What Should You Pay for Growth?
If you’ve read a newspaper or turned on the news recently you’ve undoubtedly heard concerns regarding “slowing growth” around the world and in the US. Typically anytime someone murmurs those concerns stocks respond negatively, and sometimes severely so. The U.S. economy is heading towards year eleven in the current economic expansion cycle and bull market (the longest on record) and everyone from the Fed to the Wall Street Journal is wondering “how long can this go on?” A logical next question to many investors is – how do I invest in a market that is concerned about growth slowing and ultimately coming to end for a period of time?
As is often the case, our answer is simple but not easy – when you buy a position in a business, don’t pay for growth. To be sure, we want and expect growth in the earning power of our holdings, we just want it for free and are typically unwilling to pay a premium for it.
A sensible question may come to mind – why exactly are we unwilling to pay for growth? If studying history and personal experience in the market have taught us anything we’ve learned:
- Growth, especially specific levels, is very hard to predict and frequently does not materialize as projected.
o In our view, the fewer moving parts there are in an investment, the fewer opportunities there are to be wrong and end up with an unsatisfactory outcome. The fewer factors we have to predict correctly, the higher our probability of success.
o From a simple probability standpoint, if you have one variable to predict and you are 90% sure of being correct, you have a 90% chance of overall success. If you add a second variable that you are also 90% sure of correctly predicting, your chances of overall success are cut to just 81% (0.9 * 0.9). Your chances of success drop precipitously the more variables you count on predicting correctly.
- When companies are expected to grow, those expectations are often overly optimistic and lead to downside surprises when they are not met.
o Take Ulta Beauty Inc. as a recent example. Ulta is a cosmetics business with a $13B market cap that has enjoyed solid growth of late. At the end of August the company reported quarterly results which included 6.2% same-store sales growth and earnings growth of more than 12%. The company also guided for full year earnings growth to come in between 8 and 10%. These results represented healthy growth by most measures. However, the results fell short of Wall Street’s rosier expectations of full year earnings growth between 17 – 19% and quarterly same store sales growth of 6.6%. The stock has subsequently declined by roughly 30% since the earnings announcement a little over a month ago.
o Now take the converse – In August one of our new holdings, Kontoor Brands, reported a revenue decline of 8% for the recent quarter. One would expect a stock with revenue declining by 8% to be punished – yet the inverse took place. The consensus estimate was for revenue to come in about 10% lower than the previous year, leading to a positive reaction. Kontoor Brands share price has risen over 25% since this recent report. We bought Kontoor Brands at a price that in our view implied too low of expectations and have started to see the results materialize.
- Paying no-growth valuations is one source of building a margin of safety.
o We buy businesses that we are virtually certain will earn materially more five, ten, and twenty years from now, and we typically pay a no-growth multiple for them. If we don’t pay for growth and none materializes, then we haven’t overpaid.
o The only way we can lose money is if the earnings that we are “virtually certain” will grow actually end up shrinking over time. Mistakes are part of investing and will happen, which is why we are only willing to pay a price which reflects substantially lower expectations than we actually foresee. This provides us investments that have a low bar to clear for success.
The takeaway for us is that the future is too unpredictable to count on in most cases, and we don’t have an appetite for buying companies that are optimistically priced for an uncertain future.
So how do we implement this discipline in practice?
Investing essentially comes down to summing the future earnings that a business will generate, discounting it back to a present value and weighing that value against other options. This is true for valuing any asset - whether it’s a bond, a farm, an apartment complex, or a business (or in the case of a stock, small pieces of a business). There are three variables to understand in order to estimate what a company’s future earnings streams are worth in today’s dollars, those being:
- What are the normalized earnings of the business?
o By normalized we mean earnings after adjusting for one-time factors, cyclicality, or other conditions unique to a business that may impact their long-term earnings prospects.
- What is an appropriate discount rate to apply to those earnings to arrive at a present value?
o A discount rate is essentially the rate at which you will discount future earnings into today’s dollars, alternatively thought of as a required rate of return. Discount rates are a subject that warrants their own discussion so we plan to expand on that topic in subsequent posts.
- How will those earnings grow over the long-term?
Here we focus on the third variable: growth.
Mathematically, a business’s terminal value (often a proxy for, or large component of, intrinsic value) is found by applying a terminal multiple to the company’s normalized earnings. The terminal multiple is calculated as a function of the growth rate (g) and selected discount rate (r) as shown below.
For example, at a 10% discount rate and a growth rate of 5% you would apply a 21x multiple (1.05/0.05) to the earnings of a business to arrive at the terminal value. For the same business, if you assume no growth, the multiple applied to the earnings is simply the inverse of the discount rate, in this case 10x (or 1/0.1).
As you can see, if you buy a business priced to grow a modest 5% and it fails to do so, you have risked overpaying for the stock by 110% (that is, paying 21x instead of 10x, using a 10% discount rate) and you are left with a 52% loss!
The table below illustrates the relationship between which multiples correspond to varying levels of growth across different discount rates. This is a useful reference to help understand what expected growth the market is “pricing-in” for a given business.
source: Eagle Point Capital LLC
So avoiding paying for growth is fairly simple – set “g” to zero in the terminal multiple equation and ensure positions that you are buying reflect this multiple. We recently purchased Walgreens Boots Alliance for approximately 7x our estimate of normalized earnings implying a shrinking business in almost any discount rate scenario, as you can see in the above table. We think this is far too pessimistic of a view for this business and responded accordingly. We’ve written about several other similar situations in our recent letter.
A disclaimer is warranted on this discussion. This approach is not the exact way a corporate finance student would be taught to perform a full discounted cash flow (it ignores forecasting individual year’s earnings before the terminal value). This is a simple, back of the envelope way to understand approximately what kind of growth expectations are built into a stock’s price. We are interested in being approximately right rather than precisely wrong, and this is one approach to help us do so.
It should also be noted that this approach substantially limits the universe of stocks that one will consider, given the stringent requirements. This doesn’t trouble us as we are only focused on finding the few situations with the highest probability of success and a correspondingly low risk of loss. This is one way to narrow the universe of opportunities that merit studying further. Legendary investor Howard Marks has said if he could only ask one question about an investment it might be – “how much optimism is reflected in the price?” – the process we’ve outlined helps in answering that question.
In summary, investing inherently deals with the growth prospects of assets which has a large impact on the intrinsic value of those assets. The price you pay for that growth can make or break an investment. Our approach is to avoid any business that we think is “priced for perfection”. Approaching businesses this way allows you to occasionally uncover high-quality securities with unreasonably low growth expectations. Find enough of these opportunities and we think it is likely you will do well over the long-term.
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.