The recent surge in inflation, global political risks, and monetary tightening expectations are creating havoc in the equity markets, especially with growth stocks dropping significantly from their recent peaks
The recent surge in inflation, global political risks, and monetary tightening expectations are creating havoc in the equity markets, especially with growth stocks dropping significantly from their recent peaks. At this time, I believe it is important to reiterate the basics of the Growth Investing Strategy; how to put a value on growth, as to be able to differentiate it from overvalued investments.
Growth Investments are characterized by paying a premium on the current valuation considering the future potential in the business. Simply put, a growth investor is expecting the valuation to become attractive in the future based on the forward multiples. In this article, I discuss four parameters to identify Growth Investments in public and private markets.
For this parameter to be into play, the revenue of the company must be growing significantly such that by the end of the reference period, the EV/Revenue aligns or becomes cheaper as compared to the industry benchmarks. This is possible under the below scenarios:
The market size is growing and the firm is maintaining market share relative to competitors
The market size is growing and the firm is gaining higher market share relative to competitors
The market size is stable and the market share is growing
The market size declining and the market share is growing
Since we have to account for forecast risk in the investment thesis, scenario 1 is most likely to justify an investment to be categorized as a growth investment. In scenario 2, the incremental revenue is coming from both an increase in market size and market share. Therefore, the forecast risk increases as now we are considering an additional variable of market share gain in the incremental market size. Similarly, scenarios 3 and 4 have the highest forecast risk as we have added the variable of outperforming the competition which, in most cases, is unlikely.
A company may also be categorized as a growth investment if its EV/EBITDA shows a declining trend in the forecast horizon. The EBITDA can grow primarily because of two reasons. Increase in revenue and operational efficiencies.
The increase in revenue may result in a higher EBITDA margin in firms with a higher degree of operating leverage (DOL). These are firms with a lower marginal cost for producing and selling additional units. This concept can also be explained by economies of scale in which per-unit fixed cost is reduced by the increase in production. This theme of growth is very likely in early-stage start-ups and cyclical industrial units which have under utilized capacity.
The Second possibility of a higher EBITDA margin is an increase in operational efficiencies. This is difficult to execute as it requires cost rationalization or turnarounds. While such firms are genuine cases of a growth story, the risk of forecast error is very high.
Earnings growth is one of the more traditional indicators of growth stocks. Earnings growth can come from both revenue and EBITDA growth, in addition to a decline in interest or tax burden. While we have discussed the classification of revenue growth and EBITDA growth previously, we will focus on reducing the interest burden for firms with a high degree of financial leverage. Interest burden can primarily reduce because of:
Decline in benchmark rates: Interest rate cycles can be best predicted by subject matter experts, i.e. the economists. Investing in this story is taking a bet on the economic forecast and will be suitable during the peak of the interest rate cycle.
The company is expected to un-lever such that the interest burden is expected to be reduced significantly. This theme would work provided that the company has enough FCF and is willing to repay the debt.
It is a good practice to use the PEG ratio with expected earnings growth to differentiate growth stocks from overvalued stocks. However, both P/E and PEG have become unpopular recently because in some cases either the firms are not expected to become profitable in forecast-horizon or alternative parameters (EV/Revenue or EV/EBITDA) are more suitable for valuation.
A company can become attractive based on the current price and future free cash flow (P/FCF) when there is an increase in EBITDA, reduction in working capital requirements, and/or reduction in recurring CAPEX. While we have discussed EBITDA with the above parameters, both working capital and CAPEX can be projected with a high level of accuracy provided the analyst is aware of business fundamentals. A company showing a significant decline in P/FCF on a forward basis may also have the possibility of higher payouts (dividend story) and deleveraging. Robust FCF generation may also mean there are not enough avenues for businesses to invest in the future countering the growth argument. However, as of today, that still implies it remains a growth story on the P/FCF parameter.
Simply put, a growth investment would fit in any of the above 4 or multiple parameters. On the other hand, it will be difficult to attribute an overvalued investment to any of the above parameters or will have significant forecast risk.
Things to Lookout For:
The accuracy of projections. This is a function of analyst skill, industry fundamentals, macro outlook, luck, and several other factors. The higher the conviction of projections, the higher will be the probability that the investment is a growth investment.
The forecast horizon should be able to show the investment becoming attractive based on forward multiples. If a terminal value has been used in the 4th year of forecast when the company was still looking expensive, it is highly likely it is an overvalued investment as the terminal value may be overstated.
Do not rely on sell-side equity research reports. Chinese wall between IB and Equity Research doesn’t resolve the conflict of interest. It is unlikely that the Equity Research department will issue a “sell” report on an overpriced IPO or M&A executed by the Investment Banking Division of the same institution.
Remember, Rate hikes, inflation, and wars are all temporary but the Growth Investing strategy is forever. Hope you enjoyed reading. Please feel free to share your feedback.