Knowing what you don't know

In equity markets, you will often come across people who talk extremely confidently about the future of their favourite company. They typically know their company’s products and technologies very well, and express extreme confidence in their views that those products and technologies give it such a lead over its competitors that it is blindingly obvious that the company will continue to gain market share.

We see this perceived certainty reflected in the pricing of many listed stocks. Many companies trade on price/earnings multiples of 40 times or more. By my reckoning, buying a company’s stock at more than 40 times current earnings will generally only deliver an adequate return to investors over the following 20 years if the company’s earnings are destined to grow more than 5-fold over that 20 year period.

Why does a company on a P/E of 40 need to grow at least 5-fold to deliver an adequate return? My reasoning is as follows:

• Stocks trading on P/E multiples of 40 or more almost always show above-average sensitivity to market declines, which means that they bring above-average risk to your portfolio. Your required return from such investments should therefore be at least 8% per annum.
• For most equities it is sensible to assume that they trade on a P/E multiple of no more than 20 times in 20 years’ time. Over time, the average P/E multiple on the average stock has been less than that, and while you may have good reasons for believing that a company has better-than-average prospects (justifying a higher-than-average P/E ratio) today, no one really has any idea about whether the company will be perceived as having better-than-average prospects in 20 years’ time.
• Hence, a 5-fold increase in the company’s earnings over 20 years likely only implies a 2.5-fold increase in its market value over 20 years, if your starting point is paying 40 times earnings for the company and your end point is 20 times earnings. This works out as share price appreciation of 4.7% per annum.
• As you are paying 40 times earnings for the company and it will retain a share of its earnings to fund its growth, the distributions (dividends etc) that it makes to shareholders will be relatively insignificant in the first few years, but could be more significant in the second half of your 20-year holding period. Even if we assume that the growth is front-loaded and that a higher return on capital means that the company does not need to retain a lot of earnings to fund growth, the average dividend yield that you receive is unlikely to be much better than 3.5% per annum.
• The combination of 4.7% share price growth and an average dividend yield of 3.5% only just meets the 8% return hurdle (with the dividend yield slightly devalued due to the fact that most of the dividends come in the back half of the 20-year holding period).

But how difficult is it for a company to achieve 5-fold growth in earnings over 20 years? If you look at the history of the largest companies of today, you might think that 5-fold growth in earnings was relatively commonplace, as most of today’s leaders have got to that position by growing a lot over the last 20 years.

However, looking at the growth record of today’s largest companies is an incredibly biased sample. If we instead look at the largest companies from 20 years ago, far fewer of them went on to grow earnings 5-fold. Of the 200 largest companies in the MSCI World index 20 years’ ago, I count only 11 companies that subsequently grew earnings by 400% or more. Five of these companies (Microsoft, JP Morgan, Alphabet, Apple, & Eli Lilly) now rank among the top-10 companies of today.

Many of the companies that ranked among the top-10 20 years ago have shown little or no growth in earnings, including General Electric, Exxon Mobil, Citigroup, BP, and Intel.   

Today there are 20 companies among the top-200 that are trading on more than 40 times forecast earnings for the year ahead. If the past 20 years is any guide, fewer than 20 of the 200 largest companies will achieve the 5-fold growth in earnings needed to justify this sort of multiple, and many of the companies that do achieve 5-fold growth will not be the ones that are currently trading on premium valuations.

Can we really predict earnings growth over the next 20 years?

The confidence that some analysts and investors express in their ability to foresee future growth for many of the largest listed companies of today is difficult to reconcile with how few of the largest companies from 20 years went on to achieve significant growth.

Further, the fact that this confidence is often grounded in analyst’s expectation for existing products or technologies misses the fact that some of the strongest growers over the past 20 years were companies that achieved much of their growth from products or services they had not even developed 20 years ago. For example:

• Most of Apple’s earnings growth has come from the iPhone, which it did not launch until 2007.
• Most of Eli Lilly’s growth has come from tirzepatide (Mounjaro / Zepbound), a drug that has only been on the market since 2022.
• Much of Microsoft’s growth has come from its cloud services business Azure, and from subscription-based software. 20 years ago, Microsoft had not launched either product (most of its software was sold as a perpetual license on a shrink-wrapped disc).
• A large part of Alphabet (Google)’s growth has come from Google Cloud and from sponsored search results. In 2005, Google had not launched Google Cloud and only sold banner / sidebar ads.

The strongest growth often comes from new products, and it is rare for analysts or investors to see the potential of a new market until it is already booming.

In fact, there is arguably a paradox with companies entering new markets, which is that the more obvious it is to share market investors that a new market has large potential, the less likely it is deliver good returns to the companies selling into it. The reason for this is that if many share market investors can see the potential in a new market, then other companies will also be able to see it and try to get a slice of the action, and the new entrants are therefore likely to face significant competition before they achieve critical mass.

