A Golden Age For Growth Investing
In the past decade, Growth Investing has come of age. One of the investment firms at the vanguard of this trend is Scotland-based Baillie Gifford. Their incredible success has given many traditional value managers pause for thought.
Recently, one of the firm’s star investors, James Anderson, published a ground-breaking thesis on growth investing, entitled Graham or Growth:
Graham or Growth? - 2019 (bailliegifford.com)
It is no exaggeration to describe this as a defining piece on the investment thinking of the past decade. And, to his credit, Anderson identified many of the great growth stocks years ago, including Alphabet, Apple, Amazon, and Tesla. By taking a long-term approach he has held them consistently, capturing huge returns for his clients.
Anderson’s new age thesis is basically this:
- Firstly, he believes this golden age for growth investing will continue. He defines growth investing as ‘extreme long-term growth’ over many years or decades. This is not the same as GAARP, quality investing or momentum trading.
- In this new age, business models built on ‘knowledge, technology and networks’ enjoy increasing returns to scale.
- Thus, traditional Ben Graham investing tools for working out intrinsic value do not work, as they rely on mean reversion. Mean reversion does not apply to these new age businesses in the way it did to old economy businesses. In Anderson’s words, ‘We are moving into an age where mean reversion is much less significant than mass creative destruction.’
- Buying and holding stocks such as Alphabet or Amazon are examples of this new art of extreme growth investing. They may have always looked expensive, yet they have not disappointed.
This is a bold and eloquent thesis. I am going to look at it more closely. And also to explain, that for growth investing to really come of age, it still needs to answer one big outstanding question.
The Arithmetic Of Valuation
At the heart of extreme growth investing is the idea that, if you can grow rapidly and at a high rate of return for a long period, valuation becomes irrelevant, so why even bother with it?
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One way to demonstrate this is to run a DCF where the terminal growth rate is higher than the discount rate. In that case the company has infinite value. Another example would be a company investing at 30% compound returns for, say, 20 years will turn each dollar invested into $190; so why worry about the starting P/E?!
As impressive as this is, growth does still have its limits, even for new age companies. And while they may grow faster or for longer, nothing can grow at a high rate forever. Hence the big, unanswered question: How much is enough?
How Much Is Enough... Scale?
Another core of the growth thesis is that these new age business models enjoy ‘increasing returns to scale.’ In other words, the bigger they get the more profitable and more dominant they become, due to factors such as network effects.
This is contrasted with traditional heavy industry/bulk manufacturers, who eventually face diseconomies of scale.
I am not sure I agree with this. Diseconomies of scale encompass a wide range of headwinds that all large or expanding companies have to contend with. They include things like growing bureaucracy, de-motivated staff, lower R&D productivity, communication breakdowns, time to adapt, as well as public and government opposition. All these apply to tech businesses and asset light companies too.
In fact, Scale can be especially dangerous in rapidly changing industries, such as tech-related businesses. Because it is especially hard for large companies to remain nimble and creative, they will often lose out to smaller companies as the market changes around them.
Even data can become a disadvantage. While we think more data is better, even something as powerful as the human brain tends to struggle with more than about 3-5 relevant data points. Too much data and complexity often leads to worse decision-making. In 2007, banks used some of the most complex and data-rich models ever conceived to value subprime mortgages. Yet they completely missed how the underlying securities were evolving. The organisations with the best access to data have long been governments - yet that is where you find the biggest policy failures, misjudgements and wasted money. Big data may not be the answer it is cracked up to be.
The point is, some new age companies can grow faster and for longer, but size and complexity will slow them down sooner than their business models theoretically allow. Which begs the question: How much is enough?
How Much Is Enough... For The Public?
One of the most striking things is the dislocation of how investors and employees see big tech companies, and how the public feel towards them. In the recent spat between Australia and Facebook, most people were on the side of the journalists. Support is widespread for an ‘Amazon tax’ as well as enormous fines on dominant franchises like Google. Even Jack Ma has received little in the way of public sympathy over his row with the Chinese government.
The public view big tech as increasingly sinister: effectively using private information to manipulate us with harmful and addictive products. Their enormous wealth and entitlement only sharpens that sense of injustice.
Covid has exacerbated the hostility and brought forward the crunch point. Big tech is seen as having profited from a human catastrophe. With governments and society now strapped for cash, the pressure is on for those high growth companies to pay back the ill-gotten gains.
There is a straight diseconomy of scale here: the richer and more successful they become, the less the public trust them, and the more pressure there is on governments to impose ever larger tax and regulatory burdens.
This would not be the first time this has happened when a new disruptive industry has emerged - in fact, it is every time! As Merryn Somerset-Webb has written in the FT, the rise of steel production, the railroads and the electric utilities all began with enormous profits followed by the long and bathetic grind of increasing tax and regulation:[i]
Again, some new age companies can grow faster and for longer, but a wary electorate is likely to slow them down sooner than their business models theoretically allow. Which begs the question: How much is enough?
How Much Is Enough... Hubris?
