Finding the value in growth stocks

Despite rising bond yields through most of 2020, continued low interest rates have underwritten record valuations across markets. Meanwhile, rampant M&A activity is highlighting private markets’ confidence that favourable economic conditions will continue - in contrast to public investors' views that PE ratios are too high. 

For investors looking for growth, it seems that frothy valuations are the norm. And while this trend may be fuelled by continued favourable economic policy, that doesn't mean one should be valuation agnostic.

Emma Fisher from Airlie Funds Management and Kelli Meagher from Sage Capital agree that finding growth at a reasonable price is a challenge in today's environment - but not impossible. In this Buy Hold Sell thematic discussion, James Marlay investigates the economic factors driving current valuations, how to identify growth names at an appropriate price and two names that our guest fundies think ticks these boxes.  

Note: You can watch, read or listen to the discussion below. This episode was filmed on 18 August 2021. 

Timestamps:

• 0:45 - What is behind the current record highs in risk assets?
• 2:44 - What does an environment of high PEs mean for valuation criteria?
• 5:05 - Is there more M&A activity on the horizon?
• 7:33 - What to look out for when investing for growth at a reasonable price, and a stock that fits this criteria.

Edited transcript

James Marlay: Hello, and welcome to Livewire's Buy, Hold, Sell. My name's James Marlay, a co-founder of Livewire Markets, and today we're talking about growth and how to find it at a reasonable price.

We all know the market's been on a strong run and that some of those valuations are getting lofty. Everyone loves growth, but you need to find it at a decent price. To help me with a few tips on to find growth at a reasonable price, I'm joined by Kelli Meagher from Sage Capital and Airlie’s Emma Fisher.

Kelli, it's your “rock and roll” debut on Buy, Hold, Sell, so you get the first question. Risk assets, growth stocks: They've been testing highs once again - what's behind this and can it continue?

Kelli Meagher: I think we're all aware of interest rates being at all-time lows, and that's really the bottom line. With central banks very focused on keeping cash rates low – that's basically when you're not getting money in the bank – people are looking elsewhere for returns. And we're seeing that in real estate and the stock market, particularly in growth stocks. Until we see interest rates start to turn and start to rise, I really can't see that trend changing. It certainly seems like interest rates are not going to rise substantially anytime soon.

Marlay: Emma, it's a familiar title, isn't it? It’s been a big factor in markets for the past decade, and at the start of the year we were all getting excited about higher rates and inflation, but it seems to have rolled over. Do you share Kelli's view that the interest rate backdrop is the main driver here?

Emma Fisher: It certainly is. As Kelli said, it's interest rates. I think part of the strength that we're seeing in markets is also driven by earnings. Household balance sheets are in great shape and corporate balance sheets are in great shape.

We're about halfway through reporting season now, and we really are seeing a lot of strength in results across the board. Obviously now half the country is back in lockdown, but I think the market's really willing to look through that because we can see this finish line in sight, hopefully in terms of those vaccination rates.

For growth stocks, I think it's really this Goldilocks combination of a strong economic environment, but also as Kelli said, one that’s not so strong as to bring an end to the very accommodative monetary policy settings. These have been very good for the valuations of growth stocks, but can it continue? I've got no idea. But I do believe there's a portion of the market where value seems thin on the ground, so I'd tread cautiously there right now.

Marlay: Have you had to adjust your appetite for high PE stocks, or have you had to rethink your evaluation criteria, given the backdrop we've talked about with this incredible stimulus and the low-interest rate environment? Emma, I'll stay with you for now.

Fisher: Whenever you're allocating funds to valuations that are at all-time highs, you've got to be cautious because the future is unknowable, and things can always go wrong. If they go wrong on a stock that's on 50-times earnings, it's a long way down. But at the same time, I think we need to acknowledge the limitations of what a multiple can tell us.

Multiples can tell us a lot about expectations, but they tell us nothing about a company's real prospects. Unfortunately, there's no real shortcut for doing the work – on a case-by-case basis - to understand a company and where you think it's going in assessing whether you still think there's value on the table.

Marlay: Kelli: Uncharted, unprecedented, stratospheric – these are all words that have been used to describe the multiples on growth stocks. Have you changed the way you look at multiples, how you think about what you're willing to accept and what a traditional screen might have ruled out?

Meagher: I agree with Emma that, with stocks currently trading at these very lofty, there's not a lot of room for error and that any missteps or disappointments will get knocked down harshly.

I’m approaching this by looking for companies that are least likely to disappoint and which can, preferably, surprise on the upside. In my experience, it’s high-quality companies that tend to surprise on the upside. They're the ones with great management teams, higher returns on capital, clear growth prospects and the ability to self-fund their growth. These are the types of companies that will continue to grow even if the world starts to change again, and which have some optionality in their growth.

Marlay: Have you become accustomed to dealing with slightly uncomfortable PEs; is it now just a fact of life for your investing?

Meagher: Absolutely. Sometimes we have to almost just shut our eyes to those short-term PE multiples and think longer term. For example, you might be looking at a PE that's 100- times and you think, “well, how can that possibly be decent value?” But if you think about the duration of the growth the company can offer alongside other valuation metrics like discounted cash flow, sometimes you can get those valuations to stack up. But certainly, just focusing entirely on the short-term PE multiples can be a little scary in this environment.

