The rise of Apple, Amazon, Alphabet, Facebook, and Microsoft over the most recent investment generation has led to perhaps an uneven view of American growth. From 2010 through 2020, the S&P 500 appeared to achieve top-line revenue growth of 6.7%. That was actually better than the post-WWII average of 6.2%.
But almost all of the revenue gains across the index came from these top five stocks. If you subtract the big five from the S&P 500, and only measured the top-line growth of the S&P 500 of the other 495 companies, you would only see top-line growth of 3.8%. From an investment perspective, it is quite difficult to get double-digit returns from a particular investment with revenue growth that barely exceeds inflation. Cost cuts, productivity gains, and share repurchases can only get you so far. The real wealth gets made by selling a meaningful amount of more stuff each year compared to the last.
I was recently going through Berkshire Hathaway’s stock portfolio and comparing the revenue growth against the average for the S&P 500. Some stock investments, like Apple and Verisign and Costco, have been trouncing everybody else with high double-digit growth. Others, like Coca-Cola, had double-digit revenue growth during the first decade of the investment. Still, others like Kraft-Heinz and Bank of America only had 4-5% top-line growth, but were financed on more attractive terms initially than what was available to common shareholders.
And then there was American Express, which only grew revenues at 4% and has largely lagged the S&P 500 for much of the past decade. Berkshire Hathaway shareholders would almost certainly be better off if Buffett had purchased Visa or Mastercard instead as they have 15% annual revenue growth compared to American Express’ 4% level. Is it really a surprise that Visa and Mastercard have trounced the market and delivered exceptional returns compared to American Express over this time?
When you are looking for an investment, your common sense can probably guide you to the top 2-4 giants in the sector (if it can’t, you probably have way more research to do before investing in the sector). From there, I find it helps to identify the participant or two in the sector that is achieving the highest revenue growth. Usually, this is the sign of the healthier enterprise and the one that will be delivering better returns over time (it is far easier to convert high revenue growth to high profit growth than to maintain strong profit growth without commensurate revenue growth).
Over time, these facts become part of your institutional memory. After all, if you reviewed the credit processing sector five years ago and determined that Visa and Mastercard were far superior to American Express, your knowledge has an extended shelf-life–that information is still available today.
Once you work your way through a cluster of sectors with what you are familiar with, you will eventually develop a list of 30-50 companies that you are interested in owning. From there, it is simply a matter of keeping tabs on them, looking for the opportunity when they become out of favor (due to an event hitting the company specifically or the sector generally).
We recently covered the importance of harnessing the deferred tax benefit of taxable investing (where an investor who owns a singular investment in a taxable account that compounds at 13% annually pre-tax will outperform an investor who has to buy and sell various stocks to achieve 13% pre-tax returns but make capital gains taxes along the way). In other words, the best investments are those that compound, compound, and compound. And high top-line growth is often an antecedent characteristic that portends high compounding to come.
The art of successful investing, then, involves combining the various characteristics that lead to good results. First, you look at companies that are trading below a certain level, perhaps 20x earnings or so for a certain sector. Then, you further screen the companies based on some metric, such as a ten-year record of 8% top-line growth or more. Then, you remove companies with high debt levels, perhaps at a level of 3x cash flows or greater. Such a screen alone would leave you with 32 companies in the S&P 500. If you applied this test in 2010 to every S&P 500 component using trailing data from 2000-2010, you would have been left with 28 companies that would have delivered 11% to 47% annual returns from 2010 until January 1, 2020.
I found it startling how few companies in the S&P 500 are capable of achieving revenue growth that is necessary to be an adequate compounder (which I define as 10% returns or greater). In the S&P 500 today, there are probably only 50 components that are going to outperform the index itself over the next twenty years. At a bare minimum, I don’t think there will be a single component that grows revenues below 5% that will be one of those fifty.
In some sense, I think investors perform their due diligence backwards. Instead of looking at the cheapest stocks and determining which ones might have sufficient quality, I would argue it is better to compile a list of the fastest growing companies by revenue and then narrowing the list by identifying the ones with a defensible valuation level. It’s easier to be where the pies are getting bigger than the places where you are fighting for a larger slice.