How to pick the best growth stocks
As a long-term investor I know our clients will do just fine if we own shares in companies able to reinvest capital at high rates of return. If I auctioned a $100 million bank account earning an enduring 20 per cent interest rate, I would receive more for it than a bank account with $10 million earning the same 20 per cent.
Therefore, if we buy a business today with equity that subsequently rises ten-fold while maintaining its return on equity, our investors will make a lot of money. And they don’t need to worry about Brexit, Chinese growth rates or US Federal Reserve interest rate rises. They can turn all of that noise off and indeed hope that the stock market collapses, enabling them to buy more of the shares in that company at the inevitably cheaper prices.
Unfortunately, most investors aren’t invested in these types of companies. They won’t make a lot of money. I recently examined Australia’s largest ten companies and discovered that with the exception of CSL, each company is either mature, in structural decline, cyclically challenged or simply a mediocre business. And this is where most investors returns are being generated (or not, as the case may be).
It matters not whether an individual is 25 or 85, every investor should approach the stock market the same way and every investor needs growth. It is growth that ensures an investor can maintain their purchasing power and that is what commentators, who advocate pursing currently-attractive yields, are missing. A great yield today, if static, will prove to be an unattractive investment in the not-to-distant future.
Growth however is at a premium because it is very hard to come by. The low return environment I have previously described is symptomatic of very low rates of aggregate growth.
A company can grow its earnings one of four ways; The first is that it can borrow money, however this increases balance sheet risk. The second option is to issue more shares and increase its equity. The problem with additional capital is that it dilutes existing shareholders who don’t participate in the raising on a pro-rata basis – especially when they don’t even get a look in because the company takes the cheaper institutional placement option. The third, and a preferred option for a company that can generate high returns, is to retain profits. The final option and first prize is a company that can simply increase profits without requiring any additional money. Simply raising prices without a detrimental impact on unit sales volume is an example of how this can be achieved.
My prediction of lower returns for baby boomer investors is due to their owning the wrong assets. I am almost certain returns will be poor from owning an ‘investment property’ and I am certain that low returns will come from owning our large cap but mediocre so-called ‘blue chip’ companies.
Aggregate corporate debt is sufficiently high to dissuade companies from borrowing more even with rates at epochal lows. That companies aren’t willing to expand their balance sheets any further suggests a long runway of credit-fuelled growth is off the cards.
When interest rates are high, as they were in 1981 for example, companies act very rationally and carefully when allocating capital. Restructuring was all the rage back then. The result was productivity gains, cost efficiencies and growing profits. There’s precious little of that today. Today, restructuring only comes after companies go broke and the subsequent benefits, if they do transpire, accrue to the debt holders. The equity holders are wiped out.
An examination of the use of debt since the GFC in the US reveals that an increasing and dominant proportion has been deployed on financial engineering rather than productive capital expenditure. Financial engineering includes share buy backs, mergers and acquisitions and dividends. And keep in mind, with the Price to Earnings ratio in the US and in Australia at 18 times, those mergers and acquisitions have not been conducted at bargain prices. Remember the higher the price you pay, the lower your return. It doesn’t matter if the buyer is an individual investor buying a few shares or a corporate buying another.
More concerning is that since 2010 cash flows, as measured by EBITDA have, in aggregate, been declining despite the increase in debt. I hate to consider what might happen to cash flows if interest rates actually rise!
In short, debt is not going to provide fuel for growth.
That leaves us with retained profits as an option. Unfortunately retained earnings have been diminished by company boards acquiescing to shareholder demands for more dividends. Since 2010, Australian payout ratios have expanded from circa 55 per cent of earnings to almost 80 per cent according to FactSet. It’s no surprise then that earnings per share have not grown at all since 2010.
If debt (too high) and retained earnings (too low) are not drivers of growth, that leaves only the possibility of additional share issues. I can construct a scenario where economic growth begins to emerge, interest rates go up – rendering debt more expensive – so companies issues shares to pay down the debt in order to grow. The problem with this scenario, is that even if it does transpire, more shares on issue dilutes the earnings per share and the valuation of the company on a per share basis. It’s another set back ensuring lower returns for longer for investors.
In such an environment every bit of extra return becomes much more valuable. I am more convinced than ever that buying those carefully selected businesses that can grow through generating high returns on retained earnings, will not only ensure you maintain your purchasing power, but is the only path to ensuring you beat the market and the majority of investors trapped in the the vice of low growth.
Roger Montgomery is the founder and Chief Investment Officer of Montgomery Investment Management. To invest with Montgomery, find out more.