Long-Term, Organic Revenue Growth Is A Key To Investment Success

With the market riding pretty high and stock buying opportunities limited, I wanted to take some time to put together a series of articles going a little more in-depth on the GreenDot Stocks investing process.

As laid out in the Help page, we start by using the Green Screens to mechanically filter the entire investment universe of over 5,000 stocks down to just a handful of companies that have strong revenue growth and free cash returns on capital. That gets us started in the right direction.

After that, we want to take a closer look to find in those screens the truly great companies, that would make awesome investments at the right price. While this is part science, part art, in general the diligence process comes down to 4 check boxes. In this series, I'm going to go in-depth on each of these and tell you what to look for to either give a company a "pass" or "fail" on each.

The 4 "Check Boxes"

Those 4 "check boxes" are (articles are linked):

1) Recurring Revenue

2) Long-Term, Organic Revenue Growth (this article!)

3) A Strong Economic Moat

4) Business-focused Management Teams (coming soon)

When a company "passes" all 4, then we move to a stock price valuation - which is separate from business analysis. We can cover that a different day!

Why Revenue Growth Matters

Revenue growth is probably the easiest of the 4 check boxes to quantify. Anyone can pull up their broker's research pages, or Yahoo Finance, and look at the past 3 or 5 years of revenue.

Even the Green Screens use a quantified revenue growth number to filter out stocks. For the "Tortoise" side, we want a minimum of 10% growth for both this and next year's forecast. For the "Hare" side, 20%.

The second criteria on the Green Screens is "cash return on investment capital", or ROIC. This refers to how much free cash flow a company is producing for every dollar of capital they've invested in the business. So, for example, Adobe (ADBE) has a 40% ROIC figure, meaning for every dollar invested in their business, they are earning $0.40 on it annually. 40% is a fabulous figure - what would your investment portfolio look like if you could earn that kind of return year after year?!

The magic happens when you combine revenue growth together with ROIC. A firm that has stagnant revenues may have a nice ROI and strong cash flows, but they won't grow and that can lead to a stock price that doesn't move much. On the other hand, a firm that is rapidly growing sales can produce ever-higher free cash flows, sending its fair value (and stock price) up and up and up for years.

That's what we want as long-term investors!

Not all revenue growth is the same though. Let's look at the difference between "high quality" and "low quality" revenue growth.

Spotting Low Quality Revenue Growth

Research diligence is the only way to separate high from low quality revenue growth.

What's the difference? Let's list out some characteristics.

Low quality revenue growth is characterized by some or all of the following:

• Driven by acquisitions
• Supported by outside factors, like temporarily high commodity prices or interest rates
• Based off a one-time windfall
• Comes from short-term demand spikes, like a fad product or unsustainable phenomenon

Some examples of low quality revenue growth:

Green Screen stock Patterson-UTI Energy (PTEN), which has completed 4 large acquisitions since 2018, supporting much of its out-sized "revenue growth".

A number of insurance stocks, most of whom are benefiting from unsustainably high prices on automobiles and housing. These stem from short-term supply/demand imbalances compounded by inflation and high interest rates (which are uncontrollable and volatile outside factors).

Moderna (MRNA) back in 2021 was a Green Screen stock, but its revenue explosion (>100% growth) was obviously driven by what was likely to be intense but short-term demand for a COVID vaccine. Zoom Media (ZM) was a similar story with "social distanced" meetings.

It is important to spot these "low quality" growth situations. They often burn investors pretty hard when the growth is expected to last, but falls off the map as soon as the underlying cause fades away in a year or two. That leads to some dramatic declines in stock prices (ZM has gone from over $400 in 2021 to $72 today).

The Characteristics of High Quality Revenue Growth

On the other hand, high quality revenue growth has the following characteristics:

• Supported by underlying market size or growth
• Driven organically instead of by acquisitions
• Sustainable for the foreseeable future

Our focus here is on finding excellent long-term (3-5 year) investments, that will compound our capital over time. It is absolutely imperative that we invest in high quality growth. Only then can we find the 2, 3, and 4 baggers that truly deliver life-changing investment returns.

What are some examples of high quality growth? Check out any of the stock research articles for stocks in the Buy List, Hold List, or Watch List! I always provide a detailed analysis of a firm's growth prospects and why I believe it has a high quality sales growth profile and outlook.

Conclusion

Revenue growth is an obvious but critical component of winning long-term investments. Without it, it is rare to see a stock double, triple, or more within a few years time. But investors need to be careful - revenue growth is often a mirage, driven by unsustainable factors that cause it to dry up and leave you holding an overvalued stock. By ensuring growth is high-quality, we can avoid this trap.

In the next article, we will take a look at the next "check box" - the economic moat!