Published on September 23, 2020
In our view, the specific market dynamics that influence a company's sales growth prospects have a greater impact on equity returns than the overall direction of the economy.
As the saying goes, a rising tide lifts all boats – when the economy is strong, stocks tend to perform well. Nonetheless, in both good times and bad, there is dispersion among equity returns, affirming the (obvious) truth that the health of the economy is only one of multiple factors influencing stock performance.
In our view, the most important driver of equity returns, particularly for emerging companies, is the growth rate of demand for their products and services. We believe that the best opportunities for market outperformance occur when a company is operating in a sector or industry that is undergoing a transformation, creating a growing wave of new customers. In our portfolio, we seek to invest in a select group of innovative companies that are able to capitalize on untapped, expanding markets.
Cyclical vs. Secular Growth
Broadly speaking, growth falls into two categories – cyclical and secular. Cyclical growth can be thought of as passive, whereas secular growth is driven by a structural change in a sector, industry or company.
Cyclical growth, as the name implies, is highly correlated with the economic cycle. Industries that are driven by cyclical growth tend to deliver positive returns during expanding economies and do poorly during a downturn.
Automobiles are a great example. As you can see from the chart below, total vehicle sales plummeted during the Great Recession in 2008 and began recovering along with the general economy shortly thereafter.
Secular growth occurs when something fundamentally changes within a sector or industry, creating a wave of new demand. Secular growth rates can be materially higher than cyclical growth rates, as secular growth depends on changes in customer behavior rather than changes to GDP.
One of the great secular growth stories of the 21st century has been the rise in e-commerce. Online sales have been taking progressively more market share from traditional retailers for the past 20 years, a secular trend that has literally transformed how people shop.
Source: Retail Indicators Branch, U.S. Census Bureau
It is important to note that secular growth is not immune to hazards of a recession, although some trends are robust enough to withstand even the worst downturns. As you can see in the above chart, the market share of e-commerce dipped briefly during the great recession of 2008, but it resumed its steady climb shortly thereafter.
However, many secular trends are not as resilient. In fact, according to Morgan Stanley, only about 30% of growth companies are likely to repeat their success in back-to-back bull markets1. In other words, more than two-thirds of secular growth trends slow down materially following a bear market, as the underlying demand drivers often change.
Types of Secular Growth
Secular growth can take many forms, and trends can differ across industries, but at the highest level we feel there are three primary types: (1) foundational technology; (2) replacement product, existing market; (3) new product, new market. And of course, individual companies sometimes fit into multiple categories.
Some technological innovations are so impactful that they not only generate their own wave of demand, but they also create a foundation upon which other businesses can grow. Importantly, companies at the epicenter of a foundational secular trend do not necessarily perform better or become larger than the firms that they eventually spawn.
The advent of the internet is a great example. Plenty of companies profited from the development of the internet infrastructure, but over time the biggest winners have been firms that successfully leveraged the technology, including Amazon, Google, Facebook, and Netflix.
Smartphones are another example, as the iOS and Android operating systems created an interconnected network of portable devices for businesses to exploit. Obviously, handset manufacturers like Apple and Samsung benefitted from the smartphone revolution, but so did companies like Uber and Lyft (among many others).
And more recently, the rise of cloud computing has created a new foundation upon which many other businesses are emerging. It is among the most significant secular changes happening today, as software users around the world are beginning to appreciate the benefits of cloud deployments (faster implementation, automatic upgrades) versus the hassles of local installations. Software vendors like the shift also, as it allows them to move to a subscription business model, which creates smoother, more predictable revenue streams. Both cloud providers (e.g., Amazon Web Services and Microsoft Azure) as well as cloud-native software firms (e.g., Salesforce.com and Adobe) have benefitted tremendously from this secular trend, and it shows no sign of slowing down yet.
Replacement Product, Existing Market
Another major catalyst for secular growth occurs when an innovative startup builds a “better mousetrap,” taking market share from established incumbents. The key element to this type of growth is that the new company already knows that a viable market exists for its products/services. If they can truly deliver a superior solution, customers happily migrate, which results in outsized growth.
Amazon is an excellent example. As discussed above, online shopping has been taking market share from traditional retailers since it was introduced, and Amazon has been both the primary beneficiary as well as a major catalyst for the transition. The company has been able to expand continuously by capitalizing on consumer’s desire for convenience, and by creating a digital marketplace that obviated the need for in-person shopping. Features such as close-up photos, detailed product specifications, and crowdsourced reviews help Amazon customers feel comfortable purchasing items that they have never seen in person.
Oftentimes, when a disruptive product enters an existing market its growth is driven by underlying factors that are more important than the product itself. For example, the first electric cars were far less convenient than gas powered cars – they had limited range and charged much more slowly – but they still were commercially viable because they allowed environmentally conscious consumers to reduce their carbon emissions. When we evaluate companies in this category, we not only look at the differentiated strength of the product, but we try to understand the underlying drivers that are likely to motivate customers. We only seriously consider investing in companies if we feel the secular growth trends are compelling and durable.
New Product, New Market
The third major type of secular growth occurs when an innovative startup develops a new product/service for a new market. In this case, the new offering must address a growing problem that has been previously unsolved, creating naturally strong demand.
