Life Cycles of Companies...Growth Companies (Small and Mid Caps)

Life Cycles of Companies...Growth Companies (Small and Mid Caps)

Along with the dividend growers, this is my favourite part of the market to invest in. They can be a diverse group, the smaller growth companies while more established than the microcaps are still in the early stages of their growth and can display erratic metrics. Make sure their balance sheets are not too levered and insist upon positive cash flow from operations. One of the very best signs is when the management of these companies decides its stable enough to pay a dividend. This is a major capital allocation decision and management teams don’t make them lightly. The institution of a dividend is an indication that management is confident about the future prospects of their firm.

The midecap growth companies get more of their value from investments they expect to make in the future and less from investments they have already made. The value of their growth assets is both a function of how much growth is anticipated but also the quality of that growth. It is the return they make on the capital they have invested in their business. Remember our definition of return on invested capital (ROIC).

‘Return on invested capital is the return a corporation makes on every dollar of capital invested in the business (both equity and debt). Good companies will have ROICs in the mid teens. It is the ability of a company to create value. Value is created when a company's return on capital is greater than the cost of that capital. Over time the additional return on capital can be re-invested in the business to help accelerate its growth as an ongoing concern. It ties in closely with management's ability to allocate capital efficiently.’

ROIC is a key metric when measuring the growth potential of these companies as is senior management’s ability to allocate capital effectively in order to fund that growth in the future.

As these companies invest their excess capital in growth assets (intangible assets?) their free cash flow can be erratic. High one year, low the next or even negative. In this case it pays to track their cash flow from operations, which is the cash that flows in and out of the business as it relates to the operations of the company. It should be steady and growing.

Look for firms that can maintain their operating margins in the face of increased competition. Stay away from firms that trade off lower margins for higher growth. 

Scalable growth is best. As firms become larger, growth rates will decline. Look for companies that are able to diversify their product lines and cater to a wider customer base as they grow. Senior management's ability to allocate capital is vital. If you find me repeating this theme its only  because it is fundamental in judging profitable growth companies.  

Since markets incorporate  the value of growth assets and accountants do not  these companies will often trade much higher than their book values and speaking of book value it is a very good sign to see the book value per share of a company increase year after year. This is something that Buffet himself likes to see. It means the shareholder's value in the company is increasing over time.

An increasing dividend is one of the very best of signs.

Finally time is on your side with these companies. If they disappoint in delivering earnings the stock of the company will often be punished by short term orientated traders and sold off. That is the time to move in and buy it while its on sale. Buy right and sit tight.  


Resources

The Little Book of Valuation

Aswath Damodaran