In one of his annual shareholder letters, Warren Buffett (Trades, Portfolio) compared three different growth stories – the great business (i.e., See’s Candies) increases profits without significant capital investment; the good business (i.e., FlightSafety) reinvests a fair amount of capital to grow earnings power at an attractive rate of return; the gruesome business (i.e., airline) generates inadequate returns on the capital that finances a rapid growth.
This may not be so intuitive, but faster growths are not always better - for shareholders, at least. What Buffett was referring to as a major consideration in this regard is what it takes to grow compared to the opportunity cost (or the cost of capital). In an extreme case, if it has become too “expensive” to grow the business, rational investors would want to hope for the business not to grow at all.
Simply put, not all growths are created equal in the business world. By developing proprietary analytics, we endeavor to stay away from “the gruesome” (i.e., the value-destroying growth) and to dig out “the great” and “the good.” A few examples from our portfolios here at Hillside Asset Management – we believe that asset-light operators, such as Tobila Systems (TSE:4441, Financial) and Plover Bay (HKSE:01523, Financial), can increase their earnings without much capital reinvested; some other companies like Credit Acceptance (CACC, Financial), Constellation Software (TSX:CSU, Financial) and Alimentation Couche-Tard (TSX:ATD, Financial) depend more on retained earnings to grow – their management teams primarily concentrate on returns on capital when deploying capital for either organic investments or acquisitions.
Aside from capital efficiency, predictability and cash conversion are the other two major factors that concern us. We focus on market leaders in secular-growth industries propelled by long-term, structural shifts instead of cyclical or seasonal factors. For example, Bouvet is one of the top choices for digitalization projectsamong private and public enterprises in the Scandinavian region. Moreover, we favor highly recurring/repeatable and highly cash-generative revenue models. For example, Perfect Medical (HKSE:01830, Financial) benefits from its contract sales to “lock-in” customers and collect prepayments ahead of the services provided for the customer.
Lastly, as equity investors are long-term by definition, we would applaud any initiative supporting the sustainability of future growth, even at the expense of near-term results. Rightmove (LSE:RMV, Financial) provided significant discounts to support its customers during the spring and summer of 2020 when the UK property market was temporarily closed, causing the company’s top-line and bottom-line to drop year-over-year by 29% and 36% but potentially contributing to the robustness of the customer relationship and the healthiness of the industry at large. Last year, Games Workshop (LSE:GAW, Financial), another holding company based in the UK, decided to pay a discretionary bonus equally to all employees to reward their contributions to the significant increase in profitability. The bill totaled more than 10 million British pounds ($12.51 million), representing nearly 10% of the earnings for the fiscal year. But we think that our 10% “loss” is well spent on driving employee loyalty and talent retention in the long run.
This article was written by the author and first appeared in Hillside Wealth Management's monthly newsletter.
Disclosure: The mention of any security in this article does not constitute an investment recommendation. Investors should always conduct careful analysis themselves or consult with their investment advisors before acting in the stock market. I/We have position(s) in any of the securities referenced in this article.
