Defensive Growth Investing and Investment Ponds
In investing, there are many ways to the top of the proverbial mountain. Fortunes have been made investing in equities, real estate, venture capital, private equity, and commodities. Specifically within equities, managers and individuals have succeeded by investing in statistically cheap stocks, hyper-growth stocks that seem expensive, cyclical companies, and everywhere in between. There are no rules that dictate investors adhere to one type of asset or investment all the time. This is part of what makes investing so much fun.
Because there are different ways to “win”, sustained success requires not uncovering a single “secret” to investing, but rather figuring out what works for you and adjusting to present conditions. Howard Marks calls this shifting between aggression and conservatism as the temperature of the market changes. This entails defining what falls within your circle of competence and paying attention to the market cycle.
One analogy is deciding which investment “pond” to fish in based on the type of gear you’re equipped with and the current weather conditions and season. The mix of our portfolio invested in these “ponds” depends on what types of opportunities appear to offer the best risk-adjusted returns at the given time.
Our Investment Ponds
Our investment ponds fit into roughly three categories; compounders, defensive growth (which we’ve also referred to as ‘legacy moats’), and special situations.
We think of compounders as businesses that have long growth runways and the ability to sustain well above-average growth rates, say 15% or higher, for many years. Businesses like Facebook, Hilton, NVR, and HEICO are great examples. Generally these businesses have established moats, trade at higher relative valuations, reinvest capital to grow, and may have an element of cyclicality. Given our aversion to paying above-average valuations we find that compounders offer the best value during broader market panics or after one-off corporate blunders (looking at you Facebook in 2018).
Defensive growth businesses grind along year in and year out. They rarely have enviable one-year results but deliver tremendous long-term value creation. They too have durable competitive positions, but topline growth prospects are more modest at 5-10% and reinvestment opportunities are scarcer. With lower growth, valuations are much more reasonable. They’re not nearly as sexy as compounders, especially during periods of low interest rates when high growth companies are assigned sky-high valuations.
Defensive growth companies gush free cash flow far in excess of what they can sensibly reinvest for growth. As a result they return substantial capital to shareholders. Thanks to dividends and share repurchases these businesses can take modest topline growth and deliver total annual shareholder returns well into the double-digits. Better still, defensive growth businesses are relatively un-impacted by extrinsic factors like interest rates, the price of oil, unemployment trends and yes, pandemics.
Special situations generally consist of businesses with hidden or underappreciated assets. They usually possess or have the ability to possess many of the same characteristics as compounders and defensive growth investments but are going through some sort of transformation or corporate action. Current earnings usually have little to do with the long-term earnings power that we envision in these companies. Wells Fargo and Schmitt Industries are great current examples.
At Eagle Point we have no iron law about how much of our capital should go into each situation. We just try to do what makes the most sense given what opportunities we’re being afforded from prevailing market conditions.
Application to Today
During our spring update last year, we gathered that the terrible circumstances surrounding us made it a great time to buy stocks. This was not a bold prediction after securities prices across the board had come crashing down. Nevertheless, the environment seemed to warrant aggressive action and that’s how we proceeded. Higher growth compounders went on sale, making it an ideal time to buy stocks like Facebook, NVR, and Hilton. As we compile this spring’s letter, our attitudes have reversed in many respects.
We’ve written about several instances of financial excess recently and suffice to say, optimism dominates pessimism, aggressiveness is favored over conservatism, and little attention is being paid to risk in certain areas of the market. Necessary interventions by the government and Fed have created a tremendous flow of liquidity into equities, and especially high-growth stocks. Given the present situation, it no longer seems like aggressiveness is the order of the day.
In addition to the unprecedented stimulus, today’s near-zero interest rates have been an incredible tailwind to high-growth stocks. Businesses who derive most of their value from profits far off in the future enjoy rising stock valuations when interest rates fall, as investors discount those profits at lower rates. If you believe the Fed will not allow interest rates to go negative, which I firmly do, interest rates can now only stay the same or go up. This means valuations in growth names seem more likely to contract than expand, which presents an asymmetric situation to the downside for shareholders.
None of this means we are sounding alarm bells, calling for a correction, or concerned for the future. It does mean we are thinking about risk management closely. The most popular trade on Wall Street in recent years has been buying high-flying growth stocks whose businesses produce little cash flow today. The more Wall Street has favored businesses justified by future profits, the more we find ourselves favoring good businesses with high current cash flow yields. To that end, we’ve recently been fishing in the defensive growth pond.
Defensive Growth Characteristics
We didn’t wake up one day and decide we needed to own defensive growth stocks as some sort of macro, top-down prediction. Everything we do is based on bottoms-up research and, in general, defensive growth businesses happen to offer the most value right now. Lately we’ve gathered a handful of these names at bargain prices. Companies like McKesson, Altria, AutoZone, and Norton LifeLock all trade at 8-13% earnings yields. They also enjoy strong moats, structural tailwinds, should grow 5-10% annually for many years, and are returning excess capital to shareholders. Further, all of these businesses are valued well below where we think they should be over the long term. For those that favor sports analogies; by hitting consistent singles, an occasional double, and not striking out, we expect these businesses to put many runs up on the board no matter who is pitching or what weather prevails.
These businesses are simple, predictable, and profitable and enjoy enduring competitive advantages in areas we think are unlikely to change anytime soon. These characteristics mean it is unlikely the stocks will produce extraordinary one-year investment gains unlike some of the speculative investments that have doubled or tripled over the past year. This is fine with us. We aim to produce attractive compound returns over very long periods of time while minimizing the chance of permanent loss of capital, thereby resisting the urge to “swing for the fences”. Howard Marks’ comments in a 1990 memo titled “The Route to Performance” feel as applicable today as they did 30 years ago:
“There will always be cases and years in which, when all goes right, those who take on more risk will do better than we do. In the long run, however, I feel strongly that seeking relative performance which is just a little bit above average on a consistent basis…will prove more effective than "swinging for the fences”…the best foundation for above-average long term performance is an absence of disasters. It is for this reason that a quest for consistency and protection, not single-year greatness, is a common thread underlying all of our investment products"
We couldn’t agree more. Aided by our emphasis on defensive growth businesses, we expect our portfolio to grind along at a solid clip for many years, with downside well controlled by way of strong absolute and relative earnings yields and high business quality. Given the relative inelasticity to economic conditions of businesses like Altria and McKesson and already cheap valuations, we think they’ll provide great optionality during down markets while enjoying solid growth if the good times continue to roll. If interest rates rise and growth valuations contract, many of these businesses may find themselves at the center of the new trend on Wall Street.
Disclosure: The author, Eagle Point Capital, or their affiliates may own the securities discussed. This blog is for informational purposes only. Nothing should be construed as investment advice. Please read our Terms and Conditions for further details.