy these companies after they go public, remember they go public at the peak of their growth. Their revenue growth rate is 15% higher than the revenue growth rate of the sector they're in. That's good, right? Two years later, same companies, the revenue growth rate is only about 7 to 8% higher. 3 years later, it's 3% higher.

8:46 By the time you get to year five, the growth has faded. In most companies, growth fades as companies scale up for two reasons. One is as you get bigger that same percentage growth rate becomes tougher to maintain. It's one thing to grow your revenues at 10% of your revenues of 100 million. Entirely different game when you have a billion. Second, as you grow, you attract competition that competition goes after the same growth. Scaling up is hard to do. Something you got to remind yourself if you're a growth company investing in small growth companies.

9:19 Second, there is this very lazy view that growth is a good thing at companies. In fact, many analysts growing. But remember, growth has those two effects we talked about in the context of the valuation session. The good effect is it makes your revenues and earnings higher. The bad is you got to reinvest to deliver that growth in what in factories and R&D and whatever you need to reinvest to grow. The net effect of growth will depend on which effect dominates.

9:48 One simplistic rule you can use is if you earn more than your cost of capital, growth will add value. If you earn roughly your cost of capital, growth will do nothing for value. If you earn less than your cost of capital, you will destroy value as you grow. You'll actually be better off not growing. So every year at the start of the year, I go through an exercise where I compute the return on capital for every publicly traded company in the world. I compute the cost of capital for every publicly traded company in the world and I compare the two. What I'm trying to get a sense of is what percentage of companies globally generate more than their cost to capital and therefore add value when they grow. If you look across all publicly traded firms, the the statistics are truly scary. Across all global companies which are publicly traded, 29% earn a return on capital that exceeds their cost of capital. 29%. That's a nice way of saying 71% earn less than the cost of capital. Some have good reasons, right? They're young companies.

10:48 They have a tough year. But that number basically suggested you got to be skeptical about growth. Even if you focus in just on money-making companies, which is a very, very low threshold for success, are you making money? 46% of companies earn more than their cost of capital. 54% earn less than the cost of capital. Most companies as they grow have trouble delivering value from that growth. Now if on top of that you add how sustainable is this growth that becomes a question of what are your competitive advantages. In the words of Warren Buffett what is your moat in a in a strange way when value investors spend a lot of time on moes with mature companies the real place or the real group of companies where you care about modes is growth companies.

11:38 And there in this table I've actually tried to list out different types of competitive advantage and varants where the mode is wide. These are most sustainable to no mode. Let's take brand name. Every company claims to have a brand name right? If you truly have a top brand that's a wide mode it's very difficult to replicate. If you just have a name brand people recognize your name it's a narrow mode. I mean that recognition might by itself might not give you much. If you have a generic brand there's no mode. Switching cost.

12:06 That's a cost of switching into your product as low as possible. Cost of switching out as high as possible. If the cost of switching out of your pro of your product is infinite, you have a wide mode. If there are no costs, you have no mode. Networking benefits capture the fact that if you succeed as a company, sometimes it gets easier for you to succeed. That's what networking benefits capture. If your networking benefits are global, what that means is as you get bigger, you you it gives you an advantage everywhere in the world, then you have a very wide mode. If you have local networking benefits just in your city or town, then the mode is narrower. And if you have no networking benefits, it's no mode at all. If you have permanent cost advantages, a Ramco has permanent cost advantages in the oil business because it can extract oil at such a low cost. That's a very wide mode. But if you have temporary cost advantages, you manage to build a factory in a low labor local, that's temporary because somebody else can do exactly what you it's. It's a narrower mode. No cost advantages. There's no mode. If you have full legal protection, nobody can do what you do. Maybe because you are given a monopoly by the government. That's a wide mode. If you have partial legal protection, some things can be protected by the others and the mode gets narrower.

13:29 No legal protection, there's no mode. And it plays out in your valuation in how you think about these companies. So it's not just growth, but thinking about how sustainable that growth is and how valuable that growth is. Which brings me to the final component, which is all growth investing seems to have a momentum component. In momentum markets, when momentum is driving things, growth stocks tend to do well. So if you are good at detecting shifts in momentum, it can carry over into growth investing.

14:00 The caveat though, you can play the momentum game. And many growth investors forget they're playing the momentum game and they fool themselves into believing that they're making money because they're valuing growth companies well. In fact, they're riding momentum. Be honest with yourself. So if you decide to become a growth investor, be proud to call yourself a growth investor, don't go around, you know, calling yourself value because that's a value investor just because that's what everybody else is doing, but be clear about what kind of growth investor you are and what makes you good at that component of investing.

14:41 Now there the notion that growth investors don't care about value is absolutely false. Good growth investors care about value. Take a look at Peter Lynch's record and his books. Clearly, the man cares about value. And you could argue that in growth investing, your odds improve because you're bringing more to the table than a mature than value investors are doing with mature companies. As we enter the day of the age of AI and chat GPT, you could argue that that differential advantage you bring because there's something you bring to the table with growth investors that other people don't don't bring that's giving you those excess returns that should actually get greater as we mechanize this process and data becomes more available.

15:27 I hope you succeed as a growth investor if that's what you choose to do. And I hope you found these sessions on growth investing useful in doing that. Thank you very much for listening.