Arie Dekker: Factors influencing the performance of growth companies

Growth stocks are attractive for investors with a longer-term investment horizon. Photo / NZME

Opinion

OPINION:

The New Zealand market has seen strong performance across a broad range of New Zealand growth stocks over the past five years.

In contrast to more defensive yield stocks, these higher-growth companies tend to retain more of their earnings to support growth investment rather than maximising dividends. These stocks tend to generate earnings growth at a faster pace than the broader market.

Growth stocks are attractive for investors with a longer-term investment horizon. These investors are focused more on building wealth through increases to the value of their investments over time rather than on dividend income in the short to medium term.

Our recent analysis of a group of growth companies on the NZX has highlighted the market's willingness to forego dividends and contribute equity to businesses with attractive growth opportunities.

Mainfreight, Fisher & Paykel Healthcare, A2 Milk, Pushpay, Summerset and Infratil have all generated total returns of more than 200 per cent over the five years to June 30, 2021 compared to 83.5 per cent for the NZX50. Ebos and Freightways have generated more than 125 per cent in returns.

These growth stocks have performed well on the back of a strong sense of purpose and consistently strong execution. Not all growth stocks adopt the same approach, with differences also for the different stages of growth companies go through.

1. Early-stage companies reinvest earnings back into the business instead of paying out dividends

Across the early-stage growth-oriented stocks we looked at, we observed a conservative approach to capital structure and dividend policy settings with a strong focus on funding growth. Xero is a great example of a strong growth company that raised a sufficient level of equity early to fund much of its growth while avoiding dividends.

Similarly, today companies like A2 Milk and Pushpay Holdings are still in the relatively early stages of their growth trajectory and their approach to dividends reflects the growth runway they still see in front of them.

Despite having generated free cash flow, they are both still likely a few years away from considering dividends as they look to focus on opportunities for growth (strategic acquisitions for Pushpay) and the stabilisation of their business post-Covid disruption (A2 Milk).

2. Established growth companies with long growth trajectories in front of them prioritise reinvestment over dividends

Some of the more established growth stocks look to invest in the multi-decade growth opportunities and large addressable markets they see in front of them. This is where they place value for investors, rather than paying higher dividends and taking on debt.

This is particularly the approach for companies like Mainfreight and Fisher & Paykel Healthcare. The market has clearly been attracted to their approach to growth alongside a conservative capital structure, with Mainfreight's total shareholder return being more than 400 per cent over the last five years and Fisher & Paykel Healthcare's sitting at 240 per cent.

These companies have been able to increase their dividends but have retained enough operating cash flows to expand their warehousing and manufacturing capacity without taking on more debt.

Mainfreight has had a total shareholder return of more than 400 per cent over the last five years. Photo / Supplied

Retirement village operators like Ryman and Summerset have taken a slightly different approach, which in part reflects the more asset-intensive nature of their development activities.

Property development is a key growth driver for these companies and they have been happy to fund that out of debt. Their balance sheets have experienced rapid growth in debt with the approach to capital structure (reluctant to raise equity to help fund growth) and dividends (pay out what looks like a high portion of operating cash flows) a factor in this.

Given its greater size, the increase in Ryman's debt and its influence on its ability to sustain growth looks to have weighed on its performance over recent years.

3. Mergers and acquisitions can also be used to support growth

Some established companies have built track records on their ability to successfully identify and execute acquisitions to drive growth. Their businesses typically produce steady cash flows with a lower growth profile, and this tends to be channelled into dividends after allowing for maintenance investment.

Ebos Group and Freightways fall into this category and performed well. While it is an investment group, Infratil has taken a similar approach as it has looked to grow the platforms it is investing in.

This demonstrated capability in M&A is a key factor supporting the growth of these types of companies. To maintain capacity in the balance sheet and not subject themselves to too much debt following an acquisition, these companies tend to periodically raise equity to support their growth, with the market willing to participate based on their track records.

What does this mean for growth investors?

Growth investors tend to look for companies that offer pathways for strong and credible increases to earnings. Execution capability is clearly a key factor supporting investor interest in growth companies, while the approach taken by most companies highlights that maintaining a strong balance sheet is also important.

Investors are willing to provide equity and forego dividends from companies that are able to consistently generate earnings growth from reinvestment into their businesses, with value delivered on the back of this through share price appreciation.

Including some growth stocks in a portfolio, in addition to more defensive or value stocks, is a way investors may add diversity to their investments.

It is important to remember the difference between a company that is choosing not to pay a dividend in favour of investing in growth, versus a company that cannot afford to pay a dividend.

• Arie Dekker is Head of Research at Jarden.

The information and commentary in this article are provided for general information purposes only and does not constitute financial advice. We recommend the recipients seek financial advice about their circumstances from their adviser before making any investment decision or taking any action. For information about Jarden's financial advice service, please refer to our publicly available disclosure statement which is available on our website at www.jarden.co.nz.