Napoleon was the finest General with the finest army of his generation. Yet when he died, France controlled less territory than when he had assumed the throne. It wasn’t a lack of competitive advantage or ability that defeated Napoleon, it was hubris. Beginning with his fateful march on Moscow, the Emperor simply overreached himself, and lost everything.
Napoleon is not alone. Hubris is a well known and psychologically recognised phenomenon. After about six to eight years of unbridled success and power, the very architecture and neurochemical balance of the human brain becomes distorted. Successful people simply go mad. You see it in world leaders, businessmen, celebrities, and investors. What inevitably follows is a series of catastrophic decisions totally at odds with their former brilliance.
One manifestation of a long financial bull market is what Charlie Munger has called ‘Wretched excess.’ Or as the sage-like Lou Mannheim warns in the film Wall Street:
The thing about Money, Bud, is it makes you do things you don’t want to do.
When there’s just so much money and success sloshing around, good people do bad things. Easy money always ends in shoddy accounting, lax governance, law breaking, wasteful spending and financial fraud. It takes a long time to burn that off. The stock market stars of a decade ago - banks, energy and miners - are still settling enormous fines and taking provisions for some terrible decisions. Many companies in those sectors have not even survived. Why will this decade be any different?
So it’s not just the theoretical quality of the business model and the growth prospects you have to consider. There is the human element: great success usually leads to terrible mismanagement.
How Much Is Enough... Prediction?
In 1962, an Oxford Economist called Ian Little published a study looking at whether current valuations for individual stocks in any way predicted their future growth rates.[ii]
Sure enough, the highly valued ones grew fastest over the following year, but then by less and less. By year five, the growth rates of the highest valued and the lowest valued were completely mixed up. Similar studies have been repeated across myriad stocks markets, using analyst predictions as well as implied valuations. All reach the same conclusion: analysts can generally predict the next year or so, but by five years out things get hopeless.
If we look at our own experiences we can see how difficult predicting anything is:
- When oil was at $140 a decade ago, and everyone was talking about $200 oil, no-one conceived it could go to minus $40 a barrel.
- At the height of the European debt crisis, who thought that many Greek government bonds would trade on a negative yield?!
- And with the global financial crisis in full swing, was anyone predicting a 400% rise for the S&P 500? Or that many of the collapsing real estate markets would again surpass their peak prices?
The trouble is, with very highly valued stocks, they need to grow very rapidly and very profitably for decades to come. A few good years won’t make up the implied valuation.
Tech failures such as Palm, Pebble, MySpace and Friends Reunited remind us that
while businesses at the cutting edge of creative destruction can grow swiftly, they can shrink and die even faster.
If predicting the future is so hard, how far into the future is enough?
The Wallenstein Paradox
One answer to this is that if the leading tech companies can simply adapt and invest rapidly enough, they can navigate the unpredictable and avoid obsolescence.
This raises a fascinating conundrum that I call ‘The Wallenstein Paradox.’ In the early 17th century, the whole of Europe was at war, for over 30 years. The problem was that for any of the great kings to defend their respective empires they needed an enormous army, but the cost of keeping one big enough was unaffordable. So the only way to pay the Army was to invade other territories, where they could capture food and booty. This led to a continual state of war and destruction. There was no steady state and there were no winners.
You can make a similar case for today’s tech giants. Operating at the edge of creative destruction means battling every contiguous force continually. Every day brings new innovations and new threats. It is exhausting. it consumes all your resources. You can never stop.
Take Facebook: without multi-billion dollar annual spending on deals, Facebook would be in a sorry state. As well as competitors and start-ups, you have to constantly acquire software, patents and licences to stay relevant. Then you have to pay your best people millions in stocks options to stop competitors poaching them.
There is no such thing as steady state. It’s either spend everything on maintaining dominance and expanding into new areas, or you shrink and die quickly.
In this sense conventional free cash flow (Operating cash flow minus tangible capex) is entirely misleading. The cash flow isn’t free. To fend off disruption you have to spend it all on M&A, intangibles and enormous incentive programmes. The alternative is rapid decline.
Hence, it is unclear whether many of today’s great growth stocks are great at all. Companies such as Tesla and Netflix have shown that they can consume capital as fast as they can raise it. But can they ever actually slow down enough to make decent returns on that money? And what happens on the day when investors say enough is enough and, start looking for dividends?
The issue of access to capital leads to yet another question that needs an answer. Many of these disruptors have been able to attract billions as a result of the easiest monetary environment in history. They have also relied on government interventionism: for example with renewables and electric vehicles; and more recently with lockdowns driving activity online.
Historically statism has been cyclical. It was only a generation ago that US bond yields hit 20% and the leader of the free world declared, ‘The nine most terrifying words in the English language are: I'm from the Government, and I'm here to help.’
Today, we are in a time of easy money and government intervention in every aspect of life. With bond markets beginning to rebel, aren’t we at the peak, having gone further than anyone thought possible?
Can the golden age of growth survive if statism goes into reverse?
