Although many people today might think of growth stocks as companies such as Amazon, the investment style actually has its roots in discovering small emerging companies. We speak to MFS about opportunities in the current market.
In the past decade, global stock markets have been driven primarily by large technology companies, including the so-called FAANG (Facebook, Amazon, Apple, Netflix and Alphabet) stocks in the United States.
Often these large technology companies are associated with growth-style investing, especially as value investing, which is sometimes seen as the opposite of growth investing, has lagged markets.
But many of the early investors who are now associated with growth-style investing did not find their opportunities in large-cap stocks. They focused on small to mid-cap companies.
Philip Fisher is known for writing one of most influential books on growth investing: Common Stocks and Uncommon Profits, published in 1958.
Fisher was mainly interested in what he called “small and frequently young companies … [with] products that might bring a sensational future”.
Today, we might call these companies ‘disruptors’.
It is a philosophy that gels with Michael Grossman, Portfolio Manager at MFS Investment Management.
I would disagree with the idea that most of growth is in large caps. I think there are actually more opportunities for growth in small and mid caps, where there are disruptors in the marketplace. Usually the largest players are legacy players who lack growth, who are hinged to legacy technologies
“I would disagree with the idea that most of growth is in large caps,” Grossman says in an interview with [i3] Insights.
“I think there are actually more opportunities for growth in small and mid caps, where there are disruptors in the marketplace. Usually the largest players are legacy players who lack growth, who are hinged to legacy technologies, such as IBM, who have trouble transitioning to higher-growth areas of the market.”
Grossman sees cloud computing as one of the technologies that is disrupting the incumbent players in several industries. This technology allows new entrants to leapfrog the extensive infrastructure development that many of the established companies had to do.
He uses the financial sector as an example.
“Q2 is a digital banking technology that is disrupting banking. You have companies like Tenemos that have legacy technology stacks that were built in the ‘80s and early ‘90s, and now come along companies like Q2 that are cloud first, are far more flexible and have a far better user and customer experience,” he says.
“These types of companies are the disruptors that are just feasting all day long on the cash-flow streams and the revenues of those large-cap legacy providers.”
Another example can be found in the payroll sector in the US, where an entire cottage industry has been built around smaller companies taking market share from legacy providers, such as ADP and Paychex.
“We own a company called Paycor that has built its business around taking share from the legacy technology companies. They are cloud-based, next-generation technology with far better capabilities in user experience. Another company that is built in the same way is Paylocity,” Grossman says.
“So I would argue the disruptors are the emerging, small-cap and mid-cap players; that is where better growth is found.”
He acknowledges the power of companies such as Amazon and Google, which have managed to almost monopolise the markets they operate in. But he argues that often there is an entire ecosystem beneath these companies where young companies can develop new products and services.
“We are very careful to not have customer concentration exposure to an Amazon or a Microsoft, but there are certain innovations that are happening in markets that perhaps aren’t big enough to move the needle for a Google. We can still invest there,” he says.
He gives email security firm Proofpoint as an example.
“People thought Microsoft was going to disrupt them with their own email security, but they ended up partnering with Proofpoint and over time Proofpoint continued to outpace the market. Microsoft became more of a friend and a tailwind rather than a foe and ultimately Proofpoint got taken out,” he says.
In April of this year, private equity firm Thoma Bravo agreed to acquire Proofpoint for US$12.3 billion.
Another company that has benefited from the increasing digitisation of the workspace is IT services provider Nagarro. It is not unlike a smaller version of Accenture, but it focuses more narrowly on helping companies digitise their offering.
MFS decided to add Nagarro as a replacement for a similar company that had become too big to fit the small or mid-cap moniker.
“We owned a company called Epam in the same space for [the reason that] its earnings growth was driven by the secular tailwinds of digitisation,” Grossman says.
“But when the multiple got too high and the valuation expanded, all of a sudden we lost that second vector of shareholder return and so we rotated into Nagarro, which traded at a significant discount to Epam, but benefited from all the same secular drivers.”
Grossman and his team don’t necessarily look for businesses with short-term, hyper growth. They invest in companies that are likely to have durable earnings growth over the next three to five years and that have strong free cash flows, as well as strong positions in markets with high barriers to entry.
They look for companies that tick all the boxes of Harvard Business School Professor Michael E Porter’s five forces. These attributes helped the team to look through the coronavirus pandemic and identify which companies were most likely to not only survive, but also grab market share.
“[Last year], we added new positions in companies that we thought were going to be stronger on the other side of COVID,” Grossman says.
“The analysis that we did was about which companies in some of these heavily impacted industries are actually going to be stronger on the other side due to their pre-established scale or brand equity, knowing that smaller players without that scale could potentially fall away.”
Grossman and his team looked at the travel industry, which was heavily sold off in March, April and May last year. They added several new positions, including Thule, the Swedish producer of outdoor gear.
“Thule, which people initially lumped into the travel space, ended up benefiting from some of the trends that evolved from COVID. Outdoor activities ended up taking share of consumer wallets, as people were going on stay vacations and that required roof racks for bikes and luggage,” Grossman says.
