Donville Kent’s newsletter for July 2015.
The first half of 2015 has gone reasonably well. While the S&P TSX Composite Total Return Index rose just 0.91%1 in the first half of the year, the Capital Ideas Fund rose a respectable 13.5%2 over the same time period.
Headlines over the past few months have been dominated most notably by the fiscal and debt issues surrounding Greece and the market whipsaw that has been unfolding in China. As I write this issue of the ROE Reporter, both of these “events” seem to be coming to some type of conclusion.
My focus and that of my team remain on identifying and owning stakes in great businesses. Market corrections allow us to invest in such companies at prices lower than we could otherwise. We are currently sitting on a fairly sizable amount of cash, which we hope to deploy in the coming months.
Donville Kent - Investing in a world of secular stagnation
One of the more interesting economic ideas that has been discussed over the past couple of years is the theory of secular stagnation, which was advanced by former US Treasury Secretary Larry Summers. Some fairly complex arguments regarding the relationship between savings and investment underpin Summers’ ideas, but the central theme is that most Western economies are struggling and will continue to struggle to achieve high levels of economic growth and that the most probable explanation for the lack of growth is demographics.
Japan was the first Western country to enter a period of secular stagnation in the 1990’s. It was also the first of the major Western country’s to see a sharp slowdown in its population growth and a steep shift in the ratio of older people (+65) to the general population. Since the 1990’s, other countries have followed Japan into this demographic and growth trough, and birthrates have now slowed dramatically in most Western countries. At the same time, life expectancies continue to rise. The result is that the growth in consumption, which in a country like Canada accounts for roughly 75% of GDP, has slowed in virtually all Western countries as the percentage of consumers in the younger demographic has fallen as a proportion of the general population. Economic growth in most Western economies remains well below long-run averages. Demographics probably explain a large part of this.
Given a somewhat muted outlook for economic growth, many analysts have rightly argued that expectations for the rates of return on everything from savings accounts to stock market investments should be ratcheted down. I agree generally, but I also believe that there are pockets of growth in all economies, and that an investor who is selective, rather than simply an investor in broad asset classes, can still do quite well. Here is what I am seeing in our Canadian backyard today.
Donville Kent - Where is the growth?
I maintain a large database within which I track roughly 600 companies in Canada, and I do so with the direct assistance of Jesse Gamble, my research associate. We make an effort not to place any judgement on which companies we add into the database because we know that some of the best companies may not look great today or are operating in industries towards which we have existing negative biases. We organize our database into seven sub-divisions, which allows us to compare more easily similar companies and their valuations.
Before we talk about where there is growth, I should note that there are competing schools of growth in a microeconomic context. I consider Return on Equity (ROE) to be the best general measure of growth in an enterprise. For me, ROE measures at least two important things. The first is the growth in the net worth of an enterprise, which I consider to be the best measure of how fast an enterprise has actually grown over a specific time period. The second is an indication of the competitiveness of the enterprise, as I consider the spread between a company’s return on equity and its cost of equity to be an objective measure of the enterprises’ competitive advantage.
Within our database of 600 companies, we have identified 244 companies that have market capitalizations greater than $100MM that are not in resource or extracting industries. These companies are organised into seven subdivisions, and in six of those subdivisions (presented below) I consider ROE to be the best and most practical measure of growth.
As Figure 1 shows, while high growth companies can be found everywhere in the market, some sectors have more than others. The highest growth sector (Health) also has a large number of companies that are unprofitable. The undiscerning investor can easily get burned here. I believe the health care sector offers some of the best growth companies in Canada, but I believe that it also represents the best sector for finding stocks to short. For investors in growth companies, there are a reasonable number of companies in a multitude of sectors that allow for the construction of a diversified growth portfolio.
Donville Kent - So how are they growing?
A frequent topic of conversation among fund managers and investors is the issue of organic growth versus growth through acquisition. A cursory review of the 41 high growth companies in Canada reveals that 25 of the 41 are growing primarily through acquisition while the other 16 are growing organically. So what conclusions should investors draw from this revelation? There are a number of pundits who argue that organic growth is far superior to growth by acquisition. In the perfect world, a company can grow its revenues and profits by spending on advertising and promotion, and presto! revenues go up 10-15% or perhaps even better while margins hold and perhaps even expand. Assuming that such a business could be bought at a reasonable price, who wouldn’t want to own it?
Many of the most attractive businesses we own are attractive because they have high levels of recurring revenues and/or very sticky relationships with their customers. Much of this can be linked to a concept called “barriers to exit,” which means that the customer, once engaged, will only leave you if prices become really high or the product/service offering deteriorates significantly. Thus, the company has a customer who is quite locked in. The challenge for growth in this otherwise attractive industry is that competitors have similar relationships with their customers. So a company can increase advertising and promotion quite dramatically but the cost in relation to how much new business it can attract is quite high. This phenomenon is common in software and software-as-a-service businesses (SAAS), and to some extent in the more mature pharmaceutical businesses and professional services. Thus, while the organic growth model can be a wonderful model for certain industries, it can represent a fairly big waste or misallocation of a firm’s capital in others.
For us, the appropriateness of the organic growth vs. growth through acquisition model is entirely focused on the relationship between marketing and promotion and customer wins. Investors who have an unduly negative bias towards growth by acquisition companies and/or industries might be missing out on owning a great growth company.
Donville Kent - So what about valuation?
One of the criticisms of those who invest for growth is that they overpay. I agree with this criticism to some extent, particularly when the investor uses growth metrics that I believe are poor or inappropriate, or where a value discipline doesn’t exist in the first place. I am not a big proponent of either EV/EBITDA or P/Sales as valuation metrics for growth companies or for any kind of company for that matter. I prefer price to cash earnings which is simply GAAP earnings with amortization of intangibles added back in.
So let’s go back and look at the 41 high-growth stocks in our database. The valuations of these 41 stocks are ranked by quartile in figure 2 below (the fourth quartile has 11 stocks, the rest 10). Here we see that there is a great disparity between the cheapest quartile, which trades on average at 7.4x 2016 earnings, and the most expensive quartile, which on average trades on 28.8x 2016 earnings. Clearly, there is a massive disparity in valuations between the cheapest and most expensive growth stocks in Canada.
In summary, a number of economists and demographers have argued quite convincingly that Canada, along with most Western countries have or are about to enter a period of low economic growth. The preceding analysis has sought to show that while high growth stocks are fairly rare, they can still be found in reasonable numbers and in some cases their valuations are remarkably attractive.
The world is an interesting place and Canada is wonderful place to watch it from. We are far from a perfect country but as I watch events unfold in places like Greece, or Syria, or the Ukraine or wherever today’s hot spot is, it makes me grateful that I live here and not there.
Once again, much thanks to my wonderful team – Jordan, Ali, Jesse, Chris and Dominika – and the ongoing support of our loyal investors.
Write me if you want to chat – J.P. Donville
1 S&P TSX Composite Total Return Index is the Net Total Return version of the S&P/TSX Composite Index
2 Time weighted rates of return for Class A Series 1, net of all fees and expenses
See full PDF below.