Growth stocks come in all different shapes and sizes, but there’s a specific type of business that I like a lot for my own investments. And it’s one that has been very successful for shareholders over time. More of that later though.
Some of the UK’s outstanding companies use size and scale advantages to generate a competitive advantage and strengthen this via acquisitions. And there are several that are worth considering.
The business model
A lot of the time, bigger is better. Operating at scale often brings increased buying power, the ability to spread costs over a wider revenue base, and a more convenient service for customers.
One way of building scale is by buying other businesses. Rather than trying to establish a presence in a different country, it can be a lot easier to just acquire an existing operation.
There are a lot of benefits to doing this. It can expand the reach of a smaller business (boosting sales) and bring the opportunity to reduce costs (widening margins).
There’s always a risk of paying too much for a new subsidiary. But for companies that are able to do it well, the strategy of expanding via acquisitions can be extremely effective.
Stocks I own
I own shares in two companies that operate with this strategy. One is consumables distributor Bunzl and the other is Judges Scientific – a collection of scientific instrument businesses.
In both cases, acquisitions regularly bring new sales opportunities. New subsidiaries can often use the firm’s network to gain access to new markets, boosting sales and profits.
With Judges Scientific, demand can fluctuate with the economic cycle and this creates a risk. But I think the long-term picture is relatively strong, even though sales have faltered recently.
Bunzl’s market is more stable, but there’s a higher risk of customers switching to other providers. That’s why the firm’s ability to use its scale advantage to provide a better service is so important.
Stocks I’d like to buy
I’ve got my eye on a couple more businesses with a similar structure. One is Compass – a contract catering firm – and the other is military technology conglomerate Cohort (LSE:CHRT).
Cohort is set to benefit from an anticipated increase in defence spending. And this doesn’t seem to be a short-term response to heightened political tensions – it looks like it’s here to stay.
Contracts in this industry often come with fixed prices and this means inflation pushing up input costs can make it hard to maintain margins. That’s a risk with this type of business.
Barriers to entry, however, are high and Cohort’s subsidiaries have a lot of specialist expertise. And I think the firm’s size means it has a lot of scope to keep growing for a long time.
Long-term growth
Companies with strong competitive positions in a durable markets can be great growth stocks. And using acquisitions to achieve economies of scale can be a very effective way of doing this.
The reason I own Bunzl and Judges Scientific, rather than Compass and Cohort at the moment is simple. I think the former two have traded at more attractive valuations recently.
Defence stocks – including Cohort – have been soaring recently and Compass has bounced back strongly after the Covid-19 pandemic. So I’m looking to be patient and wait for my opportunity.
