A Primer for Growth Stock Investing

I have yet to read the book, but I have read the review (below)... Color me impressed. The lessons the book imparts are precisely those I share with you, albeit in my clumsy manner.

So although I have yet to read the book (I just now ordered it!), I will. You should as well. It appears to offer excellent fodder for thought for all the skirt chasers -- er, stock chasers -- eager to buy only those stocks that move higher now. Which method, btw, does not build wealth.

I apologize to Eric Miller for sharing below his complete review. The link to this article and his regular bi-weekly ruminations, however, can be found within the colophon.
-- David M Gordon / The Deipnosophist

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Random Gleanings:

Catching A Starbucks

What investors can learn from Michael Moe's book

Wednesday, April 11, 2007

Eric T Miller

One of Wall Street's best stock pickers recently published a book with a catchy title. Michael Moe's book entitled, Finding the Next Starbucks, beckons to a broad audience because so many readily identify with the amazing enterprise. Michael, the co-founder and CEO of ThinkEquity Partners and former director of global growth stock research at Merrill Lynch, offers a useful guide to an enterprising investor. But, it's also a caution to those not well equipped and perhaps unsophisticated in their approach.

His formula suggests scouring companies in the microcap area-- $100 million to $200 million market capitalization--who've got the right attributes and are operating in areas of the economy with strong tailwinds at their back.

The key to unusual investment success is to identify those companies poised for a long span of strong earnings. Great gains parallel great earnings growth. Simple? Not really, because the key is identifying early the enterprises with the necessary essentials. He insists, as Peter Lynch did years ago, that many investors with the appropriate methods and temperament can prosper, but it is obvious that for most people there are many potential pitfalls.

Being aware of obstacles is an essential part of an investment education and the book offers a number of illustrations and examples that are broadening. The recent controversy regarding Starbucks future growth prospects isn't relevant. That controversy in no way disqualifies using it as an example of a great growth enterprise.

How Rare Is Sustained High Growth?

To find companies that can sustain earnings of 20% to 25% for a long period, you have to concentrate on the small company area because the law of large numbers will impede the giants. The bonanzas recently were investing $1 in Microsoft in 1986 and seeing it hit $347 a share, or in 1990, investing $1 in Cisco and watching it climb to $274. Or how about investing $1 in Home Depot and watching it soar to $1153 or more recently, putting $1 in Yahoo in 1996 and having it scoot to $72.

When Michael Moe was one of the first analysts to identify Starbucks as a winner after it came public in 1992, its capitalization was $220 million. Now, it's $23 billion. And as he explained it, he visited the company almost as an afterthought while on a trip to the Seattle area. Right away, he was turned on by the buzz of the office beginning with the reception area. But he became especially enthused by the energy and vision communicated by the CEO, the now legendary Howard Schultz.

Many company leaders and analysts talk almost casually about 20% earnings growth but as Michael Moe points out, only six of 12,000 companies grew earnings in excess of 20% over the past 10 years. Of the 25 best performing companies, the average market capitalization was between $100 million and $200 million.

The major difficulty is to find them. Only 16% of the smaller companies are covered by Wall Street research. In fact, 85% of brokerage research is concentrated on companies above $1 billion in market size. If identifying promising situations is one challenge, avoiding "Roman Candles" is another because negative returns undermine the hope of compounding overall gains and pose the real risk of permanent loss. Michael Moe correlates superior portfolio results with managing concentrated portfolios. But that puts a premium on astute selection and cutting losses before they become damaging.

His book intends to help investors direct intense focus on the drivers of growth and then to maintain objectivity. One constant is the change in leading industries over time. To help identify future stars, focus should be on companies competing in large addressable markets, possessing substantial potential for expansion. They are industries with tail winds at their back. The search is for open-ended growth, with the hope of being early enough to participate in gains in market share, while enjoying an expansion in P/E multiples.

Small companies frequently have the flexibility and competitive advantage to develop a market niche which can then be exploited. The author sees the biggest opportunities concentrated largely within eight megatrends: the knowledge economy, globalization, the Internet, demographics, convergence, consolidation, brands and outsourcing. These trends are neither new nor unrelated, but remain powerful.

The Megatrends

By their very nature, megatrends are slow to develop and may be invisible early. In 1982, John Naisbitt, in his book, Megatrends, identified a number of trends that have progressed steadily, especially the continued decline of the manufacturing economy, while the information economy has flourished.

