Matthews Asia Insight
"Is it still possible for investors to find good growth companies at a reasonable price in such a low nominal GDP regime?"
Where is Growth?
It seems that by now we are all in agreement that the global economy has slowed and is possibly still slowing. China is no longer growing by double digits. Europe’s economy is still struggling and the U.S. appears to offer the only glimmer of hope. And if all that weren’t bad enough: emerging markets (excluding China) continue to suffer in the aftermath of collapsing commodity prices.
This begs a question—is it still possible for investors to find good growth companies at reasonable prices in such a low nominal GDP regime? Some of the stocks we select for our portfolios have become expensive. And the data suggest that both “quality” and “growth” are very expensive today as a result of this scarcity of growth.
As long-term growth investors, we tend to stick to the companies we like for an extended period—five or sometimes 10 years or more. The problem is that valuations can be way ahead of fundamentals at any given time—which may be a sell sign for short-term investors, but also present buying opportunities for long-term investors after some meaningful correction. Of course, there is no guarantee that a stock’s growth potential still exists after correcting.
Our goal is to find growth companies at a reasonable (or discounted) price and to monitor their rise to a compelling “potential” market capitalization size. This is why I tend to focus more on today’s market capitalization, rather than traditional valuation metrics, such as price-to-earnings ratio or the price-to-book ratio for companies. What I ideally want to identify are companies that can grow from something less than US$1 billion to above US$10 billion, within a foreseeable timeframe—so called “10 baggers.” While it is true that large-cap growth companies that have market valuations of US$10 billion can see their value increase to US$100 billion over time, it can be much more difficult to spot one. How difficult? Our posed one question to test the theory: how many companies, with a US$100 billion market cap or larger anywhere in the world, were under US$10 billion market cap 10 years ago? The answer is rather astonishing (and note that it requires roughly a 26% annual compound growth rate to achieve this). Out of 68,000 listed companies in the world today, only one fit the bill, based on Bloomberg data. However, the number of companies that have grown to a market cap size over US$10 billion today, up from US$1 billion a decade ago, is dramatically higher at 40. Still, this is less than one-tenth of 1% of the universe. I believe more opportunities exist in smaller-cap growth names than in “mega” cap names.
What Growth Looks Like Today
Now, let us quickly reflect upon the current macro environment to assess what “growth” looks like today. When I think about a company’s growth, I typically focus on sales growth, rather than earnings per share (EPS) growth, which may be the industry standard. It seems to me that top-line growth is more appropriate in the context of Asia.
Research indicates that despite some past academic studies, sales growth appears to be fairly well correlated with “nominal” GDP growth. Global growth has slowed significantly over the past four years, compared to the decade prior. Surprisingly, nominal GDP in 2015 dipped into negative growth territory, which led to negative sales growth. One might imagine that sales growth for Asian companies was much higher than their global peers. Well, yes and no.
Yes, nominal GDP growth has certainly been higher in Asia compared to elsewhere. But Asia’s sales growth also declined by an even higher magnitude in 2015.
How Hard is the Search?
Is it more difficult to find growth companies today than it was five years ago, given the slower macro environment and higher valuations for growth companies? To answer this question, I run a simple screen to identify the number of companies that increased sales by at least 10% a year for each of the last three years, with an average three-year return on equity (ROE) of 20% or higher.
Figure 1 shows the screening results over the last 10 years. The number of stocks in the top row indicates those companies that passed the test at the end of any particular year: for example, in 2015, 199 companies had sales growth of 10% or higher in each of the last three years with three-year average ROEs of 20% or higher. For 2005 and 2006, the number of companies was low, but then stabilized at around 200 starting in 2007. What can be learned from this is that the average number of companies with superb sales growth records over the past five years is no different from the previous five-year period. For a growth investor, this is good news as there is equal opportunity to pick and choose the best. A few observations here: the number of growth companies in Japan increased dramatically in the last five years, while almost no companies in South Korea made the list (the reason is not low growth, but low ROE). India is still the top dog when it comes to growth, yet the number decreased over the last five years. And there are more than a few growth companies emerging from “frontier” Asia—Vietnam, Sri Lanka, Bangladesh and Pakistan.
The valuations for growth stocks in the MSCI Asia ex Japan Index are at two standard deviations above their historical average, which we haven’t seen since the height of the 2007 super-commodity boom—and this has happened only one other time in the span of the last 12 years. However, valuation measures tend to get skewed by the companies with the highest P/E. If we split the entire market—all listed stocks in Asia above US$100 million market cap—into P/E quintiles, we can see that lower quintile companies are exhibiting the same rates of growth but have more reasonable valuations. It is clear that the P/E ratio of the top quintile companies almost doubled from 2011, while the rest of the pack has been tight and pretty stable.
Another finding is that there is a strong size bias as the median market cap of the companies in the first quintile is far larger than the fifth quintile (Figure 3). This is driven, in part, by investment flows into larger-cap companies within market cap-weighted indices. Another way to look at this is that there is a sizable discount to smaller-cap names despite fundamentals (growth rate and ROE) being the same with large-cap names. The key takeaway is that there is the same degree of opportunity in lower quintile growth companies (mostly in Q4 and Q5) today compared to those in past years, regardless of the economic environment.
We have been able to capitalize on such opportunities. In one case, we uncovered a Chinese company that is under solid management and had good pricing power relative to global brands. In fact, this company had among the lowest valuations in the growth universe in 2010. Its market cap growth was quite impressively aided by margin expansion, which led to P/E multiple expansions over time, and this is possible only if you picked up the stock at a discount due mainly to its smaller market cap bias in the market.
Needless to say, the real research work starts after the screening process is done. And the difficulty is in identifying a real growth company out of the many “pretend” growth companies. There is no easy way to know if today’s US$1 billion company can turn out to be a US$10 billion company in a decade. However, the good news is that we do have as much opportunity today as we did 10 years ago, and we certainly believe the future for Asia’s growth companies remains bright.
Past performance is no guarantee of future results.
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