Global equities and valuations are at all-time highs, but threats loom. Dave Levanson, co-portfolio manager of Sands Capital’s Global Growth strategy, discusses how we’re investing in this environment, and why he thinks selectivity matters now as much as ever.
Despite underperforming in the first few months of 2021, global growth equities are at all-time highs. Have they gotten ahead of themselves?
Levanson: There have been some speed bumps, but we’ve been in a bull market for over a decade. Now, seemingly everything “digital,” “tech,” or “tech-enabled” is up considerably.
We’ve long talked about how the pandemic accelerated existing structural shifts and how we believe it cemented new consumer behavior. For instance, we continue to see strong growth in ecommerce gross merchandise value in economies that have reopened, and more people than ever are loving the convenience of delivery. Carrying cash is becoming a thing of the past—many establishments have stopped accepting cash, while non-cash options continue to proliferate. Also, advertisers continue to shift their dollars to digital media.
Historically, a rising tide often lifts many boats, and when the tide inevitably goes out not all the boats are what they seemed. Today, difficult comparisons versus 2020’s results are on the horizon, and not every “digital” company is going to meet investors’ lofty expectations. We think it’ll be especially important to distinguish the true beneficiaries of these changes from the also-rans.
How do you do that?
Levanson: It comes down to our domain knowledge, criteria, and portfolio construction.
First, as for domain knowledge: we have developed extensive knowledge in many areas after 30 years of growth investing. We believe this helps us appreciate less obvious interconnections and anticipate potential changes in different ecosystems and business models.
Second, in terms of criteria, we only want to buy leaders. That means businesses with 1) competitive advantages to sustain that leadership, 2) the right management to steer the ship, and 3) the financial and cultural strength to withstand challenging times.
Our larger holdings tend to be companies that we expect to become or sustain themselves as dominant and well-run; companies demonstrating an ability to do a lot of different things at once and at scale, so they can handle multiple issues that may arise. Over time, they should build, evolve, and sustain substantial people, processes, systems, and “rainy day” resources. We believe these companies are less likely to negatively surprise us significantly in terms of business outcomes. As a result, we have very high conviction in them, although in the short-term, their stock outcomes tend to be much harder to predict.
Third, we think balance is important in portfolio construction. We like to hold businesses with differentiated growth drivers and end markets, underpinned by different secular trends. Not every portfolio holding needs to be a tech company growing 100 percent-plus annually. Some of our businesses seem quite boring in comparison, but have ground out high-teens earnings growth every year for more than a decade while becoming better businesses along the way.
What about valuations?
Levanson: We look to be long-term business owners—in some cases for more than 10 years—and history shows that earnings growth tends to drive value creation over long periods of time.
If we owned a restaurant, we wouldn’t care what someone would pay to buy us out today. We’d care about attracting new customers, making customers love us, turning over tables, managing costs, enhancing sustainability and competitive advantages, and eventually expanding.
Given that view, we focus on what we’re paying for a company’s earnings over the next five-plus years, not merely over the next twelve months.
As a long-term growth investor, we are essentially asking ourselves, “Do we think we can earn a fair return in the stock of this company?” The answer depends on: 1) what the company delivers in terms of economic output and strategic merit, 2) the market environment, and 3) the idea that valuation is an opinion. So, we work on future business outcomes. Doing this well is our “secret sauce.” In terms of “fair return,” we ask if the factors that go into that thinking are reasonable today and what could significantly alter that in the future—in other words, what might change in the market context or the opinions of investors?
The math of compounding enables a leading growth business to outgrow a seemingly high near-term valuation. Mathematically speaking, a business only needs to achieve 15 percent annualized earnings growth over five years to offset a 50 percent price/earnings decline. The weighted average consensus long-term earnings growth forecast for our Global Growth portfolio was 23 percent as of August 31, 2021, and our internal estimates are considerably higher. This simple mathematical concept, along with the asymmetrical payoff profiles we have observed over time, create a compelling backdrop for what we see as reasonable risk taking.
In our experience, high valuation has rarely been the root cause of a bad investment outcome. Typically, a bad outcome is due to a mistake in our analysis, unforeseen changes in the operating environment, and/or the business not tracking our expectations, with high valuation as a secondary factor.
Speaking of bad outcomes, what worries you today?
Levanson: We don’t have the same concerns as most of the market about the Fed, inflation, etc. That stuff doesn’t really affect what we care about over our time horizon.
Instead, as business owners, we monitor factors that can erode earnings power. Generally speaking, for growth businesses, those factors include market saturation, competition, or regulation. While it’s possible for truly special businesses to withstand these pressures longer than the average company, we believe that understanding these factors and their potential impact on a business’ earnings trajectory is a key part of our job as fundamental investors.
Today, regulation is a threat that we’re monitoring for some of our U.S. and Chinese technology businesses.
In the United States, we believe the regulatory risks for the mega-cap tech companies we continue to own are manageable over our investment horizon. While news flow could drive volatility in the near term, the political environment and the legislative process will likely limit the actual earnings impact.
In China, we’ve been marginally shifting our portfolio’s emerging market exposure to other geographies. Today, our China weight is the lowest it’s been in five years. The beauty of this portfolio is that we have the freedom of investing practically anywhere in the world, so if we conclude that there are other emerging market businesses that are earlier in their lifecycle and lack regulatory pressure, we’ll own them instead.
The portfolio positioning seems to be in really good shape. We continue to balance higher-growth businesses with ones that seem more predictable, and we think this balance will help us deliver our mission of adding value with prudence over time.
The views expressed are the opinion of Sands Capital Management and are not intended as a forecast, a guarantee of future results, investment recommendations, or an offer to buy or sell any securities. The views expressed were current as of the date indicated and are subject to change. This material may contain forward-looking statements, which are subject to uncertainty and contingencies outside of Sands Capital’s control. Readers should not place undue reliance upon these forward-looking statements. There is no guarantee that Sands Capital will meet its stated goals. Past performance is not indicative of future results. A company’s fundamentals or earnings growth is no guarantee that its share price will increase. Characteristics, sector exposure and holdings information are subject to change, and should not be considered as recommendations. The specific securities identified and described do not represent all of the securities purchased, sold, or recommended for advisory clients. There is no assurance that any securities discussed will remain in the portfolio or that securities sold have not been repurchased. You should not assume that any investment is or will be profitable. All company logos and website images are used for illustrative purposes only and were obtained directly from the company websites. Company logos and website images are trademarks or registered trademarks of their respective owners and use of a logo does not imply any connection between Sands Capital and the company. GIPS® Reports and additional disclosures for the related composites may be found at Sands Capital Annual Disclosure Report. #20210205