On the Fast Track :: Date: 30/06/2006 CPA Australia
A rapidly growing company may look like a good investment choice, but there are risks involved. As one leading fund manager believes, you don’t have to be Einstein to see a growth story. Think mining infrastructure stocks, healthcare and even the childcare sector.

But how do you know that the ‘story’ will succeed for the longer duration and not fade out, only to be savaged by the market and you lose your profits?

Matthew Ryland is senior Australian equities analyst at Merrill Lynch Investment Managers. He says high-growth companies face certain advantages, such as proprietary technology or a particular market position, or sometimes they’re in an industry that is experiencing good times and rapid growth, such as healthcare and mining services.

But they’re all required to deliver good earnings and dividends and cash flow that meets market expectations. Even short-term indicators can’t disappoint. ‘The hardest thing about growth stories is that they’re attractive thematics so it takes a lot of due diligence to decipher the risks and if the market expects too much,’ Ryland says.

According to Peter Strachan, founder of online research house http://www.stockanalysis.com.au/, the definition of a high-growth com-pany is an issue. ‘You might be talking about a pharmaceutical company like Pharmaust or a mining company with a developing project such as Mirabela or Exco, or a hardware company like Legend Corporation,’ he says. ‘Each has its own risks and it’s impossible to give a blanket answer.’

Strachan says that as growth companies with a track record tend to trade on high market multiples of earnings (his examples are Patrick Corp or CSL), they are vulnerable to a downgrade if earnings growth slows and the company is re-rated or if earnings slide on a one-off basis.

He says rapidly growing companies show annual revenue/earnings growth of more than 30 per cent, such as RCR Tomlinson, UXC Ltd or Legend Corp (LGD).

‘Some investors may look at mining companies such as Independence Group or Jubilee Mining, which have developed new projects and lifted earnings, or whose earnings have simply ridden on a commodity price spike,’ Strachan says. ‘But these are not true growth stories but [rather] cyclical plays.’

‘Growth stocks tend to be smaller and so investors need to be comfortable with management and ongoing funding/debt management,’ he adds. ‘History of performance is important, and a solid top-down sector appeal is an added bonus, such as with stock in childcare or aged care or medial software, such as IBA.’

Looking at risk levels can also be helpful when it comes to high- growth companies.

‘When there’s a lot of expectations about positive things, the smallest thing can trigger a sell-off,’ Ryland says.

For example, Cochlear’s price swung from $19 a share in 2000 to $50 a share and then back down to $19, largely because of a six months sales shortfall, a reinvigorated competitor and the climbing Aussie dollar. ‘So poor old COH went down ... even though they still had the best implant by a country mile,’ Ryland says.

Another example of a fast tracker is Macquarie Bank. The profit takers jumped in when MacBank experienced hiccups with the purchase of Sydney Airport, and investors also became nervous about the fees on the infrastructure assets. These days, the price is back up, but obviously, says Ryland, the bar is raised for high- growth stock when it comes to performance.

‘We’re stock pickers,’ says Ryland. ‘Any stock has to be there on merit. Typically, it will be cheaper than what the market is thinking. The other ingredient is that we’re confident that they’ll hit earnings and cash-flow generation expectations.’

Ryland says one opportunity for investors lies in the time horizon. The market, he says, frequently underestimates the duration of the growth because of its intrinsic short-term nature.

Ryland cites ABC Learning as one example where the market said it would grow at 30 per cent, and then 15 per cent, and then plateau out. ‘But you would make money if you picked the duration,’ he says. ‘So it’s a way of seeing a genuine growth story compared with a not-so-attractive one.’

Roger Montgomery of Clime Asset Management believes that investors shouldn’t get caught up in the growth-versus-value argument because growth really feeds into value. He says it’s important to look at market-beating performance, such as dividend payout, earnings per share, and low levels of debt to equity – and invest for the longer term.

‘Nothing is as important as paying a price that’s less than the business’ value,’ Montgomery says.

‘It’s irrelevant if the company grows or not – everything has a value. For example, ABC Learning Centres has had 86 per cent earnings growth annually. But the rub is that their equity on the balance sheet has gone from $13 million to $1.6 billon, so if you give them more capital then their earnings should go up. So the measure of importance is the return on the equity generated ... and that’s dropped from 48 per cent to 11 per cent so growth is actually hurting investors. ‘Flight Centre is similar,’ he says. ‘Between 1998-02, price went up but ROE went up slightly and then dropped so the value of the business dropped.’

