Letters

Earned Growth vs. Rented Growth

September 2019

Earned Growth vs. Rented Growth

Not all growth is created equal. At Somar we distinguish between Earned Growth (EG) and Rented Growth (RG). EG occurs both when a company grows with their existing clients and / or when they take market share by offering new clients a better value proposition than its competitors[1]. RG occurs when companies offer short-term promotions and unprofitable discounts to increase sales and market share. This can be done for a variety of reasons, ranging from making the sales numbers for the next funding round to the genuine belief that the acquired customers will stay with the company once the discounts are taken away.

The current macroeconomic environment in the US and Western Europe with low or even negative interest rates, coupled with slow and decelerating economic growth, has many investors paying up for growth opportunities. This demand has trickled down to entrepreneurs and venture capitalists who have been working hard to supply investors with growth at all costs. This has inflated valuations in private rounds and sparked the raising of larger and larger venture capital funds. The record is now set at $100 Bn for a single fund.

To be sure, I believe the opportunity set is vast and we are lucky to be living in the current environment. That said, when I came to the US 17 years ago, a $100mn venture capital fund was considered to be large. The opportunity set since then has increased a lot but not by the order of magnitude reflected in new assets raised.

All of this would be irrelevant for Public Equity markets if there were no operational impact in our companies. But these highly loss-making venture backed companies now compete at the same scale as their publicly listed peers. They report operating losses of hundreds of millions of dollars and have raised more than one billion dollars of venture capital funding. This is a new phenomenon that didn’t exist less than a decade ago.

As public investors we look for companies that offer a superior value to their customers in a profitable way. To achieve this, they need to have a competitive advantage such as: network economies, patents or scale economies among others. We’ve always been attracted to investments where this advantage expands as the company grows and executes its strategy. Our mental rule of thumb when analyzing investments is: if we had $1bn in the bank could we disrupt this company’s model and take over its leadership position? Only when we believe it would not be possible, do we proceed with the analysis.

For most of the past few decades this was more of a theoretical exercise than a practical one. But the growth
of venture capital funds described above has made it practical over the last two years. It has been reassuring to see that in fact, money alone and RG don’t challenge a strong and growing competitive advantage. The large dollars invested will certainly gather media headlines, and may even lead to impressive valuation rounds, but they will not breach the strategy and progress of a well-managed company with a superior consumer value proposition that is profitable and anchored on a competitive advantage. The fight from RG competitors will impact margins in the short term, they may even slow the natural growth trajectory, but they will not change the end result.

Performance vs. Inherent Value
Our quarterly evaluation of Somar’s investment performance vs. a couple of proxies of our long portfolio inherent value progress is due this month (Fig. 1).

We can see steady progress, and even some acceleration in the sales per share indicator last quarter. That came with some margin investment which led to slower growth on the EPS indicator. Our companies are
continuing to take market share, investing in widening their moat and willing to forego operating leverage now to pursue that objective. For each company we currently own that chose this path we believe it is the
right one for long term value creation.

For each company we understand whether their growth is coming from profitably offering a superior value proposition to its customers or from short-term promotions or tailwinds. We make sure any margin investments will yield superior returns and be more than recovered by operational margin improvements in the next couple of years. We use every opportunity available to discuss these trade-offs with the management teams and cross-reference their views with those of their competitors, both existing and emerging.

Public markets oscillate between euphoria and panic about the future. Lately, the preponderance of Macroeconomic headlines around the US / China trade dispute, Brexit negotiations and US Presidential impeachment have made the pendulum swing much closer to a short-term fearful view. We have been here before and remain focused on the opportunity and extra profit being created by our companies for the next 3 to 10 years rather than the potential oscillations of their stock price in the next month.

All the best,

Pedro Ramos


[1]We wrote in detail about ways to offer a superior value proposition to your customers in our letter from April 2018.

Disclaimer: This website is for general information purposes only and is not intended to be, nor should it be construed as investment advice, nor a solicitation or offer to buy or sell any securities, related financial instruments, or  interests in the Somar Master Fund, LP (the “Fund”) or its feeder funds. The information contained herein is not complete, and does not contain certain material information such as disclosures and risk factors about the Fund or its feeder funds. Opinions expressed are current opinions as of the date of this material only and are subject to change without notice.Hedge funds: (1) often engage in leveraging and other speculative investment practices that may increase the risk of investment loss; (2) can be highly illiquid; (3) are not required to provide periodic pricing or valuation information to investors; (4) may involve complex tax structures and delays in distributing important tax information; (5) are not subject to the same regulatory requirements as mutual funds; and (6) often charge high fees.

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