- Long-term compounding growth.
- Deferred capital tax and minimal trading.
- High-throughput maintenance to gain focus on optimal buying.
- The power of specialization.
The general principles of comparative advantage and specialization are well documented, and the essence of strategy is choosing what not to do. This strategy is not about dividends, value, or passive indexes. This strategy is about growth. Moreover, this strategy is not about any type of growth, but a particular type of growth - i.e., disruptive growth.
Why disruptive growth?
Many situations lead to business growth. There are one-time events, like a small company scoring a big contract or a pharmaceutical company hitting a milestone in its drug development. There is cyclical growth and there is growth related to a sudden surge in demand associated with unexpected events e.g., the corona pandemic. Growth can also occur in unattractive industries with outstanding owner-operator CEOs using their extraordinary skills of capital allocation.
All of these examples lead to business growth and used correctly, they can be used to make great investor returns. However, these types of growth are outside of this investing strategy. Here the focus is solely on disruptive growth. Focus on disruptive growth allows a better understanding of the specific characteristics of disruptive growth. With a deeper understanding of risk, one gets increased psychological tolerance for risk, and higher risk leads to higher returns.
Defining the characteristics of disruptive growth
Let's go through some specific characteristics related to disruptive growth. One striking phenomenon of disruptive growth is smooth shape. In general, comparing subsequent quarters can be misleading due to both seasonality and amount of data, but long-term year-over-year data comparison reveals an even pattern. As an example, let's have a look at the revenue of ServiceNow (NOW). As you can see the growth is smooth and even.
Source: Created by the author using data from Macrotrends.
Second, disruptive growth can be sustained for a long time period. The reason for this is that the growth comes from slow adaption to new technology, not fads or one-time events. As an example, let's look at Amazon (AMZN).
Here are two takeaways. First, the effect of long-term compounding is so massive, that it becomes challenging to even illustrate it in one graph (in this graph years 1995-1999 look the same). Second, and this comes from the numbers behind the graph, the growth never stopped for Amazon. As the company became bigger, the rate of growth did decline, but the growth never halted. Importantly, there were several economic crises along the way. Still, the growth continued. This robustness against the effects of business cycles is a central prerequisite for the investment strategy presented in this article.
Robustness against external factors stands true not only for Amazon but is a hallmark of disruptive growth. This is the kind of growth we are looking for. An attractive industry that has the potential to disrupt - e.g., eCommerce vs brick-and-mortar - and a superior company that operates within this industry.
The core: long-term ownership of disruptive and compounding growth
The basic idea with this strategy is to buy an excellent disruptive company and hold it as long as the growth continues.
If the growth stops, the company is sold, and the money is used to buy other companies instead.
Source: Created by the author using data from Macrotrends.
Some companies get into trouble along the way. Their growth halts and turns even negative for several years, but then they solve their problems and growth continues. An individual company could experience a transient halt in growth. For that particular company, the decision to sell could be the wrong decision. However, this business life cycle derived strategy relies on the notion that there are enough companies that grow from young to mature without pausing along the way. Some companies are sold along the way, yes, but others will stay in the portfolio for a decade or more.
The basis for returns
With this strategy one should expect to get paid for bearing the risk of building the cow, not milking the cow. From the business life cycle point of view, this strategy is about owning stocks in the high growth stage.
As such, several metrics that are important for mature businesses are completely irrelevant. Forget about dividends and P/E ratios. This is not the basis for your returns.
The returns are based on the events that occur during the high growth stage. The company's leading position and moat get stronger. As the moat gets stronger, more investors start believing that there is a moat. The company breaks even and starts making a profit. There will be returns to the scale.
With increased size and liquidity, the company becomes an option to more and more institutional investors. More and more analysts start covering the company and it gets included in indexes and so on. In summary, the intrinsic value of the company is increased as it evolves towards maturity.
