The Benefits of Growth Investing

11/06/2012 10:00 am EST

Focus: STOCKS

Getting solid, above average growth over the long term is a painstaking process, but it's well worth the effort, observes George Fraise of Sustainable Growth Advisers.

Gregg Early: I am here with George Fraise, Co-founder of Sustainable Growth Advisers and Fund Manager of SGA Global Growth Fund (SGAGX). George, you have a different approach to growth stocks than many of your competitors. Could you describe a little bit what it is that makes your growth stock search unique?

George Fraise: Sure. We are big believers that growth investing done well offers tremendous opportunities for excess returns over time. There's a lot of empirical data that points to that.

And doing it well is perhaps even more important in difficult market environments, similar to the ones we've all experienced in the last five years, when individuals are frankly struggling to offset their plan retirement liabilities or institutions are struggling to meet the 7% to 9% return assumptions built into their plans.

We believe that the key to generating higher returns while incurring a lower level of risk is to invest only in the most predictable, the most sustainable, high-quality, strong growth companies. For us, quality and growth go hand in hand, and we won't compromise on either.

In other words, if you don't invest in high-quality companies, we believe that you have too high a risk of capital destruction, and if you don't invest in strong growth companies, you simply can't get the compounding that's necessary over time.

A lot of managers will focus on either one of those parts. We believe that it's very important to find those few companies that have the combination of high quality and strong growth.

Gregg Early: It does seem somewhat mutually exclusive to be able to get strong growth out of a high-quality company. Usually you don't think of those two things going hand in glove.

George Fraise: You're right, you don't. Which is why we have a process which is geared at identifying the few companies on a durable basis that have the characteristics that lead to that combination. We require five characteristics in all the companies that we invest in:

  • The first is a high degree of pricing power. We're looking for the price setters, not the price takers.
  • The second is a high degree of repeat revenues. We want companies whose products and services are used frequently and need to be replaced regularly.
  • The third is what we call global opportunity, which is long runways of growth which give you the conviction to be able to stay with an investment a long period of time. On average, we invest in companies for three to five years.
  • The fourth is financial strength. We look for companies that generate a lot of free cash flow, because they can then return that cash to shareholders in the form of higher dividends or share repurchases.
  • Finally, the fifth characteristic that we mandate is good management teams, managements that are good stewards of shareholder capital.

Gregg Early: Do you find any sectors sticking out over others using your criteria?

George Fraise: We've found over a long period of time that most sectors have a few companies that embody the characteristics that we look for.

It is a selective process though, I will tell you. In our history, for example, we only have on our buy list 60 to 70 companies today, and we have 25 to 30 in the portfolio.

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There aren't a lot of companies out there that have those characteristics, but we do find them in a number of different sectors. The exception being certain sectors that are either heavily regulated, like the utilities sector, or sectors where there is no pricing power, like telecom services, where those companies unfortunately face continued decline in pricing power.

Gregg Early: I guess there's also a silent sixth criterion, which is that to make it into the fund the companies have to do at least 50% of their business outside of US shores, right?

George Fraise: Well, it is a byproduct of the process. It is not an arbitrary rule. What we find is that the portfolio today generates more than 50% of its profits from outside of the US.

What we find actually in terms of revenues, for example-which we believe is a very important way of looking at the makeup of the portfolio-37% of the revenues are generated in the US. That's a significant portion that's generated outside of the US.

Gregg Early: Do you have any specific companies that would be good examples of your process?

George Fraise: Sure. One of the companies that we've had a good longstanding investment in is Yum! Brands (YUM). This one is a US-based company, but what we like about Yum...and by the way, Yum is the company that has a number of restaurant franchises like KFC, Pizza Hut, Taco Bell...

Gregg Early: Yes, American icons.

George Fraise: It is an American icon. One of the things that is interesting is that today it's much more than just an American icon. Yum derives 50% of its profits from China and 60% of its profit from emerging markets in general. The economics are just wonderful.

In China, for example, they have 4,500 restaurants right now-McDonald's (MCD) only has 1,500, by the way. It costs on average about $550,000 to open a KFC in China. The first year of sales are $1.25 million and cash margins are 25%, so it's a wonderful business model and one where they have the long runway of growth because we think that they can probably get to 10,000 or 15,000 units in the future, which gives them the ability to grow for a long period of time.

Gregg Early: That's amazing. I remember years ago that I think the busiest franchise that KFC had was in China.

George Fraise: It probably still is.

Gregg Early: Is there another company that embodies this?

George Fraise: Yeah, another one would be a smaller company by the name of Shandong Weigao (Hong Kong: 1066, Pink: SHWGY).

Shandong Weigao is the leading manufacturer of medical devices in China. What we like about Shandong Weigao is that it is really a good way to participate in the very rapid growth of the health-care sector in China.

The government is actively investing and trying to provide more medical services to more people in China, and as the population enters the middle class and as more and more money is being spent on health care, a company like Shandong Weigao is very well positioned to take advantage of that.

They manufacture a lot of products that are consumables-syringes and IV tubes, but they also have dialysis equipment. It's really a way to participate in a very broad-based sector of the economy, and one which should have strong tailwinds of growth for the foreseeable future.

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