THE FINANCE GHOST: Growth — but with cash flows

We have a new finance minister. Prepare yourselves for endless rhetoric about taking everything offshore and getting out of SA while you can.

I’m being careful, though — offshore is hardly a low-risk play currently.

If the ideal situation for investors is an efficient and reasonable market, then it takes one look at the so-called meme stocks (like AMC and Robinhood) to realise that we are far from that ideal. The pump-and-dump trade has been synonymous with these stocks. When money is cheap and easy to get, it’s also easier to lose. YOLO.

At some point, this madness must end. The catalyst might be growth stocks losing their shine, as the army of retail traders could choose to take their profits and spend them at Porsche instead of with Robinhood on out-of-the-money call options. Many of those traders are here for a good time, not for a long time.

Nobody can deny that growth stocks absolutely dominated 2020, as the pandemic accelerated the technology trends that were already in place. Concepts like cloud computing and e-commerce aren’t new; Covid just compressed several years’ worth of growth into a single year. This has created a culture of revenue-multiple zealots who only care about revenue growth and "sustainable adjusted core" earnings before interest, tax, depreciation and amortisation (ebitda), which strips out all the annoying expenses that cause companies to report losses.

Free cash flows? Don’t be silly! Companies can just raise more cash in the market to fund the growth engine. Huge issuances of stock as compensation for executives? Shh, these are noncash expenses anyway.

There was a time when nothing could deter growth investors. Lately it feels as though that is changing. Numerous growth companies have spent 2021 trying to grow into their multiples; some have failed dismally.

I constantly beat the drum that an investment return is a function of two things: what you choose to invest in and what you pay for the privilege. When exciting tech companies are trading at revenue multiples above 30 times, it’s a recipe for disappointment. P:e multiples above 30 times already send shivers down the spines of value investors. Revenue multiples at such levels should scare off even the most optimistic growth enthusiasts.

Before I’m accused of being out of touch, I do understand the economic models of these platform companies. As they achieve scale, the winner-takes-all economics kick in, and ebitda margins go through the roof. Network effects ensure a sticky user base, and the company founders spend their time worrying about regulators rather than competitors, mainly because the latter are few and far between.

However, very few growth companies will ever achieve a fraction of what, say, Facebook has achieved. There’s more to think about than just revenue growth and average revenue per user (arpu), which in some cases are the only measures used by younger investors. For example, focusing my analysis on free cash flows and the competitive environment a company finds itself in has ensured that I avoid Netflix entirely. Year to date, the stock is flat. Though Netflix was a solid pick in 2020, South Africans who panicked and took their money out at crazy exchange rates have seen their rand-based returns eroded by a recovery in our currency and a disappointing performance from $NFLX this year.

Many experienced investors rotated a portion of their portfolios into value stocks at the start of 2021, which has proved to be a profitable strategy. Even though the JSE has been bemoaned as a place to watch your money rot, recent returns on small and mid-caps have exceeded those on offshore growth stocks, and the rand has been quite stable thanks to huge commodity exports.

As the ridiculous US growth multiples come back down to earth (or at least into the atmosphere, burning brightly with the losses of "bagholders" who bought at the top), and the value gaps continue to close, where will the smart money go next? What might happen if the US Federal Reserve becomes more hawkish, tapering its bond-buying programmes and possibly hiking rates within the next two years?

Quality growth companies will always have a place. I’m happy to pay up for companies like Facebook and Google, which have proven cash flows and borderline unassailable competitive advantages. Twitter is an exciting story as well.

As growth multiples drop to more reasonable levels, there will be compelling opportunities to buy the best-of-breed growth stocks that will generate free cash flows over the next decade. This will be especially true if our currency can keep it together.

A focus on quality means that investors will need to read further than just arpu. Unadjusted ebitda might even start to matter once more.