In past installments, we distinguished between our definition of risk compared to volatility. Risk, is the degree of uncertainty embedded in a company’s business model. If this uncertainty enlarges due to the timing or the realization of profits or cash flows, then a company’s intrinsic valuation can be affected. Identifying companies with expansion characteristics over a long time horizon is one way of improving the portfolio’s risk characteristics, as over time, the consistency of their cash flows will be recognized, business risk is reduced, and valuations can grow more sustainably. Volatility, on the other hand, represents market fluctuations that are often unrelated to a company’s fundamentals. Sometimes, these market events may present low risk, high reward juncture points in which quality assets can be acquired at attractive valuations.
Recently, our idea generation practices have led to the identification of earlier stage growth companies, which we believe operate in industries with attractive economics and long-lived growth characteristics. The longevity of growth is one of the key influences on a company’s intrinsic valuation, and in identifying companies that are still in their earlier stages of growth, we believe that we are developing a time horizon advantage within client portfolios. The second factor that is often associated with growth companies is that their perpetual growth characteristics are usually higher than comparable steady-state peers, and this is oftentimes because of the nature of the industry – it may be early in its growth cycle, complexity may be rising over time, use cases may be expanding, or consumer preferences may be shifting in a meaningful way. For example, companion animals might be an industry that most of us can relate to. Pets are living longer, more fulfilling lives, but moreover, there are many pet-specific therapies that are still in their early stages of development. In addition, as we look upon our pets as family members, the value we place on a pet is rising, giving rise to an enlarging animal pharmaceutical industry. Zoetis, as a long-term portfolio holding in the animal pharmaceuticals space, has been the means by which we have expressed this idea.
The second aspect of portfolio management is informed decision making, and this is usually a combination of assessing the quality characteristics of a company alongside its valuation. In the early stages of a company’s evolution, its value is mostly sensitive to changes in its forward looking growth outlook. Then, as this growth becomes more consistent, investors start to focus their attention on the consistency of revenues and their durability. This is why longevity is important. The greater the longevity, the more opportunity for market expansion, which ultimately leads to sustainable earnings growth over a longer time period, and as a result, higher valuations. The industries in which we have been finding these opportunities usually have a utilitarian nature, giving rise to recurring revenues which grow as the industry expands in complexity. Industries include infrastructure engineering, mission critical data analytics, and healthcare software as a service opportunities. The commonalities between these industries are evident: They are all growing in complexity, they have utilitarian characteristics giving rise to recurring revenues, their cash flows are becoming more consistent, and there is a high degree of longevity within their operating platforms.
The third aspect of our research process is continued dialogue with investment representatives of the companies we hold. We are mostly interested in the key insights the companies have about their industry growth drivers, whether certain secular share shifts can produce meaningful expansions, and the company’s overall positioning and strategy for long-term success. For example, we recently held a discussion with the owner operator and CEO of one of our small cap healthcare data analytics companies, and learned about the increasing involvement of healthcare data analytics in informing patient decision making. During the month, we also discussed with one of our consumer media companies their vision for a more consumer-centric model of consuming digital entertainment. By following our companies, becoming more attuned to their changing business practices, and merging both our qualitative and quantitative insights, we believe we can develop expanded perspectives about how companies create value, resulting in more informed, thoughtful decision making.
We welcome your feedback and suggestions for future journal topics. We hope you are well and are enjoying the start to spring!
Grace, Sam, Leslie and Jennifer