The nature of the question stems from the way the human mind is wired – we want to buy cheap – the only issue with this is, in many cases, the businesses that are cheap have a fundamental flaw around their structure and culture which keeps them cheap.
Investing in growth companies at a psychological level is not easy – these companies will typically be available at valuations which tend to be at a premium to the rest of the ‘market’. The moment one benchmarks the investment to the ‘market’, the frame of reference around paying up to own these businesses sets in, and this results in sub-optimal decision making.
Growth investing, by its very definition, is hard and for good measure. Profits in many businesses tend to revert to mean, and this hits the investor hard especially when one overpays to own such businesses, at the wrong end of the cycle. A case in point being Microsoft, which resulted in a 50 per cent loss of capital over a 13-year period (2000 to 2013). Microsoft was not a case of a bad business – quite the contrary – revenues tripled over this period and earnings grew by 190 per cent over the same period. Investors paid a multiple of over 80 on an earnings multiple for an actual growth that turned out to be around 10 per cent. The same business over the last 7 years (2013-20) has given a shareholder return of 7x, at a time when the business was no-longer ‘popular’. It was not only about owning growth, but a focus on owning them at sensible prices. The business was fundamentally sound, all through the 20 years, though it faced multiple headwinds during periods of increased competition – this was amplified by owning the business at expensive valuations – followed by shareholder capital which eroded (over a period of 13 years).
Growth feels good at times when it gels with a narrative. Human mind derives comfort, when the investment one makes is growing at a 30 per cent+ annualized rate, and analysts tend to value the company on forecasting this growth into eternity. This results in the market at large tending to value the businesses at a premium, which makes it harder for investors to own.
ETMarkets.comIts important to understand that if humans are investing in the markets, the tendency to misprice growth will continue to exist. This fundamentally has to do with how our brains are wired, and the instant gratification and results we look for as investors, writes Naveen Chandramohan.
Rarely does one come across companies that have created wealth on a structural basis – being a case in point, which has bucked this trend – wherein there has not been erosion of capital irrespective of the time one invested in. Over the last 10 years, the bank has created a wealth multiplication of 8x on the capital, however, the investor rhetoric continues to be to find the next HDFC Bank – this is because of investors impatience in giving time to growth companies and inherently wanting to own ‘cheap’ companies.
This makes growth investing extremely hard, as there is very rarely a consistent narrative to investing in growth companies. There are significant shareholder returns to be made when one invests in the ‘right’ companies, though they are accompanied with drawdowns. However, one must be weary of distinguishing the drawdowns from those periods where there can be significant erosion of capital when the thesis and the investment philosophy turns out to be flawed.
As an investor, it is imperative to segregate two factors which help in studying growth-oriented companies. The first being qualitative – namely the culture.
The culture of a company is hard to measure through numbers but comes across over years of execution built from the top. The culture of an organization manifests itself in various forms right from, how the organization views mistakes, decentralized nature of decision making, accessibility of management to new hires, obsessive focus on customers and partners (again stemming from senior management and founders). Historically, it has been founder led companies which have focussed on company culture – this has led to the organization and team handling crisis a lot better than companies which do not have a defined culture and sense of ownership.
Though a company like
is professionally run (rather than founder-led), one can see the impact of a defined culture at work around how the company handled Covid-led lockdowns. The business had been remapped into clusters based on geography and purchase habits. The management at the centre decided to focus on only the top 100 SKUs that the consumer needed whereas the decentralized teams running the clusters were empowered with decision making around the quantity to produce (more 200 gm or 500 gm packets). The ability to trust and empower local teams for the company came through because of years of investing in people, data, and being close to the consumer.
An important aspect for growth companies to create structural value for investors is for the CEO to play a role of a good capital allocator. Its important to understand that one of the key responsibilities of a CEO is to reinvest cash flows the company generates for future growth. Some of the most profitable businesses today came through because of prudent capital allocation. One of Google’s most lucrative product today – Google Maps – came into being because of a relatively unknown startup called Where 2 Technologies which Google acquired in 2004 and gave them the freedom to build their product into Google Maps within the Google eco-system.
Similarly, Instagram which brings in 25 per cent of entire Facebook’s revenue today was the result of an acquisition done by the company in 2013 for a valuation which the entire Wall street and analyst community termed ‘egregious and stupid’. Its only with the benefit of hindsight that one gets to know the value of many of the capital allocation decisions taken by the promoters / founders. Some of the best operators tend to allocate capital with a 10-year timeframe in mind, whereas analysts tend to evaluate decisions with a 3–6-month timeframe in mind – this creates big discrepancies around understanding growth which results in interesting opportunities to buy growth companies that are undervalued.
Its important to understand that if humans are investing in the markets, the tendency to misprice growth will continue to exist. This fundamentally has to do with how our brains are wired, and the instant gratification and results we look for as investors. We do not like to pay up to own growth and this inherently creates opportunities for investors who look at investing as a combination of art and science. The art originates from the qualitative aspects of understanding a business (around culture) and the science originates from the quantitative aspects of evaluating a business (capital allocation).
(Naveen Chandramohan is Founder – ITUS Capital. Views are his own)
