Weekly Insights #39- The Other Side of Non-Linear Growth
Some types of businesses are inherently placed to deliver non-linear growth in earnings; some of such businesses that I have come across over the years includes-
CDMOs wherein commercialization of certain molecules can lead to a step-up increase in earnings.
Software products businesses, wherein the cost base is not one-to-one linked with revenues and thus if revenue growth accelerates, there is strong operating leverage that results in non-linear growth in profits.
Seeds businesses wherein a right working product can lead to widespread adoption in just a few years resulting in some exceptional growth in sales.
(readers can access our research on all such businesses here- Shared Research)
Though this prospect of non-linear growth is attractive, there is also the other side of such growth wherein the factor that leads to such non-linear growth can also create a situation for non-linear degrowth;
In case of CDMO business, if an existing commercial molecule loses its patent protection, a substantial chuck of revenues just evaporates in no time.
In software products, the companies have to invest upfront in costs like R&D and marketing and if the revenues during this period don’t keep pace with the costs, then there is a strong negative operating leverage resulting in poor profits.
In Seeds businesses, an existing market leading product can suddenly become inefficient or a new better product might come to market resulting in major loss of market share in just few years.
And because of this nature of these businesses, the entry & exit timings are quite important in such stocks because if you are unable to exit before an impending non-linear de-growth phase, you are looking at sharp corrections.
During a period of non-linear growth, the market ascribes very high valuation multiples to these companies purely on the back of the growth factor, but once the growth falters, the valuation multiples also correct significantly and thus you have a double whammy of falling earnings and falling multiples.
Simply put, the pendulum for such businesses in terms of growth, valuation multiple and thus the stock price can swing extremely wide.
The key to making money in such stocks is being placed such that you have a period of uninterrupted growth in front of you and for the most part taking early exits rather than trying to get the entire move, because the de-growth comes unannounced and if you are still holding when that happens, you will most likely give up a very large part of your gains, leading to sub-par returns for the risks taken.
That’s it for this week, new insight coming up next week. So stayed tuned!