December 6, 2021
Most readers understand that Fairlight invests across three distinct types of opportunities: high quality growth, stable compounders, and low risk turnarounds. However, our definition of growth differs from that of the broader market as we have a far higher hurdle for profitability compared to sales growth. In fact, none of our growth companies currently generates a loss. We make this distinction at a time when market commentators point out that the valuation of growth companies is currently approaching similar valuation metrics recorded during the lead up to the technology crash of 2000. In our view, this valuation risk is most evident across US Small and Mid (SMID) software as a service (SaaS) companies where it isn’t uncommon for their shares to trade at multiples of 30 to 50 times sales. Whilst there will likely be some winners amongst this cohort, we’d wager that, as a group, negative absolute returns will be the likely outcome over the next decade.
High quality growth
The high quality growth businesses that we seek usually have a long history of double-digit profitable organic growth within a growing market. This means we are far less likely to invest in fad stocks or become overly enthusiastic about total addressable market or disruption 'stories'. We are not luddites (technology is our largest sector exposure), but desire our companies to self-fund their growth opportunities whilst generating high returns on incremental capital. We believe that investing in such companies both reduces risk and generates attractive absolute returns. Finally, sustaining high returns on capital for long periods of time is rare, and so, along with advantaged competitive positions, we look for businesses with distinctive cultures which often lead them to exceed the most optimistic of forecasts.
IT research provider Gartner is an example of a high quality growth company within the Fairlight portfolio that exhibits all of these characteristics.
Gartner’s research informs clients about the latest IT trends and guides their investment in technology. Executives often use Gartner’s research to justify their decisions to their boards as well as to direct day-to-day purchases of software and hardware.
Through a research subscription Gartner offers key decision-makers access to a global network of experts in anything IT-related. Interaction between Gartner and the users happens conveniently through an online portal or over videoconferencing. Gartner’s offering is often the optimal choice in two ways: firstly, it is cheaper than engaging consultancy firms such as Accenture, especially when assessing non-critical IT infrastructure; secondly, using the service negates the need to hire a full-time person (or team) to conduct in-house research. Given Gartner’s scale and relationships with IT vendors, Gartner is far better placed to stay on top of all recent IT developments than stretched in-house resources.
Testament to this strong value proposition, Gartner’s historical growth has been impressive (Figure 1). Annual revenues have compounded at a 10% growth rate since 2005. This growth has been almost entirely organic with the bulk reflecting additional sales to existing clients and new client wins. While Gartner complements and supports its core research franchise with lower margin conferences and traditional consulting services, the overall company’s economics are attractive. Content creation involves relatively high upfront costs but this can then be resold multiple times at limited extra cost. As a result, Gartner’s annual operating profit has been growing about three percentage points faster than revenues.
Corporate IT spending is growing and IT complexity is increasing. The current COVID-19 pandemic has only accelerated these trends and so Gartner’s services should continue to remain in high demand. Gartner is already the clear industry leader generating almost ten times more sales than Forrester, its closest peer, but we expect this leadership to extend further. As the subscription base continues to broaden so does its ability to invest in additional content, which makes it increasingly difficult for smaller peers to compete effectively. Beyond this, Gartner has been successfully expanding into new verticals such as supply chain, marketing, legal and human resources. This has significantly lengthened its available growth runway through a proven low-risk strategy.
Notably, Gartner has been able to finance its growth internally. This is mainly because it charges for its annual subscriptions upfront but pays its expenses over time and in part in arrears (e.g. bonuses and commissions). This manifests in a negative net-working capital position of around 20% of revenues. Considering then that office space and computers for new employees are essentially the only capital expenditures required to sustain growth, free cash flow has and should continue to run well ahead of accounting profits.
This outstanding cash generation has allowed management to opportunistically buy back shares over time, thus creating tremendous value for shareholders. For instance, in this year alone, management has repurchased 7% of the company’s shares at an average free cash flow multiple in the mid-20s, which we see as great value for ongoing shareholders.
The Fairlight View
Almost half of the Fairlight portfolio is invested in our definition of high quality growth companies. As per the overall strategy, the emphasis is first on quality and then on growth, as the latter is generally a desirable trait only when profitable. Gartner possesses all the characteristics that we look for in a growth company. The share price has increased almost three-fold since the Fund’s initial purchase but we haven’t sold a single share. Gartner’s high-performance culture and large growth runway leave us excited about the prospects for continued high returns.