The distribution of returns
Long-term stock returns are not normally distributed. A small number of stocks are responsible for all investor returns. This same distribution applies also to the actual long-term business growth. Some companies grow very much more than others and most companies do not grow.
Long-term extraordinary growth is smooth, sustained, and compounding. Importantly, a subset of long-term superior stock returns originates from this sustained and unpaused top-line growth. This strategy tries to achieve just that.
This strategy is about long holding periods, and with long holding periods, a small number of stocks are expected to be responsible for the returns of the overall portfolio. As a consequence, the returns are boosted by the deferred tax. This strategy concentrates returns into big winners, and the tax is deferred until these winners are sold. This equals free leverage in the form of deferred capital gains tax. At least in my hands, the amount of this leverage becomes substantial.
Risk mitigation: the coffee pan effect
An important aspect of this strategy is to aim for the coffee pan effect. The coffee pan effect is built upon the skewed distribution of long-term stock returns. Let's see what happens with a 1.5 % allocation to any single stock without rebalancing. If your judgment was utterly wrong, and the growth stops right after you bought the company, your downside is limited because your investment was only 1.5% of your total portfolio.
On the other hand, you could have managed to pick a long-term winner. A small starting position allows you to keep the stock without trimming. The returns are vast and will be responsible for the overall performance of your portfolio.
Risk mitigation: the lofty valuations argument
This strategy emphasizes selling decisions based on halted growth, not hefty valuations. There are three reasons for this. First, let's say you deem that the market got ahead of itself. You might be right, but you cannot know when the correction occurs. In effect, you might sell at levels you will never see again. Market timing is a hard thing to do.
Second, this strategy should result in returns being concentrated on a few winners. Let's say you sell your 10-bagger now and manage to buy it back later at a 10% discount. Due to realized capital tax, you will get a lower number of shares back.
Third, companies in your portfolio will stop growing at different time points. In effect, you diversify your selling across time. Some selling occurs when markets are optimistic, some when markets are pessimistic.
Risk mitigation: the life cycle argument
As the company matures through the business life cycle, the risk becomes smaller because of two factors. First, the risks of bigger companies are inherently smaller. They do have stronger positions, more secure financing a wider variety of customers, etc. Second, the stock prices of small companies are more volatile. Even without any news affecting the actual business, small companies do fluctuate in prize to a considerably higher degree compared to larger companies.
With a single 1.5% investment into the early stage and individual picks eventually reaching 10x returns and beyond, one reaches a situation where more weight is allocated to bigger companies. From a risk mitigation perspective, this is the desired outcome. Please keep in mind, that although this strategy recommends buying as early as possible, this fully applies only to situations where other holdings are diversified in terms of market capitalization. Your total portfolio should be diversified across market capitalization to mitigate risk.
Risk mitigation: the argument of halting growth
Some investors feel that the buying position should be kept small because the notions above have hindsight bias. In my experience, this worry is an overstatement. With a strong emphasis on company quality, the growth most often continues.
In my hands at least, the initial position has not been too big because of realized downside risk. On the contrary. The initial position has been too big because of realized upside risk i.e., the most successful pick reaching a weight of 25% of the total portfolio. Trimming such a position results in realized capital tax and is thus not an optimal situation. This is the reason I suggest a modest 1.5% allocation into new buys.
Forget the price upon buying decisions
Buying price matters because it has an effect on both risk and return. Buying lower is better. That being said, the way to think about this is not stock price, but the stage of the business life cycle. Say you would get a 100B market cap growth company for a 10% discount. This sounds and is great but should be contrasted with the long-term opportunity of buying a 10B company.
In addition, it is not easy to determine the right price of growth stocks and the investor has to live with the options available at any given time point. Let me explain this through an example. In July 2020 I bought shares of a company called CrowdStrike (CRWD) at the price of 104 dollars. CrowdStrike is a great company specialized in AI-powered cloud-delivered endpoint protection. The stock price had risen substantially since the bottom in March, and by any metric, I found the stock utterly expensive. I bought it anyway.
