I have predominately been a dividend investor for most of my investing life. However over the last 4-5 years, I had increasingly been drawn to more growth oriented stocks that don't pay dividends.
My reasons for doing so were fairly varied.
I had observed that growth-oriented businesses were increasingly disrupting legacy markets, often leaving traditional players were unable to respond. Amazon (AMZN), for instance, was a player that was increasingly leaving a trail of traditional retailers in its wake. Businesses like Macy's (M) and J.C. Penny (JCP) and various retail malls were becoming ghost towns as consumers looked online to transact.
Traditional newspaper businesses were seeing their readership desert them as free news proliferated online, and businesses such as Google (GOOGL) provided a better way to index content and serve up relevant targeted advertising.
These were real businesses that were creating real value in the economy that traditional legacy dividend-paying businesses were unable to capture.
I also observed that businesses such as PG (PG) and Colgate, core dividend holdings of mine, were increasingly being bid up and getting to valuations that were difficult for me to justify based on their tepid growth. Both are struggling with low single digit revenue growth but sport valuations of 20x earnings.
Finally, I started taking notice of commentators such as Jack Bogle who noted that returns from the S&P500 were likely to be low single digits for the next decade, given a combination of low growth rates and expensive valuations.
I wanted to push for something a little better than a low single digit return over the next decade, so as a result in October 2015, I made a decision to start a growth portfolio.
Principles of Portfolio Construction
When I set out to compile my portfolio, I looked for businesses that were of the highest quality and growing rapidly. I wanted businesses that were cash flow rich, had high rates of revenue growth and high returns on equity. It was also very important to me that these businesses were the beneficiaries of secular tailwinds. That they would facilitate disruption and not be a legacy business which would become the victim of disruption. That was important to give me confidence to hold these businesses for the entirety of my decade-long holding period.
My strategy was focused on long-term buy and hold of these businesses with minimal portfolio turnover and minimal tax leakage, and the elimination of trading costs through unnecessary sales. Having done the work up front to select these businesses, I wanted to sit back and let these businesses continue to reinvest their capital at high rates of return and for strong compounded earnings-per-share growth.
I also wanted a diverse enough holding that I didn’t have a significant amount of my capital tied into a couple of businesses. Rather, I wanted to spread my capital over 20 businesses that would withstand the test of time. Sector diversity wasn’t something that concerned me too much so I wasn’t bothered if a majority of these businesses were in one or two sectors [which ultimately ended up being the case]. Superior economics and dominant market position were my primary concerns.
With my framework solidified, I then proceeded to implement my strategy. I considered a bucket of roughly 25 to 30 stocks that met my criteria. These included many of the companies that are still in my portfolio today. Names like Visa (V) and Mastercard (MA) were automatic entrants into the portfolio along with Booking Holdings (BKNG) and Mercadolibre (MELI). There were also holdings which have since been discarded such as Moody (MCO), NovoNordisk (NVO), and Illumina (ILMN). I went on to add a few names that were not initially in the portfolio when opportunistic market conditions presented themselves. These included names such as Alibaba (NYSE:BABA), Tencent (OTCPK:TCEHY) and Amazon.
My approach to portfolio implementation was fairly strongly influenced by numerous seeking Alpha contributors. In particular the notion of disciplined buying and looking to aggressively buy high-quality companies when they fall 20% or more from market high was something that I’ve tried to embraced in my own portfolio implementation.
Portfolio return since inception
I set myself a very aggressive goal of roughly 14% compounded annually over a 10 year time period. I knew that would be a tall order and an aggressive goal that ultimately may not be possible to achieve. The results over the first three years have more or less met my expectations. The portfolio has returned roughly 15% per year compounded annually. Outperformance over the S&P 500 has generally tracked 2 to 3 percentage points, having been as high as five percentage points annualized at certain points over the portfolio lifetime.
There are several things that I have observed in my journey thus far in building my growth portfolio.
Investing during favorable conditions helps
There’s no doubt that investing during favorable market conditions at the initial stages of any strategy is very helpful. Certainly, I’ve been a beneficiary of the fact that the last few years have been very favorable for growth investing. While there have certainly been pullbacks along the way for my portfolio, the absence a dramatic downturn has really helped the portfolio growth move along smoothly and consistently. That has been very helpful to maintain confidence in the strategy. Much of the battle with maintaining an investment strategy is psychological. Favorable economic conditions have also really helped profitability and growth for many of my holdings. This has given a nice boost to the secular tailwinds that my positions were all riding.
Embracing uncertainty juices returns
One of the principles that I try to implement in my portfolio creation is buying during periods of distress, when prices for individual stocks that meet my strict criterion fall 20% or more. Invariably, that typically means buying when there is some uncertainty. I used this principal to good effect with some holdings that were purchased after my portfolio creation. One of these purchases was Alibaba in early 2016. At that point, concerns abounded that the Chinese economy was heading into a full-blown recession. Ali Baba went down to a low of $60 a share and dropped almost 50% in a 12 month period. I sensed an opportunity and bought Alibaba in the $60 range. Now in hindsight, almost 3 years later that appears to have been a good purchase, however it meant embracing near term uncertainty that slowing Chinese growth wouldn’t bring an end to Alibaba fortunes, and keeping my eyes on the long term prize.
'Doing nothing' can be hard, but is important
There have been long stretches of time over these last three years where I haven’t done much. That's been the case for both buying as well as selling. For much of 2017 and 2018 I largely sat pat while share prices were on a massive rise. Similarly, as some of my positions booked massive games (in some cases, four times my invested capital, such as was the case with Atlassian) I sat content and didn’t sell. By not booking gains, I didn't short change myself as my business continues to grow and compound earnings. Not buying as markets were rocketing upwards has proven to be beneficial now that we have emerging signs of a correction. It meant I was able to conserve capital to deploy for more meaningful bargains. It also means that I haven’t suffered any psychological damage by having bought stocks when their prices were very expensive.
