Three Fundamental Metrics To Help Tilt Your Portfolio To Growth
Spring is all about being refreshed, renewed, and new growth. It also offers a good time to look at your portfolio to make sure it is still doing what you intend it to do, particularly as the markets have been bumpy over the last few months. In many cases, the growth story in many individual stocks may have changed over the last few months. That industrial name exposed to tariff risks might not be quite the growth stock you thought it was. Or maybe, that gold mine has had such a significant run that it is time to rebalance a little. Of course, it is not always easy to find those compelling growth names that will help drive your portfolio to the next level. We wanted to look at three metrics that can help an investor cut through the noise, and hopefully, make it easier to find that next great growth stock.
Revenue Growth
It seems obvious to say that companies with fast growing revenues are the best recipe for adding some growth to a portfolio, yet we find investors often focus on the “wrong” aspects of growth. An investor looking for growth names might put too much focus on profitability, or a cheap valuation. While these are certainly noble pursuits and items that should be considered, we believe that revenue growth trumps most of these things. When revenues are growing at a fast pace, all the other problems tend to go away (or at least are more likely to). So, when looking for that next opportunity that adds a bit of growth to a portfolio, pure, unfiltered, revenue growth should probably be at the top of the list.
In fact, Morgan Stanley published some research looking at the periods of 1990 to 2009 and found that over three, five and ten years, revenue growth was the key driver of returns in the top-performing stocks in the S&P 500, contributing to 50%, 58% and 74% of the returns over those respective time periods1. Interestingly, over a one-year period, revenues contributed to just 29% of returns. So, we might adjust the revenue growth focus a little, and say if you are looking to add growth to a portfolio with a long-term approach, revenue growth should be a top priority.
Strong Balance Sheet
You might look at this metric and wonder what does a balance sheet have to do with growth? In our view, strong balance sheets provide optionality and flexibility. A company with strong cash flows and cash on the balance sheet can take advantage of opportunities when they arise. These same companies also have more of an ability to survive in a slower economy. Macro issues aside, companies with stronger balance sheets can also better weather any storms that come their way, whether it is specific to the company itself or across the entire sector.
Strong balance sheets also provide some level of protection in terms of the “terminal value” of a company. Simply, a company with no debt and a lot of cash on the balance sheet is far less likely to go bankrupt than a company with too much debt. This ties in nicely with the long-term revenue growth focus. While revenue growth is important, the company needs to be solvent enough that they can grow those revenues at an outsized pace for a long period of time. A strong balance sheet helps the company achieve this and gives them that extra wiggle room to bridge the gap from what might be a slightly money-losing business into one that is growing, and hopefully, wildly profitable.
Stable And Expanding Margins
High margins aren’t always something an investor may view as a key part of a growth company, but can go a long way to maximizing all the hard work that is done in generating revenues in the first place. Consistency and reliability in margins are a first key part of a good growth company as they provide a bit of certainty around the company and investment itself. It is far easier to see where a company might go if they have a high-margin and recurring business. Things get far cloudier if you are more of a cyclical business that relies on one-off large contracts and profitability jumps around year in and year out. Of course, both types of companies can work, but the ones that get rewarded with growth multiples, and have the confidence to continue to invest for the future are the companies that can also be confident that the revenues will continue to roll in year after year. Often, high margins that are reliable are a key part of a growth company as it allows them to continue to invest in growth for the long term. What is even better than stable margins—expanding margins!
A company that is growing at an above average rate, but also is able to capture more of those revenues in the form of higher margins can be elusive, but very interesting names to find. This aspect essentially adds a bit of scale to the companies in question. Not only are they growing at an above average rate (and hopefully being rewarded for it), but they are getting a higher and higher share of that growth as well, creating outsized growth on the bottom-line. Further, it is also just a good signal of the quality of the business. If a company can sell more of their “widgets” and make more money off the incremental sale, this demonstrates a scalability of the business and a level of demand that remains robust.
Nothing in investing is guaranteed or will always work, but with a long-term outlook, we think being able to combine revenue growth, quality balance sheets, and high/expanding margins is a great place to start when trying to find that next growth company to add to your portfolio. There may not be a long list of these types of names, but they are out there!
Ryan Modesto, CFA - CEO, i2i Capital Management
https://snippet.finance/drivers-of-long-term-stock-performance/