How Much Earnings Growth Do We Need?
Decay of high growth rates and our strong focus on proactive capital allocation
As quality growth investors, we’re looking for two elements:
best-in-class companies (based on a variety of metrics) that are led by top-notch managers;
stable valuations and high Sortino ratios, so that we can deploy as much capital as possible at strong IRRs while keeping risk of permanent loss of capital in check.
Valuations are a reflection of investor sentiment. When times are good, investors are eager to pay up for equities (even though the fundamental picture hasn’t changed much), leading to lower IRRs afterward.
We like steady winners that have been doing it for multiple decades (or even centuries) and should continue to thrive over the next decades. Bo Annvik, CEO of Indutrade, said during the Capital Markets Day presentation in 2022:
We don’t want to surprise an audience like you.
Essentially saying: we have a clear path towards durable growth, and that’s what you should expect from us: delivering on our commitments. That’s exactly what a Compounding Tortoise company looks like: investors will rarely ever get too excited about their multi-decade low-teens % CAGR in NOPAT per share.
There will always be other and better growth opportunities available, but will their journey last? It’s like the analogy of the mistress always looking better than the wife.😁
The key question remains: how much growth do we seek and need to satisfy our expectations? High growth rates tend to decay rather quickly, attract competition, and lead to volatility in valuation multiples.
In Q1 2024, our companies delivered 13.5% EBITA per share growth. EBITA makes it easier to do an apples-to-apples comparison. In the end, all that matters is NOPAT and cold free cash. Based on our companies’ growth rates, clear targets and the computed IRRs, we continue to find good opportunities to put excess capital to work in a safe manner.
Let’s elaborate a bit more on growth rates, learnings from the Great Financial Crisis (greed, leverage), and the importance of proactive capital allocation in the below webinar (PDF material can be downloaded).