Growth investing in a low-growth environment: part 2
What are the hallmarks of an investable IPO?
Published October 9 2019
Steve Chiavarone: Hello again, this is Steve Chiavarone, portfolio manager and equity strategist at Federated Investors, and we're back with Part Two of my discussion with my good friend, Steve DeNichilo, senior portfolio manager So when you think about that, there have also been - In that IPO space, there have been some disappointing IPOs over the course of the last year, and there's some unflattering characteristics, if you will. You've got some companies going IPO that are losing sums of money, et cetera.
Steve DeNichilo: Right.
Steve Chiavarone: Talk about your - So you're evaluating IPOs, you've got company management in. What are the things that you're looking for? What are the hallmarks of an investible IPO? Then what are some of those red flags that when you look at it, you realize, okay - As you said, maybe all that glitters is not gold here? How do you think about that broadly?
Steve DeNichilo: Although gold has been quite good this year.
Steve Chiavarone: It certainly has. If the Fed keeps cutting rates, it may continue to do well.
Steve DeNichilo: So look, we're not afraid to invest in an IPO that is losing money today, especially if they have accelerating, exciting sales growth. We're able to look past that. What matters though is the capital intensity of the business; the returns they can generate vis-a-vis the capital invested. So when you have an asset-heavy company that cannot generate incremental margins, then it doesn't matter how fast that company is growing. I mean, you've seen two very high profile ridesharing IPOs come public this year where 80% of their costs is insurance to cover drivers. So the more drivers you have, the more insurance you have. That is not necessarily an asset-light company, and so that environment is -
Steve Chiavarone: You want a scalable business.
Steve DeNichilo: If you're growing 100% and your expenses are growing 110%, that's not exciting to us. What you want to see is - I mean this is not brain surgery here. You want to see low capital intensity, high incremental margins, and the ability to take advantage of that increase in sales. We look at it as free cash-flow growth. You can look at an income statement and there can be a lot of games that can be played. A balance sheet is just a moment in time. Free cash-flow statement is everything, and it's where it's very easy to see the ability of a company's success going forward.
Steve DeNichilo: We want to see a company that is self-financing. We don't want a company that's coming back to the capital markets every three months. We don't want to see big sponsor ownership where they're going to be selling down their stake, and we're going to be the last one holding the bag. So we look for clean asset light growth stories. It's something so simple to say, but when you're seeing all of these IPOs coming to market and they're very exciting, and they're front-page headline news; it's easy to get intoxicated by that but we tend to steer clear of these asset heavy companies, or companies that cannot show those incremental margins.
Steve Chiavarone: Yeah, it's interesting. You talk a lot about free cash flow and companies that are able to generate their own free cash flow or be able to cover their expenses with their own free cash flow. It's interesting because there's a lot of fear out there about a recession. So I mean, as you know, we've got our recession dashboard. We think it's still a little bit ways off. We're targeting nothing before 2021. But when you think about the later part of the cycle as you go into recession, what strikes us as interesting, and one of the things we're wrestling with on the macro side is: It's conceivable to us that at least some of these growth companies could be more defensive because they're generating their cash flow. They're living within their means. They should have the ability to continue to fund themselves. They're not overly indebted. Talk about that. What are your thoughts about - I mean, obviously, look. If there's a recession, stocks are going down.
Steve DeNichilo: Right.
Steve Chiavarone: I mean, we all agree with that.
Steve DeNichilo: It's the first thing I was going to say, everything goes down, right?
Steve Chiavarone: Yeah. I mean, it's going to go down, but what are your thoughts on the idea that perhaps growth is a little bit more defensive this cycle than maybe you would think?
Steve DeNichilo: I don't even know if it's this cycle, Steve. If you look at 2009 ... 2008 and 2009, and nobody likes to look back at that, but the growth indices actually outperformed value indices. I think it's because you still had companies that were growing. If you look at some of the biggest FAANG stocks today or just internet retailers, they were still actually able to grow revenue in that environment. So in a period of a recession where everything goes down, I still think that small cap, innovative growth companies that are not reliant on GDP should be able to do well. In your scenario of a recession, let's just say the debt market seizes or at a minimum, is just not open-
Steve Chiavarone: Let's hope that doesn't happen.
