Stocks fell sharply after Fed Chairman Powell warned of the possibility that the Fed might increase the Fed Funds rate by 50 basis points if economic and inflation data prior to the meeting is as strong as it was in January. With those comments, the futures markets’ odds of a 50-basis point increase immediately went from under 30% to over 70%. Bond yields also popped with the 10-year Treasury once again approaching 4% while 2-year bonds moved back over 5%. With all that said, bond yields remain within their recent ranges and there is plenty of data still to come before the Fed meeting starting with Friday’s employment report that could shift market sentiment once again. As I have noted, I expect a bumpy market without strong direction for the next several months until there is better definition of inflation’s direction.
With that said, I thought today I would amplify on a thought I express often in these Comments that in a relatively flat market going forward, successful investing will depend on finding stocks of companies capable of growing faster than the overall economy. If the economy, long-term, can grow 1-2% plus inflation of 2% or slightly higher, relying on the economic tailwinds will only yield nominal growth of about 4%. That is far below historic norms of close to double that rate. 4% does not add in the benefits of dividends which, for the S&P 500, currently add about 1.7%. Share buybacks could add a bit more, but combining normalized growth, dividends and the benefit derived from stock repurchases, returns probably won’t get you above 6%. That doesn’t sound bad, but, at least at the moment, with money market funds yielding close to 5% and short-term Treasuries yielding even more, 6% doesn’t sound like a great deal given the added risk one takes investing in equities.
In a market generating total returns for equity investors of close to 6%, one could expect some stocks to do better and some to do worse. Over the long-term, if there is one economic indicator that correlates most with stock performance, it would be revenue growth. Simply put, faster growth is the secret sauce for better long-term stock performance.
At Tower Bridge Advisors, we invest using a philosophy with the acronym GARP. GARP stands for growth at a reasonable price. Note that the first word is growth. If the company you are investing in stands still and doesn’t grow, the odds are high that, over any extended period, its stock price won’t increase much. Growth comes first, but valuation also matters. Thus “at a reasonable price” must be taken into consideration. What’s reasonable? A lower P/E is a good start. Lower than the market, lower than its peers, and lower than its historic norm. With that said, today I am going to focus on growth.
Growth can come from many directions. It could be the result of industry growth. Maybe it relates to a new product or service. The Apple iPhone is a classic example, but new products aren’t exclusive to the tech sector. Tide Pods allowed Procter & Gamble to not only gain market share, but the convenience factor allowed P&G to get a better profit margin. New products either displace an existing product (e.g., the Tide Pods) or they create new markets that never existed (e.g., the microwave oven). But new product revenues don’t grow indefinitely. Eventually, they get superseded by other new products. Digital cameras obsoleted traditional film cameras only to be usurped by smartphone cameras. In the computer world, mainframes gave way to minicomputers which gave way to PCs, which ceded share to laptops and finally to smartphones. Technology moves rapidly requiring companies to pivot constantly. Sometimes the new product is a fad that dies quickly. Think of GoPro cameras or Peloton bikes.
The Holy Grail is the creation of a new market that can grow for decades. Internet retailing, search, cloud computing, and the smartphone are such examples, but even in these cases, growth isn’t infinite.
Healthcare offers similar opportunities. Biotechnology revolutionized the drug industry. Today we are seeing new waves of products developed with advanced genomics and CAR-T technology. In the drug world, patents rule. It often takes a decade or more to bring a new discovery to market. The remaining patent life can often be less than a decade.
Sometimes, the better mousetrap seems utterly simple. In the 1960s, fast food restaurants like McDonalds# emerged. A hamburger, French fries, and a Coke cost $0.50 or less and the French fries were the best! Over the years, McDonalds added menu items, put in playgrounds, and pivoted generating most of its sales through its drive-thru windows. Today, more than 60 years later, it still executes better than anyone and continues to gain market share with a remarkably simple menu and a fanatical focus on always improving execution. Selling a hamburger and a Coke sounds simple enough, but no one in six decades has beaten McDonalds to the punch. McDonalds doesn’t stand alone. Think of category leaders like Nike, Lululemon, Home Depot# and Chipotle.