Indeed, a large part of the success that Apple had with touch screen phones or Tesla had with Electric Vehicles is that no other company thought to enter those markets until Apple & Tesla already had dominant market positions. If equity market participants had been excited about these products before they were launched, then other companies would have probably tried to enter the market at the same time, which potentially could have resulted in quite different outcomes for these two companies.

In a competitive market place without strong network effects, sustained growth is intrinsically hard to predict based on a technological edge or the quality of a company’s product, as company A might have what is clearly the best product in February, only to have company B launch an even better product in June, followed by both companies being trumped by company C in August. But if one company gets a strong early lead in a “winner takes all” market, it may be a decade or more before any other is able to challenge its lead.

If investors had not got so excited about Chat-GPT within days of its launch, it is possible that OpenAI would have built a commanding market position in AI services that other companies would struggle to compete with. But investor excitement helped stimulate competitive entry from the likes of Google’s Gemini and Anthropic’s Claude, and as a consequence it seems likely that all participants in this market will bleed money for several years before it begins to generate positive cash flow.

But what about all the companies that grow consistently for several years?

While I have shown that very few already-large companies grow as much as 5-fold over the course of two decades, it is also true that many companies do achieve much stronger growth for extended periods of time.

For example, my best performing personal investments have been shares I bought in Altium and Mainfreight in the early 2000s, which each achieved more than 30-fold growth in profits over the subsequent years. But these were not large companies when I invested in them: Altium had a market cap of about A$25 million, and Mainfreight had a market cap of about NZ$100 million. Companies of this scale can achieve strong growth for several years without seeing a significant competitive response, partly because the other participants in the market are often more concerned with winning customers from each other than from a smaller company that has strong customer loyalty.

Further, the growth that such companies achieve over time is mainly the consequence of a focussed management team leveraging off a strong business model and responding well to structural changes in the market that they operate in.

Having the best technology or the best product at a particular point in time does not seem to be a good predictor of long-term growth. It may help you understand why a company has gained market share over the past few months and point to continued momentum for the next few months. But continued growth would require that a company continues to stay ahead of competitors on technology and product (as well as other important factors such as customer service and value-for-money).

To identify whether a company is likely to stay ahead of its competitors on product, technology, service quality, and on value, I think it is probably more important to make a qualitative assessment of the company’s focus: are they more focussed on milking the cash cow they’ve already bred? Or on continually improving their customer offering?

In many cases, I think there is a danger in paying too much attention to what a company says it will do, whilst not having much insight into what the company’s competitors may do. And in many cases (particularly if they’re not having to communicate with public market investors), potential competitors will keep quiet about what they’re up to until they’ve actually launched a new product.

Reading (or listening to) all the materials that a company puts out about itself and what it is doing to grow its revenues therefore leads to a rose-tinted view of its prospects. You can be blindsided when another company launches a new product, often in a new product category which meets the same underlying customer need as your favoured company. TV networks were so busy competing with each other that they didn’t anticipate the competition coming from Netflix, YouTube, and Social Media. Similarly, automotive companies focussed on selling cars to individuals may find (possibly within the next decade) that they have no market left if most of their customers start using cheap robo-taxis to get from A to B.   

The column above essentially sets out my thoughts on growth investing, but you may choose to discount them, as I am not naturally inclined towards growth investing. Rather, I tend to be sceptical about the ability of myself and others to look into a crystal ball and anticipate what a company will look like many years into the future. For this reason, I tend to attribute greater value to predictable recurring cashflows, and put less focus on anticipating future growth.

Some more growth-focussed investors possibly have a more nuanced understanding of how to identify growth than I have developed with my greater focus on cashflow and avoidance of risk. However, when I listen to many growth investors talking about their favourite stocks I often fail to detect any such nuance in their thinking.  Instead, I see a lot of growth investors seemingly fooling themselves into believing that they’ve got much more insight into the future than their historical track records would support.

Nicholas Bagnall is Chief Investment Officer of Te Ahumairangi Investment Management

Disclaimer: This article is for informational purposes only and is not, nor should be construed as, investment advice for any person. The writer is a director and shareholder of Te Ahumairangi Investment Management Limited, and an investor in Te Ahumairangi Global Equity Fund. Te Ahumairangi manages client portfolios (including Te Ahumairangi Global Equity Fund) that invest in global equity markets. These portfolios hold shares in companies mentioned in this column, including Microsoft, Alphabet, Apple, and Eli Lilly). The writer and has family also directly own shares in Mainfreight, also mentioned in this column.