PS: How would you characterize a situation where an attractive growth opportunity exists in the marketplace?
Ognar: We’re looking for three attributes: robust growth, and we define that as revenue, cash flow, and earnings growth that is in the top quartile of the company’s industry; sustainable growth—in other words, how does that growth perform throughout an economic cycle for three to five years and perhaps longer; and, finally, where is that growth being underappreciated? We believe you have to marry the three, and you have to look for what about that sustainable growth profile of that company is being underappreciated by the valuation of that stock.
Eberhardy: The underappreciated part is really key to what’s attractive about any existing stock, whether it’s the longer-term product opportunity, the sustainability, or margin enhancements that the company may have—all point toward an expectation gap that we try to exploit.
PS: How do you identify an “underappreciated” opportunity?
Olson: We have always said that one of our favorite questions to a CEO or CFO is: What does the Street least appreciate about your business and understand about its growth prospects going forward? It’s amazing what kind of response that question can bring out. Very often, it’s in those out years—years two through five, for instance—where the Street doesn’t really fully understand what a new product or a new division or a new market can mean to the growth prospects of the company going forward.
PS: How do you know when those prospects have peaked?
Olson: One of the things we do is to try to stay focused on the key attributes Tom noted earlier: Are the growth prospects robust, sustainable, and still underappreciated? When we see that triangle, as we call it, break up: when we either see growth no longer being robust and sustainable, or we see competition coming in and taking share from a company, or a new product set or a new management team potentially changing how the company is looking at things in this growth opportunity going forward. If we no longer believe that growth is robust and sustainable, or if we no longer believe that growth is underappreciated by the market, we’ll sell the stock.
Eberhardy: I would agree with that, and maybe just add one other item, and that is that we focus on all the different metrics of any investment that we’re looking at, whether it’s the revenue, the margin improvements, earnings per share, or bookings, etc.; and try to understand not only what those metrics are, but also if there are any signs of deterioration on the fundamental side. If so, that’s when we look to move on. It’s not only just the company that we ask, but we’re also asking their competitors the same things. That helps us not only understand the focus company, but also helps us identify new opportunities.
Ognar: We try to poke holes in our own thesis: where we may be wrong, and why the stock is being underappreciated by the market. Or, where is the growth maybe not as sustainable as we thought? I don’t think there’s any stock in our portfolios that we would consider unsellable.