Donville Kent: Where Is The Growth?

Donville Kent’s newsletter for July 2015.

The first half of 2015 has gone reasonably well. While the S&P TSX Composite Total Return Index rose just 0.91%1 in the first half of the year, the Capital Ideas Fund rose a respectable 13.5%2 over the same time period.

Headlines over the past few months have been dominated most notably by the fiscal and debt issues surrounding Greece and the market whipsaw that has been unfolding in China. As I write this issue of the ROE Reporter, both of these “events” seem to be coming to some type of conclusion.

My focus and that of my team remain on identifying and owning stakes in great businesses. Market corrections allow us to invest in such companies at prices lower than we could otherwise. We are currently sitting on a fairly sizable amount of cash, which we hope to deploy in the coming months.

Donville Kent – Investing in a world of secular stagnation

One of the more interesting economic ideas that has been discussed over the past couple of years is the theory of secular stagnation, which was advanced by former US Treasury Secretary Larry Summers. Some fairly complex arguments regarding the relationship between savings and investment underpin Summers’ ideas, but the central theme is that most Western economies are struggling and will continue to struggle to achieve high levels of economic growth and that the most probable explanation for the lack of growth is demographics.

Japan was the first Western country to enter a period of secular stagnation in the 1990’s. It was also the first of the major Western country’s to see a sharp slowdown in its population growth and a steep shift in the ratio of older people (+65) to the general population. Since the 1990’s, other countries have followed Japan into this demographic and growth trough, and birthrates have now slowed dramatically in most Western countries. At the same time, life expectancies continue to rise. The result is that the growth in consumption, which in a country like Canada accounts for roughly 75% of GDP, has slowed in virtually all Western countries as the percentage of consumers in the younger demographic has fallen as a proportion of the general population. Economic growth in most Western economies remains well below long-run averages. Demographics probably explain a large part of this.

Given a somewhat muted outlook for economic growth, many analysts have rightly argued that expectations for the rates of return on everything from savings accounts to stock market investments should be ratcheted down. I agree generally, but I also believe that there are pockets of growth in all economies, and that an investor who is selective, rather than simply an investor in broad asset classes, can still do quite well. Here is what I am seeing in our Canadian backyard today.

Donville Kent – Where is the growth?

I maintain a large database within which I track roughly 600 companies in Canada, and I do so with the direct assistance of Jesse Gamble, my research associate. We make an effort not to place any judgement on which companies we add into the database because we know that some of the best companies may not look great today or are operating in industries towards which we have existing negative biases. We organize our database into seven sub-divisions, which allows us to compare more easily similar companies and their valuations.

Before we talk about where there is growth, I should note that there are competing schools of growth in a microeconomic context. I consider Return on Equity (ROE) to be the best general measure of growth in an enterprise. For me, ROE measures at least two important things. The first is the growth in the net worth of an enterprise, which I consider to be the best measure of how fast an enterprise has actually grown over a specific time period. The second is an indication of the competitiveness of the enterprise, as I consider the spread between a company’s return on equity and its cost of equity to be an objective measure of the enterprises’ competitive advantage.

Within our database of 600 companies, we have identified 244 companies that have market capitalizations greater than $100MM that are not in resource or extracting industries. These companies are organised into seven subdivisions, and in six of those subdivisions (presented below) I consider ROE to be the best and most practical measure of growth.

As Figure 1 shows, while high growth companies can be found everywhere in the market, some sectors have more than others. The highest growth sector (Health) also has a large number of companies that are unprofitable. The undiscerning investor can easily get burned here. I believe the health care sector offers some of the best growth companies in Canada, but I believe that it also represents the best sector for finding stocks to short. For investors in growth companies, there are a reasonable number of companies in a multitude of sectors that allow for the construction of a diversified growth portfolio.

Donville Kent – So how are they growing?

A frequent topic of conversation