Growth Stock Investing and Looking Beyond Valuation
Most of us in this business have an exalted view of Benjamin Graham and value investing, for good reason. Who doesn’t want to buy $1.00 for seventy cents? Analysts across the globe rightly spend their days in search of that undiscovered or unloved name the market has forsaken. The problem, of course, is how you define value. Too many people in our opinion use a low multiple as the defining ingredient and therefore limit themselves to too narrow a universe. It is possible to find value in high multiple names. In fact, we think that’s where some of our best ideas come from.
What do the following stocks have in common: Abiomed, XPO Logistics, Nutanix, EXACT Sciences, Ring Central, New Relic, HubSpot and iRythem Technologies? All of them are high valuation stocks. They have also all produced returns greater than 100% over the last two years with some up far greater. All were or are holdings in our small cap growth strategies.
If you hold out a shingle as a small & mid cap growth manager, you must be willing to buy stocks that appear to carry high valuations. The key to buying these stocks profitably is to be able to distinguish between a high multiple signaling good things to come and a high multiple merely as a reflection of good times passed. It’s not as simple or obvious as it sounds. The ability to make this determination requires experience, deep fundamental analysis, a thorough understanding of industry dynamics and an investment process that encourages independent thinking and the taking of calculated, informed risks.
Many investors dismiss investing in high valuation stocks for a variety of reasons. Typical excuses include: they’re too expensive; I’ve missed it; there is no margin for error; it doesn’t screen well. The excuse heard least frequently is also the hardest to admit – it takes a lot of experience and analysis to determine if a high valuation stock is a worthwhile investment.
When analyzing high valuation stocks, the investor must first admit that every situation is unique. Most of these names are expensive for a reason – either past success or high expectations for future success. The sweet spot is where future expectations, high in an absolute sense, actually underestimate the opportunity set. The reasons for underestimating the opportunity set are many and often include:
• TAM (total addressable market) is greater than perceived
• Duration of growth is greater than expected (many analysts model in growth deceleration too quickly)
• Potential for market share is underestimated
• The opportunity for ancillary product introductions is under appreciated
• Cost of goods sold is lower because of manufacturing or material science innovation
• Leverage will be greater than expectations
The commonality in these factors is innovation. Successful high multiple companies – companies that earn their multiples – usually possess a product, technology, manufacturing capability or distribution model that is disruptive to a large market. The key is to be able to analyze, identify and forecast the potential dislocations.
Abiomed was the best performing stock in the S&P 500 last year. In July 2016, when it was still a small cap, it was trading at $125 and 48x consensus estimates for FY2019, this current fiscal year. Abiomed has been so successful the past three years, its consensus earnings estimate for March 2019 is now around $4.50, which amounts to 27.7x what we paid in 2016, well below the growth rate of earnings actually produced. What happened? Four of the six bullet points we identified above were realized.
Abiomed has earned product approvals and market expansion and lack of competition has led to the company’s Impella heart pump becoming the standard of care.
It wasn’t that obvious in 2016. There were many doubters then. In fact, ABMD lagged relative to the index for a prolonged period, and then its products became entrenched and earnings followed. Abiomed is also emblematic of another truth in growth investing: active management adds value. Growth investing requires almost encyclopedic understanding of every name in a portfolio. No small task.
Growth investing also lays waste to something that should be dead and buried already: the Efficient Market Hypothesis (EMH). There is undiscovered value everywhere. Finding it is work, and requires a manager to think outside the box. And EMH has been telling us for years that all boxes are the same, and it isn’t worth finding a new one. We would posit that those that believe in EMH have never spent a day managing growth strategies and have never beaten an index.