Its been helpful learning from likeminded investors
When you deploy an active investment strategy it’s very easy to feel isolated. It seems that more and more the trend is strongly moving toward passive index investing. Seeking out best of breed businesses and buying and holding them for the long term seems to be declining in popularity compared to following an index or implementing algorithmic trading. To that end it’s been helpful for me to have a few investors that share a similar outlook and philosophy to investment. I found some like minded investors in the likes of Polen Capital, Vulcan Value Partners and Magellan Global. All three of these funds are ones that are focused on buying and holding best-of-breed businesses with high returns on capital benefiting from secular tailwinds that are cash flow rich. During the occasional pullback, it’s been useful to read their investor commentary and get their assessment of economic conditions and business prospects. It’s also been helpful for me to see new ideas and positions that each of these investors are considering. With respect to Polen Capital it’s been astonishing to me how significantly our holdings overlap.
Maintain conviction in the businesses you hold
I found that having high conviction in the businesses that I own has helped me hold onto them during periods of significant price volatility. In general that price volatility has often been temporary without any underlying driver. Alibaba has certainly been a volatile stock since I’ve acquired it. It has moved up or down in excess of 25% with great regularity during the periods that I’ve owned it. However, I’ve been content to hold the business because I have a positive outlook on its competitive positioning and the long time secular growth story of increasing consumer spending in China.
Similarly Visa (V) on Mastercard (MA) have been businesses that have been core holdings of Project $1 Million since inception and which I’ve been content to just sit pat on and let them grow and do their thing. I’ve been a long term believer in the move from cash-based payments to cashless payments which Visa and Mastercard will be beneficiaries off. Having that conviction has allowed me to leave these businesses alone in my portfolio. On the other hand Celgene (CELG) was a business that I had owned at one point in time but subsequently disposed when the price decline in the stock accelerated and it dropped by 50%. I realize that that was a business in which I had little conviction and little understanding of what the share price drivers of the stock would ultimately be. Having that core conviction in a business has been good because I’ve then been able to sit back and let the business continue to compound its profit and reinvest it’s capital at higher rates of return.
It’s OK not to get everything right
I made several mistakes in my construction of Project $1 million. Several of these mistakes were mistakes of omission where I sold some businesses too early. Initially when I put Project $1 Million together I had investment in companies such as Moody's (MCO) and Illumina (ILMN). These were great businesses and had I held onto these, my portfolio returns would’ve been all the richer. However I made costly decisions in both cases to exit these businesses too early, which meant that I missed out on attractive returns in both. In the case of Moody's, I reasoned that higher interest rates would eventually slow long term growth. Illumina was very much a business in transition when I sold, and its genetic sequencers were seeing slowing growth. Both my decisions subsequently turned out to be incorrect.
On the other hand I had a couple of businesses that were stinkers that negatively contributed to growth. This included businesses such as Celgene (CELG) and see Ctrip (CTRP) (which I still continue to hold). The cumulative effects of these poor decisions didn’t in anyway detract from the satisfactory returns that the portfolio in aggregate has generated I think this goes to show that the thinking that you need to 'hit everything out of the park' to deliver satisfactory returns on performance is a fallacy.
Network effects businesses just get stronger
I deliberately and purposely stacked Project $1 Million with a number of network effects businesses that only continue to get stronger as their franchises become more dominant. It is most obviously seen in businesses like Visa and Mastercard, where increased consumer usage leads to increased acceptance by merchant. The same principle is also in play with businesses such as Alibaba and Amazon where merchants and advertisers eventually flock to where consumers are shopping. The natural byproduct of this is that as these businesses grow and scale they become more dominant, which in turn further fuels their growth. This reflects in businesses that are consistently able to grow at a higher rate of revenue and profit growth for an extended period of time and one where share prices can experience above average growth for long stretches of time.
Founder-owned and -led businesses generally make wealth enhancing decisions for their business
In general, Project $1Million is not only stacked with businesses that have superior competitive advantage, large free cash flow and high returns on invested capital, but it also has a significant portion of businesses that are owner-led and -operated. In many instances the CEOs of Project $1 Million are founders who have material amounts of their wealth tied to these businesses. Founder-led businesses in Project $1M include Amazon, Facebook (FB), Atlassian (TEAM), Mercadolibre (MELI), Baidu (BIDU), Tencent and Alibaba (up until last month). Founder led businesses are important for several reasons.
On the one hand founders continue to bring with them the vision that has propelled their various businesses to the heights they have already achieved. This is often a trait that is lacking in career CEOs who come in for short periods of time on fixed contracts. Additionally the existence of personal wealth that is invested into the business ensure that the economic incentives of the company and shareholders are aligned. Founder CEO's are also more often able to take the hard decisions to invest long term, versus hitting near term numbers. Mark Zuckerberg's (Facebook) decision to pare back ad load on the Facebook platform and invest heavily in compliance and risk measures at the expense of short term profitability in favor of long term health of Facebook is one example. Marcos Galperin of Mercadolibre made the hard decision to increase shipping subsidies and decrease near term profitability and free cash flow to ultimately grow users and strengthen the MELI platform. This economic alignment that founder CEO's have is typically is very good for shareholders because these owners are motivated to take decisions that materially enhance not only their own long term wealth but that of their shareholders as well.
I’ve been pleased with how Project $1 Million has tracked thus far. The various holdings that I have have continued to demonstrate solid performance. All are placed as well, if not better then when I started my portfolio. I continue to remain cautiously optimistic that I will hit my long term targets, and achieve annualized performance of around 14% for the balance of term.
Disclosure: I am/we are long ALL STOCKS MENTIONED. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.