Home / Growth / Three ‘fortress’ growth stocks for volatile times

Turbulent markets make it timely to review three growth businesses that boast strong free cash flow and robust balance sheets for volatile times, writes Francyne Mu, portfolio manager at Franklin Equity Group.

The economist and speculator John Maynard Keynes once famously quipped, “Markets can stay irrational longer than you can stay solvent.”

This same principle can hold as true for companies as it does for speculators. Today, inflation and its resulting capital market dynamics have created a less forgiving funding environment, and one result has been a violent sell-off of growth stocks.

However, not all growth stocks require access to capital, and we believe that much of the market has, to a great degree, thrown the proverbial baby out with the bathwater by shunning growth companies indiscriminately. In fact, to the contrary, there are many growing businesses that enjoy strong free cash flow and robust balance sheets.

In this article, I’ll review three companies that continue to benefit from strong fundamental growth drivers and boast both strong balance sheets and enviable free cash flow dynamics.

Tyler Technologies: Municipal service supports healthy recurring cash flow

Tyler Technologies is an American company that provides software and technology solutions to the public sector, including local governments, schools and courts. The company offers a range of products and services spanning financial management, property appraisal, tax assessment, court management, and school administration software.

Because its software offerings provide mission-critical services, the company has earned a sticky customer base with a high degree of customer lock-in. This allows for strong revenue visibility, with recurring revenues at about 80 per cent, up from about 55 per cent in 2010. This has been driven in part by the switch from a perpetual license to the much more profitable cloud-based SaaS delivery model.

In addition to strong customer relationships, the company generates strong free cash flow while continuing to innovate within its market. Historical cash flow margins have averaged over 20 per cent.  The company has generated cumulative free cash flow of $1.2 billion over the last five years, relative to about $200 million in capex spend for growth. A debt-light balance sheet further insulates the company from the need to access the capital markets.

We believe Tyler will be able to maintain and even grow its competitive position by leveraging its strong relationships within the public sector channel to take additional share in what is a $12 billion-$15 billion addressable market. We also note that this growth could be accelerated by further stock market dislocations that create attractive acquisition opportunities.

Synopsys Inc.: Integrated into the future of computing

Synopsys Inc. provides technology solutions for the design, verification and manufacturing of electronic systems and components. The company’s products and services are used by companies in the semiconductor, computer and electronic systems industries to design and test their products.

Decades of accumulated expertise in the development of cutting-edge semiconductor design and electronic design automation technologies means the company’s businesses have both high barriers to entry and high customer switching costs. The company’s strong business model results in robust operating cash flow. Full-year 2022 free-cash-flow margin was over 30 per cent at about US$1.6 billion. In addition, Synopsys commands a fortress balance sheet with $1.4 billion of cash on hand against only $600 million of long-term liabilities.

We see the company as positioned to benefit from the increasing growth for connected devices, the internet of things (IOT). Furthermore, Synopsys is well placed to help the semiconductor industry deliver scalable solutions to the rapidly expanding enterprise and consumer demand for artificial intelligence (AI) – think ChatGPT – through custom chip designs.  

Humana Inc.: Scaled healthcare delivery

Humana Inc. is an American for-profit health insurance company based in Louisville, Kentucky. It is one of the largest health insurance companies in the United States and has operations in all 50 states. The company offers a range of health insurance plans, including Medicare Advantage and Medicaid plans, as well as individual and group health insurance plans. The company also operates a number of health care centres and clinics and has a growing presence in the telehealth market.

We believe Humana has a sustainable competitive advantage in the fast-growing Medicare Advantage market, which caters for an older population cohort. Humana is the second largest Medicare Advantage plan provider, serving over 5 million beneficiaries. It has been growing this business at over 10 per cent since 2017, well ahead of the overall market, which itself is poised for continued growth as Medicare eligibility increases. The company’s strong business position has underwritten attractive returns of capital to investors over recent years through a combination of share buybacks and dividends.

Looking forward, our analysis indicates that the company’s Medicare business will continue to support robust free cash flow over the medium term. This, in combination with its balance sheet which boasts strong cash coverage ratios, should hold the company in good stead to weather any economic turbulence in the years ahead.

Free cash flow and growth can go hand in hand

With high-flying corporate failures dominating the headlines, it can be easy to forget that growth and healthy cash flows are not mutually exclusive. Our experience as investors has demonstrated that strong business models can and do align with secular growth trends to create profoundly profitable businesses which can grow independent of the vicissitudes of capital markets and, to a degree, the economy at large.

We are encouraged by the market’s current opportunity set, which we see as offering many high-quality businesses at attractive valuations.