In 2016, Michael Mauboussin, a highly-regarded researcher and author in the investment industry, co-wrote a research paper published by Credit Suisse titled The Base Rate Book. Mauboussin and his co-authors studied the sales growth rates for the top 1,000 global companies by market capitalization since 1950. They found that it was rare for a company – even for ones with a low revenue base – to produce annualised revenue growth of 20% or more for 10 years.
For example, of all the companies that started with revenue of less than US$325 million (adjusted for inflation to 2015-dollars), only 18.1% had a 10-year annualised revenue growth rate of more than 20%. Of all the companies that started with inflation-adjusted revenue of between US$1.25 billion and US$2.0 billion, the self-same percentage was just 3.0%.
The table below shows the percentage of companies with different starting revenues that produced annualised revenue growth in excess of 20% for 10 years. You can see that no company in Mauboussin’s dataset that started with US$50 billion in inflation-adjusted revenue achieved this level of revenue-growth.
But in a research piece published in June this year with Morgan Stanley titled The Impact of Intangibles on Base Rates, Mauboussin noted that Amazon (NASDAQ: AMZN) had defied the odds. The US ecommerce juggernaut ended 2016 with US$136 billion in revenue and Mauboussin wrote (emphasis is mine):
“… work that we did in 2016 [referring to The Base Rate Book] revealing that no company with [US]$100 billion or more in base year sales had ever grown at that mid-teens rate for that long. Our data were from 1950-2015 and reflected sales figures unadjusted for acquisitions and divestitures but adjusted for inflation. The analysis was not specific to any particular business, but the clear implication was that it was improbable that a company that big could grow that fast.
Amazon will be at a [US]$515 billion-plus sales run rate by the second quarter of 2022 and will have a 6-year sales growth rate ended 2022 of 27.6 percent, if the consensus estimates are accurate… If achieved, Amazon’s results will recast the base rate data.”
In The Impact of Intangibles on Base Rates, Mauboussin also shared the two main ways of making forecasts: The inside view and the outside view. Psychologist Daniel Kahneman, who won a Nobel Prize in Economics in 2002, has an interesting story in his 2011 book, Thinking, Fast and Slow, on these two ways of forecasting.
Kahneman shared in his book that years ago, he had to design a curriculum and write a textbook on judgement and decision making. His team consisted of experienced teachers, his own psychology students, and an expert in curriculum development named Seymour Fox. About a year into the project, Kahneman polled his team for estimates on how long they thought they would need to complete the textbook. Kahneman and his team assessed their own capabilities and concluded that they would need around two years – this was their inside view. After conducting the poll, Kahneman asked Fox how long other similar teams took to complete a curriculum-design from scratch. It turned out that around 40% of similar teams failed to complete their projects and of those who managed to cross the finish line, it took them at least seven years to do so. This was the base rate, the outside view. Kahneman and his team were shocked at the difference.
But in a validation of the outside view, Kahneman’s team eventually took eight years to finish their textbook. A key lesson Kahneman learnt from the episode was that incorporating the base rate would be a more sensible approach for forecasting compared to relying purely on the inside view.
In an investing context, taking the inside view on a company’s growth prospects would be to study the company’s traits and make an informed guess based on our findings. Taking the outside view would mean studying the company’s current state and comparing it to how other companies have grown in the past when they were at a similar state.
Jeremy and I manage an investment fund together. The fund invests in stocks around the world, and we have invested nearly all of the fund’s capital in companies that (a) have strong historical growth and thus high valuations, and (b) have what we think are high chances of producing strong future growth. For the fund to eventually produce a good return, its portfolio companies will need to grow their businesses significantly, in aggregate, in the years ahead.
Before we invested in the companies that are currently in the fund’s portfolio, we studied their businesses carefully. After our research, we developed the confidence that they would likely continue to grow rapidly for many years. We took the inside view. But we also considered the outside view. We knew that trees don’t grow to the sky, that it’s rare for companies to grow at high rates for a long time, and that some of our companies already had massive businesses. Nonetheless, we still invested in the companies we did for two reasons. First, we knew going in that we were looking for the outliers. Second, we had suspected for some time that the base rates for companies that sustain high growth for a long time have been raised from the past.
Mauboussin’s research in The Impact of Intangibles on Base Rates lends strong empirical evidence for our suspicion. He found that companies that rely heavily on intangible-assets grow faster than what the base rate data show. This is an important observation. According to the 2017 book Capitalism Without Capital by Jonathan Haskel and Stian Westlake, investments in intangible assets around the world overtook investments in tangible assets around the time of the 2008/09 global financial crisis and the gap has widened since. As more and more intangibles-based companies appear, the number of companies with faster-growth should also increase.
But intangibles-based companies also exhibit a higher variance in their rates of growth, according to Mauboussin’s data in The Impact of Intangibles on Base Rates. Put another way, intangibles-based companies have a higher risk of becoming obsolete. The quality of an investor’s judgement on the growth prospects of intangibles-based companies thus becomes even more important.
Why did we suspect that companies today are more likely to be able to grow faster than in the past? A key reason is the birth of software and the internet. In our view, these two things combined meant that for the very first time in human history, the distribution of a product or service has effectively zero marginal costs, and can literally travel at the speed of light (or the speed at which data can be transmitted across the web). Paul Graham shared something similar in a recent blog post of his, How People Get Rich Now. Graham is a co-founder of the storied startup accelerator and venture capital firm Y Combinator. He wrote:
“[B]ecause newly founded companies grow faster than they used to. Technology hasn’t just made it cheaper to build and distribute things, but faster too.
This trend has been running for a long time. IBM, founded in 1896, took 45 years to reach a billion 2020 dollars in revenue. Hewlett-Packard, founded in 1939, took 25 years. Microsoft, founded in 1975, took 13 years. Now the norm for fast-growing companies is 7 or 8 years.”
If you’re an investor in stocks, like us, then I think it’s important for you to realise that we’re in a whole new world of accelerating growth.
Note: An earlier version of this article was published at The Good Investors, a personal blog run by our friends.
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Disclosure: Ser Jing owns shares of Amazon.