Growth investing in a low-growth environment
How to identify opportunities in the growth space.
Published October 9 2019
Steve Chiavarone: Hello and welcome again to the Hear & Now podcast. I'm Steve Chiavarone, portfolio manager and equity strategist at Federated Investors. Today I'm joined by Steve DeNichilo, senior portfolio manager.
Steve DeNichilo: Thank you. Nice to be here.
Steve Chiavarone: Let's start today with you and your team. You all are bottom up stock pickers. What are some of the keys to success and growth investing? What's the secret sauce?
Steve DeNichilo: Sure. What we think is that a consistent approach to investing is what's really important. Typically, what we look for in stocks is accelerating growth on a year-over-year basis. Really focusing on second derivative growth we think is very, very important. If you're growing at 30% it may sound great, but if that 30% is all of a sudden inflecting to 15%, it's not so good. Think about if you just had dinner at the best restaurant in New York last night, and then you went to the 30th best restaurant in New York. Maybe that that meal wouldn't seem as good.
Steve Chiavarone: All about the margin.
Steve DeNichilo: Right. So it's all about comparative and where you're going from. So when you think about growth investing, look, these stocks are typically not cheap. And we think really, valuation is reflective of the fundamentals. So we remain very, very keen on those fundamentals in that growth rate. If something is at 20% and it continues to grow at 20%, typically that valuation can hold. And so we're very, very focused on that second derivative growth. In addition, look, in growth investing, you get exciting companies with very charismatic CEOs and interesting ideas and things that blow your mind. You can't believe what they're inventing or bringing to the market.
Steve Chiavarone: Sounds like you.
Steve DeNichilo: Right. It is. I'm a very charismatic guy. But if you can't show a clear pathway to free cash flow growth, then we're just not going to be interested. And look, that has made us miss a lot of very successful growth stocks. But it's our arbiter of success. And it can't just be a great idea, it needs to generate cash. If you're a pizza place across, I keep focusing on food maybe because it's around lunch time but
Steve Chiavarone: I'm with you.
Steve DeNichilo: if you're just a pizza place down the street and you can generate significant free cashflow, we'd be interested. In fact, speaking of pizza, there's very, very successful global pizza brands that have been an absolute juggernaut of free cashflow growth. And so really we use free cashflow growth as the ultimate litmus test of a successful enterprise.
Steve Chiavarone: I think that's so important right now. And obviously we look at markets from a different perspective. You all, from the kind of bottom-up perspective, we're very macro and top down. As we look at the equity market, we break it up into three groups, right: the dividend payers and growers, the value cyclicals and then the growth companies. And what's interesting to us is we think the growth companies, despite having done well, can continue to do well, because they're disrupting the business models of so many companies. And because that growth is less economic dependent, we think they could actually be more defensive. And so let me segue there for a second.
Steve DeNichilo:Yeah, you're absolutely right.
Steve Chiavarone: Because you all have tended to have, you've got a little different view on the economy. You tend to look at companies that can grow no matter what. Talk about that view. Talk about what you're looking for there and how you find companies that don't need the economy to do well necessarily.
Steve DeNichilo: Right. And look, I agree with your three different segments of the market and value cyclicals and dividend payers certainly have their time and place in a diversified portfolio. But there's a clear reason why secular growing companies, is that what you called your third group? I forget.
Steve Chiavarone: Yeah. Yeah.
Steve DeNichilo: If you look at environments where you have slower absolute growth, I'm not talking about negative growth, but in this 1, 2, 3% GDP environment, which we've been in for some time. In that environment, premium, high-growth companies are supply and demand.
Steve Chiavarone: Scarce.
Steve DeNichilo: Exactly.
Steve Chiavarone: Yes, it is.
Steve DeNichilo: It's more scarce. And so in that environment, the market actually values these companies higher. If you look at from 1950 to 2000 where you just had rampant GDP growth, you had brick nations expanding at 10, 12, 15%, In that environment, a rising tide lifts all boats, and that's where you see value cyclicals that perform. We think definitively, you are not in that environment right now. The Fed has been trying to create accelerating growth for some time. It has not worked. And we think we're going to continue to be in this sort of malaise. And in that malaise, growth companies will be valued, higher offense will win.
Steve Chiavarone: Yeah, no, I mean I think we agree. And just taking it in a different lane for a second. It's one of the questions we have about U.S. versus international. When you look at the US indices as an example, they're much more growth heavy. You've got big exposure to tech. If you add comm services, internet, retail, biotech into that, the United States as much growthier environment than you have overseas. And it begs the question, will the United States out-performance continue? So far we think that's right. And obviously that's an asset class decision rather than stock specific, but
Steve DeNichilo: Oh, sure.
