Notes: We’ll be breaking down the characteristics of growth stocks. How they work. And how we hunt them. We’ll also explain why we’re hunting them in China as opposed to the U.S. in this article.
Growth stocks are the stuff of legend, and up until recently, America has historically dominated the world in terms of where most of the growth companies/Multi-National Corporations originated from.
Just take a look at some of these common household names.
Focusing your entire investments in this for the past 20 years would have made you quite the millionaire.
And yet today – a paradigm shift is happening.
This happened too.
So why China?
To Understand Why China, You First Have To Understand How Growth Companies Function
It is not that growth stocks do not come from other countries as well – some of them clearly do.
So why do a large majority of the growth stocks seem to only originate in the U.S and in China?
It comes down to two basic reasons.
- size of the populations within the country
- homogeneity of its people. (how similar are its people?)
First, a stock represents a stake in a company. And second, a company’s stock price typically follows its earnings.
If there is a drop in earnings, there is almost always a drop in share prices. If there is a rise in earnings, there is almost always a corresponding rise in share prices as well.
Given this context, a growth stock, is a company which is able to 1) rapidly increase its earnings, and 2) do so over a sustained period of time.
Repeat after me.
- Rapidly increase its earnings.
- Continue to rapidly increase earnings over a sustained period of time (3-5 years is a good benchmark typically, or at least until it has gained a dominant market share within the country of origin, whichever is sooner).
So how can a company achieve the two above objective to be qualified as a growth company?
On Size of the Population
If you think carefully about it, rapidly increasing earnings is not possible with small population sizes.
- How many Mcdonald burgers can you eat in a day? And in case you happen to be capable of eating ten, can you say the same for your friends, family, extended family and acquaintances?
- How many underwears do you buy from Giordano in a year? How many shirts from Uniqlo?
- How many subscriptions can you have as a Netflix user? I know me and 4 friends banded together to form a family subscription. How many of you do the same and how do you think this affects growth?
- How many cups of bubble tea can you drink in a day?
Following the idea of earnings down to the end-user the company is serving is a useful thought process that lets you figure out whether a company can really rapidly increase its earnings.
It’s the simple reason why supermarkets sell nearly everything. You could be there for the weekend’s groceries and at the same time pick up toothbrushes, toothpaste, new lamp lights and kitchen lighters all at the same time.
In turn, the supermarket gets to benefit from multiple products, and you as the end-user get to benefit from the convenience of having them all at the same place.
But even product diversification by itself will not be enough to rapidly boost earnings.
Beyond the impossibility of owning all the products a consumer can ultimately use/consume, as a business, you will still be constricted by the size of the population.
You could own everything the consumers use, but if your total customer base is 5,000, you’re not getting anywhere fast in earnings. And even if you somehow manage to grow your earnings rapidly, you can’t sustain it simply because the population size is not large enough.
Population size matters.
On Homogeneity of People
Asia, for example, is an extremely diverse arena. We speak multiple languages, have multiple religions, multiple cultures and even multiple standards of economies and industries.
Things change for businesses rapidly too when you consider that different people have different tastes.
I might like the Angus beef, and my friend might like the fillet o fish. His friend, however, might just want nasi lemak. What’s a business owner to do? Scratch his head and scream!?
The aspiring business owner must find a customer base that is largely comprised of people with similar tastes in culture, food, music, etc cetera. That way, given that its a large enough number, the business owner can enjoy a larger pool of potential customers.
How likely can a business expand given highly fragmented populations? The answer is “not very much”. Or at least not without large sums of resources driven towards sculpting existing products to fit new customer demands.
China & The U.S
Summing up, two simple points, a business can really only rapidly increase its earnings over a sustained period of time if there exists a large potential market for it.
Period. This is a large part of the reason as to why China and the U.S are where most of the growth companies and eventual Multi-National Corporations come from.
The other part is that large population sizes confer greater piles to businesses which dominate.
Once the companies have solidified control of the market in their country, they can focus their attention and turn unused resources (typically cash piles) into trying to enter foreign markets.
And the larger their dominated country, the more cash they have, and the more times they can try to expand into foreign markets.
The same is not true for companies from smaller countries.
Smaller countries mean smaller cash pile surpluses which represent more limited opportunities for expansions. With smaller cash piles, the company can ill afford to make mistakes, unlike say….Macdonald’s or Apple, or Samsung.