My alternative would have been to wait for a more reasonable entry point. I anticipated rotation and a general correction in growth stock prices, but of course, I could not have known that this would actually happen. Nor did I know when this would happen. Now the correction did happen and there has been a substantial decrease in CrowdStrike's stock price from more than 250 dollars to below 180 dollars. Even with this correction, I was far better off with my buying price of 104 dollars.
The alternative to timing the market, is to pick another, less expensive, stock. This is also problematic. First, by looking at price, one gets tempted to compromise on quality. This strategy is based on long-term compounded growth, and in such a setup compromising quality is a risky deed. Second, the market is quite efficient and most often I find a quality-based reason for why one stock is cheaper than another. If I do not find this, the reason is more likely to be bound to my limited ability, not strong market inefficiency. To sum it up, focus on the stage of the life cycle rather than price.
Focusing on the life cycle model upon buying decisions
Once a company is bought into the portfolio, it will be kept there until the growth stops. No speculation on whether the growth should stop. No speculation on whether the stock price got too rich. Simple decision based upon the actual reported numbers. This is a decision. This is strategy. The benefits: high efficiency.
With a high-throughput approach to the decision of holding and selling, one can allocate more energy to the buying decision. Even more, the growth most often continues and selling rarely occurs. With less capital to allocate, one puts more effort into any single buying decision. There are other benefits, lower trading costs, tax efficiency, but the benefits of allocating more resources to buying decisions should not be understated.
Let's study how to make a buying decision based on the business life cycle. Early-stage companies might offer a compelling story, but there are no numbers to support this story. Mature companies, on the other hand, should be judged solely on numbers.
The interesting companies are a mix of both, and the critical question is how much realized actual numbers are needed to support the story. For this strategy, the numbers are about whether or not the company has what it takes to succeed big time. The numbers are not about stock valuation.
Some companies do fail, and the company track record helps in assessing the size of this risk. Understanding the technology and the actual competitive landscape, including alternative technologies to solve the same problem, is challenging. The track record of the company - e.g., past revenue growth - mitigates this type of risk.
However, overemphasizing the track record to the level of buying only companies with a market capitalization above 500B definitively destroys the chances of hitting 10-bagger returns in any of the picks.
Hence, one should aim for finding the optimal mix of story and numbers. In other words, an optimal mix of management promises and a track record of delivering on those promises.
This is the main point of this article: the optimal buying point is when you are convinced that this company really has what it takes to succeed in the long run. Not earlier, not later.
The conflict of sell and buy
As buy and hold is such a central piece of the keep-the-compounders approach, one finds a clear conflict: if I want to buy now, I have to sell now (and pay capital gains tax).
An alternative to selling earlier is to buy later on. This is also problematic. If I am convinced about a business now, and buy it two years from now, I could still make a great investment. However, this is not the optimal approach.
Let's take an example. I am personally convinced that Pinterest (PINS) should have what it takes to really succeed. The problem is that I would have been convinced already at the stage when Pinterest went public. Pinterest went public with a market cap of 10B, now the market cap is 47B. I still see Pinterest as a great long-term investment opportunity, but keeping "conviction in 2019" in mind, this would be a suboptimal buying decision.
Focus on companies that are investable tomorrow
The key to this dilemma is to shift focus from companies that are investable today to companies that are investable tomorrow.
Thus, you focus on companies within disruptive or soon-to-be-disruptive industries and ask yourself what needs to happen to make you convinced that this is about continued growth, not speculative growth. Defining your own conviction point requires experience and skill. For inexperienced growth investors, my advice would be to start with more solid track records, like Pinterest and Sea Limited (SE). Learn about the growth drivers, competitive positioning, and moats. Buy the companies and learn how to hold them.
The investor timeline of the buying process
Once you have experience in identifying the hallmarks of sustained growth, you can start to work your way down towards earlier stages of the business life cycle - i.e., smaller companies.
1) Start with a list of potential companies.
