An Interview with Sands Capital Management
Sands Capital’s Sunil Thakor, co-manager of the Global Growth fund, and Chris Ralph, Chief Global Strategist at St. James’s Place, discuss how to select growth stocks, when to sell them, and how growing companies should think about cashflow.
How would you explain the investment philosophy at Sands Capital?
I would describe Sands Capital as having a private buyer’s mentality to owning public equities. My colleagues and I are much more interested in businesses and how they work and ways in which the world is changing, than we are in the stock market, so to speak. We think of the stock market as just the execution mechanism.
It is a liquidity pool for us to go express our opinions, but we really are business analysts. We have a set of criteria that steers us towards businesses that we think can sustain growth at an above average rate for the long run. We think these criteria are being in an attractive business space, having a leadership position within that space, and having competitive ‘moats’ built around the franchise to sustain that leadership position. Those three things are the necessary three conditions to sustain growth. If you can find them, they will give you your margin of safety to help a business sustain growth over the long run. You do not ignore the valuation, but the impact of a valuation mathematically is reduced the higher the growth and the longer the holding.
For every single one of the businesses we own, the reason we own it is because we think it is going to be way bigger from an earnings perspective five or 10 years from now; but even if there are higher interest rates, or slower economic growth, the businesses we’re focused on should benefit from structural change and keep growing.
One of your criteria is seeking sustainable earnings growth from companies that provide people with what they “need” rather than “want”. How do you identify when something is a “need”?
Well, it is a little bit of a nuance, because I think we have to accept that food, water and shelter are really our only needs. There is an old joke about capitalism. “What is capitalism? It is the process of selling people stuff they do not need.” On some level that is the case. Everything is a “want”. Do we really need a PC to be able to do a video call, probably not, but I think we would both agree that it is a need in our respective businesses.
But really what we mean by that is things that are less discretionary in nature and that are not getting cut back on during a challenging environment; that if you must pull in the purse strings, you are likely to save somewhere else.
A great example would be in the life sciences space. If you have haemophilia you need certain drugs to stay alive and in a challenging economic environment you might cut back elsewhere, but that is not going to be the first place. An example therefore would be a business such as CSL that is the world leader in blood plasma collection and plasma-derived therapies, of which haemophilia is one of the critical end markets. That is the kind of business that ought to be able to grow secularly through a challenging environment, because they are selling a need.
Another example is a company like Charter Communications which sells broadband infrastructure. Is that a need? In the strict sense probably not, but it is among the basic expenses that most people incur. You see very high levels of stability in subscribers during economic downturns.
One of the other criteria you look at is significant competitive advantage. In a world that is globally connected, where geopolitics is having more impact on economies and markets around the world, is it harder to find companies with those advantages?
I do not think it’s any harder or less hard than it was in the past, it just looks different. One of the things that I find really fascinating about the investment approach the Sands family have laid out over the years is that on the one hand, it is exceptionally simple. A great way to generate a lot of wealth over time is to own high-quality assets. Own a few but own the very best. A disproportionate amount of reward in any industry tends to accrue the leader. If you do something that is hard to copy, it’s easier to stay the leader; if you do something that’s hard to copy, you’re not going to have a ton of competition.
What is also so powerful about that basic set of criteria is it drives enormous clarity of thought in terms of what you are looking for and it’s a filtering mechanism to filter out the world. What is also fascinating about it is it stands the test of time in different types of environments where it is different things that are driving the big disruptions in the world.
In our minds innovation is speeding up. We have seen more industries where they have more of a winner emerging. In the digital world you have more of a winner-takes-all dynamic. So you get bifurcated markets rather than stratified markets. We assert that plays to our advantage. Because our whole approach has always been to play at that very top slice: do not mess around with everything else just buy the best. That does not necessarily mean the biggest, it means the best.
Look at Visa, which we have owned since the IPO in 2008, and still have not sold any IPO shares. The competitive advantage there when you boil it down, is really a first mover advantage that happened about 50 years ago when the banks decided they needed to set up this mutual association of process transactions. That is an industry where first mover advantage ended up being “game over”. 50years later, it is still game over. Looking at many of the innovations in fintech and whatnot, they are primarily innovative ways to get on, ordo transactions through, the Visa/MasterCard networks outside of China.
You have indicated that you have long holding periods for stocks. What makes you move out of owning a company?
The reasons you sell should be the same as the reasons you buy. We have got a very simple set of criteria that starts with only owning leaders that are operating in attractive business spaces with significant sustainable competitive advantages. The second question is, do we believe that those three things will continue to result in sustainable and above average growth rates? A breakdown of either one of those two things is why we would sell. It is a breakdown structurally and not cyclically. If you are going to own a business for 10 years I believe that you have to incorporate into your investment case a belief that that business is going to make mistakes along the way, they are going to have some bad quarters. Businesses are run by humans. We all have bad quarters, why are the companies we invest in any different? You should also assume that you are going to own that business through at least one big crisis that you did not expect.
We happen to be in the middle of one right now, and I think it is noteworthy that we have had very low turnover across our portfolios year to date. There is not a whole lot to do in a crisis if you have done your homework right.
There are certainly businesses across our portfolios that are weaker or stronger this year, and it is basically on the physical/digital divide. One of our physical businesses, Rentokil, is having a more challenging year, while Amazon is having an amazing year. But we have felt for a long time that both are structural growers and will survive and thrive, so you have not seen us change really either position.
What proportion of a company’s cash should be reinvested in the business, how much should be returned to shareholders, and does that change as a business matures?
It is an awesome question, and it entirely depends on the economics of the business model and the stage of growth. If you go back to the finance textbook it tells you that what you do with a dollar of cash for your company is apply it to the highest return area that you can. Sometimes that is reinvesting in the existing business, sometimes that is buying your own stock or just giving it right back to shareholders.
If you look at our portfolio, where the weight of average revenue and earnings growth rates are about 20% and 30%respectively, the most rational thing for the managements of those businesses to do is to take every penny of cashflow they get and plough it right back into the business. Many of them are undergoing non-linear growth, they have tremendous investment opportunities in front of them and so they should be suppressing profitability, investing like crazy and trying to get as big as they can, because what they are really after is not the free cashflow of today, but building a free cashflow flywheel that can be 10 times bigger in the future.
Look at Netflix, which for a long time was bumping right along the zero line of profitability, generating free cashflow but not paying a penny of it back to shareholders. In fact, they take in a lot of capital to augment their free cashflow and then plough it all right back into content. But if you step back and look at what they are building, at what they have built, the underlying profitability of that is such that that reinvestment has made a ton of sense and now they have got a global juggernaut. There will be a day in Netflix’s history it will simultaneously generate a lot of cash, reinvest all they need to sustain their growth and return a bunch of cash to shareholders. But that is not where Netflix is in its lifecycle.
Sands Capital is a fund manager for St. James's Place.
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The opinions expressed are those of the fund managers listed above and are subject to market or economic changes. This material is not a recommendation, or intended to be relied upon as a forecast, research or advice. The views are not necessarily shared by other investment managers or by St. James’s Place Wealth Management.