Steve DeNichilo: Right. But let's just say instead of raising money ... I mean, we're seeing a lot of also-ran companies raising money at 5%. That's not necessarily sustainable or normal, and it allows a lot of zombie companies to survive. These growth companies are not hoping for finance. They're not worried about refinancing, do not have large debt maturities coming, and so it's just one less risk that you have to worry about. It's not going to protect you completely in a bad scenario, but it should be more defensive, and I think it's something that investors forget about.
Steve DeNichilo: I think we've been stuck in - Even though at this point it's 18 years old, we've been stuck in this 2001, growth is dangerous environment post the dot-com bubble, and you probably have a lot of now baby boomers in their retirement who are saying, I don't want to get blown up like that again, because a lot of people were. It was our era's Nifty Fifty, right? And where a lot of people choked on a lot of stocks going down pretty hard. I just think it's a different environment. I think these companies are better capitalized, have better balance sheets, have better margins and have stickier revenue base.
Steve Chiavarone: Yeah, we see that from the top down. I mean, when you look at the tech index, yeah, it may be sitting at or near all-time highs, but it's certainly nowhere near all-time high valuations. I mean, even at these elevated levels, you're not in the kind of stratosphere. You talked a lot about debt in that last answer and so - A couple of things. One of the things we've observed -
Steve DeNichilo: Debt is bad.
Steve Chiavarone: Well, sure! But when we talk about debt, one of the things that we've observed is: A lot of the kind of older companies that don't have the growth have used low rates over the course of the last decade or so in order to do leverage buy backs, where they're taking out debt and buying back shares, or they're using it for various reasons. Again, as we enter that next recession, it's interesting. A lot of the companies that are traditionally more defensive, but may actually be getting disrupted by some of the growth companies that you're looking at, also have higher debt loads.
Steve Chiavarone: We've got an excess amount of debt around the world. We've got the 17 trillion of negative yield in global debt, which we hear about ad infinitum. How do you all think about debt balance sheets? You got into it a little bit, but let's explore that because it strikes me that that's another area where you can be a little bit more defensive.
Steve DeNichilo: We always think it's funny when people say, Well, we can service our debt. Well, okay. I mean, that's like just saying, I want to be mediocre in life. Just being able to service your debt today in an economy that has been growing for 10 years and what you said is potentially a late cycle. It's a little nerve-wracking for us. In general, we are skewing much more towards cleaner balance sheets and gosh, levering up to buying back stock. We have a couple of examples of stocks that we owned that did that, and we sold them on site. We had a company who was looking for acquisitions, their business slowed the acquirer, and so their multiple got chopped in half, and so they couldn't make creative acquisitions anymore because the targets were trading at a much higher multiple than now their current stock.
Steve DeNichilo: So instead of - Their bill of goods was: We were out there looking for acquisitions to grow, and so they pivoted and they took a billion dollars and bought back stock, and levered up in excess of four to one, and they can afford it, and it's a creative to the bottom line. But we don't think that creates sustainable, long-term shareholder returns. I mean, we want to see a company investing back in its business because there are exciting things to do, or making a creative acquisitions that broaden a company's scope of potential growth. Just buying back stock, we think, is financial alchemy. It doesn't do anything for the shareholder. Then you're just hoping for what? Higher multiples on higher earnings that are simply grown because of buybacks? It's just not a sustainable way to make money we think, and we tend to steer clear of companies where that's their number one avenue for growth.
Steve Chiavarone: Well, it's interesting because when you look at the per-share earnings growth -
Steve DeNichilo: Right.
Steve Chiavarone: Over the last, let's call it two or three years, it looks pretty good. It looks better than pretty good. When you look at the aggregate earnings growth, it doesn't look quite as good because you've had a lot of that buyback and alchemy.
Steve DeNichilo: Of course.
Steve Chiavarone: So as scarce as growth seems, it's actually even a little bit scarcer when you strip away some of that per-share type analysis.
