Is looking for superstar firms among disruptive tech, consumer innovators and small caps a quest for the obvious? Or does it make more sense generally to focus on companies that are sustainable, in both senses, as steady and resilient performers over time and as responsible entities?
Not interchangeable: superstar and sustainable
Our goal is to invest in companies with sustainable business models. Superstar firms may be sustainable, but the opposite is not necessarily true. For example, we often invest in younger companies that have not yet established the kind of market dominance or high share of profits typically associated with a superstar, but that we believe can do so over the long term. While size can admittedly bring significant economies of scale and network effects, there are also risks such as unsustainable overheads, bureaucracy and reduced efficiency and nimbleness.
We also invest in companies that dominate a niche market, and can thus generate sustainable positive returns on invested capital that exceed their cost of capital, despite not being very large in terms of revenues or market capitalisation. Giant retailers and global supply chains have driven many old-economy high-street businesses to the wall. The smaller businesses that have survived are those that could not be undercut by one-stop shop retailers or global suppliers.
These smaller ‘survivors’ either offer a specialised retail experience, a niche product or serve a particular part of the market others cannot reach. While highly profitable and creating value, these companies may never be viewed as superstars from a global perspective, but they can deliver significant shareholder returns over time.
To unearth those promising companies, we use fundamental stock research by sector specialists to identify sustainable companies with enduring competitive advantages trading at attractive valuations. It should be noted that not all superstar firms meet our valuation criteria. We seek to invest in companies trading at a compelling valuation relative to peers and the stock’s own history as well as in absolute terms based, for example, on asset value.
So, for us, sustainable means more than ESG1. It also involves financial, economic and strategic perspectives. In this sense, a sustainable company has a resilient business model. Resilience implies the company has a wide ‘economic moat’ built on enduring competitive advantages that stem from innovation/intellectual property, product differentiation, market power, unique assets and/or a distinctive brand, and/or barriers to entry.
In addition, resilience comes from a solid balance sheet, sound business strategy, and a large or growing market opportunity. From an ESG perspective, a sustainable company should, at least, do no harm, and preferably contribute in a positive way to environmental, social and governance goals.
Small caps, consumer innovators and tech disruptors
Where would we find promising candidates? Certainly among the small caps, but also in sectors such as consumer innovation marked by global secular themes including population growth and ageing, and e-commerce. Candidates can come from industries ranging from biosciences, cloud computing, and artificial intelligence to robotics, the internet of things and health & wellness.
Indeed, it is fair to say that a lot of innovation is being driven by smaller-cap and private companies. But equally, many superstar firms have the drive – and the means – to pursue innovation. It is one reason why we believe investments in innovation and disruption should be distributed across market caps.
Diversify because superstars of all sizes do not last
Historically, that also makes sense. Research2 has found a level of turnover among the superstar companies. This could reflect a phenomenon whereby societal changes are always pushing a natural rotation among the most profitable companies.
Superstardom is no guarantee of long-term success; as we have seen in recent decades, disruptive innovation can change the landscape dramatically and create openings for new companies. Hence our focus on ‘sustainability’ and our efforts to avoid potential fallen angels by continuously re-evaluating the fundamental characteristics of the sustainable, resilient business models of companies of any size.
1Applying environmental, social and governance stock selection criteria 2McKinsey Global Institute: Superstars, the dynamics of firms, sectors and cities leading the global economy, discussion paper, October 2018