We had quite the turnout for our summer investment seminar Tuesday evening. Thanks to everyone who made it a special evening. It’s always so cool to see folks reconnect if it has been awhile, or watch others making new friends with each other and discovering they have a common interest or a shared friend. For those of you unable to attend, please come to our next one! Until then, we highlight some of the topics we touched on.
But first, we announced that we have finally updated the “Meet The Team” page on our website, www.monarchcapitalmgmt.com. All 10 of the Monarchians are now present and accounted for, with photos and bios to represent. So come get to know the team. Even if you feel like you already know who we all are, you’re bound to find a few new nuggets. Many of us have Master’s degrees, but who has a PhD? Who was the valedictorian of their class? (We also have a salutatorian, though it is not shown in the bios…major bonus points if you can guess who.) How many gardeners are there here, and what is it with investment advisors and gardening?
After Dave introduced the Monarchians, Adam shared a story originally attributed to legendary investor Ralph Wanger. He observed a man walking his excitable dog around Central Park every day. The dog would dart to the left, to the right, backwards and forwards as much as the man’s leash would allow. The dog’s path, if it were charted on a map, would look highly erratic, compared to the man, whose path was straight along the path. And yet they both arrived at their destination together. Everyone enjoyed watching the excitable dog and his antics, but nobody cared much about the owner’s straight path. So it is with the price of a stock (as portrayed by the dog)—it attracts a lot more attention than the fundamental value of the business (as portrayed by the owner), but in the long-term, they converge to the same point.
It’s a lot more exciting to watch stock prices, and we stock pickers are often guilty of doing so, but it can distract us from tracking the value of a business. The point is that, in the short-run, the market is a good gauge of sentiment for a stock, but in the long-run, it will reflect its value. You must therefore conclude that buying growth stocks is imperative to long-run success because the valuation will work itself out, but without growth, a company doesn’t become more valuable.
Every company tries to grow, of course, but most do not succeed. Even if you consider only publicly-traded stocks, the data are not reassuring. Adam showed the results of a study of all stocks that traded at any time from 1989 – 2015. As it turns out, 44% of stocks lost money over their lifetime during that 27 year period. 25% lost 75% or more. For reference, the S&P 500 generated a return in that time of +636%. “Overachievers” is a misnomer, since the threshold of >300% total return is far less than the S&P’s performance. But alas:
John then elaborated on our mission of buying growth stocks, as long as they meet our criteria for quality. We’ve been spending more time lately thinking about the life cycle of businesses, and viewing the companies we own through that lens. Here’s a good chart showing business life cycle:
This is overly simplistic, to be sure, but it’s a good template for defining a company’s phase of life at any given time. The “Growth” phase begins when the business is no longer a startup, and is growing very rapidly, before it hits its first major speed bump. This phase is populated by young businesses, some which aren’t even profitable yet, and others whose highest-profit days are (supposedly) years down the road. The transition from Growth to Established is hard for a business. This is when its business is not growing rapidly anymore, thanks to a slowdown in its market as it matures, or perhaps because competition has entered the market. Companies that find themselves here must reinvigorate, restructure, and/or reinvent in order to get back to faster growth. This transition is even harder for investors in these businesses, because Growth-phase stocks can trade at wildly overly optimistic valuations which don’t reflect the possibility of a slowdown anytime soon. The greatest risk is if a company hits Maturity, perhaps en route to Decline unless the company’s reinvention is successful.
We looked at two stocks we own, totally drawn at random—Home Depot and Microsoft. One of our customers told me after the presentation that he came to the seminar armed with two questions…to ask about Home Depot and Microsoft! They both had their golden era in the 1990s and their stocks peaked in early 2000, when the dot.com bubble hit its peak. They both continued to grow sales strongly in the next cycle; Home Depot by 90% from 2001-06 and Microsoft by 140% from 2001-08. Earnings grew commensurately. And yet both stocks were miserable…9 years of nothing for Home Depot and 12 agonizing years for Microsoft. Despite continuing to grow sales and earnings, their growth rates were slower than in the 1990s, and this was corroborated (caused?) by a few key bad decisions by management in the 2000s. Naturally, the market had decided that each company’s best days were behind them and the outlook was so bleak that it was hard to see how they would be able to grow in the long-term. In other words, the market had declared that they had moved from Growth to Established and straight on to Maturity.
When in fact, both companies had been working tirelessly to reinvigorate and reinvent, and were merely moving from Established into Expansion. Check out their sales and EPS growth since 2009 (Home Depot) and 2012 (Microsoft). Quite the comeback! Microsoft’s earnings from 2012-15 trailed the resurgent sales growth as the company moved more and more business to subscription-based (in the cloud) instead of upfront software license fee.
