Identifying genuine growth stories is not easy but can be extremely rewarding. Nvidia (NVDA:NASDAQ) may be the ultimate growth stock example now but who was flagging its potential 10 years ago when revenue and profit was just a fraction of what it is today and when the widespread application of AI was still restricted to think pieces in periodicals. Some did catch on early and would have enjoyed extraordinary returns if they held all the way through to the stock’s current highs. Investment trust Scottish Mortgage (SMT), whose whole purpose is to find growth companies, has achieved a return of more than 8,000% on its initial investment in the chip specialist in 2016.

A slightly more recent convert is Tim Gregory, manager of Vermeer Global (BZ000X7) (soon to be rebranded as Goshawk Global Fund). ‘People have been talking about AI for years but it was listening to a call that the Nvidia CEO Jensen Huang did about three years ago, which highlighted that the industry had reached an inflection point where the combination of 5G speeds, edge computing, the cloud and artificial intelligence was going to lead to an industrial revolution in computing. That was the trigger to buy the shares and we’ve benefited hugely from that.’

In this article we hear from a selection of leading fund managers on how they identify genuine long-term growth opportunities among the stories which might shine bright for a short time then fizzle out. We also identify two names which we believe can deliver growth over the long run.

ADOPTING A GROWTH MINDSET

Being a growth manager is not just about looking at the numbers – it requires a certain mindset and an inquisitive mind. Manager of Allianz Technology Trust (ATT), Mike Seidenberg says: ‘Our process is predicated on a strong intellectual curiosity which is annoying to my kids but serves us well in technology investing. At our core, we are product people and love good products. My background having worked in enterprise software allows me to operationalise and understand how the products work and interact within a corporation IT environment. 

‘We pride ourselves on observing and interacting with users of the products we invest in. The ability to identify happy customers in technology investing is important and happy customers give you the right to sell them more stuff.’

Scottish Mortgage manager Lawrence Burns says: ‘Rather than relying on information from the investment industry, which often focuses on the short term and is already priced into valuations, investors need to seek broader and differentiated views.’

As Burns says, this requires going outside the world of finance to build networks with founders of private and public companies, leading academics and ‘captains of industry’.

‘It’s important that I spend time learning from people who are far smarter than me to understand how the world is changing and thus where opportunities are emerging. Then comes the psychological part. It is necessary to accept and indeed embrace opportunities where the range of outcomes is wide. These opportunities are uncomfortable but often ultimately the most valuable.’ Burns notes owning Nvidia and Tesla (TSLA:NASDAQ) hasn’t always been an easy ride but it’s undoubtedly been rewarding.

WHAT IS THE RULE OF 40

The ‘rule of 40’ is a neat way to help measure the trade-off between growth and profits as a company matures. Originally dreamed up by venture capitalists to assess fast-growing software start-ups running up huge losses, it is today used by investment professionals the world over, and there’s no obvious reason why it cannot be applied to any ‘growth’ stock.

Crucially, it is simple to use, a filter any retail investor can apply.

The metric is based on the principle that a company’s combined revenue growth rate and operating profit margin should be at least 40%, and ideally better. So, a company with revenue growth of 30% and margins of 20% would beat the rule of 40 (scoring 50), while one with growth of 12% and margin of 23% would not (35).

It can be applied to lossmaking businesses by subtracting the negative margin from the growth rate. So, two companies with 60% growth but margins of -12% and -25% would result in one that beats the rule and one that doesn’t, with respective scores of 48 and 35.

Measuring only a company’s latest fiscal results won’t tell you much, but applied over multiple years, the last five say, can be a useful way to track the progress of a fast-growing business as it expands, matures, and eventually, becomes more focused on profits, cash flow and shareholder returns.

Interestingly, a study by Morgan Stanley in 2023 found companies which had most frequently surpassed the rule of 40 hurdle (at least 10 times, on a quarterly basis) drove 56% of the outperformance of the Nasdaq, and 124% of the S&P 500 outperformance since 2018.

As Redpoint venture capitalist Tomasz Tunguz has said, ‘the rule of 40% might be a good filter for investors to identify outliers’, or relatively rare businesses capable of producing a sustainable mix of growth and profit into maturity.

‘The spirit of the R40 is a good one,’ Tunguz adds. It ‘establishes a relationship between the growth rate and burn rate of a business and defines a healthy operating zone for a growth stage business.’

