If history repeats itself, and the unexpected always happens, how incapable must Man be of learning from experience.
— George Bernard Shaw
I like the dreams of the future better than the history of the past.
— Thomas Jefferson
It would be convenient if to pick tomorrow’s winners you just had to look at past results. Unfortunately, that plan doesn’t work because the world is constantly changing.
If you were to look at the leading industries in 1925, you would have found that 23 of the 100 largest capitalization companies in the US market were in the railroad industry. Ten were automobile companies, and four were in metals and mining. Zero of the 100 largest companies were in information technology, healthcare, or financial services.
Fast forward the clock to 2013. Only two companies were in automobiles or railroads, one in metals & mining and zero in railroad amongst the largest 100 companies. Conversely, 25 information technology companies were amongst the 100 largest, 20 financial services companies, and 17 healthcare companies.
While we know that we won’t find the winners of tomorrow by reviewing the winners of the past, it’s instructive to analyze the top performing companies so to learn what to look for in identifying the stars of tomorrow.
Accordingly, we conducted our annual study on the mega-winners over the past 10 years. To identify the All-Stars in the stock market, we evaluated over 10,000 companies to find which were the 25 top performing stocks from 2002 to 2012 on a total return basis. Who made the list was interesting, but not that shocking – after all, any knowledgeable follower of the market could have picked these in hindsight. And since we know the past isn’t a prologue for the future winners, what’s noteworthy isn’t who made it, but how they got there.
In order to place my convictions in perspective, I analyzed the top-performing company characteristics to highlight where growth companies come from and how they create value for shareholders. Notably, many of these companies exemplify the Megatrends that prevailed during the study period – a fact that is far from coincidental.
In the study, the average top-25 performing company had an initial market cap of $91 million in 2002; grew earnings 42% annually and experienced annual P/E multiple expansion of 70% — to yield annual price appreciation of 45% through 2012. At the end of the ten years, the average market capitalization of those same twenty-five companies had grown to $27 billion!
As this concise study highlights, profits are fundamental to a growth stock’s longer-term performance, and with a significant portion of the performance being contributed by P/E multiple expansion – despite relatively “high” multiples at the outset – there is a clear premium the market affords to companies that are able to consistently capitalize on their market’s rapid growth.
This premium of P/E multiple expansion that arises is what differentiates a growth company from a growth stock, i.e., a premium company earns a premium valuation. By comparison, companies that rely upon the broader economy to help then achieve long-term growth will find it far more difficult to achieve a premium valuation in the absence of a strengthening economy, decelerating inflation and rising consumer and business sentiment.
Just to make sure that this 10-year period wasn’t a fluke, we went back five years to the 1998-2008 period to see which 25 stocks were top performers, and what were the characteristics.
Lo and behold, the medium market cap for the top performing companies from 1998-2008 was $122 million. The average P/E was 19.4x and the average earnings growth was 33%. The class of ’98 had an average stock price CAGR of 32%.
After considering the profiles of the top-performing companies, it is apparent that long-term stock performance is principally determined by earnings growth, not initial valuation, while the prevailing valuation is the result of proven operating success. The conclusion is that investors seeking to identify the top performing companies on these lists in the future should not focus on “bargain” stocks or even “momentum” ideas, but rather identify growth companies, competing in large addressable markets, that possess dynamic long-term growth potential.
In addition, companies that operate in industries propelled by tailwinds will generally outperform the market. A tailwind is when a company and/or industry benefits from the trends that are shaping society. For example, companies that provide protection and screening services have received a tailwind from Homeland Security legislation. In contrast, a headwind is when negative trends are affecting an industry, such as non-smoker rights legislation creating a headwind for the tobacco industry. Those companies that are capable of successfully capitalizing on growing markets, rather than simply relying on the favorable “tailwind” are those that will capture larger market shares, be rewarded with premium valuations and ultimately deliver the greatest shareholder value.
Stocks blew off some steam to end the year on Monday and begin the New Year on Wednesday. For the week, the NASDAQ was up 4.8%, the S&P 500 advanced 4.6% and the Dow was up 3.8%. The Dow had its biggest opening day of the year ever, jumping 308 points. Catalyst for the strong upward movement for equities was the aversion of falling off the “Fiscal Cliff” and a decent jobs report.
Other positive news last week included same-store-sales growth for retailers at +4.8% and impressive sales from the automotive sector. While Ford‘s sales rose just 2% and GM‘s rose 4.9%, Chrysler‘s sales were up 10%, Toyota‘s were up 9%, Honda‘s sales were up a whopping 26%, and Volkswagen’s were up an amazing 35%.
It’s encouraging to have stocks act well for the start of the year and we believe they are positioned to have a strong 2013. Bond yields, despite shooting up 21 basis points last week to 1.90%, remain incredibly low and an easy competition for stocks. Fundamentals on many of the leading growth companies remain strong and valuations attractive. We are bullish.
2013 kicked off with strong bubblin activity across many of our focus areas. In the education technology space, developer training platform Pluralsight received $27.5 million fresh funding from IVP. Pluralsight started off in 2004 and initially was sending coaches/instructors in-person to teach classrooms or clients. Three years later they switched to being purely online, and today they offer 400 web-based classes for developers to more than 200,000 users from 100+ countries. Pluralsight’s model is similar to Spotify by charging $29 per month for members, with a premium option for $49 that gives users access from mobile phones, both on and offline. Businesses with 25+ people receive discounts based on size of the company. Some of its frequent users are from Salesforce, Twitter, Facebook, Bank of America, Dell, EMC, Walt Disney and KPMG. Looking ahead, Pluralsight plans on developing courses specially focused for platform technologies like Twitter and Facebook. This is certainly a good one on for our watch list given the nice progress.
UK-based Frostbox, which wants to become the Dropbox of social media, is offering equity to investors who have a Klout score of 60 or higher. While that’s extremely non-ordinary, this offering makes sense as Frostbox wants to have socially active investors to further promote the product. Frostbox allows users to save all their historic data from social sites such as Twitter, Facebook, LinkedIn, Gmail, Foursquare, etc. It’s interesting how companies are starting to offer the historical social data for the user himself. Twitter launched its own archiving a few weeks ago, Facebook did the same with its timeline two years ago, and many others are following that trend. Integrating Klout scores as means of investor approval is something new and interesting.
Pinterest, which is one of the fastest growing startups in the past two years, made its first acquisition after buying recipe discovery site Punchfork. The latter was founded in 2010 and helps users to cook at home more often. It aims to make cooking more enjoyable and offers top recipes from other sites. The acquisition will also help Pinterest users to sort through Punchfork’s massive archives. The deal price was not disclosed, but Punchfork’s founder and CEO Jeff Miller will join Pinterest’s engineering team. Back in August, Pinterest had 23 million users, up from 10 million in January last year.
A few weeks ago we wrote about our 2013 focus themes. One of them is Self Driving Cars, a theme pioneered by Google and its driverless cars taking 360 pictures for Google Maps. Now, Toyota and Audi confirmed they will demonstrate self-driving features at the Consumer Electronics Show in Las Vegas next week. Audi said it will demonstrate features such as driverless parking… which could mean that sometime soon, one would be able to simply drop off his car at arrival at a busy mall parking, and the car then will find and park itself. My guess is there will be an app with that, showing the parking spot location. This means Knight Rider is finally coming to the masses soon…
- @Twitter’s Developer Tools Put Company Deeper into China http://t.co/0J9cwE5uwu
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- @Roku Raises $25M amid Growing Competition from Amazon and Google http://t.co/NFfB0drnuh
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