Our growth equity strategy has always been and continues to adhere to a strict valuation discipline. We resist the siren songs of narrow, momentum-based markets in favour of investing in select high-quality growth companies only when the company’s stock sells at a meaningful discount to our estimate of the company’s intrinsic value, or true worth. In 2020 after the Q1 “Covid crash”, a relatively few, largely low-quality “work-from-home” stocks realized outsized returns, well in excess of 100%. The embedded expectations in these bubble-like valuations demonstrated a recency bias where investors assumed revenue growth driven by the Covid lockdown environment would continue indefinitely into the future. In our experience, periods when market leadership has been similarly concentrated in a narrow group of companies expressing a popular theme are typically precursors to major inflection points and substantial corrections in those high-flying companies. In both 2000 and 2008, high-flying company stock prices suffered significant corrections at a time when both the benchmark and our peer group had substantially elevated exposures. Our bottom-up observations of the hyper-growth stocks in 2020 are consistent with behaviors we have seen at prior inflection points. We had already seen by the end of 2021 that some of these “work-from-home” stocks – such as Zoom or Peloton - were off 40%-60% from their highs. Credit Suisse HOLT has followed a group of hyper-growth stocks for over 40 years, since 1980. A hyper-growth company is defined as one forecasted to realize at least 10% growth in each of the coming five calendar years. Even with some stock price corrections in 2021, 98 companies met the hyper-growth criteria as of the end of last year. The history of the last few decades belies that this expectation can be met. In fact, since 1980 only 69 companies have achieved this high bar for top line growth. That’s about two per year, on average. If all 98 hyper-growth companies for 2021 succeed, it would be about 50 times the annual historical average over the last 40 years. These valuations levels have not been seen since the dotcom bubble of 2000. These experiences lead us to believe that the scenario will not be fundamentally different this time. This data driven understanding leads us to keep a cool head and stick to our discipline, of high-quality companies with secular and profitable growth, which sell as a significant discount to our estimate of intrinsic value.
Even when we believe we have identified a quality company with high, sustainable and profitable growth, we are not yet satisfied.”
What is the difference?
One of the main elements we look at before investing and on which we base our investment thesis is a company's ability to generate and grow free cash flow, i.e. the cash flows it will be able to use freely to finance its future growth. Coupled with low or no debt, this characteristic may be even more critical in an environment of rising rates where free money is gone for some time. According to our definition, quality companies also tend to exhibit strong returns on invested capital and highly capable management teams who can efficiently allocate capital. In addition to quality, the biggest difference between the growth companies we want to own and the hyper-growth cohort is valuation. Even when we believe we have identified a quality company with high, sustainable and profitable growth, we are not yet satisfied. Unlike investors who bid up the valuations of “work-from-home” stocks in 2020 leading to embedded hyper-growth expectations, we seek to create a margin of safety by investing in a select group of high-quality growth companies only when they trade at a significant discount to intrinsic value. In fact, when buying a business, we require at least a 2:1 anticipated upside-to-downside, reward-to-risk opportunity. Holding all else equal, the larger the discount between market price and our estimate of intrinsic value, the greater we view our margin of safety. Our discipline is unwavering. What’s more, our deep understanding of structural long-term winners selling at discounts to intrinsic value simultaneously leads us to recognize structurally deficient companies selling at meaningful premiums to intrinsic value, which are shorting candidates in our Long/Short Growth Equity strategy. So, while we resist the hyper-growth stocks in our long portfolios, they may create attractive shorting opportunities.
What opportunities in particular?
As 2022 has unfolded, the momentum has shifted from investor exuberance to investor fear as more companies release disappointing earnings results. Just as we saw recency bias on the way up, investors now indiscriminately extrapolate near-term headwinds as fundamental changes to long-term opportunities. The other side of recency bias and herd mentality. We instead measure and monitor our long-term investment thesis for each company through bottom-up analysis of a company’s fundamentals, not by the fluctuation in daily stock prices. Our approach always looks beyond the current environment. What’s happening today or on a daily basis does not dictate what we will do for the long-term. The only relevance of what is happening in any environment is our pursuit of taking advantage of what is presented to us in terms of attractive valuations. Valuation drives the timing of our investment decisions for both long and short positions. Our conviction, as measured by reward-to-risk, drives our position sizes.
While we resist the hyper-growth stocks in our long portfolios, they may create attractive shorting opportunities.”
The first quarter of 2022, created some rare entry points to invest in high-quality growth companies. After a meaningful correction off it’s 52-week high, we have invested in Shopify, the 2nd largest e-commerce platform behind Amazon in the United States. Their business model is original because it allows merchants to create and manage their own online store and consolidate their sales from any channel. Also, their open platform technology approach is innovative. With a focus on the success of its merchants, Shopify’s architecture allows developers to build applications that extend the functionality of the company’s core commerce solutions. Today there are more than 8,000 apps available to merchants through Shopify’s App Store. Shopify is playing on the retail field, worth some $24 trillion in annual spending (excluding China). We estimate that today e-commerce has penetrated “only” 14% of this addressable market, up from just 3% penetration in 2006, when we purchased Amazon. We believe the penetration can exceed 30% over our long-term investment horizon. This is a tempting long-term perspective. We have also invested in Netflix, whose stock price had also done a “round trip” to at or below pre-pandemic levels. Even with the anticipated loss of upwards of 2 million subscribers in the coming months, our long-term investment thesis remains intact. In fact, we took advantage of the recent price weakness in the stock experienced on this news to increase our position and lower our average cost. Just as recency bias led investors to excessively bid up the price of Netflix’s stock price in 2020 due to pandemic level subscriber growth, investors now believe its post-pandemic - not wholly unanticipated – near-term decline in subscriber growth reflects a fundamental change in the company’s long-term opportunities and overreacted. Founded in 1997, Netflix is one of the world’s leading internet entertainment platforms and a pioneer of subscription video on demand (SVOD), which it first launched in 2007. We believe Netflix’s strong and sustainable competitive advantages include its focus, scale, brand, and a large installed base of clients that are protected by high barriers to entry. For example, Netflix has over 10,000 hours of original, quality content – more than 2x the next five competitors combined. With over 220 million subscribers, accounting for about 50% of SVOD market share, we believe the company has the potential to grow to 400 million subscribers over our investment time horizon. Despite near-term inflation concerns, we believe their long-term pricing power remains strong. Importantly, this is not a “winner take all” market. We are also an investor in Disney where we believe the streaming business will become increasingly important over our investment horizon.
What about selling opportunities?
During the first quarter of 2002, we sold Cisco Systems, which we had held since 2006, primarily to reallocate capital to better reward-to-risk opportunities. We also sold Colgate and our long-time position in Schlumberger. This may seem counterintuitive in an environment where oil companies have been buoyed by the energy crisis we are experiencing. Regardless of the environment, we realized that our original investment hypothesis had not fully incorporated the impact of volatility in the industry, which reduced our intrinsic value of the company. We took advantage of being able to sell into a rising market.
An interview with Hollie Briggs,
Loomis, Sayles & Company
and Allnews.ch - 28 April 2022