In the recent market rebound, sectors such as health care, communication services, software and online education have generated strong performance, with price-to-earnings multiples for innovative companies in Asia rising. Among fast-growing, innovative companies, intellectual property, network and data may be key drivers of future cash flows. A natural question on investors' minds: “Can growth companies continue their upward trajectories? Or will growth companies see a reversion to the mean?” Portfolio managers Taizo Ishida and Michael Oh, CFA, remain optimistic about the long-term growth potential of innovative companies. In this issue of Asia Insight, we explore the growth drivers for Asia's new economy sectors, including how to measure and assign potential future value of intangible assets.
Growth stocks enjoyed a strong rally the first half of 2020. What's driving gains?
Michael Oh: Returns for growth stocks were indeed strong in the first half. However, if you look closer, you will see a bifurcated market. Companies and sectors that investors perceive as having the potential to come out stronger on the other side of the pandemic have generated much larger gains. Therefore, we need look under the hood and find out what is driving that growth for individual companies. Often, these growth drivers fall into the category of intangible, or nonphysical, assets.
For an e-commerce company, the size and demographics of its user base might be its most meaningful intangible asset. For a biotech company, a patent for a blockbuster drug in a large market such as China might be most important. For an internet search engine, the strength of its algorithms and its position of dominance within local markets might prevail. Each of these falls into the category of intangibles. For high-growth companies, we are most interested in how these intangible assets can help companies grow quickly, while building a competitive moat. As growth investors, we assign a potential future value to these intangibles over time for our portfolio companies.
Many of these innovative companies are running asset-light businesses with the potential for achieving rapid scale at low marginal costs. Valuations matter, but traditional P/E metrics may only tell part of the story. For example, if a company has the potential to double its market cap in the next five years, then its present valuation may be entirely reasonable, even if its stock price has recently appreciated. As always, we believe stock selection and time horizon are key for long-term investors.
What criteria do you use to assign future value to intangible assets?
Taizo Ishida: For measuring intangibles, I tend to start with five key categories. These include the strength of a company's management team and the depth of its product pipeline. I also like to look at the size of a company's comparable industry peers, as well as the size of a company's customer base. Finally, I consider the future potential value of a company's intellectual property. None of these appears on a company's balance sheet. A company that derives its growth potential from these types of intangibles might appear expensive on paper, while still providing the potential for strong returns on a three to five year view.