Marlay: Emma, it’s the same question for you. Are you finding yourself becoming more comfortable with multiples that previously would have been an absolute “no”?

Fisher: Yes, in the short term and across the whole market, not just growth valuations. At the end of the day, many people say that the market's very expensive and everything's overvalued. That's true in a historic sense, relative to where valuations have been, but it's not true when you consider these valuations alongside a cash rate of 10 basis points. It goes back to what Kelli said at the start: It's all about interest rates. If the cash rate stays around here and interest rates stay lower for longer, then through that framework, there actually is value on offer in the Australian market.

Marlay: And taking a side-step into some market activity, Afterpay recently received a bid from Square. It was a huge transaction on a stock that's been emblematic of the growth story. Emma, M&A activity: What's the significance of that deal and are you expecting to see more like it?

Fisher: Referring to not only this deal but to others we’ve seen in M&A recently, in Afterpay you’ve seen what I, as a non-owner, might call an exorbitant valuation. And on the infrastructure side, we’ve seen mid-20s EBITDA multiples for businesses like Sydney Airport (ASX: SYD), Telstra (ASX: TLS) towers, Spark Infrastructure (ASX: SKI). These are significant because you've got the private market clearly still willing to tie up capital over the long term at an extremely low implied discount rate. And this has happened while the debate in public markets over the last year has been whether discount rates are too low. Are interest rates going up? And bond yields have been rising over the bulk of the last year. This disparity we’re seeing is very interesting. What does this mean? Yes, we should expect to see more of it because if the private market is looking at valuations through this lens of very low discount rates, many things still look quite attractive to that side of the market.

Marlay: Kelli, do you have anything to add on the M&A space? Are there any signals or messages that you've taken from the heightened activity there?

Meagher: Emma's right – I think it will continue. Cheap money. The Afterpay transaction was a reminder that anything's up for grabs, particularly if it's in the tech space and has a global franchise, best in class software, and can add value to another global player. As we've seen with Afterpay, price doesn't have to be an issue.

Another company that could be in play is Xero (ASX: XRO) – or Altium (ASX: ALU), where we've seen Autodesk have a crack already. That could come back into play. With cheap money now, anything is up for grabs.

Marlay: Putting some of the theory into practice, Kelli, I'm going to start with you. I'd like you to call out two or three things you look for when hunting for growth at a reasonable price, and one of the companies that fit the bill for you.

Meagher: When we're looking for growth, it's easy to find from the fundamental side but much more difficult when you’re also looking for reasonable value. In terms of growth, we're looking for companies:

• that operate in a healthy growth industry
• that are well-positioned to have strong, sustainable, competitive advantages and higher returns on capital
• have plenty of growth options, and
• have strong management teams to execute on those growth options.

In terms of getting comfort that we're not paying too much, it just comes back to optionality. We get a lot of comfort if we can clearly see a good outlook for growth. And even if we’re slightly uncomfortable with the price, if in the back of our minds we know there are other growth options that haven't necessarily been articulated by management, but which it could execute on in the future, that gives us a lot of comfort.

For example, look at Domino's (ASX: DMP). If you can get comfortable with the business as it stands today, that's fine. But also, you know that its propensity to buy a new territory down the track is not actually in the price now. If they're not talking about it, but you know it’s a likely thing to happen, that gives you more comfort that the price you're paying today will end up being reasonable. Or we hope.

Marlay: Emma, to wrap up the show today, can you answer the same question. What are two or three things that help you build conviction that you're buying growth at a reasonable price, and what's a company that represents that for Airlie?

Fisher: The number one thing for us is returns. A business that can earn a good return on its capital, in our minds, is a good business. Such a company should trade at a high multiple because of every dollar of cash that it throws off, more will come back to you as a shareholder because less must be reinvested in the business. You need to just accept that these sorts of businesses, those that have high return characteristics, are naturally going to trade at higher multiples. The dream situation is when they don't.

And before I go on to my stock example, which is nowhere near an onerous multiple, the other thing we look at is the management team. Even for the best business, the wrong management team can drive it into the ground, so you've got to be careful. And then the balance sheet. As I said, the future's unknowable. Things can always go wrong. You really need to give yourself breathing room and optionality on the balance sheet.

When the stars align and you can find all these things and find it undervalued, one example is Mineral Resources (ASX: MIN) – and it’s probably not a company people naturally think of as a growth stock. Well, what is a growth stock? It's a business whose earnings today are not reflective of its earnings in the future. And I think that's the case for Mineral Resources.

If the company gets its iron ore volume to where management wants it to go over the next five Mineral Resources will be producing 90 million tonnes. To put that number into context, Fortescue (ASX: FMG) produces 180 million tonnes, but is a $70 billion market cap company. Mineral Resources has a $10.5 billion market cap. We think there's a lot further to go just from the iron ore volume story.

Everyone focuses on price and iron ore pricing, but if they're going to lift volumes four times beyond where they are today, pricing could fall by 75% and earnings would be flat. That's one company we think fits the bill of a good, solid growth stock that is incredibly cheap.

Marlay: Well, that wraps up our introductory show on finding growth at a reasonable price. If the PE makes your eyes water, I suggest you focus on the fundamentals like our two guests today and have a bit more of a look under the bonnet.

Thanks very much for watching. If you enjoyed the show, give it a "like," and if you've got your own thoughts on growth investing, why not leave a comment.