Executive summary: 

• Companies that experienced a growth boom in the past decade are now transitioning to a new phase of their lifecycle.
• Investors are rightfully beginning to wonder what the long-term economics of these businesses will look like.
• Successful companies will be those that can strike the right mix between visionary and optimizer leadership.

By 1850, observers assumed that Cincinnati would be the future metropolis of the Midwest. Indeed, Horace Greeley of the New York Tribune envisioned at the time: “It requires no keenness of observation to perceive that Cincinnati is destined to become the focus and mart for the grandest circle of manufacturing thrift on this continent.”

Thanks to its advantageous location on the Ohio River and the introduction of canals and steamboats, Cincinnati’s economy and population boomed in the first half of the 19^th century, rapidly becoming the sixth-largest city in the young United States.

Source: Boston University, Brookline Connect, Wikipedia, Author’s calculations

Within a decade, however, the city’s growth trajectory flattened out. The impacts of the Civil War, the railroad revolution, and further westward expansion took opportunity elsewhere in the country.

It was a painful transition for the city leaders to acknowledge. Still, they pivoted from a boundless growth mindset to promoting civic pride, including building art museums, music halls, and urban parks. These efforts were critical in maintaining the city’s relevance in the subsequent 150 years.

A similar transition is happening at some high-profile companies that experienced a growth boom in the past decade. As growth slows, investors rightfully begin to wonder what the long-term economics of the business will look like.

In previous posts, we’ve shown how an investor’s assumptions about a company’s terminal value, or steady-state growth and profitability profile, account for at least 75% of its intrinsic value. Naturally, previous growth rates have no impact on current market valuations. What matters is how confident investors are in the company’s long-term economics.

To illustrate, consider the following two sets of companies:

	Year Founded	5 Year Revenue Growth	Estimated P/E	EV/EBITDA
Old School
Estee Lauder (EL)	1946	2.2%	44.4x	23.0x
McDonalds (MCD)	1955	2.8%	26.4x	19.2x
Illinois Tool Works (ITW)	1912	1.4%	23.4x	16.8x
New School
Etsy (ETSY)	2005	39.6%	20.8x	16.9x
Salesforce (CRM)	1999	24.0%	29.7x	16.1x
Uber (UBER)	2009	27.8%	52.2x	22.1x

Source: Bloomberg, as of 5/22/23

The “old school” group of companies trade with similar, or in some cases higher, multiples to the “new school” group that grew far more rapidly in recent years.

Why might this be?

The answer can take many paths, but ultimately what matters is what the economics of each of these businesses looks like in 10+ years and how confident investors are that they’ll achieve those figures.

With these selected “old school” companies, there’s a track record of execution. They’ve all been through various growth stages and cycles and have even stumbled multiple times, but they have come through the other side.

On the other hand, the “new school” companies have established themselves as forces to be reckoned with. Still, it remains to be seen what their margins and incremental returns on invested capital profiles look like when growth slows.

To this point, three sell-side analysts – Scott Davis, Carter Copeland, and Rob Wertheimer – wrote the book Lessons from the Titans. The trio covered industrial conglomerates and drew lessons from the successes and failures of these companies that they argue can be applied to many of today’s tech companies transitioning from high-growth periods.

The authors note that industrial companies were the “original tech” a few generations ago and once “had seemingly magical market positions, but most of them squandered that advantage. Arrogance led to wasteful investment decisions, poor labor relations, and countless scandals.”

The successful industrials they studied had “three common drivers: a relentless discipline on costs, cash flow, and capital deployment,” that they used to widen their moats.

Headlines about tech layoffs have increased as companies have started the painful transition from boundless growth to sustainable growth. Such changes require different skills from management and an adjustment to corporate culture. With a blueprint for success established, the new school companies need less visionary and more optimizer leadership.

 

Striking the right mix between visionary and optimizer will be critical to the outcomes of new school companies during this transitionary period. They must retain the cultural spark that drove talented employees to their company while doing so in a more economical manner.

Of course, it’s much easier to see with hindsight where companies should be on the Visionary-Optimizer spectrum, but in the moment, it’s unclear. Take Alphabet (Google), for example, which already boasts generous 30%+ EBITDA margins and attractive returns on invested capital. Figures any Optimizer would applaud. Nevertheless, the company has announced cost-cutting initiatives including eliminating 6% of its workforce and cutting back on office supplies and some of its famous employee perks.

All of those efforts are firmly in the Optimizer camp. Yet, Alphabet simultaneously faces an acute challenge in the form of rapidly advancing artificial intelligence (AI) technology, which will require a Visionary mindset.

 

Investors calling on Google to rein in spending, increase buybacks, and become more operationally efficient make reasonable points. However, if Google management takes that advice too far and becomes a complete Optimizer, its relevance in the next generation of technology could be at risk. Imagine if Google listened too intently to the investor complaints about investing in unprofitable growth initiatives like YouTube or DeepMind years ago. We believe Alphabet management is taking the appropriate steps to navigate this challenge thus far.

We have a mix of old and new school companies in our portfolio and are confident in all their long-term economic potential. Each group has its own set of risks and opportunities. With the old school names, we’re primarily focused on low growth risks and their reinvestment runways. With the new school names, we’re watching how they balance growth and innovation with more financial discipline.

No company is a static asset, and they either get stronger or weaker each day – and they will be materially different a decade from now. Whether they are old school or new school companies, how they address new challenges and transitions is what matters. The best companies come through stronger on the other side and we want to own these companies in our portfolio.

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