The table shows some high-profile names which qualify under the rule of 40 – using data from SharePad on the average operating margin and revenue growth rate over five years. [SF]

A TOP-DOWN APPROACH

While stock selection is a key part of a growth manager’s armoury, Peter Hewitt, who steers the CT Global Managed Portfolio Trust (CMPG), explains how he adopts a top-down approach to identify ideas.

‘I often start with examining big macro trends and filter that down to country level. If there is something of possible interest, I will then do some investigative work to identify if there are investment companies specialising in an area or sector that I am interested in.’

Vermeer’s Tim Gregory also looks at the macro as a starting point: ‘We read a lot – not just about companies, but about the wider world and the forces changing it. That gives us a macro view and helps us identify a range of themes with the power to generate strong tailwinds behind companies. These include, for example, AI, automation, aging populations and the challenge of transitioning to a low-carbon world.’

Odyssean Investment Trust’s (OIT) Ed Wielechowski has a similar starting point. ‘Firstly, we look to identify markets that will grow sustainably at levels above real GDP, driven by long term secular drivers,’ he says. ‘Within these markets we look to back companies with leading positions, as that leadership typically confers benefits of scale, reach and investment which can drive future growth at levels above the wider market.’

Along the same lines, Blue Whale Growth’s (BD6PG78) Stephen Yiu says: ‘With thousands of companies to choose from, narrowing down the options is crucial. This involves both positive and negative filtering. Companies operating in industries with significant structural tailwinds—such as AI and digital transformation—move to the forefront.

‘Conversely, businesses in declining industries or those facing political scrutiny are usually excluded. The next step is identifying potential “winners” within those promising industries. Key traits include operational moats, best-in-class products, high margins, and pricing power, which signal a company’s potential for sustained success.’

SORTING THE WHEAT FROM THE CHAFF

As Yiu observes, from a starting point of having identified winning themes, the work of identifying the right ways to play them begins. Odyssean’s Ed Wielechowski says: ‘Ultimately there are no shortcuts, and finding the best opportunities takes time and effort to sort the wheat from the chaff. We are sector focused, spending our time on areas richer in business models we like. Within these areas we bring to bear multiple decades of investment experience across the Odyssean team. By focusing on fewer areas and knowing them well, we believe we are able to better understand market dynamics, identifying likely winners; better able to develop a deeper understanding of business models to spot ‘self-help’ stories; and better able to judge ‘fair value’ for an investment to avoid overpaying.  

‘We combine this experience with many hours of our own in-depth, detailed primary diligence on each new investment. We set high bars and only select what we view as the most attractive opportunities for our portfolios.’

Montanaro European Smaller Companies (MTE) manager George Cooke says: ‘With thousands of companies to choose from in the European small-cap universe, we believe you need two key ingredients if you are to regularly identify the “hidden gems” – those companies that offer the best long term growth opportunities but which may not be well known or covered by the sell-side.’

Cooke explains this encompasses a well-defined investment process and a large team – something Montanaro has at its disposal. 

‘Our process ensures we only invest in profitable, market-leading companies run by the best management teams. And we do our own homework, thanks to our 16 in-house sector analysts, meaning we have the chance to unearth companies that other investors have missed altogether.’ 

Investment manager at Baillie Gifford US Growth (USA), Gary Robinson, says: ‘Research shows that a small group of exceptional growth companies drive a market’s return over five years and beyond.’

According to Robinson, these companies exhibit certain general characteristics which enhance their potential for achieving faster and more sustainable growth compared to their peers. These enterprises are characterised by their disruptive nature, innovation, and adaptability. They possess exceptional ambition and target significant opportunities relative to their size.

‘We also look for companies which we believe have a sustainable competitive advantage and a purposeful and effective company culture,’ Robinson adds. ‘Few companies possess these traits.’

James Cook, co-manager of popular trust JPMorgan Global Growth & Income (JGGI), says he looks for three key criteria. ‘Superior quality of earnings, faster earnings growth than the benchmark average (which is important because these companies have historically outperformed, especially in downturns); and normalised free cash flow yields similar to the market.’

QUALITY GROWTH

A company could double in size in revenue terms just by buying a similar-sized business but if both are basket cases, and the acquirer has loaded up with debt to complete the deal, then shareholders are unlikely to enjoy any benefit.

