Commentary from companies over recent reporting seasons has highlighted the anaemic growth in the current economic environment.
The economy is now well and truly in an environment of low growth and with a lack of revenue growth options available to most companies, there has been an increasing focus by management to reduce costs, thereby increasing margins and earnings. It is not surprising then that companies that are achieving strong revenue growth are being rewarded with share price performance.
Outperformance has prompted caution for growth stocks given an increasing dispersion in the price to earnings ratio (PER) between growth companies and low growth companies. There is no doubt that current strong share price performance diminishes expected returns in the future, however, the consideration for a company’s valuation should be guided by its long term earnings potential, rather than short term earnings and short term valuation metrics. Over time, share prices should follow a company’s earnings, and we look for businesses that can grow their earnings predictably and consistently.
The difficulty, we believe, is selecting companies that have a way of protecting outsized returns sustainably over the long term and whether the current share price adequately compensates investors based on the earnings potential. We focus on some of the attributes that we believe to be important below:
A large market potential
Ability to sustainably generate substantial organic growth depends on the size of the market opportunity. Domino’s Pizza Enterprises (DMP) is an example of a company that has been able to leverage its world class technology and franchising model from Australia to the globe, currently in seven key countries. Other factors to consider include favourable structural shifts within a market, such as the transition from print-based advertising to online advertising.
[1]Sustainable competitive advantage
There is no use capturing a large market if you are unable to protect outsized returns. Typically, when an industry’s economics are favourable, competitors will enter the market, eroding the returns on capital that are available. Companies that can consistently generate high returns and achieve high margins tend to have a sustainable competitive advantage. REA Group’s (REA) sustainable competitive advantage comes from the strong network effect on its property advertising website, which provides it considerable pricing power.
Consumers in the market for property are drawn to the website with the greatest number of listings, while agents will place listings on the site with the greatest number of eyeballs, creating a virtuous cycle. Further, given the advertising cost represents a small percentage of the cost of a house, this places REA in a strong position.
[2]Ability to reinvest capital
Companies need to invest capital back into their business to drive future earnings growth and protect their sustainable competitive advantages. We look for companies that have capital light balance sheets and are able to reinvest that capital at high rates of return.
There is a balancing act required between investing and meeting short-term earnings expectations. Larger investments come at the cost of reduced earnings in the short term, however, provide the potential for additional gains in future years. The market’s short term focus on earnings can result in opportunities and this was evident with SEEK (SEK) when it reported its 2015 full year results in August 2015.
[3]Control over destiny
Generating returns from a portfolio of stocks is as much about what you exclude from your portfolio as what you include. We exclude companies that have no or limited control over their destiny in terms of the product or service they sell. The weakness in the resources sector highlights the lack of control companies in this sector have over their revenues and profits. This cyclicality makes it very difficult to provide comfort that earnings can be generated sustainably over the long term. Other factors that we look negatively on include excessive gearing, lack of organic growth options and high capital intensity.
Mark Arnold is the chief investment officer of Hyperion Asset Management.
Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regards to your circumstances.