Our sweet spot as stock pickers is finding undervalued stocks which the market believes have entered Maturity but in actuality are reinvigorating under the surface, about to move from Established to Expansion. Not only do you benefit from the growth of the company, but the valuation increase as well. Witness their stock charts:
It’s worth emphasizing that these companies have done a lot right in order to successfully reinvigorate…neither is a simple case of growth just finding its way back to them. And we had very good reasons to hold onto the stocks, although we certainly did not forecast the two big events that happened to reshape the trajectory of each. For Home Depot, the financial crisis resulted in many regional and local home improvement chains going out of business, which gave the company 3 things: 1) concentration of market power, which gave them pricing power and margin expansion, 2) a highly-experienced sales floor workforce which became available when the housing bubble busted, and 3) no pressure to build any new stores because they were already national, which freed up cash flow to invest in omnichannel (selling via website, ship-to-store, etc.), Pro (catering to contractors), supply chain, a much higher dividend, and the buyback of half of the company’s shares since 2007.
In Microsoft’s case, the narrative in the early 2010s was that of a mature Windows and Office business, both of which were suddenly facing competition, and lack of success in mobile. We, however, saw a robust SMB (small and medium-sized business) suite of productivity application software and, far more significantly, Microsoft was still huge in data center, with a comprehensive suite of database, middleware and application software. This became the springboard for the company to jumpstart its Azure business of hosting customer data centers in their cloud.
The major takeaways are: 1) good companies are continually reinventing themselves, although it isn’t obvious sometimes, 2) the commonly-held narrative around a stock isn’t always right, 3) stocks can be wildly successful as they transition from Established to Expansion, and 4) valuation doesn’t matter as much in the long-term, but it very much does in the short-term. For Microsoft and Home Depot, the “short-term” was roughly 12 years as their sales increased exponentially but their stocks went nowhere.
As growth stock investors, the 2010s was a very kind decade to us, although things took a dramatic turn in 2020, when Growth outperformed Value by 37%, which is an almost unprecedented gap. Growth stocks that did the best were the youngest, fastest-growing, and unprofitable companies. In fact, the median performance of unprofitable stocks in 2020 was +73%!! Growth at any price with no regard to quality. These companies are firmly in the Growth phase of their life, having not yet seen the Established phase. The consensus opinion is that these companies should have 10-20 years of strong growth ahead of them, by which time they will finally be quite profitable. Some of them no doubt will. But it harkens back to a very similar time, in 1999, when young Growth companies were also seen as having 10-20 years of unassailable growth ahead of them. Below is the list of the components of the Dow Jones Internet Index at the peak in 2000. Remember that these were the titans of the internet, not the fringy e-tailers like Pets.com:
If you were a student of the market in the dot.com boom, you will surely remember a lot of these names. But how many are still around? Only 5. Granted, some were acquired, but none was acquired at a price above their 2000 peak price. Most, however, were out of business by 2001 or 2002. So much for 10 years of 30%+ annual growth! They went straight from Growth to Decline in months, without even pausing to stop in Maturity. Of the 5 survivors, two have modest gains in their stock since: Check Point and Verisign are up 15% and 10%, respectively, in 21 years. Kudos for surviving the dot.com shakeout; it helped that they were in an enduring business (cybersecurity) or have a near monopoly (website domain registration). But still, the S&P 500 has tripled since then; these stocks are woeful underperformers, and this despite EPS growth of 600% (Check Point) and 1,400% (Verisign). Valuation apparently matters even over 20 years.
The 3 winners were Amazon, eBay, and Priceline (now known as Booking.com). Profiting from holding the stock since then required going through the dot.com bust, when their stocks dropped 94%, 77%, and 99%, respectively. That would take some serious intestinal fortitude, to hold a stock after it fell from $151 to $1 (Priceline). eBay succeeded largely because of its development and ownership of PayPal. Amazon has clearly been a huge winner, although it’s worth noting how rare it was among these 40 titans of the internet.
Finally, we shared our economic outlook. The economy is on fire right now and should continue to grow rapidly into next year. Beyond that, we are concerned about two things. First, the “stimulus cliff”…once most of the pent-up demand and savings are spent, how much will that drag down consumer spending? Secondly, inflation is really hot right now. While supply chain bottlenecks and product shortages should eventually be solved, labor market inflation is poised to ramp up to uncomfortable levels going forward. There were 9.2 million unfilled job openings as of April, which was an increase of 1 million in just 1 month. Wages have already taken off and must accelerate further, which will push businesses to raise prices, which they are doing right now. But at some point price increases might not be received as readily by buyers. If they are not, businesses will shut down the engines and stop hiring. If they are, we could be looking at a wage-price spiral, where everyone becomes accustomed to inflation until it becomes systemic. There is a way through this, however, if pent-up demand is spent gradually. Judging by how home sales have suddenly cooled off, and the shortage of certain products like cars, this could very well happen.