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I discovered Peter Seilern by reading his book, Only the Best Will do, in which the author explained how to pick the best stocks and to invest in “quality growth businesses”. What can be quite impressive, it’s his ability to have better performances than well known indexes such as the MSCI World TR or the S&P 500 TR.
If we look at the Seilern world growth fund factsheet, we can see that this fund has a CAGR of 11.6% over the last 10 years vs a CAGR of 8.3% for the MSCI World TR for the same period !
In this article, I will give you the 10 golden rules in order to select the best quality growth stocks that I found in Seilern’s book.
But before this, let’s define what a “quality growth” stock is. “Quality” is represented by the balance sheet, i.e. the quality of the assets and its governance. “Growth” is how good the company is in increasing sales, net margins and cash flows.
Defining a universe
The first step is finding companies which grow faster than the GDP of the countries where the companies are managing their businesses. Next, you have to select companies based on the criteria which will be explained below in this article. After following these two steps, you will already end up with around 60 companies out of the 50,000 companies listed. The remaining 60 companies are in principle established/well-known with steady profitability and growth.
1.A Scaleable business model
A scaleable model helps the company to increase its sales and profits. We have two main types of scaleable models, the platform model like Mastercard which growth is driven by volume and stable processes and capacity-driven model like Fanuc where growth is driven by output increases.
These two scaleable models are however sustainable as long as growth opportunities exist.
2. Superior industry growth
Investing in industries with growth above GDP growth are less correlated to economic cycles. This will lead to sustainable earnings growth and in the long run, share prices appreciation.
In contrast, companies in cyclical industries linked to economic cycles will go through poor/unsteady growth.
The author advises to avoid cyclical companies as the different economic phases are difficult to predict.
3. Consistent industry leadership
The quality growth company has to have a large market share and a well established name. Indeed, once a company has been a leader in its sector for years, the competitors will struggle to remove the leader from its position.
Another advantage of leadership is pricing power, that is to say being able to change prices without losing clients. Pricing power has however to be used sparingly in order to avoid hurting the business reputation.
4. A sustainable competitive advantage
What makes a company a leader in the long run, is usually few competitive advantages. We have two types of advantages : superior product or superior business model like Inditex with its fast fashion model.
A sustainable advantage can mean being able to produce at a cost so low that same product companies cannot compete.
The ultimate goal is to maintain competitive advantages as it helps to ease forecasts on sales and cash flow growth.
5. Strong organic growth
What is considered strong growth, is sales and earnings growth getting close to double digits. Therefore, quality growth companies are known for their strong steady growth record (up to 20 years) and sometimes despite crisis and recessions.
If earnings growth is made through lower expenses and tax optimisation, this is not considered a sustainable way of creating growth.
Besides that, growth should be achieved by the business itself and not through acquisitions as this carries risk.
6. Wide geographic or customer diversification
Diversification makes companies more resilient in case of demand drop in a specific area. In other words, it can help to better absorb market ups and downs. Besides that, a wide geographic diversification helps companies to gather wider data, which can enhance marketing and innovation.
Peter Seilern sees a lack of diversification as a risk for investors.
7. Low capital intensity and high return on capital
Companies with low capital needs can be seen as less dependent on external funding, and therefore have less debts. High return on capital generates added value by exceeding cost of capital.
Companies with low capital needs and strong return on capital generate growth and mitigate capital loss risk
8. A solid financial position
Having too much debt will push the company to use the profits for interests or debt repayments instead of investments. Excessive debt will have an impact on earnings and valuation in the long run. Furthermore, high debt levels usually send bad signals to potential investors such as poor management or lack of organic growth.
Debts can however be needed sometimes, but have to be balanced against earnings and cash flow forecasts.
9. Transparent accounts
Transparent and responsible accounting is necessary for investment decisions. Transparent accounts will ease the understanding of economic flows and the value and risk assessment.
Most quality growth companies have straightforward accounts, and if we have too many extraordinary items that can be considered a threat. On the opposite side, banks and insurance companies tend to lack transparency especially with unclear loan quality and complex actuarial models.
Overall, transparency mitigates risk and supports growth forecasts.
10. Exceptional management and corporate governance
A company can become a quality business only if its management/governance is exceptional. One of the key elements is that the management should have the same interests as shareholders. Companies with a “shareholder-friendly culture” are therefore to be preferred.
Top management should acknowledge mistakes when something went wrong, give team gratitude and avoid self-promotion. A good example would be companies controlled by families, as they tend to think long term and look for sustainable growth.
ESG factors should not be forgotten as they are crucial for sustainability, ethics and reputation.
The author stresses the point that these 10 golden rules of quality growth investing have not changed over years and should not be changed for political or economic reasons.
These rules will help investors to rely on the businesses and not just the valuation made by the stock markets.
