Q4 2016 CIO Insights: U.S. Growth Equity – Large Cap
Much of this edition of CIO Insights has been devoted to an election theme. While the presidential election is important, it has comparatively little influence on how we manage money day to day. Rather than electoral votes, we focus on dollar votes—that is, how a company generates and allocates capital relative to its competition and stage of development.
Fundamental Insight into Enduring Advantages
We use extensive fundamental research in an attempt to find companies with enduring, systematic advantages relative to their competition. We prefer companies smartly investing in their businesses and realizing high returns on invested capital. But much as with claims of today’s electoral candidates, it pays to look at results and statements of corporate management with a healthy degree of skepticism. The goal is to understand how they are able to outcompete their competition, and whether or not they are likely to be able to do that consistently over time. Then we can ask the question, does this company have the growth profile and likely performance contour that we want in our portfolio?
Analyzing a Movie, Not a Snapshot
There also needs to be a recognition that companies in different stages of their development cannot be evaluated equally. The analysis must be specific to the context of a company’s own lifecycle and its current stage of development. For example, a company in its growth phase should have lower profit margins and free cash flow generation than one at a mature phase.
We’ve used this analogy before, but it bears repeating—the goal is not to define a company by its financial snapshot at a given point in time, but approach it as one might a feature-length film. In this way, we consider the likely lifecycle of the business to understand the potential to generate cash flows and reinvest them successfully.
Our investment focus is on how companies cast their dollar votes.
This is necessary because high levels of investment at early stages of revenue generation naturally combine to produce subpar or even negative returns on equity. As a result, early-stage companies cannot be evaluated on the same basis as mature businesses; rather, a fundamental analysis of the potential business model beyond the current time period is required to divine the company’s potential. This includes studying capital intensity, the operating cost curve, working capital dynamics, and scalability of fixed to variable expenses, as well as the company’s competitive position and underlying market growth.
Every Vote Counts
This is not an academic exercise—how companies generate and allocate capital turns out to be crucially important at determining winners and losers in almost any business over time. In the short run, companies may be able to sustain operations and endure a negative return on equity by raising capital from financial markets. But this is not a viable business plan in perpetuity.
We see time and time again that companies that can fund operations out of their own cash flows and that are better at deploying capital outcompete those that cannot. This was true during the tech and telecomm bubble of the late 1990s and early 2000s, and we’ve seen it again more recently in the biotechnology and energy sector sell-offs, and in the current technological transformation of whole swaths of the consumer and tech sectors. So while we will keep our eyes on the latest polling data, our investment focus is on how companies cast their dollar votes.
The opinions expressed are those of Greg Woodhams, CFA, and are no guarantee of the future performance of any American Century Investments portfolio.
This material has been prepared for educational purposes only. It is not intended to provide, and should not be relied upon for, investment, accounting, legal or tax advice.