Growth investors focus on trying to pick the companies that will grow rapidly for many years to come, hoping to be rewarded by a consummately increasing share price. This can be anywhere from Venture Capitalists investing in tiny startups to enormous mutual funds betting on whether Twitter will continue to put up such strong growth. These companies tend to have high share prices compared to their current level of profitability, but have a good story, and will have rapidly grown in the past.
There are certain strategies that people use when trying to persuade someone to invest in a growth stock. This could be the startup team pitching to a VC fund or an analyst in a hedge fund pitching to his portfolio manager. I have more experience with the latter, so this will focus on companies with market caps above $100m.
Many of these strategies are intellectuality illegitimate. As such, I intend this as a sort of ‘Defense Against the Dark Arts’ – how to spot people using these rhetorical strategies in the wild. Perhaps this will also help people employee these strategies – if so I apologize to the world. I take the virtue of silence seriously – but in this specific instance I think sunlight is the best disinfectant – and hopefully it will make for an interesting blog post.
Choosing a growth stock to pitch
The first step is to choose the right stock. Pick something which has seen strong increases in share price over the last few years. A relatively smooth glide path up is best – don’t pick something that rose 20% in one day and has done nothing else. The goal here is to use the halo effect1 to make people confuse the historical share price movements with the company itself – to make it seem like the company itself actually has the property of steadily growing, rather than this just being a property of history of the market’s valuation of this stock.
However, it can be a good idea to pick something which has very recently seen a sharp fall in the share price. This way, your PM won’t feel like they’ve “missed it” – they’ve got another chance to get in. Regret Avoidance is a powerful effect, and you save them from this. Plus, the recent sharp fall means they’re safe from being the guy who bought in at the peak. That guy will look very stupid, so they’re happy to be safe from his fate.
Of course, you need an explanation for why these have happened. The steady rise is easy – the company is also steadily growing. The sharp fall is harder – people don’t want to invest in things that fall! – but there are some easy explanations on hand. ‘Hedge fund de-levering’ is always available as an excuse, and with any luck will act as a semantic stop-sign.
So far this has actually been pretty intellectually respectable. Or at least epistemically lucky – the first requirement, for steady share price growth, probably means the stock has strong momentum, which has historically been a strong predictor of returns (albeit with high kurtosis and negative skew, so beware!). The recent share price fall means the stocks will do well on short-term reversal, which has also historically been a good predictor. The next steps, however, are more dubious.
Total Addressable Market and the Conservation of Conservativeness
Having selected your company, the first step is to work out what the Total Addressable Market (TAM) for your stock is. Is it a household product? Take the number of households in America and multiply by the frequency of purchase. Is it a car? Look at the total number of cars. A better type of steel? Look at total US steel consumption. The key is to get a really really big number. If the number is insufficiently big, just look at a larger category of which the true market is a subset.
Next, multiply that number by their expected market share. As the company has been growing rapidly, it’s probably been expanding its market share of its current niche. So say you assume they’ll keep their current market share even as that niche grows into a major market. This assumption is conservative, you’ll say, because actually they have been growing their market share. This number should be reassuringly small – say 1%. It’s small size will help reassure people that you’re being conservative. If you want increase the total market they’ll eventually control, scope insensitivity means its easier to increase the TAM size than their market share. It’s obvious that 20% market share is a much more aggressive assumption than 2% (especially if their current market share is 2%), but not nearly so clear than $100000000000 is a more aggressive TAM estimate than $10000000000 – especially if you only present one of the numbers.
Next, assume a profit margin. If their current profit margin is high, just say you’ll conservatively assume no economies of scale. If their current margin is low, or they make no profits, just compare to vaguely similar companies and go for a slightly lower number. If ‘comparable’ mature companies have a 30% margin, say 20%. This sounds very conservative, but actually only reduces their profits by 33%.
Finally, assume a valuation multiple. The company is currently trading on a very high multiple, because the market is expecting rapid growth – maybe 30x earnings, or maybe 500x if you’re Amazon. So simply say you assume they’ll get a market multiple. Going from a 30x multiple to a market 15x multiple will cost you 50% of the valuation – but gain you a lot of apparent conservativeness.