Montgomery upholds the three basic investment tenets: how the market works, how a business works and how to value the business.

Ryland adds: ‘You have to see whether that growth is a function of the cycle, or structural, or the skill of the management team ... so mining is an example but you could still see a longer term growth where you’re getting a supply response. Orica and their explosives business will benefit from the upswing arguably longer than a pure play miner, which is growing long after commodities prices fall.’

An example of a structural long-term growth profile, says Ryland, is healthcare stocks such as Sonic or DCA Group. These display a long-term structural driver of growth due to an ageing population and demand for medical tests and diagnostics in Sonic’s case, and radiology in DCA’s case.

Another factor, Ryland says, is when highly competent management teams create their own growth and repeatedly take advantage of situations, such as Wesfarmers, who allocate capital, generate cash then redeploy that capital and so on.

Ryland says that many investors are drawn to growth in sectors such as technology and biotechs, but that these carry high risks.

‘While technology caps have done well, it’s a combination of good management and cyclicals – SMS technology and Oakton are two such examples,’ he says. ‘For instance, SMS is riding the ‘back to locals’ outsourcing theme as well as the willingness of corporates with strong balance sheets to reinvest into IT.’

So, if growth delivers returns (albeit in a volatile way), why not just go out and buy growth stories after you’ve done the analysis?

‘If it was that easy then we’d all do it, but there’s no surer way to stuff up,’ Ryland says. ‘It’s like saying, ‘Buy value, you’ll do well’. I’d argue that at the end of the day, portfolio construction is still stock- specific.

Entrepreneur Tim Pethick says many Baby Boomers are keen to get involved in businesses as private investors. And while that’s great for entrepreneurs, it’s important that both parties do their homework about each other.

Many of these prospective investors are cashed up from divesting part of their own businesses or through stock options or from property wealth. Now they’re looking to do something different.

As a business builder, adviser and mentor, Pethick notices that many small and medium businesses will ‘take money from anywhere’ without looking into their investors. ‘It’s like a marriage,’ he explains. ‘You need to be sure that they’re the right person and not just having money to invest. You need to know about their expectations, their outcomes and whether these are aligned with what you do.’

Pethick says businesses should ask themselves three main questions about potential investors: Do I like them? Do I trust them? Do I respect them? And if you say yes, only then should you proceed to financial diligence. ‘There’s no half-way house when it comes to investors,’ he says. ‘The process of entrepreneurship is quite creative and emotional, and so if you have had that business for a long time and you’re bringing in an investor, it’s tough because you may stay sitting on the sidelines, saying, ‘I would have done it differently’.’

Pethick has four businesses – Nudie Juices, Symmetry PA and Lifestyle Services, Max Super and joyherbal.com.au – and is working on another five.

‘The next wave will be entrepreneurial businesses tackling the big players,’ he says. ‘We tend to have oligopolistic structures in Australia, which are ripe for picking. I don’t think that proposition has been realised fully here. It has in the US. But here, business tends to carve out a little niche. Now, the next wave will be corporates who take on the big players.’

As the former CEO of LookSmart, Pethick saw many tech ideas rise and fall throughout the 1990s but thinks many of the better concepts, which have since resurfaced, will fly now because the timing is better. And that takes capital. Indeed, a recent survey of private companies by Ernst & Young showed that 25 per cent of respondents planned to raise funds through private equity or venture capital this year.

Julia Bickerstaff, partner of Deloitte’s Growth Solutions, finds private investors for her clients to ease a capital shortage. ‘These [investors] are individuals who really understand the sector and industry,’ Bickerstaff says. ‘For example, there’s a lot of private investment into technology but the success is where they understand the space and the future trends, such as convergence. So they see the overall picture and where things fit ... and can evaluate the business opportunity.

‘I tend to think of a business angel as someone who wants to help the business and give back ... and they may be few and far between,’ adds Bickerstaff. ‘For a private investor, the attraction of the high- growth company is that it’s innovative and can move fast, and so the value of their holding will accelerate.’

Reference: June 2006, volume 76:05, p. 38-41

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