Growth for its own sake is just as likely to destroy value as it is to create it. The growth stories which stand the test of time need to generate sustainable returns and cash, which they can then reinvest in the business, as Stephen Tong, portfolio manager at Mid Wynd International (MWY), explains: ‘Our starting point is quality companies generating high returns on capital that are reinvesting in their business to drive future growth. We look for cash flow growth in particular, not necessarily sales growth, as this is what builds investor wealth over the long term.’

Gerrit Smit from Stonehage Fleming Global Best Ideas (BCLYMF3) says: ‘As the late Charlie Munger reminded us, long-term investment opportunities boil down to the returns on invested capital that the business generates.’

The manager of the small- and mid-cap focused trust from the Fundsmith stable – Smithson’s (SMIN) Simon Barnard – adds his perspective: ‘We use a range of sources including financial screens, corporate networks and relationships with the management teams of companies we already follow to look for smaller companies of very good quality with high margins, strong free cash flow and excellent returns on invested capital.’

TWO GROWTH STOCKS TO BUY

Trustpilot (TRST) 284p

Market cap: £1.2 billion

In our view, Trustpilot (TRST) has a lot of the hallmarks of a long-run growth stock. With more of us buying stuff online, is it any wonder we are increasingly reaching out to fellow consumers for their seal of approval (or gripes) about products and services, and that’s great news for Trustpilot’s reviews platform.

The platform now hosts more than 300 million consumer reviews of products and services across hundreds of thousands of websites, according to half-year results in September 2024. Thousands of businesses now turn to Trustpilot for customer transparency and the underlying consumer data analytics it provides to clients, and its value to them is being proved by client retention rates of 101%.

Crucially, this creates valuable network benefits. The more consumers using the platform and sharing opinions, the richer the insights Trustpilot can offer clients. Done well, this creates a virtuous circle where consumers feel drawn to Trustpilot because it is where meaningful services are listed and reviewed, and the more consumers who use Trustpilot, the more businesses will feel they need to be on the platform.

That first-half revenue, bookings and ARR (annual recurring revenue) increased 18%, 16% and 16% respectively was highly encouraging news for investors, as were plans for a £20 million share buyback. This accounts for around 3% of the shares in issue, a clear demonstration of capital allocation discipline in the face of what the company believes is a discounted market valuation. It also reflects the company’s improving cash flow.

It’s been a virtual one-way street for the share price this year, rallying from 139p, a run which Shares predicted in a Great Ideas pitch at 161p in January 2024. Positive trading and repeated earnings upgrades by analysts will do that, and there’s no indication that the wheels are about to come off. In fact, quite the opposite. [SF]

Windward  (WNWD:AIM) 120.5p

Market cap: £108.6 million

Leading AI-based risk management SaaS (software-as-a-service) and data platform company Windward (WNWD:AIM) operates in the global shipping, energy and maritime logistics sectors.

It’s software suite and data platform allows customers to monitor, assess and predict trade vessel compliance with sanctions and track individual sea cargo in real time and predict estimated time of arrival and delays.

Windward floated on the AIM market in December 2021 at 155p per share and has grown revenue at a compound annual growth rate of 31% over the last six years and is expected to reach £36.3 million in 2024.

The company is one of the fastest-growing listed enterprise software providers in the UK according to analysts at Canaccord Genuity.

Its total addressable market is roughly $10 billion, reflecting low rates of digital transformation in the maritime industry. This provides a large and sustainable runway of growth for Windward.

The company’s unique solution automates due diligence and sanction compliance by leveraging third party data sources, big data analytics and predictive AI algorithms.

Windward’s blue-chip client list spans multiple industries and includes Shell (SHEL), HSBC (HSBC), BP (BP.) and the Department for Homeland Security in the US.

The company is continually expanding the product offering for both the commercial and government markets, growing its total addressable market and moving the business into the broader compliance, security, and supply chain markets.

Nearly 100% of revenue is generated through subscriptions, a higher proportion than data platform peers such as RELX (RELX), providing a high-quality source of income.

Increasing global geopolitical tensions should act as a tailwind for the business over coming years. With the company expected to reach breakeven in 2024, the business looks well set to continue growing at a fast pace and generate shareholder returns. [MG]

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