Steve DeNichilo: Yeah, look at the largest multi-industrials that are sort of canaries in the coal mine for the global economy. They're growing at 1 or 2%. Look at railroads in the U.S. I mean, if you look at rail car loadings, it's down a few percent. If you look at - We spend a lot of time - And we're not necessarily always focused on the macro, and we're really focused on stocks, but look at air freight out of Hong Kong. I mean, think about it. If you need something today and you're conducting commerce that needs to happen this week, you will air freight it instead of putting it on a ship. Those air freight numbers are down mid-single digits. Durable goods orders are negative. I mean, there's clearly a slowing and malaise out there. I don't necessarily think that means we're going to have a minus 30 or 40 in the market, or a minus three in GDP. It's just we're in this sort of muck right now, and in that environment, I think you want companies that can create their own shot.
Steve Chiavarone: It's very interesting because one of the things that we've focused a lot of time on is it's almost two economies in a way, right? You're absolutely right in saying that business spending, B2B trade related manufacturing activity, kind of global industrial activity, has slowed and slowed significantly. We think that's one of the reasons that central banks are kind of back in play. At the same time, at least for now, those consumers, at least in the U.S., remain robust. Job growth remains robust. Wages are rising.
Steve DeNichilo: Is it robust, or is it just stable because they have jobs?
Steve Chiavarone: Well, we're still bringing in 130,000 to 170,000 folks per month off the sidelines. If you look at even some of the more recent job reports over the last couple of months, you've got participation rates rising. You're pulling folks in off the sidelines, and so you know, the retail sales are doing okay. It's interesting the perspective that you can get depending on who you're talking to, and I want to segue here into sectors because again, I think if you were to talk to a retail analyst today, they probably feel very different about how they're - In certain segments, than you might feel when you're talking to someone like yourself that covers more industrials and materials. So as you look broadly, and feel free to make any differences by market cap; when you look broadly by sector, where are there opportunities that appear to be more abundant and where are there opportunities where there's just more risk than opportunity?
Steve DeNichilo: I mean, look. If you look at general industrial materials, things tied to China, GDP, things are very blah. I mean, it is a cloudy, overcast day in those sectors. It's not terrible, but it certainly is not growing, and you're hoping for what? If you're a global industrial company, you're hoping for a China stimulus. You're hoping for the European ... Excuse me, the European economy to hook up and actually start posting some positive GDP. I mean, there's not a lot of excitement out there if you're a technology/software company. If you're a healthcare device company, if you're a biotech that's benefiting from only being 10 years in from mapping the human genome, which used to take three years and a couple of billion dollars, and now you spit into a little cup and you can get your DNA mapped in a couple of weeks from 23 and Me. You know, the world is dramatically changing, and I think bifurcated is the perfect way to put it.
Steve DeNichilo: I don't see how that can change right now. The only way you'd get these more cyclical sectors and value sectors to start outperforming is if you have a massive draw down and sort of a reset in all the global economy. But if you're in an environment where China has to grow by X percent or the US has to grow - Sort of equate it to baseball. I'm a New York Yankees fan and -
Steve Chiavarone: Oh, thank goodness.
Steve DeNichilo: The New York Yankees had a fantastic run in the mid-90s to 2000s. By what? By having homegrown, organic growth. Then all of a sudden, Derek Jeter starts announcing that we have to win every single year, and if we don't win the World Series every year, the whole year is a failure. In that environment of having to win every year, what happens? You go out the risk curve, you make bad moves. You can't. It's not organic growth, and that's the same thing where we are in the economy.
Steve DeNichilo: If you're an environment where you have to grow; if the White House does not allow a recession to happen and you keep stretching and stretching and stretching it, eventually that rubber band is going to break. Organic economic expansions are what are most powerful, and we're in this weird time right now, admittedly, and I think you guys agree; where we've had the low growth for a long time. No one is allowed to have a recession anymore, and you keep coming back, coming back to the well looking for different ways to grow. So in that environment, what have we had? Just low growth and nothing amazing. So these global cyclicals have not done well, and investors should continue to focus on companies that don't need all that noise.
Steve Chiavarone: If you think about it -
Steve DeNichilo: You like that metaphor? I thought that was a good one.
Steve Chiavarone: Well, you know how I love baseball. No, I think it makes a lot of sense. When you start reaching for that player that used to be a blue chip that's in the decline, and then hoping that they find the fountain of middle age again, that's a problem.
Steve DeNichilo: Right, because your organic growth, your organic homegrown talent is not there.
