Growth Diversification

Cover Story, by Mark Robertson, Managing Partner December 1st, 2011

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We consider one of the most powerful — and compelling — approaches to prudent diversification to be growth diversification.

We consider one of the most powerful — and compelling — approaches to prudent diversification to be growth diversification. A core feature of portfolio design is seeking and maintaining an appropriate blend of slower-growing stalwarts and faster-growing promising companies. This month, using the list of fastest-growing companies provided annually by Fortune, we explore a better understanding of the role of growth in portfolio design and management. Effective immediately, you’ll see much more emphasis on growth expectations vs. a wide variety of efforts to define “size” for shopping and diversification purposes.

The topic is one that we’ve visited on multiple occasions. Discovering and owning a suitable mix of small, medium and large companies in our portfolios seems to form a large part of the foundation for success in long-term investing. The subject is one that we explore and reinforce during our classroom sessions and webcasts as we review portfolios during our Dashboard Diagnostic webcasts.

Growth forecasts are influenced by the life cycle of companies and characteristics like market share. Some companies emerge from development, achieve elevated growth early in their life cycle and slow down and stabilize as they mature. Some companies stagnate and growth stumbles. Others reinvent themselves. Still others are part of delivering some staple, continuing for extended periods at a mature growth rate that often depends on the effectiveness of management.

The Role of Growth

“I prefer small companies because you can make more money with them.” — Ralph Wanger.

Ralph Wanger has been hailed as the “dean” of small-cap investing. As founder and manager of the Acorn Fund from 1970-2003, Wanger achieved an annualized relative return of 4.2%, achieving 16.3% for Acorn while the S&P 500 advanced 12.1% per year.

Small companies? Small cap? Best yardstick?

All companies go through a life cycle with several stages of development. In an idealized evolution, companies move from a start-up phase (usually with red ink) to an emerging growth phase. This is often the most dynamic and highest growth rate during a firm’s history. The third stage is established growth with a relatively constant and stable growth performance. Most companies eventually enter a mature phase characterized by lower growth, increased cyclicality and the offering of dividends.

The connections between life cycle position are strong and lead to a natural attempt to define company size. And the opinions on this are many including market cap (Wall Street), annual revenues and still others using other criteria.

It’s here that sometimes we feel like we’ve been taking something written in English, translating it to Portuguese … and taking that and translating it to Russian and then back to English. Like the parlor game of “telephone,” some distortion often takes shape. Do we gain anything by assigning arbitrary definitions?

What about American Airlines? AMR became a small-cap literally overnight. We simply think that a company shouldn’t be able to change from one designation to another in a week’s time. The vice versa is also true, some technology companies go from “small” to “mega-large” within days if market cap is used to establish size.

Using annual revenues can also get confusing. Is a $7 billion company a small company? What if it’s an integrated petroleum company? (Exxon has $400 billion in annual sales.) In that case, $7 billion is tiny relative to other companies in the peer group.

What about the $200 million company operating in a $300 million total market? This seemingly small company is a large frog in a small pond.

Market share matters. We think that focusing on the sales growth forecast is a better idea because life cycle and market share are among the most powerful forces when it comes to growth potential. It’s simpler.

And the Doctor Ordered … An Apple

In our experience working with portfolios, using the overall sales growth forecast seems to be a more representative method of gauging this all-important element of diversification.

In our investment clubs, we’ve often encountered a debate when it comes to Apple (AAPL). Apple is clearly a large company, or is it? Actually AAPL seems to behave like a small company with higher growth rates and volatility.

So is it a large company in small company sheep clothing?

Apple has a relatively low market share in computer hardware and a startup market share when it comes to phone stuff. iTunes (music) is a market leader and they’re launching efforts in the realm of movies and television. From market share to potential share to growth rates that are above average, Apple behaves like a small company but we submit that it’s not only moot and much less confusing to simply observe that it’s a fairly fast-growing company.

And with that, we have a new favorite list …

Fortune’s Fastest Growing

Every year we celebrate the Forbes list of the Best Small Companies around Halloween. It turns out there’s another compelling list that takes shape around Thanksgiving. It’s the Fortune Fastest Growing companies list and is quite consistent with our theme here, “It’s about the Growth Expectations, Silly.” The list is free and can be found at:

http://money.cnn.com/magazines/fortune/fortunefastestgrowing/2011/full_list/

We committed the 100 companies featured at Fortune to their own dashboard. Investors can take a closer look and do some shopping/studying using:

http://www.manifestinvesting.com/dashboards/public/fortune-fastest-100-2011

Shopping Among The Leaders

Ralph Wanger also pointed out that much of his success at Acorn centered around an emphasis on identifying industry leaders. It may be tempting to speculate on #3 or #6 on a list of promising competitors, but be careful. Early leaders seem to be persistent and more sustainable and it is worth the patience necessary to wait for a leader to take shape in a new area. There are, of course, exceptions — but time after time an emerging leader will continue to lead the pack when it comes to growth and profitability.

Ken has another favorite list that he likes to use in combination with the 100 Fastest Growing, that being the Fortune Most Admired List. This can be a direct path to Wanger’s leaders of the pack. Witness fast-growing companies like Apple, Google (GOOG), Amazon (AMZN), and Costco Wholesale (COST) among a field of established stalwarts.

“At big companies, you talk to executives. At small companies, you talk to owners.” — Ralph Wanger.

Owners investing with owners … sounds like a capital idea to us.

Prudent Diversification

Do you find it intriguing that the NAIC 1984 Investors Manual does not contain a single reference to sector diversification? In fact, there’s one sentence on industry diversification. In sharp contrast, there’s an entire chapter (and part of others) dedicated to heeding growth rates while designing, maintaining and diversifying portfolios.

Going forward, we’ll stop playing “telephone party line” and start using Growth Diversification as the first diversification chart shown with dashboards while designing and maintaining our portfolios based on a suitable blend targeting 11% for the overall growth forecast.

Grow at will.