The key principle here is the conservation of conservativeness. You want an estimate for them that is both very large and sounds conservative. To do this, you take advantage of scope insensitivity and arbitrage between the TAM stage and the company-specific stage. By making the company-specific stages (market share, profit margin, valuation) sufficiently conservative sounding, you can get away with an aggressive TAM estimate while keeping the whole thing sounding conservative. Scope-insensitivity means you can increase the TAM estimate at a lower cost of conservativeness than you can the company-specific elements, so there are gains from trade.
So once you’ve multiplied your TAM, market share, profit margin and valuation, you come up with an estimate for what this company could be worth in the future. However, you now deny that this is an estimate. Instead, it’s just an idea of the size of the market – you don’t actually expect they’ll reach it. This explicit denial protects you against any accusations of over-optimism, but you’ve successfully primed your audience on a really high number. If market sentiment is a battle between greed and fear, you’ve helped the greed side.
And a crucial subtlety – that valuation that you didn’t make is what the stock might be worth in the future. Because of the time value of money, you would need to discount that back to get to a current valuation. Since it credibly might take 10 years for the market to mature, even with a moderate 10% discount rate your valuation should really take a 61% hit. But by denying it was a valuation, you’ve avoided this step.
The next step is to argue that the stock has “limited downside” or “downside protection”. This will reassure your audience that even if everything goes wrong, they won’t be fired. You’re trying to quieten their tendency towards fear, so that greed may reign.
Your goal here is to come up with a plausible story for why the worst-case scenario is 10% downside. 10% is just high enough that it sounds vaguely plausible, but low enough that it sounds reassuring.
There are a variety of ways of doing this. One is to name some assumptions you’re making, reduce them slightly, and claim that is the worst case. If the worst case looks pretty bad, just increase your original assumptions, so the haircut versions are higher.
Another is to look at some recent M&A in the sector, pick the most expensive deals, and argue that if the share price fell at all they’d be acquired on that valuation. There is always some expensive M&A going on, so this excuse is always available.
Finally, don’t forget to add that if the shares fell by this much, you’d think this represented a buying opportunity. This is totally misleading – the fact that the shares might be lower in the future is an argument for buying them then, not now, but it sounds level-headed and responsible. It also helps re-direct attention back to the optimistic forecasts of TAMs.
The actual valuation
Since you denied the TAM was actually a valuation, and the downside estimate was definitely the worst case scenario, you haven’t technically actually done any valuation just yet. Since that is ostensibly what you’re doing, you should actually have a go at estimating fair value. Doing all this has probably taken a long time so far, so you won’t have much time left for this stage.
There is an easy way to do it though. Project a high rate of revenue and earnings growth for the next 2-3 years. Place a multiple on the 3-year-out numbers that is lower than the current multiple. Discount that value back, using a high discount rate, to arrive at a share price 30% above the current level.
Fending off criticisms
Since you know more about the stock, you’ll probably be able to come up with a counterargument to any specific concern they mention, and they won’t be able to judge the issue. Any major concerns you have you can simply omit to mention.
If people ask you about execution risk, agree that it’s a risk, but then explain that’s why you used such a high discount rate. This suffices to rebut their attack. This is totally illegitimate. The discount rate (and implicit Equity Risk Premium) compensates investors for the variance of expected future earnings/dividends. It does not compensate you for lower expected earnings/dividends. Their concern is for the latter – your model implicitly assumes everything goes perfectly, whereas a true calculation of expected profits would include probabilities of lower performance. Your attacker will almost certainly not appreciate this fact. If by some misfortune they do, explain in an exasperated manner that you’ve already covered the downside case, and then change the subject.
As a last resort, simply utter the sacred words: “high risk, high reward.” People treat this utterance like magic – we want high rewards! Of course, it’s also nonsense. The phrase should be “high risk, high expected reward.” There is no guarantee you will get the reward! That is why it is ‘high risk’. But as people intuitive understanding of risk is terrible, you can safely abuse the phrase, just like everyone else.
So there you have it – how to pitch a growth stock. Or hopefully, how to spot the intellectually dishonest manoeuvres that are frequently used in growth investing.