The fundamental principle of a growth business is that it provides something better than its peers. This may be a better product or service, or sometimes a better price. The best opportunities lie where there is no product in the market to serve that particular need. Advantage based solely on price is usually eroded over time.
Cyclical businesses are those which are exposed to the vagaries of the economic cycle, and they may well be in market segments which are already mature. The managers of such companies often find that in tough economic times they struggle to maintain the status quo rather than being able to grow the business. As a result they often need to retain cash in good times, which impinges upon their ability to return that cash to shareholders in the form of dividends. They are also exposed to the risk of making poor investment decisions at the wrong point of the economic cycle.
In contrast current examples of structural growth markets would be healthcare, robotics and cyber-security. These are all sectors which are on multi-year growth trajectories. When companies in such sectors gain a lead in their niche, the growth in their profits can exceed even optimistic projections.
Truly great businesses earn high returns on their invested capital for multi-year periods. The U.K. is a small market, in which the ability to grow is limited by the market size. By successfully “going global” companies can grow at high growth rates for many years.
Market leadership typically denotes a strong market presence which is difficult for rivals to undermine. However technology has torn down barriers to entry in many industries, and we need to be alert to this. Our portfolio companies all possess some of the characteristics which should allow them to perpetuate their position, such as brands, patents, market share, regulatory barriers, or industry-specific technology.
Debt can accelerate growth and amplify returns for equity investors. It is also quicker to raise than equity capital. However too much debt can make management short-term in their decision-making. A sensible debt level will differ for each business depending on how secure their cash flow is. It is important to us that management share our view on the sensible level of debt for their business, and to understand how they manage working capital.
We have approximately 120 face-to-face meetings with management each year, and do ongoing monitoring of their companies’ performance. At least half of management teams we meet do not show a passion or deep knowledge of their business. We do not consider investing in these businesses. We like our management teams to own substantial equity in their business too so that they see things from our perspective and benefit from their own success or suffer from their failure.