Monday, June 15, 2015

Long-Term Winners

Imagine if you had invested in Apple in the ’80s or Google a decade ago. Many investors dream of getting in early on the next big thing, an innovative company that changes the world and enriches them.

But a T. Rowe Price study shows that finding these companies is extremely difficult and holding them through rough markets can be even harder. They often are operating not in such dynamic industries as social media and technology but are engaged in such mundane undertakings as bread making.

To identify companies that achieved a 20% or more annualized return over 10 years—a sixfold total gain—the study examined all companies in the Russell 3000 Index with $1 billion to $3 billion in market capitalization over rolling 10-year periods, from 1996 through 2013.

In the 11 different 10-year periods, an average of only 18 companies achieved such stellar performance per period. When not double counting companies that hit the mark in more than one 10-year span, the average dropped to 10.

“The ability to grow revenue at a double-digit pace is really, really hard to do over an extended period of time, and to be able to compound wealth at 20% or more is very rare,” says Henry Ellenbogen, manager of the small-cap New Horizons Fund.

While discovering such potential overachievers may be rare, sticking with them through rough patches can be even more challenging. To reap the outsized rewards these stocks eventually provided, investors had to endure an average decline of 27.1% at some point during that decade.

“It shows you that even during a period when a stock is compounding between six- and eightfold, its price could drop significantly along the way,” Mr. Ellenbogen says. “So you have to be patient and know that you are going to go through a rocky period where the company may be in transition in which it has to reload for the next phase of growth.”

The study also demonstrates that such success is not concentrated in such high-growth sectors as information technology and biotechnology. In fact, the leading sectors for outstanding performance included consumer staples, energy, and industrials.

Flowers Foods, for example, makes bread, snack cakes, and other household staples but was one of the few companies to star in multiple 10-year periods. “Here’s a company whose end market— bread—has had modest growth at best,” Mr. Ellenbogen says. “But it’s a company with good systems and people, runs itself very efficiently, allocates capital well, makes smart acquisitions, and has organically gained market share.”

Success Keys
Not surprisingly, the companies that achieved exceptional performance over 10-year periods exhibited superior financial characteristics. On average, these leaders had median annual sales growth of 19.5%, median annual earnings growth of 17.1%, and average annual return on invested capital of 18.4%—all significantly higher than the average firm in the study.

Value, Too
Exceptional performance does not just come from high-growth companies. Value investors seek the same outcomes but from a different starting place.

“We’re trying to find companies that may offer the same kind of compelling growth prospects but they’re not necessarily fully valued and are actually cheap,” Mr. Wagner says. “These are companies that for whatever reason may have fallen on hard times and their returns may actually be decreasing, but with the strategic moves that could actually make them look like a growth stock down the road.”

“There generally are three ways small companies might achieve outperformance,” Mr. Athey says. “The first is that it is truly a growth company and consistently puts up high-growth numbers. The second is a company that may be near bankruptcy or is really deep value and it comes back from the dead. “The third is a little of both—a company that may be under the radar screen, perhaps with a checkered history, and it’s really cheap, but not because it’s a horrible company. It’s just been neglected and hasn’t performed very well, but maybe new management comes in and the company starts doing better.”

Whether a growth or value investor, Mr. Wagner says, the study’s lessons are the same: “Think long term, be patient, and recognize that even the best companies on the planet will have periods when things don’t look so good.

“Also, when you find something really good that’s working well for you, you should appreciate that’s a rare thing. You have to recognize that you are going to look at a lot of companies before you find one that could be a really big compounder of returns.”

-- T. Rowe Price Report, Summer 2014

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