Naisbitt observed that the most powerful trends occurred independently and across borders to become later collective trends that accelerate. The eight megatrends that Michael Moe identifies now as drivers of opportunity are to a large degree extensions of past megatrends:

1) The Knowledge Economy supplanting manufacturing as we've moved from a physically-based economy, to one based on knowledge. This requires a continual upgrading of labor as human capital replaces physical capital. In the 1950s, 40% of our labor force was in manufacturing. Now, 10% is. Service employment has grown from 14% to 76% over the same time. Among the results is a widening of the wage gap.
2) Globalization has remained a trend since Christopher Columbus, but has accelerated explained in part by the factors enumerated by Thomas Friedman. Everything is affected for better or worse and China and India will be the two major forces shaping the next 50 years. The two comprise 40% of the world's population, while Asian in aggregate accounts for 60%. Already, China has 100 cities with a population of one million or more, while the U.S. has nine.
3) The Internet: Many thought that the Internet was being over-hyped in the late'90s. But Michael Moe agrees with the later assessment that it actually was under-hyped. He regards this as a megatrend effecting all industries, and believes that it can turn our traditional education system "on its ear" with online education increasing access, lowering cost and improving quality.
4) Demographics: The assertion is that an understanding of demographics opens a predictable window to the future. It requires no leap in imagination to correlate an aging population with a need for health care, more interest in travel, a broader appreciation of premium brands and a demand for financial services. Due to the increases in women in the workforce, home services have risen. It is also widely recognized that the Hispanic population is our fastest growing ethnic group and may comprise 20% of our population by 2020--up from 14% currently.
5) Convergence: Michael Moe is referring to the coming together of two or more distant phenomena such as in a product like the Blackberry. This is a trend especially characteristic of the IT and communications world. For kids, the cell phone is replacing the computer.
6) Consolidation: There remain many classic fragmented businesses and the consolidator can see the advantages of scale. The keen investor has the potential for seeing the whole field and anticipating the opportunities for consolidation before it's obvious to all.
7) Brands: Starbucks is a prime example of a company creating a powerful brand, but there are many other such as Ralph Lauren's Polo, Coach and its products and Google.
8) Outsourcing: Rounding out his list is the megatrend of outsourcing. It's a fighting word to the likes of Lou Dobbs and some politicians, but it's a fact of life for company after company, striving to compete and win or merely survive. For many, it's the only way to produce the highest quality and lowest cost products.

Finding the Companies

In discussing the megatrends, the author lists a number of industries that qualify, but how do you go about finding the individual stocks? He contends that the better investor makes complicated ideas simple, and that the future superstars are likely to have four characteristics: great people, a leading product, huge potential, and predictability.

Evaluating the people correctly in a company is probably 50% of the task of picking a winner. The entrepreneur or leader has to have vision and passion exemplified by such people as Schultz, Bill Gates and Sam Walton. And that inspiring leader has to build a great team. Their concentration is taking a product or service, hopefully, "one of a kind," to new heights. Examples range from an education company such as Apollo, to a discount retailer like Costco.

There should be few limits as to how big they could become and yet you hope to find predictability in recurring revenues in exploiting a trend rather than just milking a fad. If an enterprise has these ingredients, sustained earnings growth and investor recognition should follow.

Valuation Methodologies

Very rarely can you find a company with such promising characteristics at a bargain-basement price. Price is not unimportant, but the real focus should be on spotting companies that can go up five or 10 times. The three primary valuation techniques that Michael Moe advocates are discounted cash flow, the price-to-earnings ratio compared to the future three to five-year growth periods and the price-to-sales ratio. He suggests several matrixes incorporating appropriate metrics depending on size and profit margins. While he's first to admit that a host of factors impact stock prices such as inflation and interest rates, and supply and demand trends, it's earnings that ultimately matter.

As for information sources, since you won't find broad coverage of the small company universe on Wall Street, you have to find ideas by reading extensively and using the Internet as a regular tool. He pegs Google as an invaluable resource and among publications; he gives special attention to Investors Business Daily and the Economist magazine. He also advises paying heed to collective intelligence as a powerful source to tap into.

Hot categories in the next few years will be far ranging but will embrace the exploding use of cell phones. Online advertising remains promising and he describes biotech, which had been "the land of hope and dreams" as now "the land of opportunity". He nominates education as being the health care industry of 30 years ago while acknowledging the continued attraction of health care. He describes education as highly fragmented and inefficient, but with enormous potential for the introduction of technology.

Corporate training and the need for life-long learning are but two major market opportunities. The field of nanotechnology is cutting across wide swaths of industries and, of course, alternative energy will remain a rapidly changing area of development.

But if some of these categories seem too vague and unpredictable, the continued importance and demand for premium brands remains appetizing, especially as the huge consumer markets in Asia mushroom.

This writer wouldn't describe the book as the ultimate "how-to" book on investing--such a book will probably never exist. But in any book on investing or business management, you hope to find one or two ideas or provocative thoughts that reward you for your time. Michael Moe has achieved that and more with his review of what has worked for him by providing a number of specific examples and comparisons. He's also provided a number of pertinent comments and observations of others that support or expand on a number of the points made.

You may not succeed in finding another Starbucks, but you'll be better equipped to try.

Eric Miller is the former Chief Investment Strategist of Donaldson, Lufkin, & Jenrette.