Google fits into this category nicely. Prior to the advent of the internet, there was no need for search engines. But once the web was born, search became indispensable, as people needed a tool to navigate the ever-expanding landscape. Initially there were multiple competitors in the space, but over time Google established its dominance, currently controlling over 92% of all search traffic globally. The chart below shows the steady increase in Google searches from 1999-2012.
Source: Internet Live Stats
It’s worth noting that Google also fits into the previous category (replacement product, existing market), as the site has effectively replaced traditional reference materials such as atlases, almanacs, and encyclopedias. But in our view, the specific category of secular growth is less important to the investment decision than the magnitude and staying power of the underlying trend(s).
Secular Growth in Practice
As emerging growth managers, we are constantly searching for companies that are well-positioned to take advantage of an untapped secular trend and deliver above market returns. The chart below provides a visual representation of our objective – to invest in companies just as they enter a period of sustained revenue acceleration.
Below we have listed three companies from our portfolio that we feel have identified important secular growth trends and that we expect to deliver attractive returns over the near to medium term.
Beyond Meat, Inc. (BYND)
Beyond Meat is the well-known producer of plant-based meat substitutes that are designed to emulate chicken, beef, and pork sausage. It is a textbook example of a company that has created an innovative new product in an existing market that is well-positioned to take share from incumbents.
Beyond Meat is unusual because it has the opportunity to pull customers from two distinct markets – existing plant-based meat substitutes and animal-based meat products. Consumers of traditional meat substitutes, such as garden burgers and tofu, are fans of Beyond Meat because the taste and texture are a more realistic facsimile of the original.
Consumers of actual animal products are switching to Beyond Meat not only because it looks and tastes like the real thing, but because they appreciate the environmental and health benefits of plant-based foods. This is the key secular trend that makes Beyond Meat such an attractive investment opportunity. As concerns about climate change continue to mount, we share the company’s view that consumers will be drawn to plant-based foods, as they have repeatedly been shown to be one of the most effective ways to reduce an individual’s carbon footprint. The company estimates that the market size for meat products is $270 billion in the U.S. and $1.4 trillion globally, which gives them substantial upside that could last for many years.
We also believe in the firm’s management team and like how they are rolling out their products. They distribute direct to consumers through grocery stores, and they are also establishing relationships with large fast food chains such as KFC, Papa John’s, and Carl’s Jr. Likewise, they are building an international presence.
Enphase Energy (ENPH)
Enphase Energy is an energy technology company that designs and manufactures software-driven residential solar energy solutions. Enphase is another example of a company with an innovative product in an existing market that is poised to take share from the incumbent – in this case, the utility industry.
The secular trend that we expect to drive Enphase’s growth is the shift toward renewable energy, which is motivating more households to purchase solar systems as a way to reduce their fossil fuel consumption. The Energy Information Administration projects that renewables (including solar) will comprise almost 40% of electricity generation in the next 30 years vs. just 18% currently. In the near term, Enphase projects that the addressable market for their products will increase from $3.3 billion in 2019 to 12.5 billion in 2022 – an increase of over 350%.
The company’s market is expanding, and its product suite is highly differentiated. Enphase manufactures an integrated system that generates, stores, and manages solar energy. Their microinverters convert DC power from the panels to AC power that can either be sent to the grid or, in the event of a blackout, directly to a battery that can provide electricity to the home. Enphase also builds cloud-based monitoring and management software that is available from any device. The company has several new products in the pipeline and we think it is in a strong position to generate sustainable growth for the near to medium term.
Avalara is a software company that allows vendors to more efficiently address a very boring and fundamental issue – sales tax. The company clearly fits into the “new product, existing market” category, as businesses have been using technology to compute sales tax for a long time. But the scale and complexity of the problem has grown exponentially as retailers have moved online. Brick and mortar businesses only need to calculate sales tax for their own region, but online retailers with customers in multiple states/countries must compute sales tax for potentially dozens of localities while simultaneously monitoring the evolving regulatory landscape. For these types of businesses, a platform like Avalara is the only viable way to ensure compliance.
Avalara is the clear leader in its space, with partners such as BigCommerce and Shopify, and is actively expanding its capabilities. According to the U.S. Census, domestic sales tax receipts exceeded $470 billion in 2017, and Avalara’s addressable market is increasing rapidly as eCommerce has surged in 2020 due to the pandemic. Avalara has 65,000 customers out of an addressable market of close to 6 million businesses, so the growth opportunity is substantial.
In addition, the platform is cloud-based, which reduces its IT overhead and allows clients to onboard more easily. We feel Avalara is well positioned to grow for the next decade as it penetrates a large market with its leading cloud-based software and automation capabilities.
In our view, identifying secular growth trends is the key to generating sustainable above market equity returns. We are always monitoring market developments for new trends, with topics such as artificial intelligence, the internet of things, and big data currently on our radar.
1 - Dennis Sherva, Morgan Stanley, “Investing in Emerging Growth Stocks,” April, 1987
This piece was originally published on June 5, 2019.
James L. Callinan
Chief Investment Officer – Emerging Growth
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Opinions expressed are those of the author, are subject to change at any time, are not guaranteed and should not be considered investment advice.
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