Rick Dentith is head of UK equities at 9research0 at RLAM The past two years have seen significa...
Rick Dentith is head of UK equities at 9research0 at RLAM
The past two years have seen significant outperformance by so-called value companies and the discrediting of many of the methods of valuing growth companies.
Much of the problem has been caused by the downturn in the economic cycle, which has exposed the fragile market positions of many companies.
While we believe that the worst for the global economy has passed, continuing low inflationary conditions mean sales growth will be hard to generate and investors will have to analyse prospective investments with great care.
In order to generate value for shareholders, a company needs to be able to generate revenue growth. This comes from a combination of changes in volume and price. The underlying growth potential of the market will have an influence on the companies potential to grow revenue. Experience suggests that certain markets, which were expected to generate sustainable long-term growth, were in reality very cyclical. The challenge for a growth investor is the ability to differentiate companies that can grow through the cycle from those where investors are merely extrapolating recent good performance.
A company's position in its marketplace is key and so we look for a sustainable competitive advantage. A strong market position can however, be eroded in a number of ways and it is important that investors are always aware of the dynamics in a marketplace.
There are numerous examples of supposedly impregnable market positions being subjected to intense competition within a very short period of time. As such, a thorough analysis of barriers to entry, the availability of substitute products and the changing relationships between customers and suppliers is important when forming a view on market position.
In order to capitalise on its strong market position, a company needs capable management. Measuring management ability remains one of the great tests for an investor. The first stage is to examine management's goals: are they clear and, more importantly, are they achievable?
The factors mentioned above tend to be long term in nature and there are a number of shorter-term tools that can also be used to aid decision-making. Revenue visibility is a key support in times of economic slowdown and the cashflow characteristics of the business model can act as a comfort or an alarm bell.
Finally, any investment decision has to include an assessment of the right price for the security. Does the current share price correctly reflect the prospects as you see them? The analysis of market and management should enable you to decide on a target valuation and this can be compared with the current valuation in the market place.
As companies develop, they change, and this process will have an impact on the company's valuation. In the early stages of this life cycle, when growth is high and the company is immature, a high valuation can be justified.
As the company matures and growth slows, the valuation of the company tends to fall, even if the growth rate remains high.
Low inflation will reward growth firms.
Company value depends on lifecycle position.
Outperformers have good market position.
Poor management can affect market position.
Strong economic growth can flatter companies.
Past performance can be misleading.
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