The Sustainability of Growth
Here at MFAM we aim to own a small number of companies in our portfolios and hold them for the long term. I sat down with my colleague Matt Trogdon to talk about how we look for companies with sustainable growth.
Matt: You’ve said that very few companies can grow sustainably for a long period of time and that’s why we hold very few companies in our funds. Given that context, how do you think about growth and value investing?
Tony: Value investing is fundamentally based on the concept of reversion to the mean. Companies that have outperformed recently will pull back in line with the norms of their industries. Companies that have underperformed will catch back up. That’s how reversion to the mean is traditionally driving value investing.
Growth investing is somewhat antithetical to that, where you are saying that a company that has grown in the past can continue to grow. I think across a broad base of companies, reversion to the mean is very real, and companies that are growing now will not necessarily grow in the future. We are focused, though, on the highest-quality businesses, where we spend most of our time and effort analyzing whether or not that sustainable growth trajectory can be maintained. So if you look at a company like Amazon, for example, the argument against that company is that it’s just a retail business and trying to predict that they will grow faster than other retailers can be a fundamentally flawed approach to growth investing, where that reversion to the mean does happen.
We believe that when you look at the sustainability of the growth and what truly sets this company apart — what about its competitive advantages makes it different — you can find a small set of companies where sustainable growth is truly possible. And we tend to invest in a relatively small number of companies in our funds relative to peers and the benchmark.
Not many companies can sustain growth. Most companies will have reversion to the mean. But by focusing on only the highest-quality businesses, we feel we can successfully invest in growth that way.
“Growth investing is somewhat antithetical to that, where you are saying that a company that has grown in the past can continue to grow.“
Matt: How do you guard against overconfidence, or against falling in love with the particular companies you’ve identified as having that potential?
Tony: That can be dangerous, especially since we do focus on management and culture of businesses and spend a lot of time getting to know the businesses we are investing in. Really, one of the biggest things we do is take a team approach. We discuss each investment idea as a group. One person is primarily responsible for doing the work, and the rest of the team will question that person’s views. We want to take an industrywide approach to make sure that the businesses we are investing in truly do have that sustainability in front of them. The other piece of it, other than the team approach, is being aware of new issues that may change our previous analysis. A lot of times, growth investors will look at historical performance and project it out into the future. Being aware of the psychological flaws that all of us have in terms of forecasting and trying to predict things prevents overconfidence.
Matt: Do you find that specific industries increase the risk there, or is that something you have to be vigilant about regardless of industry?
Tony: Each industry is different, and generally, some industries are more innovative than others. Some are very mature. There is a different set of considerations for each industry. When you look at industrial companies, for example, some companies are making the same products they made years ago, but there are places where there are new innovations coming out. So you need to assess each one differently.
When you think about reversion to the mean, it comes down to competition. If a company is taking market share and growing faster than their competitors, in many cases, the competition is not stupid, will catch up, and will take back that market share in the long run.
We try to find the companies where they are sustainably innovating and coming up with ways to maintain their advantages. In a lot of cases, when you look at tech companies — look at Amazon or Microsoft as an example — they are continuously evolving and changing their product offering to try to maintain that advantage. In other industries, like restaurants, for example, it is very hard to find companies that sustain growth above the industry averages, because the competition is fierce, and it is difficult to have any innovation that is not easily replicated by the competition.
Chipotle is a great example of that. The biggest advantage they had, more than a decade ago, was the assembly-line approach with the customer. The fast-casual approach was new 10 or 15 years ago, and now every city has dozens of stores that have similar layouts. So that innovative approach that Chipotle had gave them great growth for several years, but it’s not a sustainable advantage over the competition.
“We try to find the companies where they are sustainably innovating and coming up with ways to maintain their advantages”
Matt: You talk about overconfidence a little bit. What are some other cognitive frameworks that you guys think about and try to protect against?
Tony: Overconfidence is a big one, but that has many different pieces to it. One of the pieces is the fundamental idea that the more easily you can visualize something, the more you tend to raise the probability that you believe it will occur. So if someone asks you to predict the probability of an event that is relatively low for most of the cases, but if they give you more information to help you visualize it, those extra details will make it less likely by definition, but being able to visualize it in causes people to raise their confidence and raise that number. And that’s why taking the outside view approach is so valuable, which is simply looking at the historical norms and the historical rates of an event on average.
So to bring it back to investing, you look at industry growth rates. Trying to predict the growth rate of a specific restaurant stock, you need to begin by looking at how quickly the restaurant industry is growing. How fast are the household formations in the area of where they are selling growing? How much more food they can sell than they have in the past is largely based on how much more food will be bought in a macro-economy sense. From there, you can adjust it based on an individual company basis, but you need to start with that outside view. Overconfidence really comes back to being aware of biases and any assumptions you are making based on future growth. You really need to go back to the beginning and figure out where those assumptions are coming from.
Matt: As a growth investor who works on portfolios that have low turnover, how do you protect against reversion to the mean? Is it just a matter of continually finding what you think are great companies? Or is there something else to it? Because that strikes me as being really difficult.
Tony: If we could continually find new, great companies, that would be awesome. The reality is that most companies will have reversion. That’s how competitive markets and free markets work. If someone is earning excess returns, competition will arise to try to take some of those returns away. So reversion to the mean is a fundamental principle of free markets.
There is a small subset of companies that can sustain their growth, that have such strong competitive advantages that they can continue to grow and generate excess returns for investors for sustainably long periods of time. There aren’t many of those companies. We try to identify them in our daily work. When we find a company that is working for us that we believe can sustain its growth, we look for signs that it is beginning to revert. But we believe that focusing on the long term, we can find a handful of truly great businesses that we can hold for a long time.
“There is a small subset of companies that can sustain their growth, that have such competitive advantages that they can continue to grow and generate excess returns for investors for sustainably long periods of time. There aren’t many of those companies. “
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