From the December 2011 issue of Investment Advisor • Subscribe!

November 28, 2011

Hiding in Plain Sight

Opportunities in sustainable growth companies are predictable, provide low risk and are set for growth—and they’re ripe for the picking

Illustration by Enrico Varrasso Illustration by Enrico Varrasso

The past decade has not been kind to most equity investors and their advisors. Two bear markets, two recessions and dramatic swings in volatility have prevented many from meeting the return assumptions built into their investment plans.

Looking forward, advisors and their clients are struggling to see how they can meet future liabilities with little expected return from fixed income allocations and diminished faith in equity markets. Economic growth will likely continue to be anemic over an extended period of time given the structural impediments facing economies in many parts of the developed world, and volatility is likely to remain high.

It seems that many market participants are counting on increased allocations to hedged strategies or alternative asset classes to serve as both an engine of high return and a brake on downside volatility—something very difficult to engineer. Advisors should consider a category that presents a realistic option for powering long-term return objectives with moderate risk by looking at high-quality, predictable global businesses with strong cash-flow growth—sustainable growth companies that can expand even in uncertain times. The good news is that the skepticism of equity markets and the recent dominance of short-term investment strategies have presented a big opportunity in this category. The stage is set for sizeable excess returns in a straightforward long allocation to a selective group of growth equities—an opportunity hiding in plain sight.

The great challenge for advisors these days is to get the proper configuration of the long equity portfolio to deliver good returns with moderate risk. Index strategies will likely continue to be disappointing as corporate profit growth is stalling and will likely be scarce in coming years given economic headwinds. It is imprudent to expect expansion given the uncertainties about growth and financial stability. It is the combination of strong cash-flow growth and high quality that advisors should seek out, focusing on those rare high-quality businesses that enjoy secular growth tailwinds as well as unique competitive advantages that protect profitability. These companies can predictably sustain above-average growth regardless of the environment, while maintaining high levels of cash-flow productivity. This ensures a portfolio with a low level of business risk, the risk that a company’s growth trajectory will be derailed either as a result of the environment or competitive challenges.

Price risk—the risk that you can buy a great sustainable growth company and still generate disappointing investment returns by overpaying for it—must also be managed carefully by adhering to a cash-flow-based valuation discipline. Unlike many who may choose to focus on operating earnings to make valuation judgments, we analyze the future streams of cash flow available to shareholders (CFATS) to determine the real value of a business. CFATS is a conservative estimation of the cash ultimately available to business owners, unvarnished by accounting after all claims, like acquisitions, unfunded liabilities and necessary capital expenditures. It is the bedrock of empirical value.

This measure allows one to ascertain the cash productivity of a business by comparing it to reported earnings, and to discount future streams of cash flow to estimate opportunity the way any good acquirer would. It can also be used to calculate the cash flow yield of different investment alternatives, a good shorthand gauge of relative valuation. Today, the companies we are invested in convert about 90 cents of every dollar of earnings into free cash flow. That’s nearly 50% more than the broader market. These sustainable growth businesses also trade at a cash yield of two and a half times that of the 10-year Treasury bond rate. That is more than twice the long-term average and it confirms an exciting valuation opportunity.

Red Hat

Red Hat (RHT) is the world’s leading vendor of open source software solutions, offering support contracts that allow customers to outsource the maintenance of their Linux software. Open source solutions are increasingly used by enterprises and governments to reduce software procurement and maintenance costs and avoid vendor lock-in, providing the company with a secular tailwind of growth. Introducing open source software into a corporate or government IT architecture, however, involves considerable risk of destabilizing productive systems. RHT mitigates that risk by delivering rigorously tested versions of open source software, certifying to its customers that various third-party hardware (e.g., IBM, HP, Dell) and software (e.g., SAP) products are fully compatible and by providing 24/7 global support through 58 offices in 28 countries. Lower maintenance cost and lower risk are the core of the Red Hat support value proposition. The economics of this service are impressive. Subscription maintenance contracts generate a high level of recurring revenues (with 80% to 85% renewal rates) at very high gross margins (+90%). Because customers pre-pay their contracts and accounting rules force the delay of revenue recognition, the company generates far more free cash flow than earnings. In fact, for every dollar of earnings, the company currently generates more than $1.50 in free cash flow.

Ambev

AmBev is the world’s fourth largest brewer and the largest Pepsi bottler outside of the United States, generating three-quarters of its profits from Brazil, with the remainder coming from other Latin American markets and Canada. Brazil is the second largest beer market by profits. Beer and ready-to-drink beverage consumption is relatively stable thanks to low price points, ubiquitous distribution and habitual consumer behavior. The company has a dominant and stable share of 70% of a market with over 200 million consumers and a rapidly growing middle class. Its brands enjoy an 80% preference rating with consumers that allows it to price at roughly a 15% premium to its competitors, leading to robust profit margins and strong cash generation. For every dollar of earnings, the company generates nearly 95 cents of free cash flow.

Meeting client return assumptions in today’s low interest rate and GDP growth environment will require highly selective long equity allocations. Advisors must be careful to discriminate and focus on those few high-quality businesses that offer strong, predictable and sustainable growth prospects in order to both ensure growing empirical value and limit business risk. Determining the free cash flow available to shareholders is important to properly measure the return opportunity and manage the potential price risk of those investments. Given currently low valuations, nearly comparable to those in early 2009, this approach should produce rewards that will likely exceed those of the broader indexes and help power compounding in portfolios.

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