Growth investing principles

Many investors think of growth in terms of high returns on invested capital (ROIC), or high returns on equity (ROE).  The problem is both of those figures are backwards looking.  An ROE metric, or ROIC metric will tell you what a company did in the past, not what they'll do in the future.  ROE's are not predictive, think of a pager company in the late 1990s.  They were posting fantastic ROEs, now their products are being sold in slummy parts of town next to check cashing stores.  A more contemporary example is Blackberry.  A company who posted excellent results year after year, but those results didn't predict the quagmire they're in now as their products fell out of favor.

In some ways it's simple to discover if a business will be successful.  Successful businesses offer products and solutions to clients that provide clients more value compared to the value they give up to purchase the product.  If that last sentence confuses you re-read it and think it through.  A buyer gives up something of value (often money) to purchase something of greater perceived value.  This is the essence of a sale.  If a buyer doesn't perceive value from a product or service greater than what they're giving up they won't purchase, no matter how many steak dinners a salesperson takes them to, or how cool the commercials for the product are.

The first step to finding a growth company is finding a company with a product that satisfies an essential need.  This sounds easier than it is.  There are many products that seem essential, which under the magnifying glass are just 'nice to haves'.  Consider the context of the product.  Users don't need a Macbook to exist, but a graphic design studio might not survive without one.  Often the most successful products fill very specific needs, that if left unfilled would leave the purchaser in a very vulnerable position.

It's easy to see how a company selling products to another business fills this role  Think about a company selling conveyor belts in an assembly plant.  Conveyor belts seem like a commodity item, yet to the purchaser without them their assembly plant would be at a standstill.  They need conveyor belts that are so reliable that they don't need to think about them.  The best products are ones whose users never think of them when they're working well.  The worst products are ones where users are constantly thinking about them.

Maybe it's hard to see where a consumer product fits into this mix.  Why does a person need Under Armor, or Starbucks?  The answer to this is found in Ca$hvertising (I'm currently reading it, and so far would recommend it to those interested in marketing).  The author states that there are eight life forces that we are biologically programmed with the desire to satisfy.  These forces are: survival and enjoyment of life, enjoyment of food and beverages, freedom from fear, pain and danger, sexual companionship, comfortable living conditions, to be superior and win, care and protection of loved ones, and social approval.  Products that serve these life forces satisfy a consumer's biological desire. Consider Starbucks, they fit enjoyment of food, and social approval, two life forces.  Under Armor fits comfortable living conditions and survival, we need clothes to protect us from the elements.

Create a product that meets a life force, effectively make potential customers aware of the product and a company has a success on their hands.

Creating awareness and product marketing is often misunderstood.  Posting quotes on Twitter, or creative ads isn't great marketing.  Marketing is using a medium to sell a product.  As Claude Hopkins said in Scientific Advertising (the Security Analysis of marketing):

The only purpose of advertising is to make sales.  It is profitable or unprofitable according to its actual sales.  It is not for general effect.  It is not to keep your name before the people... Treat it like a salesman.  Force it to justify itself.  Compare it to other salesmen.  Figure its cost and result.

 

Marketing is a different type of sales.  Marketing that can sell products is powerful and valuable.  A great example of this type of marketing is Proctor and Gamble.  They product a variety of products, each is too small for a salesperson to sell to the end consumer.  So the company sells through their marketing.  They treat marketing like a science.  They sell to consumers through their ads in magazines, on the radio and on TV.

For a company to develop the correct product, target its market, and then market and sell effectively takes the correct set of people.  A successful company needs capable management that listens to their employees.  Take this quote from the creator of Crystal Pepsi for example:

It was a tremendous learning experience. I still think it's the best idea I ever had, and the worst executed. A lot of times as a leader you think, "They don't get it; they don't see my vision." People were saying we should stop and address some issues along the way, and they were right. It would have been nice if I'd made sure the product tasted good. Once you have a great idea and you blow it, you don't get a chance to resurrect it.

 

The executive thought the idea was brilliant and charged forward without stopping to consider if the drink ever even tasted good.  The executives reports were telling him to stop and reconsider, he didn't listen, he just marched forward.  As a result Crystal Pepsi was a failure, something that many in the company knew before it launched.

The last ingredient a company needs for growth is a large addressable market.  A company selling barber shop poles is going to struggle to grow as there are only so many barbers, and the number is shrinking.  A growth company needs to be in a growth industry.  There are plenty of niche profits in servicing obsolete markets, but these are long tail declining profits.  Growing profits come from growing markets.

If we put it all together the ingredients for success for a growth company are: product that serves a vital need, excellent marketing and sales, and employees/management that can pull all aspects together.  A company needs all of these elements to become a successful growth company.  It's like a three legged stool, if any leg is missing the stool falls over.

The difficulty a public market investor faces is that much of the vital information needed to make a decision about growth companies isn't in a 10-k or 10-q.  So how does one go about finding these companies?  Get out and talk!  The best place to start is a company with high margins, and revenue growth.  Spend time talking to the company's customers.  Ask why they purchase from the company under investigation verses a competitor.  Talk to suppliers and former employees.  Then finally talk to management.  Understand where they see the future and how the company plans on getting there.  Good management is key to navigating a company through growth.  Companies hit plateau's that need to be carefully approached.  Often the best leader is one who's been through growth challenges in the past.  A good leader is also one who is willing to listen.  A know-it-all executive is a red flag.

If a company has a great product, and a way to get it to the market then it's the people that make or break the company's success.  Great people will take a great product a very long way.  Lousy people will find a way to destroy products with incredible potential.

Maybe all of this sounds very hard, and like a lot of work.  That's because it is.  The rewards of investing in a growing company compensate for the work required.  It's not uncommon for a growing company to rise 5x, 10x or more over a number of years.  Likewise a growth hopeful won't just sit flat, it'll fall like a rock if expected growth isn't achieved.

In my view growth investing is best left to professionals and individuals who have a lot of time on their hands to do intense feet on the ground research.  Finding good growing companies is a lot of hard work, but hard work alone doesn't ensure success.

One problem with finding growing companies is that there aren't many of them.  There are a lot of companies that are growing, but not a lot of companies that have all of the attributes necessary to take their business from $10m a year to $500m a year.  Most growing companies will stall out, or will encounter culture problems as they hit certain levels.  Very few companies that look good remain that way for decades, or even years.  A big risk with investing in growing companies is paying a growth price for a company whose growth isn't sustainable.

Finding good growing companies that are wonderful businesses is difficult.  You might be wondering if there's an easier strategy?  There is a much simpler way to invest in growth businesses, but the simplicity eliminates a lot of the outsized returns associated with this strategy.  The simple way is to buy the leading company in a growth industry during a temporary downturn.  When industries go through crises it's usually the top company in the industry that comes out stronger.  The top company in an industry is often the most efficient and growing the fastest.  There is a reason they are at the top of their industry.  Buying during a market dip ensures an investor doesn't overpay for this marque company.  While this approach might beat the market, it pales in comparison to the returns of the investor who can correctly identify great growing companies.