How Much Is Enough... Consensus
The core contention that today’s growth stocks are more valuable than the past as they can grow faster and for longer might be true. However, to generate outperformance from that contention, it requires that most investors do not understand it and price it in. Ten years ago, that was certainly the case. However, take the following remarkable facts into account:
- Valuation dispersions – the gap between the most highly valued and lowly valued stocks – are wider than any time in history.[iii]
- The top 12 mega tech names (think Apple, Microsoft, Tesla) have risen 170% on average in the past year.
- The most valuable five companies in the world are all tech disruptors. These huge companies are far larger as a proportion of the global market than any of their predecessors.
- The value of new IPOs over the past year is four times the previous record at the height of the TMT bubble. Furthermore, over 70% of these new listings are unprofitable, indicating a new willingness of investors to fund years of losses as they pursue returns to scale.
In other words, investors are pricing growth stocks more highly than any time in history. Nevertheless Baillie Gifford and others still maintain that the point “When growth investing becomes accepted by the industry at large appears still far off.”
If it is still far off, we’re certainly a heck of a lot closer than we’ve ever been before.
If the golden age of growth is not priced in yet, then when is enough?
Round Tripping Versus Selling Too Soon
A Journalist once asked John Pierpont Morgan how he got to be so rich. Morgan replied, ‘By getting out too soon.” For the richest man in the world, selling too early was enough.
What has historically held back growth investors has not been a shortage of new technologies and fabulous growth opportunities, but the perception (fair or unfair) that they can never get out in time. Blinded by their own hype, they wind up riding the boom and bust all the way back to where they started.
While value investors may not have the same wild ride to the stratosphere, they do have an exit strategy, involving some assessment of intrinsic value. Indeed, deep value investing has a lovely habit of simply wiping itself out at the top of the market: if you cannot find stocks to meet your standards and at a big enough discount, you leave the field or look elsewhere.
Momentum investors too have a predefined exit strategy typically involving relative strength or moving averages.
Growth investors have come a long way, and while growth stocks may go on for longer than before, the perennial question still needs an answer: When is enough?
What Is Value Investing, Really?
I am often asked, ‘What is value investing?’ It is not just a profession or a way to make money, it’s more than that: it’s a lifestyle choice.
The most successful practitioners have all viewed it this way. Value investing is hungry on human virtue: patience, equanimity, creativity, independent thinking, perseverance and above all, the idea of the inner scorecard – holding yourself to your own standards rather than being swayed by those around you. These traits are not just valuable financially, but across every aspect of life. Value investing is just an extension of how many of us want to live our lives.
This is why value investors have persevered merrily through decades; happy to ride out periods of market panic, volatility and underperformance. It’s also why they’ve been able to sidestep those catastrophic speculative bubbles that periodically wipe out almost everybody else.
When looking at value investing, too many people are obsessed with Warren Buffett. Yet there are many others – such as Rick Guerin and Ben Graham - who made similar returns, but simply lost interest in making ever more money. They parlayed their skills into other things like family, culture, writing, teaching and even surfing. Personally, value investing has been good to me. It let me retire in my 30s and have time for my family and many other things I care about. There is no need to be a celebrity or billionaire. The value mindset gives you the freedom to be satisfied, to value what is important and to have enough.
Too often, investors obsess with relative performance and the perception of others rather than their inner scorecard. Even successful ones get caught in a trap. There is always a more expensive painting, a more valuable wristwatch, a rarer Ferrari, a more grandiose display of philanthropy, a finer house or a bigger yacht. But you can only cherish a limited number of things at one time. Too much just creates its own set of anxieties.
Kurt Vonnegut once recounted how he was at a dinner party given by a billionaire with fellow author Joseph Heller:
“Joe, how does it make you feel to know that our host only yesterday
Made more money than your novel ‘Catch-22’ has earned in its entire history?”
And Joe said, “I’ve got something he can never have.”
And I said, “What on earth could that be, Joe?”
And Joe said, “The knowledge that I’ve got enough.”
No philosophy of investing, however successful, is worth it if it never lets you find your enough.
Concluding Thoughts - How much is Enough?
In the past decade, growth investing has come of age – brought to bear by the creativity, intelligence and hard work of many. For all investors, there is a lot to learn from this new understanding and these new ideas.
Einstein is said to have once quipped, ‘The difference between genius and stupidity is that genius has its limits.’ Similarly, the difference between growth and value is that value has its limits. For growth investing to really stand the test of time, it still needs to test and find its limits: to answer the 64 trillion dollar question – how much is enough?
For these golden age growth stocks, enough is likely to be long before the imagined possibilities of the business model:
- When do scale and data become a burden?
- When does hubris lead to failure?
- When do governments and the public call time?
- How far into the future can we honestly see?
- When has consensus caught up?
- And when will it become clear to investors that, in some cases, their value will be consumed in an unwinnable war between formidable opponents?
About the Author
Andrew Hunt is a global deep value investor and author of “Better Value Investing: A Simple Guide to Improving your Results as a Value Investor.”
[ii] HIGGLEDY PIGGLEDY GROWTH - LITTLE - 1962 - Bulletin of the Oxford University Institute of Economics & Statistics - Wiley Online Library