With no “pretty way to say it”, investing in high-growth companies, particularly those in the areas of technology and software, has been incredibly challenged over the past year. After setting record highs throughout the early months of 2022, the market narrative of “exponential returns”, long-term investing, and “secular growth”, has given way to shrinking multiples, tales of the Dot-Com crash, and high scrutiny of quarterly earnings. A litany of headwinds have tested the convictions of many investors around the world and we’ll spend this note detailing a few of them, and providing insight into how we view the road ahead for the companies in our portfolio:
Behemoths vs. the Competitors
2021 into 2022 has continued the trend where large companies, particularly the three or four largest mega cap software companies, are seeing increasing economies of scale and accelerating growth even as their businesses reach such large absolute size it makes those growth rates so difficult to comprehend. This is particularly the case in the Cloud business which is dominated by 3 companies, all valued over $1 Trillion in market cap.
The high growth in these businesses, has led investors to shy away from smaller high growth businesses, as the safety of these large cash generative businesses are a “safer place” in times of market turbulence.
Another surprise over the past quarter has been just how significant the change in Apple’s privacy settings has been for an entire ecosystem of companies that depend on ad revenue. In what could be argued as anti-competitive practices shrouded in consumer privacy, Apple radically reduced advertisers ability to target ads based on search histories and other data points. The result? Less effective ads and corresponding decrease in ad revenue received by a group of companies primarily in Social Media. The anti-competitive twist comes in who are the largest beneficiaries of this change… Apple who has seen strong growth in Ad Spend for its app store, and Alphabet (Google) who reportedly pays Apple $8-12 Billion dollars a year to be the default search engine on all Apple devices (New York Times, 2020). We believe some of this will be temporary as the software engineers at ad-based companies work to understand, code, and implement new algorithms for ad targeting.
Interest Rates & Growth from
Perhaps the most talked about headwind for growth stocks has been the quick rise in interest rates. From 50bps in the summer of 2020, the 10 year US Treasury is approaching 2% at the time of this writing. This both increases the “discount rate” used to value growth stocks’ future profits, but also increases the cost of financing their businesses which may not be earning profits right now as they invest in the future. Joining this dynamic is the reality that cyclical businesses like those in Energy & Materials have seen staggeringly high growth rates in recent quarters as the input commodities have moved higher including oil at nearly $100 p/barrel. While we like dividend growth stocks in these areas, we don’t believe the high growth of today means high growth 3 or 5 years from now which is the focus of this portfolio.
We’ve talked about before our desire to own the secular winners from the COVID disruption in the economy, those companies that not only saw a quick bump in revenues from stockpiling, necessity, or change in behavior, BUT also are poised to retain, strengthen, and grow their market positioning as adoption of their product or service is not likely to be given up as the economy re-opens. The market has in our minds thrown a lot of babies out with the bathwater as many companies that do have long-term staying power, have seen steep pull-backs. E-Signature is one such business that has seen stocks correct sharply, but in our minds has seen a permanent improvement in the business prospects from pre-pandemic.
The Long Game
As we’ve written before, it’s our goal to find, invest, and hold the most innovative businesses we discover through our research. The unfortunate reality of this approach is that volatility is high as market sentiment can change quickly, and the price of a business who’s most profitable years may be many years in the future can fluctuate wildly with a relatively small change to metrics such as interest rates, economic growth, or inflation. During these times we rely on the tenants of why we began this strategy:
Growth Duration: We want to own companies with what we believe to be decade(s) of high growth potential, not just a cyclical upswing from inflation or commodity prices
Innovation & Entrepreneurship: In our minds, these factors are the primary wealth creators in the modern world. The process takes time, but historically is rewarding to both founders, investors, and the country at large.
People: We want to invest behind what we believe to be the best founders and managers of the best businesses in the markets. While it may take a couple quarters, strong management teams adapt to a changing landscape around them when necessary.
While our convictions in the process hold, there is certainly a lot of change going on in the world around us. As a result, we are sharpening our scrutiny of each business, re-underwriting what we believe to be their prospects, and will make changes if/where necessary to continue to position the portfolio to benefit from the tailwinds of growth, innovation, and disruption that we see ahead.