Finance 4820-803 – Growth Stock Investing

1. Finance 4820-803 – Growth Stock Investing Investment Process and Stock Example Brian Demain, CFA

2. Who is Janus and who am I? • Janus is a $170B asset manager. Approximately $110B is invested in growth or core equities, managed out of our Cherry Creek HQs • I manage the Janus Enterprise Fund, a mid-cap growth fund. Before that, I was an analyst following media, telecom, and internet stocks. I have been with Janus 12 years

3. What does it mean to be a growth stock investor? • Perception of growth investors as the party animals of the investment world, who love the party while it is going on but are left with a hangover at the end of it. Few newly minted MBAs want to be growth investors, and everyone idolizes the value heroes • Real distinction is between value and momentum. Growth investors believe they are buying a good value. Momentum investors believe that a rising stock will continue to rise • Growth investors believe value is created by growth that comes at high returns on capital • Google came public in 2004 at $85, or 60x 2004 earnings of $1.40. “Value” investors laughed at this. However, Google will earn about $34 in 2011; it actually came public at 2.5x earnings just a few years out. Future growth meant that Google was a value stock. Growth and value are not mutually exclusive • Denver is one of the growth investing hubs

4. Growth stock investing is about returns as much as growth • What are the returns this business generates? • How sustainable are these returns? (Porter’s 5 Forces) • Will returns rise or decline over time? • How will the rate of growth impact returns? • With time and money, can this business model be replicated?

5. Growth stock investing is about returns as much as growth • Coca Cola (16x earnings) versus Carnival Cruise Lines (13x earnings) • Would you borrow money at 10% to invest in a CD yielding 5%?

6. Growth stock investing is about returns as much as growth

7. Growth stock investing is about returns as much as growth • From 2000 to 2010, Medtronic grew its earnings from $1.00 to $3.40, and yet the stock has gone down. The P/E multiple has gone from 60x to 11x • Return on Invested Capital went from 23% to 11% due to a large number of acquisitions

8. How do growth investors find ideas? • Secular themes • Technology • Healthcare • Emerging economies • Industry themes • New technology in old industries • Unique business models • Share shifts • Ideas come from industry knowledge. Talk to companies, suppliers, customers, competitors • Big Ideas. As one colleague puts it, swing at beach balls

9. Qualitative Research – Learning the Industry • How does the company make money? • Price/volume/mix • What do they sell? • Know the product • What does it cost to make it? • Fixed versus variable costs • Porter’s Five Forces and Return on Invested Capital • Who do they compete with? Consolidated or fragmented industry? • Who are their customers? Is there concentration or fragmentation? How much value do their customers see in the product? • Who are their suppliers? Could suppliers raise prices? • What are the substitutes? Is there a cheaper alternative? Are there new technologies that are potentiall disruptive? • What are the barriers to entry? Time? Money? Distribution? Regulatory?

10. Qualitative Research - Is this a good business? • Predictable and sustainable growth • Is this a big market? • Is this a growing market? • What is the company’s share today? • Competitive advantage • Better, faster, or cheaper product? • Is the advantage sustainable? • In the best of all worlds, the product is better, faster, cheaper, and that lead is sustainable • High quality business model – margins and ROIC • Protect against exogenous shocks • Beware the capital pig • Good management • Insider ownership • Good incentives • No excuses

11. Grassroots Research • Industry conferences • Web boards • Consume the product • Talk to customers/suppliers/competitors/industry experts • People love talking about what they do for a living!

12. Meeting management • Will not (can not) yield great insight into current business trends • Management is responsible for strategy, execution, and capital allocation, and this is important • Yes, you are younger and less familiar with their business than they are. But they work for your clients!

13. Public Disclosures • SEC filings • 10K • 10Q • Proxy • Website presentations and calls

14. Quantitative Research – What a Model Should Do • Great is the enemy of good • A model should include income statement, balance sheet, cash flow statement, as well as a DCF. The DCF should consider ROIC • What matters in the model? Think in terms of 2-3 leverage points. Price, units, mix, cost structure, capital structure, etc. Get those right; everything else is details

15. Quantitative Research - Absolute vs Relative Valuation • Relative valuation – like winning the NIT • Distortions in bubble periods • No two companies are exactly alike • Great for relative value long/short investing, but not for long term investing • The DCF is a blunt instrument but the best way to measure value that we have

16. How to Pitch an Idea to a Portfolio Manager • Key levers to an investment thesis – can you pitch the stock in an elevator ride? • Take 3 lines of content and expand, not the other way around • Swing at beach balls – if it is complicated and nuanced, it may work as a value stock, but not as a growth stock

17. A Specific Growth Stock Example – Crown Castle (ticker: CCI)

18. Is the wireless tower industry a good business? • Predictable growth • Recurring revenue from investment grade credits • Built-in 3% price escalators from those tenants • As sure as the sun rises in the east, the telecom companies will spend capital on their network • Sustainable growth • iPhones and Blackberries for early-stage wireless internet • Wireless broadband over the longer term

19. Is the wireless tower industry a good business? • Competitive advantage • Not in my backyard prevents competition • Customers (wireless carriers) literally brand their business around the quality of their networks. Network quality requires a presence on lots of towers • High margins and high incremental margins • Little opex • Easier to hang a second antenna than build a new tower • Earnings grow faster than revenue as a result

20. How we research this industry • Industry conferences. • Speak with network engineers • Pour over financials • Meet with management • Talk with competitors • Detailed financial model focusing on leverage points

21. Valuation • Cash flow, not earnings • Discounted cash flow, not relative valuation • Future growth is important to the valuation. • If we never saw growth again, the stock would be worth much less than the current multiple • Growth, at high incremental margin and returns, and with long duration, is worth a tremendous amount • This is where growth investing meets value investing; how confident are we in the growth the business will exhibit?

22. Tower economics • A single tower costs about $250K to build • A tenant pays $19K per tower per year, with built-in rent escalators (assume 3% for the sake of this exercise) • Today, the average tower has 3.5 tenants. Where could this go? We think to 4.5 over the next 5 years • A tower costs $20K in fixed costs to operate, and then $1,000 per tenant in variable costs • A tower with ONE tenant generates ($2K) in cash flow on a $250K investment. This has a negative IRR and negative DCF value • TWO tenants = $16K on a $250K investment. 10% IRR and $261K DCF value • THREE tens = $34K on a $250K investment. 22% IRR and $532K DCF value • FOUR tens = $52K on a $250K investment. 31% IRR and $802K DCF value • FIVE tens = $70K on a $250K investment. 38% IRR and $1,073K DCF value • Moving from 3 tenant sto 4 tenants over time is growth, with high incremental return on invested capital. A DCF that doesn’t consider this growth will value this business at $566,000 x the number of towers. But each tenant creates $300,000 in value! • Currently, the stock is valued at $750K/tower. Premium to 3.5 tenants/tower but below fair value

23. Growth stock resources • Peter Lynch’s “Beating the Street” • Joel Greenblatt’s “The Little Book that Beats the Market” • Porter’s “Competitive Strategy” • Ralph Wanger’s “A Zebra in Lion Country”