Investing in growth companies can add significant alpha for equity investors. As a business builds and scales up, investors can profit not only from the perspective of an earnings increase but also the multiple that investors are willing to pay for those profits. However, as with all investments, higher rewards are commensurate with higher risk.
This risk requires intense focus; not getting it wrong is as important as getting it right in the search to generate alpha for our investors. Growth puts strain on a company’s management, workforce and infrastructure that may not be apparent until it’s too late. Modest, single-figure growth per annum can be effectively handled by a good management team. However, experience shows that annual growth above 15% - what we term ‘super growth’ – requires a different level of due diligence, to better understand the risks a business is taking.
Going the extra mile
Part of this focus on risk involves the usual financial analysis of a company and an attempt to forecast its earnings power, cash flow and balance sheet risk. But a successful investment strategy cannot be run solely via spreadsheet. There is another side to the investment equation that is equally important: regularly undertaking company visits with investee companies. We also extend our visits to a company’s suppliers and competitors. And of course, we meet with prospect firms.
This embedded process offers several advantages. Seeing management teams at investor roadshows offers no differentiating insight when they are overloaded with investor and fund manager meetings. You rarely get more than an overview and are unable to dig deeper into structural and growth issues.
On other hand, when visiting a company’s head office and principle operational locations, you see management in their natural habitat. In this relaxed setting, they are often more open about the long-term structural and strategic issues facing the company. Moreover, visiting a company’s site exposes you further to the equally important layers of middle management.
You can also see how the company has invested in its facilities, gauge expansion potential, assess stock levels and myriad other capital items. It is also easier to pick up on ‘soft issues’ such as how well the management team interact with each other, inherent conflicts, workforce quality and working conditions.
MiFID has accentuated the need for fund managers to increase the quality and quantity of their own research, due to the increasing paucity and declining quality of broker research particularly for small cap stocks. Therein also lies the opportunity, as this creates a more fertile bed for the patient and diligent investor to find real hidden gems with long-term potential.
There are multiple practical examples that prove company visits assist not only in finding great growth stocks, but also as importantly in avoiding poor quality companies. Two excellent recent visits we have undertaken were to relatively new IPOs. JTC, a trust business based in Jersey; and Knights, an emerging legal firm with an administrative centre near Stafford.
After initial investor interest share prices in both had drifted. The visits allowed us to spend significant time with senior and divisional management and understand that both firms were even better investment opportunities in terms of longer-term growth opportunities than we had initially believed. We have since substantially added to small initial positions.
A classic example last year of avoiding problem companies was the spectacular collapse of Conviviality, a bargain alcohol chain put together through a series of acquisitions by seemingly competent, experienced management. It was, in some ways, a classic growth stock – until the wheels quickly came off.
In reality, it was a low-margin, cash-consumptive distribution business combined with an underinvested retail business. Operationally these are complex businesses and putting together a number of such companies in a short timescale was always going to be challenging. In reality, management totally lost control both operationally and financially, resulting in a total loss. Having undertaken company meetings and visits and knowing the quality of some of the businesses from previous ownership, we declined to invest.
Company visits are time consuming, not only because of being out on the road constantly, but also due to the substantial preparation that is necessary. The payback, however, can be substantial. Company visits are invaluable in finding great accompanies and trying to avoid those seemingly attractive growth opportunities that are anything but.