The great investment strategies: growth investing

In this new series, investing expert Julian Hofmann discusses growth investing, the rules you should follow, and how the great growth investors have made it work for them. The theory is simpler than the strategy is sometimes portrayed.

Growth investing – put simply, an attempt by an investor to actively grow their capital - is one of the hardest investment disciplines to master. It can sometimes feel like taking a punt on untried management, or new technology without any real idea whether they have long-term prospects. In short, it is not for the faint-hearted.

However, as with most of the great investment strategies, the nature and scope of growth has changed significantly, and investors can legitimately ask whether “growth” currently means buying a company’s monopoly market power.

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Growth investing can also be called capital appreciation, or capital growth, and is focused primarily on increasing investment capital within a defined time period. Unlike value investing, growth investments are not really concerned with shares that trade at a discount to inherent value, but rather those with the potential for exponential profit growth which can continue for many years.

Growth investors tend to accept the proposition that the relatively limited number of such shares will translate into higher earnings multiples at the time of purchase. Investing in a growth company is about limiting the amount you overpay for the shares, rather than trying to find a bargain basement deal.

When size isn’t everything

Growth investment tends to have a bias towards mid- and small-cap companies at a relatively early stage of their development. Medium-sized companies have historically outperformed large companies in terms of earnings growth as a proportion of total profits, rather than dividends still making up the greater proportion of total return. The ratio tends to reverse as a company matures and dividends become more important as profit growth slows.  

Analysing a mid-cap company for the purposes of growth investing is relatively straightforward. Having established themselves, they are likely to be profitable and will remain so as the business continues to grow, while the management team will have been in post for long enough to be well seasoned.

Key investment features of mid-cap growth companies:

1. Lower inventories and receivables

If a company is turning its inventory and receivables quickly into cash, this means higher cash flow and greater profits in the long run.   

2. High margins

High gross and operating margins are a hallmark of mid-cap companies and is a sign of high profits growth.

3. High current ratio

Mid-caps tend to have better balance sheets than smaller company equivalents. Look for companies with a current ratio (current assets/current liabilities) of greater than two, as this means the balance sheet is cash generative.

4. Well covered debt

A quality growth company should have debt of no more than twice current assets. This means liabilities can be paid easily with cash flow and makes the balance sheet much more stable.

The monopoly age of growth investing

Part of the appeal of growth investing is that there isn’t really a lodestone of growth investment theory to weigh down on decision-making. Value investors, in some ways, will always (metaphorically at least) have Benjamin Graham’s book The Intelligent Investor waved at them every time they need to make an investment decision. By contrast, growth investing’s flexibility is paradoxically both its strength and weakness.

It is fair to say that Terry Smith is one of the most successful growth investors on the UK investment scene. His often-trenchant views on market abuse and the various ways that products, particularly exchange-traded funds (ETFs), are mis-sold has earned him a loyal following among retail investors.

Smith’s argument, which he lays out in a collection of his writings Investing for Growth is that quality counts in the long run. He uses the example of French cosmetics giant L'Oreal (EURONEXT:OR) which was rated at a price/earnings (PE) ratio of 281 in 1973. However, had an investor bought L’Oréal, even at those eye-watering rates, you would have realised an annual return of 7% a year above those of the underlying index. In this case, a highly visible consumer brand combined with rising earnings for female consumers drove L’Oréal’s profits. In Smith’s view, a high return on capital employed will eventually lead to a compound growth in earnings and the share price and is worth paying for. 

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The interesting thing about Smith’s success with his eponymous investment fund Fundsmith Equity is that he seems to have identified far earlier on than most growth investors that many large-cap companies, particularly technology, were generating returns that were far beyond the “normal” for the current stage of their development. The big tech companies such as Apple (NASDAQ:AAPL), Microsoft (NASDAQ:MSFT) and Oracle (NYSE:ORCL), have founding dates clustered around the mid-1970s, and there is a growing sense that the monopoly power is what is driving such high returns for companies that are well into their corporate middle age.

His rationale for investing in Microsoft (NASDAQ:MSFT) at $25 a share, despite a lot of scepticism at the time, is worth quoting in full: “One of the lessons this illustrates is that you may only get to invest in really good businesses at a cheap rating when they have a problem. Our Microsoft investment coincided with the troubled period under its previous CEO when it managed to come third in a two-horse race in mobile devices and second in a one-horse race in online search.” In essence, this is a politer version of the old investment wisdom: invest in a company that can survive being run by idiots, because one day it will be…

It is also a tacit acknowledgement that Microsoft has a largely unchallenged position, despite years of anti-trust cases and the rise of smartphones and cloud computing.

Smith’s Growth Investment Rules:

1. It is quality that counts.
2. Management candour is important.
3. Avoid any company that does lots of accounting adjustments.
4. Lowly rated does not equal good value.
5. Highly rated doesn’t equal expensive.

What is certain is that Smith is prepared to put his money where his mouth – he invests in his own fund – and that Fundsmith has seen a 425% per return between 2010 and 2020, compared with 54% for the FTSE 100. So, it seems that quality has a beauty all of its own.

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