US Equities: Too big to grow?
No company can grow its earnings forever, but drawing the ‘ex-growth’ line is almost impossible. Joseph Mariathasan delineates the characteristics of pro-growth mega-caps from the US equity market
Companies cannot grow forever, that much is obvious.
“You can have a relatively small company and think initially that the company can grow forever,” says CT Fitzpatrick, founder and CIO of Vulcan Value Partners. “But, in reality, if it stays true to the core business that gets it to its successful position, it cannot continue growing at its historical rate, when it dominates the market.”
Or, as Matthew Benkendorf, portfolio manager at Vontobel Asset Management, puts it: “How many cans of pop can Coca Cola sell?”
But, of course, as both observe, deciding at what stage a company has reached its ‘post-growth’ phase is not straightforward. Apple has enormous market share, global distribution and a strong brand. But many anticipate a lot more growth from this remarkable company.
“Most mega-caps are low, steady growth companies that pay a healthy dividend,” says Dennis Lynch, head of growth investing at Morgan Stanley Investment Management (MSIM). “They can be very good investments and many come with good growth opportunities even if they are not super dynamic.”
GMO identifies high-quality companies as those with high, stable profitability and minimal use of leverage.
“We find that this definition tends to highlight the types of companies that have built strong competitive positions through a variety of techniques including strong brands, patents, and economies of scale,” says Tom Hancock, co-head of Global Equity. “On average, these competitive advantages persist over time – the highest quality companies tend to maintain their high profitability for years into the future. Slower top-line growth is not, by definition, a bad thing for high quality companies: persistent above-average profitability enables a high-quality company experiencing slower growth to redirect capital otherwise earmarked for growth in shareholder value-enhancing activities such as dividends and share buybacks.”
So high-quality mega-caps need not be completely ‘ex-growth’ or ‘post-growth’. But they may not grow any faster than GDP in general over the long term. Deciding when a company such as Apple has reached that position is not clear. Recent price movements suggest that many investors think it is there already – but they do not go unchallenged.
“Apple is priced as a value stock,” says Fitzpatrick. “That is a very nice place for us to be as you have a stock that may not grow as fast as in the past but will still grow at an attractive rate – but is priced as though it will not grow at all.”
The limits to growth are dependent on the business strategy that a company chooses to follow. As Nick Thompson, director of US equity strategies at Janus Capital Group argues,
Dell may have limited prospects in computer hardware manufacturing where its business model of quick delivery and cost no longer gives it any competitive advantage, but Apple has built an ecosystem around a seamless integration of innovative products and applications that goes way beyond production of commodity hardware. Thompson asks if the limit to Apple’s growth should be set when every person on earth has an iPhone.
Possibly – but even that apparently clear line is complicated by the fact that it could introduce an equally successful product in the future on the one hand, and the fact that it faces an uncertain level of future competition from the likes of Samsung on the other.
There are some clear characteristics that successful, growing mega-caps possess. Warren Buffet favours companies with an economic ‘moat’ that protects them against competitors. His recent bid for Heinz exemplified this: he bought a well-known brand name, pricing power and large market share.
But disruptive technologies and business models can overwhelm even the widest moat. Kodak is a classic example: its domination of photography could not withstand the impact of digital technology. Even Microsoft, once renowned for the depth of its moat with its ubiquitous Windows operating system and Office software packages, faces a number of challenges.
“The push to cloud computing means that companies are giving away software or offering it by subscription, which makes the economics less attractive,” says Lynch at MSIM.
Intel’s famous ‘Intel inside’ slogan reflected the fact that its processors dominated the PC market, but it now faces challenges as smart phones and tablets take an increasing share of computing power. “They are using processors from ARM Holdings whose designs use less power and therefore are more suitable for hand-held devices,” Lynch explains.
But disruptive technologies can also resurrect ailing industries. As Thompson points out, the lower US energy prices resulting from the hydraulic fracturing revolution, combined with increased labour costs in countries like China, may lead to a renaissance of US manufacturing and is already boosting free cash flow at US chemical producers.
In addition to Buffett’s ‘moats’, Benkendorf looks for companies that are able to get better as they get bigger. The two certainly do not always go hand-in-hand – just look at the banking industry. Citibank has a global footprint, but its value lies in having strong local franchises in countries like Mexico that often have few synergies with its US operations.
Banking in the post-crisis world is likely to be a utility that grows in line with GDP. The insurance industry is a case in point. Locally regulated, its capital is required to be domiciled domestically, giving few benefits from size beyond reducing overall volatility of results.
At the reinsurance level, however, size can bring benefits because of the nature of the business and the size of the transactions. Buffett’s own company, Berkshire Hathaway, is a pre-eminent example of this (although high-quality management helps – the business that is turned away is just as important as the size of premiums that are received). Elsewhere in financial services – or is it really technology? – Fitzpatrick sees credit card companies such as Visa and Mastercard, already massive and an oligopoly, as both having the potential to grow much faster and the ability to become better as they get bigger.
The third key characteristic, which virtually all mega-caps have, is the ability to seek customers in emerging markets. High-quality consumer staples companies may be mature in the developed markets, but their growth potential lies in emerging markets.
“Brands can define a person’s position in society,” says Thompson. “Individuals look to developed-market brands as a sign of quality and an expression of wealth – and many of those brands are US.”
Developing that brand recognition and loyalty in the next decade or two in China and in India alone would generate exposure to growing middle class pockets of wealth among populations that encompass one-third of humanity.
“Unilever has a current enterprise value of $110-120bn [€86-92bn] but over long time periods, it has the potential to be much bigger because it has been in emerging markets for a long time,” says Lynch.
Some argue that Unilever could end up bigger than Apple. Proctor & Gamble is the nearest US equivalent. But while it has the potential to emulate Unilever, Fitzpatrick sees Unilever as executing its strategy much better, both in terms of expanding in new markets and holding its own in its struggling domestic environment.
“Proctor & Gamble has not delivered the bottom-line results they should have and have underperformed their potential – in contrast to Unilever, which is doing a super job,” he says.
For Benkendorf, the US technology sector is one of the most attractive environments in which to hunt for the future mega firms among today’s large-caps. Here are companies with high moats, getting better as they get bigger, building emerging-market footprints.
“Technology has some better days ahead of it, and for us it means taking a big bite of the right apple over the next 5-10 years,” he says. “The wars have been fought now, and the franchises are much better defined. The victors can now claim their spoils.”
Google is a good example. Lynch points out that even though Google takes in $50bn of advertising revenue each year, that still represents less than 10% of the $600bn annual global advertising market.
“There is still a huge mismatch between advertising spend on the internet and that on TV compared to the actual amount of time people spending on each, even though it is shifting,” says Benkendorf.
Amazon is another company that Benkendorf sees getting better as it gets bigger. Lynch sees it not as a retailer but as a logistics company, and says that the cost of competing with it is far higher than competing with high street retailers. “Its infrastructure has become so powerful that it can rent it out to other companies to sell goods and offer web services through cloud computing,” he says.
Outside of genuinely disruptive technologies and business models, there are few discernible threats to the very best mega-caps once investors have accepted that they can still achieve growth. “The biggest risk for most the companies we own is anti-trust regulation in the US that will force them to split apart,” says Fitzpatrick. “We don’t like that problem but we certainly prefer it to others that we might have.”
These US companies – and they do tend to be US companies – may be insurmountable with their wide moats, their ability to gain improvements as they gain size, and their growing footprints in the emerging economies of the world. Valuations can be a challenge and, as Apple shows, disagreement over the size-to-growth potential ratio can result in volatility, but ultimately these are fast becoming the solid core of many long-term portfolios.