Ideas Farm: Growth rates rising

  • Why the rise of intangibles means investors should expect higher growth rates
  • Why we should also expect more bitter disappointments
  • …and why it makes sense to pay more attention to forecast trends
  • Plus loads of idea-generating data

Last week, Steve Clapham, a former hedge fund analyst and founder of training company Behind the Balance Sheet, highlighted in the IC why broker forecast trends should be a go-to metric for investors

Recent work by Michael Mauboussin, an academic, author and Morgan Stanley’s equity-research doyen, points to a reason this kind of analysis may be becoming increasingly useful. 

One of the many influences Mauboussin has had on investment thinking over the years is highlighting the importance of using base rates when making forecasts. Base rates provide historical, real-world evidence about how likely something is to happen. 

For example, if analysts were forecasting a company with over $100bn sales would grow revenue at a compound annual rate of 16 per cent for the best part of the next decade, the credibility of such expectations could be tested by seeing how often this feat had been achieved in the past by companies of similar size.

Those heady forecasts just mentioned were predictions for Amazon‘s (US:AMZN) growth from 2017 out to 2025. The message from the history books was: ‘You’re having a laugh.’ That was based on Mauboussin’s excellent base rate study stretching from 1950 to 2015.

But fast forward to today, and Amazon is on track to hit the revenue forecast for 2025 in the second quarter of 2022. Mauboussin thinks this may be more than just a ‘long-tail’ anomaly. 

Central to Mauboussin’s ideas on why growth base rates may have changed is the fact that intangible investment (spending on things like research and development, software, brand-building etc) has become the most important means of creating value for companies. He calculates that intangible investment by Russell 3000 companies stood at about $1.8tn in 2020 compared with $800bn spent on tangible assets. 

This is something that has many significant implications for investors (‘Finding hidden value’, 25 Feb). One such implication is that the characteristics of the growth generated from intangible investment tends to be different from that from tangibles. 

Often intangible assets, such as software, are easy to share. Once the asset is created, the incremental costs of creating extra sales from it are minimal and constraints on the scope to which it can be re-used are low. This means that for winners in fields dominated by intangibles, growth rates can be very high and very profitable. 

There is a flipside, too. Intangible assets can be quickly supplanted. A new superior software can quickly replace the old favourite, for example. So as well as more rapid growth, companies in intangible-intensive industries can be expected to experience more rapid decline. Mauboussin cites Blackberry’s 27 per cent average annual revenue decline over the past decade.

All this sounds feasible, but does it wash in the real world? Mauboussin’s work suggests so. He compared median growth rates in the two most intangible-intensive industries with the two least intangible-intensive ones. The five-year compound annual sales growth rates for the industries can be seen in the accompanying table, which is ordered from most to least intangible intensive, along with standard deviations (the standard difference in the experiences of individual companies in each sector compared with the average company). The results suggest that intangible-intensive companies do indeed tend to produce superior growth rates while individual experiences inside these industries are more variable.

  5yr Sales CAGR Standard deviation
Healthcare 11.5% 30.6%
Technology 9.7% 13.0%
All 7.4% 12.0%
Consumer 6.9% 9.5%
Manufacturing 5.4% 9.4%
Source: Morgan Stanley, FactSet data 1984-2020

“There are two main lessons for investors,” says Mauboussin. “First, it is important to be mindful of the potential shift in the base rate as the result of the rise of intangibles. Second, skillful investors may be able to identify the companies that will grow faster than expected, hence providing the potential for attractive returns.”

It’s this second point that suggests there is potential for an increasingly important role for analysing broker-forecast trends.

Read Michael Mauboussin’s paper here

Read Steve Clapham’s article here

Read about the powerful results from screening for forecast trends here