2) Make the list shorter based on qualitative characteristics of the story, such as recurring revenue, owner-operators, scalable business model, high or shrinking gross margins, founder-led companies, high customer retention rate, attractive and growing industries, etc.
3) Define what needs to happen for you to believe that the story will succeed big time. A conviction cannot be bought or borrowed. These must be your criteria that are based upon your own experience. Think about how much number-based evidence you need to support the story. In other words, make a concrete definition for your "earliest possible full conviction point". Some examples of such criteria:
- I will buy Desktop Metal (DM) if full-year revenue for 2021 equals 78 million dollars.
- I will buy Berkshire Grey (RAAC) if revenue growth exceeds 200% on a year-over-year basis or if the year 2022 revenue equals to 119MUSD.
- I will buy fuboTV (FUBO) if they succeed in monetizing sports betting.
4) Follow whether the company meets the criteria you defined.
The process above is designed to weaken the conflict between sell and buy and is summarized in the figure below.
Buying in same-sized blocks is justified. If you get an idea of "buying a starter position and adding later to it," don't. This is a sign that you are not convinced about the business and deem the risk too high.
Instead, study deeper and ask yourself what needs to happen to the business for you to be convinced. Define criteria. Follow whether criteria are met. If they are met, then you buy a full block at once.
Buying small is justified because it eliminates the need to trim an overgrown position at a later stage. Trimming is not optimal, because it results in tax through realized capital income. Also, try to avoid adding to your positions. This is not optimal, because from the business life cycle point-of-view, buying into old positions is buying post-conviction.
The benefits of SPACs
This strategy is not limited to SPACs or special purpose acquisition companies but definitively is set to deliver from some characteristics of SPACs. Small size is beneficial. Many great companies going through the traditional IPO route are large. For example, at the end of its first trading day, Airbnb (ABNB) was trading at above 86B. Given that few companies ever reach beyond a market cap of 500B, the upside is clearly limited. Small size brings great potential.
The second benefit of SPACs is that they are allowed to make long-term projections about their future growth. This is useful because it helps to screen for cases that should have super strong long-term potential.
However, it is highly likely that many of these future expectations will never be met and here the "what needs to happen for me to believe in this" comes as a handy tool. In addition, data suggest that SPACs can be bought at a significantly lower price twelve months post-merger. In addition to the hyped price, buying a SPAC directly from the merger announcement is problematic due to the general SPAC structure. The problem is the unknown degree of dilution caused by the share redemptions and warrants. Wait one year and you have a clear view of the number of shares and the real market capitalization.
Killing that boredom
If discipline is the ally, then boredom is the enemy of buy-and-hold. Focusing on "not yet" companies has the advantage of killing your boredom in a way that minimizes the dangers of the feeling of an urgent need to act now. If bored, you can also choose to track your own performance in predicting and holding growth. This can help to turn the focus from short-term stock price fluctuations. As an example, this is how I view my HubSpot (HUBS) position.
What to expect from this strategy?
This is a high beta strategy. This means that the market value of individual holdings and the entire portfolio will fluctuate to a large degree. Second, this is a time-consuming and time-demanding active stock-picking strategy. Because of these characteristics, this strategy will not be suitable for all investors.
That being said, the core is buy and hold and the selling decisions are based on efficient high-throughput criteria. Also, if time constrained it is straightforward to allocate less time and compromise a bit on the buys. Ultimately the benefits of this strategy are increased risk tolerance, low trading costs, and deferred capital tax.
This article was written by
Analyst’s Disclosure: I am/we are long NOW, AMZN, CRWD, PINS, HUBS, ROKU. 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.
Seeking Alpha's Disclosure: Past performance is no guarantee of future results. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. Any views or opinions expressed above may not reflect those of Seeking Alpha as a whole. Seeking Alpha is not a licensed securities dealer, broker or US investment adviser or investment bank. Our analysts are third party authors that include both professional investors and individual investors who may not be licensed or certified by any institute or regulatory body.