Steve Chiavarone: It's a similar logic
Steve DeNichilo: And clearly, look, if you look at the S&P 500, the Russell 1000 indices, those are our market-cap weighted. And so they're going to be skewed by the stocks, which had been very successful. But it is interesting if you look at the Russell 2000 index, for example, smaller cap and less driven by one or two names, those indexes have not eclipsed their highs from August of last year. Right?
Steve Chiavarone: Yeah.
Steve DeNichilo: And so it shows that the volatility's that's out there. And I think in general, investors continue to be under invested in growth stocks. If you look at just the fund flows, the Morningstar fund flows, end growth has outperformed value every single year since 2006. It amazes me that there are still more fund flows into value areas of the market as opposed to growth.
Steve Chiavarone: Particularly, when you have such disruption in part of those values
Steve DeNichilo: Right. We're surrounded by change in our life. The cars we drive, the medicines we take, how we communicate, it's technology, and innovation is around us, and it's really the golden age for innovation. And really the headquarters are the United States. And so there's just a ton of opportunities in growth investing, right now.
Steve Chiavarone: We do a lot of talking about an industrial revolution in that technology and that disruption. And it strikes me that in the growth part of the market particularly, and I want to segue here, as you move down the market cap. We've heard a lot of investors talk about being a little bit nervous about small caps because it's late cycle. We always kind of laugh at that because there's no built in clock in a small cap company-
Steve DeNichilo: Right.
Steve Chiavarone:-that knows that it's late cycle.
Steve DeNichilo: Right.
Steve Chiavarone: They've done quite well. Our view on the macro side is that they can continue to do quite well, particularly in a low-rate environment, because a lot of their debt is variable rate. What's the outlook from a growth perspective as you move down that market cap, and get into the small caps? Are you feeling as good about that part of the market as you have been?
Steve DeNichilo: You have over-levered companies with private equity sponsors, four or five times levered, growing at 1 or 2%. And so they could service their debt, but you're not going to get multiple expansion in these names and they just keep getting cheaper. I mean you're seeing certain small cap value cyclicals trading at six, seven, eight times earnings. And I don't know what are going to drive those stocks higher.
Steve DeNichilo: Now on the growth side, if you have a small cap innovative company that can be completely removed from a Trump tweet, or from a trade war, or from interest rate volatility, or risk on or risk off markets, all these cliches that you hear in sort of the investing universe, that's where an investor should be focused on. This is 1 billion company with a clean balance sheet, profitable today, that is growing 20 or 30% we think for the next few years.
Steve DeNichilo: And typically at Federated, we are longer-term investors. From quarter to quarter, of course you're going to get a lumpiness or illiquidity, or odd capital market transactions. But in general these small-cap companies are idiosyncratic, can be a little bit sort of hit or miss in the short term. But they're exciting opportunities for somebody who can just think past quarter-to-quarter investing, which is really, you asked me before, what's the key to growth investing or successful investing. And there's a lot of different specifics, but one of them is just let time mark.
Steve DeNichilo: I think the hardest thing for investors is that we are completely engrossed in day to day markets. The market is up because of this. It is down because of this. And we like to have headlines. But if you're a billion-dollar small-cap healthcare device company, that is going to change the way we attack diseases, sometimes you just need some months and years to go by, and that's really what creates successful investing.
Steve Chiavarone: I remember us chatting probably about 10 years ago just about trading during the course of the day. Not that there's aren't exceptions to this, but trying never to trade before 10 a.m. before-
Steve Chiavarone: 10 a.m. 11 a.m. now.
Steve DeNichilo: 11:00.
Steve DeNichilo: I have a sticker on my desk that says just 11 a.m. And I don't do anything before 11 a.m. Little investing secret.
Steve Chiavarone: But talk about that. I mean, as I remember, it was about letting the data sit in-
Steve DeNichilo: Right.
Steve Chiavarone: -not making that emotional first move. You get your earnings report in the morning.
Steve DeNichilo: Right.
Steve Chiavarone: You have a tendency to overreact. I think from a macro perspective, one of the things that we've been trying to do as we talk to clients is give them that perspective, right? You wake up in the morning, you see the tweet, you see the piece of news. Maybe there's a Fed speak, and the market's going some way. Just take a break, look at the data, think longer term and make a better long-term decision. It sounds like that's the same kind of thing you're doing at the stock level, is to just try not to overreact to short term noise.
Steve DeNichilo: Right. I mean, look, I think that's what Federated Investors is founded on, is just trading versus investing. And we just live in a fast food nation, where everybody wants a headline, and everybody wants a reaction. Our President wants a reaction to what he's saying, or a trade war, or a tweet and we always need to find a reason for something, we, sort of collective wall street community. And at Federated it's more about investing for the long-term. So I do that on a micro day to day level, by just not doing anything before 11 a.m. You come in, in the morning, let's say it's 8 a.m. You have five earnings releases and some are good, some are bad. You have the macro news, which moves the futures up or down. You have oil doing this or that, and gold doing this or that. It's risk on, it's risk off. And it's very easy to get caught up in that emotion.
