There are plenty of stock fund managers who rely on proven longtime industrial powerhouses for their investment gains. Not Henry Ellenbogen. He spends much of his time searching for upstarts—small, scrappy companies with great profit potential. The fund that Ellenbogen manages—T. Rowe Price New Horizons Fund—has been successful in spotting these little giants for more than five decades, becoming an early investor in such successful innovators as Walmart and Starbucks.
Bottom Line/Personal asked Ellenbogen why little companies with big long-term potential are especially attractive now and how investors can find them…
Compounding earnings growth
The stock market is no longer the huge bargain that it was two years ago. And with the economy sputtering along, no one knows how long most companies can keep producing good earnings. So small companies that can continue to grow their earnings faster than the rest of the market are a smart investment now for long-term investors.
Their stocks don’t have enough shares yet to interest large institutional investors. And most professional traders are looking to pick hot companies that can produce explosive short-term returns and then sell them at the right moment. The appeal of the small-cap growth firms I buy is that they reward patient buy-and-hold investors.
Warren Buffett credits the compounding of interest as one of the keys to his wealth. But it’s also the compounding of earnings growth over long periods of time that pays off big. A company whose earnings growth averages 20 percent a year for 10 years will see earnings rise sixfold over that time, thanks to compounding, and I expect to see its stock price rise by that much as well.
Here are the characteristics my fund looks for that have produced long-term winners…
A large, fragmented industry
I like companies that operate in an industry ripe with opportunities for gaining market share. Any company I pick can supplement its growth by making acquisitions of weaker companies. The bigger it gets, the more efficient its business becomes with economies of scale, so it also can outprice competitors.
A unique product or service
I also like it when the company has come up with a product, service or strategy that is unique and visionary enough to change its industry. For example, I invested in Amazon.com in 2007, when I managed the T. Rowe Price Media & Telecommunications Fund, because I recognized that it was more than just an onlineretailer. To me, Amazon.com wasn’t a bookstore—it was a data company that had a revolutionary ability to track consumer shopping patterns.
Inevitably, competitors will try to mimic the advantage that a visionary company has, so I watch to see if the company develops a strong corporate culture that can enhance and innovate beyond the original vision.
Consistent earnings growth
I look for businesses that I am confident can grow their earnings at above-average rates —15–20 percent — for at least the next 10 years. Consistency is the key. I shy away from red-hot companies with soaring growth that get all the headlines. Those stocks often crash and struggle to recover when growth slows or investors find something more exciting.
Sustainable growth gives me the discipline to hang on to a stock year after year and the patience to understand and gain confidence in the company’s business strategy and management team.
Strong cash flow
I like companies that generate strong cash flows by establishing contracts with customers that are renewed year after year. The companies don’t need to borrow lots of money to keep growing the business.
Companies that do require a lot of borrowed capital have a hard time maintaining consistent growth rates. They often can’t borrow at favorable interest rates when they need money the most—during downturns in the economy.
My favorite stocks now
You may not yet have heard of these relatively small companies—but I predict that you will. Each exhibits most of the traits described above. My favorites now…
- Acuity Brands(AYI) is a US market leader in high-tech lighting systems and components for commercial buildings, selling under brand names such as Lithonia, Holophane and Gotham. One of the easiest ways for building owners to save money is to reduce monthly lighting costs, which eat up more than 10 percent of the overall cost of operations, meaning that Acuity’s energy-efficient products pay for themselves quickly.Because of sluggishness in new commercial construction, the price of Acuity’s stock is down by more than 25 percent so far this year. The good news is that the company doesn’t need the real estate industry to pick up in order to keep growing at a double-digit percentage rate. The potential US market overall for retrofitting existing buildings with more efficient lighting will be worth $100 billion. Recent share price: $42.96.
- Clean Harbors (CLH) is the largest operator of hazardous-waste disposal and incineration facilities in North America, servicing more than 50,000 customers, including a majority of Fortune 500 firms. Federal law mandates strict and costly regulations under which companies must dispose of their hazardous waste. Clean Harbors already dominates an industry that will see rapid growth in the future. The company owns more than half of all incinerator facilities in the country, and its competitors have shrunk from 20 to five in the past few years. Moreover, no new domestic hazardous landfills or incinerators have been built in about 15 years. Recent share price: $53.88.
- Financial Engines (FNGN) provides investment portfolio management services, mostly for employer-sponsored defined-contribution retirement plans such as 401(k)s. The company, founded by Nobel Prize–winning economist William Sharpe, brings a simple but revolutionary concept to the industry—provide corporate employees with the same kind of high-quality, personalized investment advice traditionally available to only large institutions and the affluent. Financial Engines works with about 25 percent of Fortune 500 companies as well as 401(k) service providers, such as Fidelity Investments. But the potential market for small-investor portfolio management—the average portfolio for a recipient of Financial Engines advice is just $84,000—will be worth tens of billions of dollars in the next decade as employees realize how difficult it is to oversee their own investments. The company’s stock has gone up about 60 percent since shares were first offered to the public in March 2010. Recent share price: $19.45.
- Gartner. (IT). One of the greatest challenges in running a business nowadays is knowing how to implement the right information technology, figuring out the kinds of new computer hardware, software and communications you need to make your workers more efficient, expand into new markets and better service existing customers. Gartner provides research and consulting services about trends in information technology and helps companies make smart purchasing decisions.Gartner already has 60,000 clients in 80 countries ranging from small businesses to major corporations and government agencies. And once Gartner spends money to compile proprietary data, it can sell that data again and again to many different clients. In the next 10 years, I expect Gartner’s earnings to grow by 20 percent annually. Recent share price: $36.04.
- Global Payments (GPN) is a payment-processing company that allows merchants to accept debit and credit cards. While many firms are benefiting from the trend of credit cards replacing cash and checks around the world, Global Payments has become a leading player in an enormous underserved niche—small and midsized merchants who process less than $300,000 a year in debit and credit card transactions.Global has been able to expand revenues at an 18 percent annual growth rate over the past 10 years, with especially strong growth in emerging-market regions such as China and Russia. This is one of the rare small-cap companies with true global potential. Foreign accounts were responsible for nearly half of the company’s revenues last year. Recent share price: $41.35.