“Another name is On The Beach, which is an online internet travel company that sells vacation packages to beach areas in the UK and in the rest of Europe.”
The analysis that we did was about which companies in some of these heavily impacted industries are actually going to be stronger on the other side due to their pre-established scale or brand equity, knowing that smaller players without that scale could potentially fall away
He also added takeaway business Just Eat. Although in hindsight it seems like an obvious choice, it wasn’t clear at the start of the pandemic that the fast food sector would thrive under the worldwide lockdowns.
“Early on, it got hit pretty hard. The whole market sold off and that one did happen to sell off along with the market, but it ended up benefiting from a shift toward in-home eating and food delivery, which wasn’t necessarily perfectly obvious in March of 2020,” Grossman says.
“So we look at companies’ earnings power and what a company is going to look like three, four, or five years out. Quite frankly, we didn’t care what earnings looked like in 2021 or 2022.
“Now, certainly we were looking at the balance sheets to make sure that they were going to survive and get through to the other side, but we were looking at what the earnings power was and that didn’t change much.
“So we talk about time horizon arbitrage and we are really looking for the long term.”
Not all companies suffered during the onset of the pandemic last year. Not only did many companies in the medical industry do well, but for those that operate in the ribonucleic acid (RNA) technology industry, last year turned out to be a pivotal moment.
“These companies have created a lot of value, just in revenue through the RNA-based vaccines,” Grossman says.
“But what COVID has done is that it has proven RNA technology in general more broadly across therapeutics. The thesis from here is that RNA is applicable to more than just vaccines, even extending as far into solid tumours.”
One company he particularly likes in this space is Maravai LifeSciences, which was listed not long after COVID-19 emerged. The company has developed a technology, called CleanCap, which enables a more efficient way of RNA capping, a process critical to the production of effective vaccines.
“They are like an arms dealer for many pharma companies. What we like about Maravai is that here we aren’t betting on an individual asset to make it through the clinical [trials] and into the approval process. They will support anyone who adopts RNA technology because they have great [capping] technology, which basically makes a molecule more effective,” Grossman says.
“COVID only highlighted the value-add and the importance of these CROs (contract research organisations) in the drug development process.”
The Energy Transition
Although Grossman and his team are bottom-up investors, the long-term nature of their approach means they do keep an eye on some of the larger growth thematics in the economy.
Arguably, one of the key thematics that is currently underway is the transition from fossil fuels to renewable energy and a low-carbon economy. Asked if this provides any opportunities to the team, Grossman answers carefully.
“We would never buy a basket of EV (electric vehicle) stocks. There are 7000 stocks in our benchmark and we own roughly 100 stocks. Those are 100 excellent opportunities that we see globally,” he says.
“Now, for a company to generate that durable earnings growth we’d rather be investing in companies that are higher quality and have some exposure to a secular tailwind rather than a secular headwind in order to achieve that above-average earnings growth.
“So while we can’t own a name like Tesla and don’t like to make bets on specific technologies, what we can do is own companies like Sensata Technologies, which make sensors.
We are not going to invest in a utility, but we do look in the recycling space and we like reusable products that consume less energy
“If you think about the electronification of vehicles, then Sensata is a market leader in both the passenger vehicle and the commercial vehicle sectors, as well as in a lot of industrial applications, where there’s just an increasing amount of sensor content, semiconductor content, which is why we have the shortage as we do today.
“It is a cheap diversified way to gain exposure to that secular tailwind. Now, we are investing in Sensata because we would argue that the secular tailwind will help them achieve their growth rate. We’ve owned the name for quite some time at MFS across various strategies and, in fact, I was the analyst that covered the stock when they IPO’d some 10 years ago.”
Sensata covers the portfolio’s exposure to changing technologies as the world moves to a low-carbon economy, but from a climate change perspective the team plays into the growing awareness around pollution, especially plastic pollution, rather than renewable energy utilities.
“We are not going to invest in a utility, but we do look in the recycling space and we like reusable products that consume less energy,” Grossman says.
“An example of that would be SIG Combibloc, which makes paper-based packaging that replaces PET, plastic-based packaging,” he says.
MFS International Australia Pty Ltd (“MFS Australia”) (ABN 68 607 579 537) holds an Australian financial services licence number 485343 and is regulated by the Australian Securities and Investments Commission.
Michael Grossman’ s comments, opinions and analysis are for general informational purposes only and should not be considered investment advice or a recommendation to invest in any security or to adopt any investment strategy. Comments, opinions and analysis are rendered as of the date given and may change without notice due to market conditions and other factors. This material is not intended as a complete analysis of every material fact regarding any market, industry, investment or strategy. For institutional use only.
This article is paid for by MFS International Australia. As such, the sponsor may suggest topics for consideration, but the Investment Innovation Institute [i3] will have final control over the content.
[i3] Insights is the official educational bulletin of the Investment Innovation Institute [i3]. It covers major trends and innovations in institutional investing, providing independent and thought-provoking content about pension funds, insurance companies and sovereign wealth funds across the globe.