Classic growth stocks are the engines of the UK stock market. They deliver strong, stable growth of varying levels with high returns on capital and rising dividends.
We divide growth stocks into two categories- ‘Dependables’ those with growth rates up to 15% and ‘Super Growth’, those with higher growth but higher risk and reward potential.
Unlike speculative growth or “blue-sky” companies, classic growth firms we look for are typically driven by profitability and underpinned by robust balance sheets and low capital requirements. These high returns and growth can then compound to give superior returns. Classic growth stocks always possess a unique edge; this can sometimes be a technological innovation, market-leading process or unique brand that allows these companies generate higher profits within their respective markets.
Classic growth stocks can be found in multiple areas including technology, consumer discretionary, media and engineering sectors. The following are five examples of classic growth stocks that I am playing through the portfolio with the potential to deliver strong potential returns over the long term.
ITV is the dominant free-to-air television network in the UK. It is also the only provider of significant audiences in key advertising demographics. Recent results showed a sixth year of double-digit growth. Earnings estimates have been upgraded and the company delivered an unexpected special dividend.
A classic cash compounder, ITV’s high margin business and strong conversion of profit are generating an increasingly attractive return profile. Potential upsides, currently not priced in, are an uptick in retransmission fees (on Sky) and increasing takeover speculation around the Liberty Global stake. Its balance sheet continues to be strong offering further potential for acquisitions and special dividends.
Victrex is a supplier of high performance plastic, PEEK, to specialised markets in medical, aerospace, automotive and oil and gas. Sales are largely driven by the substitution of metals or other plastics to PEEK’s superior performance characteristics.
Limited competition has underpinned extremely high margins and returns. EBIT (earnings before interest and tax) margins of over 40% have driven returns on capital to over 25% despite recent investment in new capacity. New markets (e.g., IPhone) offer significant opportunities to increase sales volume – albeit at slightly lower margins. A strong balance sheet and rising net cash means special dividends are likely this year or next.
A radical market disrupter of the beverage mixers market Fever-Tree was founded in 2005. The business is driven by a passion to source the finest ingredients, in contrast with Schweppes which contains artificial saccharin. Previously the marketing leading Incumbent Schweppes had let its brand become stale and had a low price point, not helped by its diffuse corporate ownership across different geographies.
Fever- Tree’s 2015 revenue growth was 71% which combined with the company’s asset light model has turbocharged returns for shareholders.
In my view, huge growth opportunities remain for Fever-Tree. In the UK, for example, Fever-Tree service only 3,300 of 13,300 potential supermarket locations. In the on-trade (i.e., bars, clubs and restaurants), for example, the premium gin, Bombay Sapphire is stocked in 55,000 locations, while Fever-Tree is only stocked in 7,500 locations.
Overseas markets also offer huge potential. The US expansion is perhaps the most interesting with current market share only 6% and a current growth at 53%. New product innovation continues with the company currently looking at releasing its own premium cola. Its rating remains high with a PE of 40x but forecasts look very conservative and substantial upgrades are likely.
Gamma is a mid-sized supplier of telecoms services. Despite strongly competitive markets, high levels of intellectual property and re-investment have led to 10 years of superior growth.
Now the market leader in SIP Trunking and Cloud PBX new technologies, Gamma is differentiated by its own innovative software and systems. The company is also spending significantly to become the UK’s fourth business mobile player – something not yet factored into forecasts.
Given the conservative forecasts, the high PE multiple (c., 20x) is well underpinned. The company retains a strong balance sheet and high levels of cash flow. There may be some investment in capital expenditure but rising cash may be returned to shareholders if acquisition opportunities to do not materialise. EBIT margins stands at 15% and return on capital is over 25%.
One study* underlines the compelling opportunity that lies in software robots and robotic process automation (RPA): 47% of US jobs could be automated within the next 10 years. The market leader in RPA is Blue Prism.
The investment case is that any repetitive task can be automated by rule-based processes. This presents huge cost and productivity savings. This recurring revenue stream licence fee model is the equivalent ‘wage’ of the software robot. While there is limited patent protection in respect of Blue Prism’s technology, IBM’s position as key partner underlines that the technology is not easily replicable. The US key market business remains pivotal and the company continues to grow its channel pipelines to drive sales.
The company maintains high gross margins. However, it is highly operationally geared with new customers and may be lossmaking while it grows rapidly. Earnings forecasts remain conservative.
Philip Harris is fund manager of the EdenTree UK Equity Growth fund