These larger companies can just keep hurling money at the problem until they eventually solve it. Smaller companies won’t be able to do the same.
So Why Are We Focusing On China?
Two key reasons.
First, China has a population of 1.386 billion people. The U.S has a population of 327.2 million people.
If we count just the coastal cities, China has close to 600 million people – double that of America’s total population size.
Second, China is still an emerging economy. And it’s nowhere close to being fully ready to be called a developed country yet.
The two things together combined means that we see more opportunities to hunt growth stocks in China than we do in America. Further,as we have said previously larger populations -> larger chances of earning more money -> larger stock valuations -> which means larger profits as investors.
Take a look at how far some of China’s companies have climbed.
Alibaba (E-commerce, AI)
Tencent (Internet-related services, games, entertainment, advertisement, AI)
Baidu (China’s Google)
Kweichou Moutai (Liquor Company)
Ping An Insurance Group
What is my point in illustrating the returns of such companies to you?
It is that it is possible to ride on the growth of such stocks and become vastly richer beyond your imaginations.
No other business in the world will reward you for a one-time effort, then allow you to sit back and simply monitor things while your $1 multiplies like rabbits. None. Zero. All businesses require some form of upkeeping. Only in investing can you magically see your early efforts to identify stocks turn a dollar into a hundred, and a hundred into more. That is the power of investing.
How Do We Hunt Growth Stocks?
A large part of why people fail to identify growth stocks is due to doubt and a faulty investment process. For starters, if you’re hearing your friend talk to you about it, you’re late on the bandwagon.
Second, most growth companies look at least a little scary to buy into prior to their rapid upwards explosion in price upon their success story.
So how exactly do we hunt growth stocks before they become well-known household names?
We employ what practitioners and hedge funders would call a Quantitative-Qualitative Assessment towards the data that we have on Chinese Companies.
Officially, our strategy is known as the GPAD Strategy.
Generally, our research process is comprised of two components.
First is the Quantitative Component, also known as the numbers, where we look for companies which exhibit certain numerical qualities we want, including – but not limited to;
- 5-year gross profitability
- 5-year average free cash flow
- growing earnings per share
- growing free cash flow
- growing profitability
- profitability above the sector median
- operating profit margin above the sector median
- bottom 20% of price to sales
- bottom 20% of price to free cash flow.
Next is the Qualitative Component, also known as the story behind the stock, the details of which would probably be too much and too varied to discuss in this article, and should rightfully have an entire article detailed to it.
Note that you can flip this process around as well if you’re comfortable enough with your logical reasoning and ability to analyse. I choose to do it the quantitative way first because I believe it makes the most logical sense, but that is not to say it cannot be done any other way.
Also notably, most growth stocks are found by their stories first because people are involved in the profession (design people Apple, well..the chart’s above) or people are passionate about something the company produces (vegan food, Beyond Meats went from $66.22 to $234.90).
China is a key area we will be focused on in the years to come. It has already superseded the US in terms of the number of Fortune Global 500 companies.
We believe in time, given the population size and the unrealised potential, there will be significant bargains to be found ahead given a company’s potential and therefore significant returns for the alert and hardworking investor.
There is a good reason why Warren Buffett and Charlie Munger likes to invest in China too.
Nothing is more satisfying than learning something, unfolding it and watching it develop. Nothing. Learning is a process of pure joy all of us should learn to appreciate more.
Yet I would be a fool and a hypocrite to say that everyone in the world today has the time, energy and money to spare losing to the markets.
Successful investors are born of thousands of hours of hard work, and thousands more of dollars lost in “tuition fees”. No one is exempt from this.
The sad truth is that not everyone can tolerate losses in the market. And not everyone has the time, energy, or additional mental capacity to mug hours upon hours after work, week after week, month after month.
For those of you who wish to shorten the learning curve, we offer introductory classes where we do live walkthroughs of how to find undervalued/growth stocks based on evidence-driven data.
Consider if its right for you. If it is, we’ll see you there.
If it’s not, I hope this article has been informative for you.
Give it a share if you feel your friends and family can benefit from it.
And good luck.
Behavioural Psychology fanatic. I like good food, movies, intelligent conversations and logical reasoning. I also dabble with options, factor-based investing, and data analytics.