Some growth companies aren’t immune to economic cycles. In technology, the semiconductor sector comes to mind. Almost all manufacturing companies are cyclical. Producers of capital equipment are most cyclical. That doesn’t mean they don’t grow at solid compound rates across business cycles. Names like Deere and Caterpillar come to mind. It would be helpful not to buy either at the top of a cycle. But over time, they outperform largely because of better execution.
For all, there is a common ingredient…management. Staying static almost guarantees failure. There are no components of the Dow Jones Industrial Average who have been in the average since it began. Very few companies last 100 years. Huge names from just a generation ago are gone or close to oblivion. Eastman Kodak, Sears Roebuck, Pan American, RCA, Zenith, JC Penney, AOL, and Xerox are just a few names that come to mind. Did I mention Penn Central? As the world changed either these companies didn’t or they tried and simply failed.
Sometimes, new management can turn around a tired company or perhaps, it simply improves upon what’s already there. It’s probably fair to say that each new CEO is either superior to his predecessor or worse. Superior means accelerated growth and market share improvements. In some cases, when the predecessor was top notch, successors have a hard time. Take Microsoft. Founded by Bill Gates, the company was one of the classic growth companies from 1980 into the start of this century. It rode the coattails of the PC boom. Windows was the majority operating system for the PC industry. Gates’ right-hand man, Steve Ballmer, succeeded him and kept to the Gates roadmap. The only problem was that the industry was changing. PCs weren’t stand-alone desktop devices anymore. They were networked. The Internet made the operating system less important. The focus changed to the enterprise and not to stand-alone devices. Ballmer didn’t pivot. Microsoft started to stagnate. Fortunately, there was another CEO change. Satya Nadella replaced Ballmer. He saw with much great clarity where the computing world was headed. Windows became secondary. Cloud computing was the new opportunity. Software was sold as a service via annual subscription and support. Microsoft took off once again. Now it faces a new world, one where virtual reality will create new opportunities. Microsoft appears ready. Will it be the leader again? Only time will tell, but it is developing lots of resources to be a leader. The odds favor some degree of success.
No crystal ball is perfectly clear. In the 1990s AOL dominated email while Yahoo was the leader in search. They didn’t last. Microsoft and Google disrupted the disruptors. That is a constant hazard in technology. It’s nice to create barriers to future competition but those barriers don’t always last. Moats dry up.
So, let me wrap this up.
1. Growth matters. Name a long-term success in your portfolio and it almost certainly has grown over time at least as fast as the overall economy.
2. Growth can be based on new products, increased market share, or better margins. Almost always it depends on superior management and a solid balance sheet to fund what is needed to grow.
3. Great companies always pivot. Think of Apple. The iPod, a device that played music morphed into the iPhone. Then Apple added services like the App Store, Apple Music or Apple Pay. Microsoft’s focus changed from the desktop to the enterprise, from the closet supporting an office network to the cloud servicing the universe. Now its focus pivots to artificial intelligence.
4. Valuation always matters. Buying growth at any price works often but takes a licking when euphoria in the stock market bursts.
5. Great products and great companies are not synonymous. A hot product usually has a short half-life. Great products can be the seed of great companies, but only if management can build on initial success.
6. It’s hard to grow without a solid balance sheet. New companies get support from early investors, but in the end, they must generate cash flow to maintain growth. That is particularly important in tough times. Your friends during euphoric periods don’t want to hear from you when you are bleeding money during a recession.
We can all name great companies from the past. Finding the next great company is more challenging. It’s a combination of outstanding products, superior service, constant innovation, and top flight management. There aren’t many. You don’t have to discover them at the beginning, but you do need to find them before the rest of the world drives the stock price too high. You can find them by reading analytical reports, but you can also find them through personal experience. We all cross paths with companies like McDonalds or Nike constantly. I was once asked to explain the stock market to a third-grade class. I asked them which they liked better, McDonalds or Burger King, Six Flags Great Adventure or Disney World. Guess what? The third graders got it right. So can you.
Today Mickey Dolenz of The Monkees is 78.
James M. Meyer, CFA 610-260-2220