Growth versus growth

Key takeaways

• Growth stocks are far from a homogeneous group; rates of growth differ hugely
• Some definitions of ‘growth’ – and some indices – actually exclude some of the world’s fastest-growing businesses
• Genuine hyper-growth stocks are cheaper than they appear at first sight

Nobody wants to read another discussion of the merits of ‘value’ versus ‘growth’. So let’s not rehearse familiar lines here. There is, however, a discussion that we think is worth having – one that we might call the ‘growth versus growth’ debate.

There is a problem in the way ‘growth’ is usually measured

To identify growth, Morningstar uses a five-factor approach combining historic growth in a company’s:

• revenues
• cashflows
• book value
• earnings per share
• ‘long-term’ projected earnings growth (it regards two-year forward estimates as long-term).

But there’s a problem: these factors often send false signals about growth. The fastest-growing businesses often reinvest all of their excess profits into their growth and are not concerned with maximising their short-term cashflows or earnings per share. Meanwhile, there’s a huge amount of noise in factors such as earnings per share and book value.

Measuring ‘growth’ using factors designed to assess mature companies is nonsensical

It is akin to the Victorian approach to parenting whereby a child’s behaviour was measured according to adult norms. Having thought long and hard about our definition and considered potential alternatives, we concluded that the best measure is actually very simple: we believe the best measure of growth is actually the sustainable rate of a company’s revenue growth.

Profit multiples are useless in assessing emerging companies

The distribution of growth: what is ‘average’?

Today, the companies in the MSCI AC World Index are expected to grow their revenues at an average of 11%. Only 5% of companies are expected to see revenue declines; just 15% are expected to grow their revenues more than 50% per year. The majority of companies (53%) are expected to grow their revenues somewhere between 0% and 15% per annum.

So we think 10% revenue growth is currently a reasonable lower bound for a company to qualify as a ‘growth’ stock.

There is a wide distribution in rates of earnings growth across our investment universe of >7300 stocks – but not all of them appear in major market indices: two-year average revenue growth expectations consensus

To make the grade as ‘growth’ fund (rather than ‘core’ or ‘value’), we think the average revenue growth rate of its holdings should be meaningfully above this lower bound – so let’s say 15-20%.

And with a good proportion (32%) of listed companies expected to grow their revenues at above 20% per year for the next two years, this should be an easy target for growth investors to hit. But is it? The requirement for many ‘growth’ funds to manage their risk relative to the index means it rarely is.

Managing risk relative to the index hinders many ‘growth’ investors

The distribution of companies shown in Chart 2 is not the distribution of the index. Indices such as MSCI ACWI are increasingly dominated by mega-caps. This skews the incentives of fund managers: perhaps inevitably, they avoid taking too much risk relative to their benchmarks.

MSCI ACWI only contains 40% of our investable universe of 7,394 companies (revenue-generating liquid stocks). Indeed, many of what we regard as being the most interesting companies are not in the index.

Furthermore, many of the companies that we think have the highest sustainable growth rates do not (yet) meet the gatekeepers’ Victorian definition of growth – or of what is a respectable constituent of a mainstream index. Although we have grown used to seeing indices and active funds with Amazon, NVIDIA or Tesla in their top 10 holdings, remember that some of them were not considered grown-up enough to feature until relatively recently... Tesla, for example, wasn’t included in the S&P 500 until December 2020.

Strong empirical evidence suggests disruptive innovators are the main source of equity market returns

We target the ‘power law’ of equity-market returns; returns from global equity markets are driven by a small group of highly successful stocks

How we define growth companies

Our portfolio is diverse: our holdings are disrupting different industries, addressing different sustainability problems and are contributing towards a variety of the UN’s Sustainable Development Goals. You will be familiar with some of them – but others may be new to you. What all of our holdings do have in common, however, is that they are growing their revenues at a high and (we believe) sustainable rate.

Such companies tend to be found where declining technology costs are intersecting with major social and environmental challenges. As such, they have significant positive impact – and are often entering the hyper-growth stage of their lifecycle. These are growth companies.

Why growth is often cheaper than it appears

The catch, of course, is that growth companies attract growth multiples and levels of volatility. This means they tend to look both expensive and risky in the short-term.

At the same time, however, they might prove to be very cheap in the long-term and, by offering a hedge against the potential for disruptive change to destroy established industries and incumbent operators, they may actually offer a less risky home for investors’ capital…

Rapidly-growing companies tend to get ‘cheap’ very quickly – negative-growth companies never do

We think it’s worth rolling up our sleeves and doing fundamental analysis to try and figure out if that’s the case.

• Growth companies might be very high-quality businesses with emerging competitive powers that are as yet underappreciated.
• Growth companies may have competitive powers that are not yet reflected in their cashflows or their returns on capital, but which might instead be signalled by high gross margins and pricing power.
• Growth companies might be capital-light businesses with recurring revenue streams, strong balance sheets (net cash) and low costs of capital (open access to debt and equity markets).

Not all growth funds are made the same

A ‘growth’ fund will have a revenue growth rate that is either at or above its benchmark index and a low tracking error. A growth fund, in contrast, should be growing far more quickly.

This is what a growth fund looks like…

The range of companies and the dispersion in the rates of growth across the global equity market is extremely wide. We believe it’s our job to look beyond the average companies and large index positions that populate so many ‘growth’ portfolios.

If we pick wisely, we can back investments that are high-growth, high-quality – and which have the potential to deliver genuine ‘value’ for our clients over the long term.