‘Growth at an unreasonable price’: how to win the long game

Does a stock for a great future-orientated business look too expensive to buy right now? You might want to read this.

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These days there is so much news to absorb every hour, let alone every day.

The frantic nature of the world has seen share markets also move very quickly. For example, many experts reckon last year’s recovery after the March COVID-19 market crash would have traditionally played out over years, not months.

Whether it’s China, inflation or the pandemic, there is always something for investors to fret over.

Forager Funds chief investment officer Steve Johnson said this year it’s now not unusual to see a stock rocket up 100% then plunge 50% within a few weeks.

“This sort of market activity, it does worry me and it makes me nervous,” he told a Forager video in April.

“It is not normal for large numbers of stocks to be doubling and then halving.”

But one fund manager is urging investors to block out the noise and look to the long term.

Short-term thinking is everywhere

Montaka Global Investments research analyst Lachlan Mackay said famous British stock-picker James Anderson is “a legend” to his team.

Mackay wrote on the company blog that Anderson turned £1000 of his clients’ money into £18,000 in 22 years.

“A true visionary, he took big stakes in dominant high-growth technology stocks such as Amazon, Netflix, Alibaba and Tencent,” he said. 

“And Anderson ignored the cries of critics and began investing in Tesla at just US$6 per share (now US$660, split-adjusted).”

The trouble is most professional fund managers must show off outperformance on each quarterly and yearly report, which incentivises short-term wins.

Anderson despised this.

“Anderson has long condemned the financial industry. One of his major criticisms is its structurally short-term focus,” said Mackay.

“In a recent article with The Guardian, Anderson lamented the ‘near pornographic allure’ of earnings reports and macroeconomic headlines.”

Margin of potential upside

According to Mackay, professional investors’ short-term obsession presents an opportunity for those willing to go long.

Anderson lived by a philosophy called “growth at an unreasonable price”, which Mackay says aligns with Montaka’s strategy.

“Classic value investors seek a ‘margin of safety’, where they buy at prices significantly below market value,” said Mackay.

“Anderson likes to look for a ‘margin of potential upside’.”

This ‘margin of potential upside’ is obtained by calculating the chances of “asymmetrically high returns” versus the probability of a 100% downside catastrophe.

“This requires investors to adopt a unique mental framework: to dream up the next decade of real options available to a business,” Mackay said. 

“If the upside significantly compensates for the downside, regardless of today’s relative price, you have a viable investment.”

Tomorrow’s growth stock winners can’t be judged on today’s share price

This means that if a company has potential for a massive future, investors mustn’t think of the current share price as too expensive.

“It’s when exponential progress, dramatic transformation and brilliant entrepreneurialism come together and prove that an ostensibly horribly expensive stock turns out to be extraordinarily undervalued,” Anderson said.

“The initial price is then unreasonably low by any standard and the return to patient investors is absurdly large.”

Anderson cited Amazon and Tencent as shares that have always been considered too expensive but they have kept growing as they keep inventing new opportunities.

Forager’s Johnson made the same point in May. 

He said businesses that show strong growth over many years can make current price-to-earnings (PE) ratios look absurd.

“‘Rocket to the Moon’ trades at 40x earnings, therefore it is expensive: It’s a lazy conclusion (I’ve been guilty),” he said.

“And it can be very wrong.”

Johnson’s example was Cochlear Limited (ASX: COH), which he’d dismissed 20 years ago as “expensive” when it was around $35 with a PE ratio of more than 30.

The medical devices maker has grown 15% each year since then, with the shares going for $245.43 on Friday afternoon.

“With the benefit of hindsight, you could have paid 150 times earnings and have still generated a 10% annual return (including dividends).”

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John Mackey, CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool’s board of directors. Motley Fool contributor Tony Yoo owns shares of Amazon. The Motley Fool Australia’s parent company Motley Fool Holdings Inc. owns shares of and has recommended Alibaba Group Holding Ltd., Amazon, Cochlear Ltd., Netflix, and Tesla. The Motley Fool Australia’s parent company Motley Fool Holdings Inc. has recommended the following options: long January 2022 $1,920 calls on Amazon and short January 2022 $1,940 calls on Amazon. The Motley Fool Australia has recommended Amazon, Cochlear Ltd., and Netflix. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.

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