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Liang Chen
Liang Chen
Articles (4)  | Author's Website |

Secular Growth: The Ultimate Reinvestment Opportunity

Secular growth is crucial to the compounding effect of stock returns as companies find opportunities to reinvest at attractive rates of return

Background

When it comes to investing, it is widely understood that not all growth is equal. Only the growth resulting from reinvesting retained earnings internally may deliver the most benefits to shareholders because it is organic, requiring no outside capital and, hence, no financial leverage or dilution. This leads to the compounding effect of return. These opportunities to reinvest at attractive rates of return are often driven by secular growth (i.e., long-term trends) along with more sustainability than the cyclical growth accompanied by more risk. This is one factor for many great investors, such as Warren Buffett (Trades, Portfolio) and Charlie Munger (Trades, Portfolio), as they try to evaluate a business.

Some prevailing areas where secular growth often lies are listed below. Investors should carefully examine companies' growth stories to find the next 10-baggers.

One thing worth mentioning is that the lack of growth opportunities is usually not management's fault, but growth with low returns is. Return on invested capital is the key. If you have it, flaunt it. If you do not have it, try to get it. If you cannot get it, get out.

International expansion

This seems to be the most natural way to grow a business: selling products or services in more regions, especially emerging markets. One factor that investors need to determine is whether the product or service travels well. For example, Coca-Cola (NYSE:KO) does, while See's Candies' chocolates do not.

Another thing one needs to be aware of is that, usually, geographic expansion is harder than it sounds. Local environment matters. Think about the recent retreat of Amazon (NASDAQ:AMZN) from China, in light of the fiercely competitive landscape there that simply destroys value for shareholders, as well as Google's (NASDAQ:GOOG)(NASDAQ:GOOGL) exit a few years ago when it faced regulatory issues.

Moreover, different operational models produce different levels of mobility. For example, McDonald's (NYSE:MCD) and Domino's Pizza (NYSE:DPZ) were able to quickly expand into many cities worldwide, benefiting from the capital-light operations of the master franchise model. In contrast, other brick-and-mortar businesses, like Costco (NASDAQ:COST) and TJX (NYSE:TJX), took a much slower pace with their directly-operated store model.

Last, while international expansion does add to the diversification cost (i.e., more management involved to handle different locations), it sometimes brings synergies, especially in terms of the network effect. Think about Paypal (PYPL) and Mastercard (MA).

Demand upgrade

In addition to "horizontal" (i.e., geographic) growth, many companies have succeeded in growing their businesses "vertically" by selling products and services to the "upgraded" demand from their customers.

The technology sector is a frequent provider of such opportunities. Cloud computing is one phenomenal trend as businesses have moved their digital assets from on-premise to the cloud. For years, the tailwind has been offering new growth drivers to upstream infrastructure providers like Microsoft (NASDAQ:MSFT), Amazon (NASDAQ:AMZN) and Alphabet's Google as well as downstream consulting companies like Accenture (ACN) and Infosys (INFY).

Nevertheless, investors need to be aware many technological disruptions destroy value for shareholders, mainly due to competition (while creating ones for customers and perhaps society as well), and know how to distinguish long-term and fundamentally sound trends (e.g., software as a service) from short-term but overly promoted hypes (e.g., thousands of group-buy copycats in China).

Source: Statista.

When it comes to individual consumers, the so-called "consumption upgrade" is taking place around the globe, including some emerging markets like China. As disposable incomes increase, consumer needs go from none to basic, then from basic to premium and from premium to luxury. For example, the premiumization trend in terms of heightened demand for quality liquors has pushed high-margin sales at brewers such as Diageo (DEO) and Brown-Forman (BF.A) (BF.B) as the Western economy keeps improving.

In Asia, luxury brands like Hermes (RMS) and LVMH (LVMH) keep posting record high sales as they satisfy the status-conscious needs of China's rising middle class. Brand loyalty is the key here for luxury products, so investors need to watch out for the cyclicality risks (if any) of such consumption. But the good news is that thanks to the macro tailwind and scale advantage, relatively little capital expenditure is needed.

Source: Statista.com; data as of April 29, 2019.

Vertical growth is by no means exclusive to the consumer discretionary sector. Businesses selling basic goods can also find such opportunities. McDonald's, for instance, revived its growth by introducing all-day breakfast, innovating its menu and adding delivery options, all of which offer upgraded customer experiences at a consumer staples level. Innovation is the key here and, as discussed in previous articles, can support the business in widening its moat.

Aging population

According to Statista, at least one out of four people in the world will be over the age of 60 by 2050. This percentage could increase to one out of three people by 2100.

Source: Statista.

With the global life expectancy increasing, the aging population is one of the safest trends business leaders can bet on. While older consumer groups typically spend less than the younger groups, there is one area where they definitely take the lead: health care.

Source: Statista.

This means antibody developer Bioventix (BVXP) may receive more royalty payments from the diagnostic companies using its products on more blood tests taken; Novo Nordisk (NVO) may sell more drugs due to more diabetes patients being cured; and Intuitive Surgical (NASDAQ:ISRG) may install more da Vinci Surgical Systems as more robotic-assisted surgery procedures are performed.

Facing such a widely recognized trend, investors should watch the competitive landscape. A wide moat is crucial to fending off competition. Luckily, many competitive edges can be found in the health care space thanks to patent protection and high switching costs.

Other trends

Some other trends do emerge from time to time, offering decent opportunities for management to reinvest retained capital. For instance, since one-third of the world's population still brushes their teeth without toothpaste, companies like Colgate-Palmolive (CL) may benefit from expansion. The growing pet economy, where household animals are considered important family members even during times of budget constraints, has been a solid growth driver for businesses like IDEXX Laboratories (IDXX).

Investors should be careful, however, with trends that might fade quickly, which could interrupt growth for companies like Pandora (OCSE:PNDORA), Industria De Diseno Textil (XMAD:ITX) and Hennes & Mauritz (OSTO:HM B).

Summary

Superior cash returns on capital usually indicate some sort of moat, providing downside protection. In regard to upside, secular growth is important for investors looking for compounding returns.

Investors can start by checking the payout ratio to see whether the company is retaining its earnings for potential growth or not. Of course, rare opportunities that require no or very little capital to fuel growth, such as See's Candies, do exist.

We examined the four major categories above regarding secular growth. Certainly, the categories are not exclusive to each other. For instance., Intuitive Surgical has been reinvesting its earnings in international expansion along with demand for upgraded surgical treatment among the aging population. This may help explain why the company pays no dividend and spends little on share buybacks. A check on the return on research capital would confirm management did a good job of allocating capital.

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About the author:

Liang Chen
Liang Chen (Steven) is a quality-focused investor (with bottom-up opportunistic approaches), an ex-hedge fund analyst on Wall Street, a serial entrepreneur in tech, computer scientist and free-market capitalist. He contributes to well-known financial media sites, such as GuruFocus, SeekingAlpha, TalkMarkets, and Investing.com. Steven is also the founder of Urbem Media (HK) Ltd. and Urbem Partnership (www.urbem.cn).

Visit Liang Chen's Website


Rating: 5.0/5 (6 votes)

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Comments

Thomas Macpherson
Thomas Macpherson premium member - 1 week ago

Great article Liang. Very much look forward to reading more of your work here on GF. Best - Tom

Liang CHEN
Liang CHEN premium member - 1 week ago

Thanks Thomas for the comment! Appreciate it!

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