One growth can hide another

Netflix yes, Tesla no: don’t confuse quality growth with hypergrowth. Dealing with the exuberance of the market with Hollie Briggs of Loomis Sayles.

The first quarter of the year saw very unusual valuation gaps among quality growth companies, which have been less popular in recent years than hypergrowth stocks, i.e. those whose top-line revenue grows by more than 10% consecutively for each one of the next five years. An interesting period for Loomis Sayles, who made quality growth stocks a specialty and alpha generation heart for all of his stock strategies. Hollie Briggs, vice president and director of product management on the Equity Growth Strategies team at Loomis, Sayles & Company, looks back on those turbulent times.

“One of the main things we look at before investing is the company’s ability to generate free cash flow.”

How did you manage the increase in certain Growth stocks at the start of the year?

Our growth equity strategy has always been to follow a strict valuation discipline. We resist the siren calls of scarce, impulse-based markets and invest in high-quality growth companies only when the company’s stock is selling at a significant discount to our estimate of the company’s intrinsic value, partnership, or actual value.

In 2020, following the Q1 “Covid Crash”, a relatively small number of low-quality remote work stocks saw exceptional returns, well above 100%. The expectations embedded in these bubble-like valuations demonstrated a novelty appetite bias, in which investors assumed that the revenue growth induced by the containment environment related to the pandemic would continue indefinitely into the future.

In our experience, periods when market leadership has similarly focused on a select group of companies on a trending topic are often harbingers of major inflection points and significant corrections for these companies with strong potential. Thus, in 2000 and 2008, the stock prices of high-performing companies underwent significant corrections at a time when the benchmark index and our benchmark group had substantially high exposures. Our bottom-up analysis of 2020 hypergrowth stocks is consistent with the behaviors we’ve seen at previous inflection points. By the end of 2021, we had already seen that some of these home office stocks, like Zoom or Peloton, had lost 40% to 60% of their maximum value. Credit Suisse HOLT has tracked a group of hypergrowth stocks for over 40 years, dating back to 1980. Despite some stock price corrections in 2021, 98 companies met the hypergrowth criteria at the end of last year. The history of the last few decades belies that this expectation can be fulfilled. In fact, since 1980, only 69 companies have achieved this high level of revenue growth. That’s about two a year on average. If all 98 hypergrowth companies in 2021 are successful, that would be about 50 times the historical annual average for the past 40 years. These levels of appreciation have not been seen since the dot-com bubble of 2000. These experiences lead us to believe that the scenario will not be fundamentally different this time around.

This approach has led us to keep a cool head and maintain our discipline, investing only in high-quality, profitable, secular-growth companies that are selling at a significant discount to our estimate of their intrinsic value.

What is this difference?

One of the key elements that we analyze before investing is a company’s ability to produce free cash flow, that is, cash flow that it can freely use to finance its future growth. Along with low or no leverage, this feature can be even more crucial in an environment of rising fees where free money disappears for a while. Quality companies also tend to have high returns on invested capital and highly skilled management teams capable of efficiently allocating capital. Aside from quality, the biggest difference between the growing companies we want to own and the hyper-growth group of companies is valuation. Even when we think we’ve identified a high-growth, sustainable and profitable quality company, we’re still not satisfied. Unlike investors who outperformed home office stock valuations in 2020, we have not changed course and focused on high-quality growth companies and only invested when they present a significant discount to their intrinsic value – a potential gain versus risk of at least 2 to 1. Other things being equal, the greater the discount between the market price and our estimate of intrinsic value, the greater we consider our margin of safety. Our discipline is unshakable. In addition, our deep understanding of long-term structural winners who are selling at prices below their intrinsic value leads us to recognize structurally deficient companies that are selling at significant premiums to their intrinsic value and that are candidates to sell short in our Long/Short Growth Equity Strategy. So while we resist hypergrowth stocks in our long portfolios, they can create attractive short selling opportunities.

“We invested in Shopify, the 2ndand largest e-commerce platform behind Amazon in the United States.”

What opportunities in particular?

As 2022 wore on, investor exuberance gave way to fear as more companies reported disappointing results. Investors are now indiscriminately extrapolating short-term headwinds as fundamental shifts to longer-term opportunities. The other facet of novelty bias is the herd mentality. What happens today or on a day-to-day basis does not dictate what we will do in the long term, we look beyond the current environment.

The first quarter of 2022 created some rare entry points for investing in high-quality growth companies. After a significant correction from its 52-week high, we invested in Shopify, the 2ndand largest e-commerce platform behind Amazon in the United States.

Focused on the success of its merchants, Shopify’s architecture allows developers to build apps that extend the functionality of the company’s core commerce solutions. Today, over 8,000 apps are available to merchants on the Shopify App Store. Shopify is active in retail, which accounts for about $24 trillion in annual spend (excluding China). We estimate that today e-commerce has penetrated “only” 14% of this market, compared to just 3% penetration in 2006, when we bought Amazon, a rate that could, in the long run, exceed 30%.
We also invested in Netflix, whose share price also “goes back and forth” to levels at or below pre-pandemic levels. Even with the predicted loss of more than 2 million subscribers in the coming months, our long-term investment thesis remains intact. In fact, we took advantage of the recent share price drop related to this news to consolidate our position and reduce our average cost. In the same way that investors boosted Netflix’s share price in 2020 on seeing subscriber growth, they now believe its post-pandemic decline — not entirely unforeseen — reflects a fundamental shift in long-term opportunities. However, Netflix’s competitive advantages are strong and lasting. Netflix has over 10,000 hours of quality original content, twice as many as the next five competitors combined. With over 220 million subscribers representing approximately 50% of the SVOD market share, we believe the company has the potential to grow to 400 million subscribers within our investment horizon. We are also investing in Disney, whose streaming business will become increasingly important.

What about sales opportunities?

During the first quarter, we sold Cisco Systems, which we have owned since 2006, primarily to reallocate capital to better risk-return opportunities. We also sold Colgate and our long-standing position in Schlumberger. This might seem counterintuitive in an environment where oil companies have been boosted by the energy crisis we are facing. Regardless of the environment, we realized that our original investment assumption had not fully considered the impact of volatility in the industry, which reduces the intrinsic value of any business. We took the opportunity to sell in good condition to go out.

1 Source: Credit Suisse HOLT.

Leave a Comment