Growth investing has to go beyond the obvious
I find nothing exciting to buy now.” I was surprised to hear this and other similar views from exasperated peers at a recent event. Such statements echoed in that chamber which was hosting about a hundred investors from across the country. That evening, I wondered what such interactions really meant to me. There weren’t any obvious great ideas in the market to invest in. The obvious ideas had all been taken, occupied by early-stage value investors, momentum investors, and mutual funds. So, investors are left with mostly tough choices. What makes the choices tough is that they don’t look greatly promising in the near term. We all knew it. So, why complain? All we needed to do was study the available choices and then decide if we need to try something new in our investing approach.
So, I started combing the choices. Our current choices are actually arranged over a wide array. We have the initial public offers (IPOs) of good businesses that look badly mispriced (actually overvalued). Then, there are companies that will do well for a fairly long period of time but don’t seem to offer much margin of safety over the near term. We also have commodity options like metals, where the domestic consolidation and restructuring will leave the field narrow and nimble. Last, we have companies that have raised money from large investors recently and are taking a pause to create assets.
As far as the array of companies goes, this looks like a fairly broad range of choice. Yet, individual investors seem diffident to rush into these decisions. So, why aren’t we seeing anything exciting?
The reason is simple. Most investors have placed greater emphasis on acceleration of earnings over the last 2 years to create wealth. The combination of earnings acceleration and multiples expansion has worked extremely well for most of us. Growth made it easy to achieve the desired results. Commodity prices softened and this abetted rapid earnings expansion. Now, with most of the companies’ earnings growth slowing and commodity prices rising, their earnings seem to be struggling to keep pace with investor expectations. To make things tougher, the valuations of such companies look stretched. Straightforward growth investing has run its course. Buying a growing company at an attractive price-to-earnings (P-E) ratio and watching the P-E expand quickly gave us bumper returns. All one needed to do was study the quarterly numbers regularly and anticipate which company would see a positive swing in the next few quarters. As primitive and crude as it sounds, such analysis has actually given the most compelling returns over the past year.
But now the pressure to discover new ideas is high and the markets have discounted most near-term plays of profit transformation. We can no longer merely study the quarterly profit statements regularly and bet on companies. The game is definitely set to change.
So, where is the market’s investment ideation moving? Ideation is mostly moving away from the profit growth driven model to a balance sheet driven one. We will now see companies that are showing adequate will to transform their balance sheet and those which have ample room to effect that transformation to deliver the best returns. This approach involves an intense study of company balance sheets, identifying their stress points, formulating ways which could reduce such stress, anticipating events to play out, and looking for evidence of actual change on the ground. Quite obviously, such change will not be easy to identify or be self-evident. One needs to scout actively for evidence. Such evidence is widely scattered and needs to be pieced together. This is hardly simple. Actually, migrating from a simpler growth-driven ideation process to a complex transformation-driven ideation process is not going to be easy for most investors. It requires a trained mind, a hard-nosed approach to math, and a pragmatic bent to assess the rate of change. In some cases, mergers and acquisitions are holding the key to transformation. One needs to assess the potential of such M&A activity and assess their impact on the companies much before we see any evidence on the ground.
Anticipation in balance sheet driven investing is of a significantly higher order than in plain growth investing. So, we can safely conclude that opportunities are aplenty. But, there isn’t an easy and straight way of playing them. Our future investment ideation approach needs to be far more nuanced and detailed. Yet, I daresay that this space is also seeing an intense competition among investors. Ideation of turnarounds is an important pursuit. We are getting into areas where we don’t see near-term profits and yet find the investment idea compelling. But ideating a slow growth idea is never going to be easy especially if the immediate future looks uncertain.
One simple rule to remember when one moves over to balance sheet driven, transformative investing is: if you want to grow your investment ideas, you need to demolish your expectations. The art of waiting becomes the most important. For example, if an investor is rebalancing her portfolio because equity allocations have gone up, she can invest in liquid assets till suitable stocks are found. For investors who seek to always keep it simple, the best option would to stay in liquid assets and wait for valuation of growth plays to moderate. Make your own pick.
Shyam Sekhar, founder of ithought, an investment advisory firm
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