There is obvious merit in investing in high quality companies with extraordinary prospects. Many of you may be familiar with what defines a quality business – a high return on equity, sustainable competitive advantages, solid cashflows, minimal debt and first-class management.
But many investors may not properly consider a company’s prospects, and yet these are as critical to long-run returns as everything else combined. We find assessing a company’s quality is relatively straightforward, however a company’s prospects are revealed only in the future, and the future is largely uncertain and hence difficult to quantify. The investing car we drive enjoys a great rear view mirror, but a rather murky and blurred windscreen.
Think about longer term growth prospects
Nevertheless, your returns will be driven by the future and not the past, and so it is vital that the prospects are bright.
If a company has many of the characteristics associated with quality, there is a better chance it can maintain reasonable returns into the foreseeable future. But as a company becomes larger, it will become harder to maintain a high growth rate. Just ask Warren Buffett, whose Berkshire Hathaway returns, over the most recent five years, have failed to keep ahead of the S&P500. Ultimately, the growth prospects of a company are likely to plateau, and in Australia that happens sooner rather than later thanks to our geographic isolation and relatively small population.
So the key to successful value investing is not whether something is cheap, but whether its prospects for long-term growth are good. That idea certainly flies in the face of value investing’s conventional wisdom but as we all know, conventional wisdom is long on convention and short on wisdom. Identifying those companies that are capable of growing earnings materially in five, ten or twenty years is the search for the goose that lays the golden egg.
One of the questions we like to consider is not only whether a company can grow its share of the market – that’s helpful - but whether the company has sufficient ‘momentum’ to grow and become the market.
Charlie Munger, the other half of Berkshire Hathaway, offers some advice on this topic:
“Averaged out, betting on the quality of a business is better than betting on the quality of management. In other words, if you have to choose one, bet on the business momentum, not the brilliance of the manager. But, very rarely, you find a manager who's so good that you're wise to follow him into what looks like a mediocre business.”
Going beyond the present day fundamentals
When investing, the priority is to ensure a business’s fundamentals are sound. But to assess long-term potential, you need to think like a visionary. Where will the company be if it continues to do the same thing for the next couple of decades, maybe even one hundred years?
The founders of Google are doing just this. In the company’s first annual report as a listed entity in 2004, the founders Sergey Brin and Larry Page stated that Google’s mission is “to organise the world’s information and make it universally accessible and useful”. This is an infinitely large task for a long term company.
Since inception, the founders have been focused on owning every part of the information chain. If investors initially framed the company’s potential as its ability to grow web searches, they may not have realised the value that Google was capable of generating (Larry and Sergey also discuss this issue in the report).
Google has gone on to introduce wearable technology, invented driver-less cars, invested in fibre-networks, and even plans to launch weather balloons in remote regions to provide wireless internet connection. To the founders, the focus wasn’t on sustaining a certain level of growth. Rather, the focus was on creating the most dynamic company achievable. When considered from this perspective, there seems to be no limit to the growth that may result.
Of course, valuation is just as important. Even if the company has extraordinary prospects, if the share price is trading at a prohibitive premium, you must consider the opportunity cost of your returns. With that said, identifying a company’s long run potential will influence your assessment of its intrinsic value, which may prevent you from selling if growth disappoints in the short-term, or perhaps encourage you to enter if growth appears to be maturing.
Value and growth are thus two sides of the same coin.
Brin and Page concluded their first shareholder letter with:
“If Google were a person, it would graduate from high school in 2016. Given a typical life span, it would expect to be around for almost a century – or more, thanks to continual innovations in healthcare technology. Today, it would only have seen a glimmer of its full potential. We’re just getting started.”
When a company becomes the market, it can be very difficult for competitors to penetrate its position, or scale the buttresses upon which the platform for sustained growth is built. As Google’s visionary leaders are demonstrating, the growth in long run intrinsic value will be determined by the management’s ability to seize the prospects.
Roger Montgomery is the founder and Chief Investment Officer at The Montgomery Fund, and author of the bestseller ‘Value.able‘