Steve Chiavarone: And I think you were talking about flows. That's one of the reasons why I think you do see folks going back to the value cyclicals because in years past or in cycles past, if you were going to get stimulus or you were going to have any kind of pickup in growth, these were the folks that led. What they're missing is some of the disruption. Right? For example -
Steve DeNichilo: And no pickup in real growth.
Steve Chiavarone: China, a resumption in China growth may be less resource intensive than it was in the past. It might be more concrete. It might be more concrete and less copper. It might be more consumer. It's not all of the things being equal, and I wanted to dig into this, because even within a sector ... Right? So when you think about the classic example, I think everyone sees on the news, is what's going on in retail. You can have tremendous new retail opportunities, your belt company notwithstanding, and at the same time you can have massive death. I mean we've seen as many store closures and retail bankruptcies over the course of the last couple of years that we've maybe ever seen.
Steve DeNichilo: Look, I mean even this year, you've seen bankruptcies in traditional mattress companies, which isn't a very exciting sector. Yet, you're seeing upstarts and online. All of a sudden, we don't have to take the terrible trip to the mattress store and people are buying mattresses online and those companies are being very successful and very profitable, and it's a complete disruption of something that nobody really realized had to be disrupted.
Steve Chiavarone: So I think as we wrap it up, here's my question. I don't think we've talked about it yet, but I'm big on technology. I'm big on technological disruption. It's come up a bunch of times. What are some of the cutting edge technologies or areas of technology, be it in biotech, be it in more generalized sectors that you guys are paying attention to, excited about? Maybe seeing some opportunities and specific companies around these key technologies?
Steve DeNichilo: You know, it doesn't always have to necessarily be cutting edge, although we spend a lot of time on cutting-edge companies. I mean, in the healthcare device land, we have companies that are changing something as chronic as sleep apnea; where you have technology that is literally 40 years old and has not changed, and you have new upstart, different ways of attacking a problem that has been around for a long time. I mentioned on the biotech side, since we've been able to map the human genome, how we attack diseases has fundamentally changed and it's only been five years old, right? Then there's some more mundane sectors. For example, I think our kids' kids will not use single-serve plastic bottles. You won't have bottled water anymore. You won't have the red Solo cup anymore. It is not fully recyclable. It is completely ruining our environment, and there's been a slow groundswell of pushback.
Steve DeNichilo: You're seeing San Francisco recently ban all plastic one-use containers. What is infinitely recyclable and much more green, although you wouldn't think about it, is aluminum. So something as simple as aluminum beverage cans, we think, is like a 10 year growth horizon, right? So there's disruption everywhere. It isn't always science or technologically related. It could be just something consumer focused.
Steve Chiavarone: Societal!
Steve DeNichilo: That's right. Society awakening to a problem that needs to change, and the reality is, it's that using a plastic container for one sip of water and then throwing it out is not really sustainable. The world is always changing, and that's what's exciting about being a growth investor. It's that you're constantly thinking about tomorrow. You're taking today's norms and thinking: How can this change? And that sort of disruption occurs if GDP is positive 5% or negative 5%, and so we think that growth investing and growth portfolio always has a place in a diversified portfolio of our clients and we're excited to offer it every day.
Steve Chiavarone: And that's - To kind of wrap it up, that is one of the two pillars of why we've remained bullish over the long run. As we look at the U.S. economy, particularly when we compare it to some other developed economies, there's two ingredients that we see here that just don't exist in other major economies right now. The first is population growth. We continue to have it, I mean it's slower, but it's still population growth. We don't have the decline -
Steve DeNichilo: People don't think about demographics, but it's very powerful.
Steve Chiavarone: In the end, I mean that's probably the most significant contributor to long-term growth. Then the second thing is: The United States is ground zero for innovation across multiple sectors, multiple avenues, and so it keeps us in the long run as you talk about those sustainable returns; that long-term focus, it keeps us very constructive. Steve, thank you, and thank you to our listeners. We hope you enjoyed this two part discussion and we look forward to having you join us again on the Federated Hear & Now podcast.
Disclosure: Views are as of September 6th, 2019, and subject to change due to market conditions and other factors. This should not be construed as a recommendation for any specific security or sector. Federated Advisory Services Company.