Equity Beat: Discovering Young Redwoods

There’s almost nothing I enjoy more than hiking in the woods. The natural beauty, sense of adventure and physical exertion provide a perfectly restorative antidote to my daily overconsumption of caffeine and slouched posture from sitting in my office chair. While attempting to tackle the 2,000+ mile Appalachian Trail, famed writer Bill Bryson offers a different perspective of the outdoors: “Woods are not like other spaces…They make you feel small and confused and vulnerable, like a small child lost in a crowd of strange legs.” Against this poetic canvas, Mr. Bryson is fortunate to have avoided Redwood National Park, located in Northern California and home to the tallest trees in the world. Coast redwood trees can grow to more than 380 feet, compared to the tulip poplars and eastern white pines of the Appalachians which peak close to 150 feet.  

What allows redwoods to reach such remarkable heights? A combination of unique biological, environmental, and evolutionary factors. They possess a high rate of photosynthesis supporting rapid growth. They have specialized tissue that efficiently transports water from roots to leaves even at great heights. In addition, redwoods grow in dense forests where competition for sunlight drives trees to grow taller. Young redwoods can grow 3-6 feet per year, much faster than their Douglas-fir and western hemlock neighbors (1-2 feet/year). Interestingly (at least to me), it’s difficult to differentiate young redwoods from the others as they lack mature features such as bark and cones that make older trees easier to identify.

Let’s now draw the inevitable analogy to equity investing. According to the World Federation of Exchanges there are 53,555 publicly listed companies. Website “CompaniesMarketCap.com” lists fewer than 1,800 companies globally with a market capitalization above $10 billion. There are therefore literally tens of thousands of “young (or small/mature) trees” in which to invest. But which of today’s small/mid-cap companies are early-stage redwoods with the potential to generate truly extraordinary long-term compounding growth? According to CompaniesMarketCap.com, only 188 publicly listed companies in the world have market caps north of $100 billion, while a mere 11 are worth more than $1 trillion. Thus, redwoods are clearly the exception rather than the norm in the dense forests of public equities.

Yet locating even a handful over a multidecadal career can lead to a tremendous long-term track record and more than offset inevitable errors of both omission and commission. A 2018 study by Arizona State professor Hendrik Bessembinder found that just 4% of U.S. stocks accounted for the entirety of domestic equity market wealth creation during the 1926-2016 period. Less than 0.4% were responsible for half of the wealth created by U.S. stocks during that 90-year timeframe. 

With these statistics in mind, I recently attended an investor conference with colleagues where hundreds of small/mid-cap companies presented their business models and growth strategies. As I listened intently and networked with other investors, I couldn’t help but wonder whether fast casual Mediterranean restaurant concept CAVA – with 382 locations – could grow into the next Chipotle which has about 10x its number of restaurants. Could drive-through coffee chain Dutch Bros expand to become the next Starbucks? Could energy beverage company Celsius eventually eclipse incumbent Monster Beverage in market share?

What about companies that are creating their own markets? Which smaller companies today are in the process of developing breakthroughs in entertainment, technology, and science/medicine? Easy comparisons may not exist for these companies, but the total addressable opportunity in a “white space” of the economy might prove even greater. 

In equities, how does one attempt to differentiate the young redwood from a less extraordinary sapling? We’ve asked portfolio managers within our equity research team to opine on this topic.

Ken Stuzin (Portfolio Manager of Brown Advisory’s Large-Cap Growth strategy) comments, “When we consider business models for investment we must first develop and then regularly update our thoughts on companies’ competitive advantages as well as the risks to those moats, especially competition. For companies that carry long duration supremacy, over time we witness a steady decline in investor skepticism and controversy, creating the opportunity for strong, compounding returns for years or even decades. Most people think of success stories among technology companies, but we’ve discovered redwoods in other economic sectors as well, such as Intuitive Surgical, Mastercard, Costco and Cintas.”

George Sakellaris (Portfolio Manager of Brown Advisory’s Mid-Cap Growth strategy) states, “At its core, our investment philosophy is to discover companies that will expand from mid-cap to large-cap. While most mid-cap stocks won’t succeed in making that transition, we look for companies that carry unique attributes in large secular growth markets with the opportunity to meaningfully gain share profitably. Companies that have succeeded, such as Waste Connections, CrowdStrike and FICO promote sound governance with effective leadership. Importantly, every redwood has experienced a drawdown period or perhaps several along its journey of compounding growth. We must take advantage of these attractive moments as they don’t come along too often.” 

Michael Poggi, CFA (Portfolio Manager of Brown Advisory’s Large-Cap Sustainable Value strategy) takes a slightly different approach given his strategy’s investment philosophy. “Budding redwoods are typically not undiscovered and carry a valuation premium. Given our process of searching for value opportunities, we are more focused on finding perfectly good Douglas-firs or hemlocks that will grow just fine but may be overlooked sitting next to a redwood.”

Dan Mooney (Director of Equity Research) adds, “We can never know for sure that we’ve identified an early-stage redwood, but so much of our approach revolves around pattern recognition. Improving returns on invested capital combined with a competitive landscape and market opportunity that appear more favorable over time help us draw parallels to past successful investment experiences. It’s just as important, if not more so to stick with the redwood once it’s been discovered. Short-term data points can shake investors out of a long-term compounder; we must maintain perspective of the forest from the trees.”

Despite Bill Bryson’s humorous yet intimidating depiction of trail hiking in his bestselling memoir A Walk in the Woods, I’m more inspired than ever to visit Redwood National Park to admire nature’s giants. Perhaps I’ll give them nicknames like Microsoft, NVIDIA and Apple. Better yet, I’ll attempt to identify a few young redwoods. Their nicknames? I’d best keep them to myself for now.

Thanks for reading, and remember to never skip a Beat – Eric  

For more posts from the Equity Beat archive, please visit the Brown Advisory website: https://www.brownadvisory.com/us/the-advisory/equities

Source: FactSet®. FactSet is a registered trademark of FactSet Research Systems, Inc.

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An investor cannot invest directly into an index. 

Compounding growth refers to the process where an investment's earnings, whether from capital gains or interest, are reinvested to generate additional returns over time.