Steve DeNichilo:That emotion typically starts to wane after 11 o'clock. I mean, I don't have a scientific clock for that, but you can just tell. I mean that first move in a stock, I'm amazed at how... I always said if I had the earnings release before the entire market, would I get what that stock was going to do? Would I guess right what that stock was going to do in a given day? And I'd be wrong in those first two hours. Most of the time, we see good reports on the stock gaps down 15%, because you have hedge funds that are the majority
Steve Chiavarone: That's your buying opportunity.
Steve DeNichilo: You have the hedge funds and ETFs, which are the majority of the liquidity in the market today. And it's funny, in a world where people keep saying more and more, it's more efficient and it's harder and harder to be active managers. I think that's completely wrong, because on a day to day basis we see more idiosyncratic, incorrect, inefficient moves in stocks than ever before, because the liquidity is driven by either a dumb ETF that isn't thinking fundamentally, or a hedge fund that has a day to day P&L and move. And so in that environment, if you're a long-term investor, it makes fantastic opportunities to take advantage of this volatility.
Steve Chiavarone: It's funny you say that because in a similar way we always read economic releases from the original source first, form an opinion, and then see what the market does. And if the market moves in the direction we would have expected, we'll then work consensus and there's nothing to be done.
Steve DeNichilo: Right.
Steve Chiavarone: If it moves in the opposite direction, well now I've got a money making opportunity.
Steve DeNichilo: Right.
Steve Chiavarone: If I can take the longer-term view. And I think that longer term view allows us to exploit the shortsightedness of some of these players. You started that answer talking about fast food, it's lunchtime. We're both hungry.
Steve DeNichilo: Back to food.
Steve Chiavarone: We're -crosstalk 00:13:40- New York. In the food space, we've seen some interesting IPOs this year.
Steve DeNichilo: Yeah.
Steve Chiavarone: And you and your team are laser focused in the IPO space, particularly on the kind of smaller cap side, but throughout the market cap range. We had a little bit of a delay in the first quarter with the government shutdown on some filings, but then since then it's been kind of a gangbuster year for IPOs. What are you seeing? What are the trends? Where are the opportunities? Give us an idea the number of companies that have come out, the number of meetings you've had, what your processes and evaluating those?
Steve DeNichilo: Right.
Steve Chiavarone: It's been a banner year.
Steve DeNichilo: Right, Look, I think year to date it's certainly a very strong year when it comes to the number of issues, and people like to quote that. I look at it as shots on goal. I mean just because you have a hundred companies come public, doesn't mean that they're going to be good ones. The reality is, is that most IPOs are companies that you have not heard of, are not large ride sharing type companies or just things that are going to gain headlines. They're 100, 200, 300 million offerings that the majority of main street isn't focused on. But at Federated we are quite focused on.
Steve DeNichilo: And so look, sometimes the more exciting the IPO that seems on paper, all that glitters is not gold, as they say. So in general, brands can become bigger and relevant faster than ever before. If you think about social media, Instagram followers, targeted marketing that is more precise than ever before. You can have a very specific company in a very specific niche that historically would not be able to gain the economies of scale. That is completely out the door. Information flies faster than ever before, and companies can scale up.
Steve DeNichilo: And so where sort of a large retail brand, or something that's ubiquitous is not necessarily an exciting investment anymore. Because look, we have too many stores, companies are closing stores. The bigger a brand gets, the less attractive it is because now, in today's environment, you can just be more niche than ever.
Steve Chiavarone: We're talking about your belt yesterday.
Steve DeNichilo: We are, look, we're not allowed to talk about specific companies, but I recently bought a belt, which is not that exciting and I don't know how profitable this company is. But this is a company that all they do is buy belts. And I was targeted on Instagram because I guess I'm in the prime belt buying age of my lift, if that's a thing.
Steve Chiavarone: How do you go about getting into that?
Steve DeNichilo: I mean it was a very exciting transaction. But it just shows that companies can become big and relevant faster than ever before. Anytime you have fast change, where the rules move, where the goalposts move, that creates opportunities for small cap companies, and subsequently, exciting IPOs. And so there's examples in the grocery area. Look, groceries are historically terrible companies, low margin. You're lucky to have 2% EBITDA margin. And there's been successful investments because companies are getting bigger and faster and serving more niche environments better than ever before.
Steve Chiavarone: That'll do it for Part One of our discussion. Thank you, Steve, for joining, and thanks to our listeners. Please look out for part two of the discussion, and we look forward to you joining us again on the Federated Hear & Now podcast.