It’s time to buy the best beaten-down stocks in tech and elsewhere, and this winning fund manager shows you how

‘Grow right through’ rate increases

Tech companies are down in large part because of worries about rising interest rates. That increases the discount rate in valuation models, which lowers estimated net present values. Armbruster acknowledges the challenge, but downplays it as a meaningful issue for tech over the medium term.

“Whether the fed funds rate is 1% or 2.5% is not going to affect their ability to grow unless it slows down the economy,” he says. “We have had interest rate hike cycles in the past and the very best tech companies grow right through them.”

The key is to be in the right tech companies, and this is where things get complicated. Fortunately for us, Armbruster took the time recently to share with us the key qualities he looks for in tech and other sectors, below.

Big picture, you want to be in companies that have competitive strengths to fend off rivals and maintain their long-term growth potential.

This will remain a source of doubt among many investors looking at tech for two reasons, beyond interest rates.

1. The pandemic pulled forward a lot of demand. That will hurt the cadence of growth over the next couple of quarters, and that will make investors nervous.

2. The best tech companies will continue to invest in their businesses, as they should. This creates uncertainty about their path to profitability. “These uncertainties are going to weigh on the multiples until we get a trend line of growth that people can model.” But they aren’t long-term issues.

The bottom line: Take advantage of the confusion to pick up the companies that look like winners because they have the following characteristics.

The five most important characteristics

Armbruster says buying names with the following five qualities has helped him build his record of outperformance. Besides tech, the list includes companies from other sectors, as examples, but most of them are in tech. You can consider picking some of these up on your own, or just buying Armbruster’s fund for broader exposure to these qualities.

1. High switching costs: This helps investors because it locks in customers and revenue. This quality is often found in software companies. “Once you go through the process of implementing the software, especially at the enterprise level, the inertia is very high, as long as the product is still good,” says Armbruster.

For this to really pay off in software, the company has to have upgrades and additional add-on modules and products to sell to customers. He cites Workday WDAY, +3.53% in human resources and finance cloud apps, and Datadog DDOG, +5.82% in security monitoring and analytics, as examples in his portfolio. Another example is Okta OKTA, +8.30% in identity management software. Once it’s part of all of a customers’ apps, it’s a headache to switch.

High switching costs can crop up in a lot of sectors. For instance, you can look for situations where a service is embedded in a business process. Here he cites the credit score company Equifax EFX, +0.71%, from his holdings. “The credit score is engrained into the credit decision process,” he says. You can also find switching costs in industry, when a company’s product gets designed in to its customer’s product. Since a redesign can be expensive, switching costs are elevated. Amphenol APH, +1.08% in electronic and fiber optic connectors and cables is an example.

2. Scale advantage: Bigger is better if it brings down costs and enhances clout. An obvious example is Amazon.com AMZN, +2.55%, which has built a huge competitive advantage in its extensive fulfillment network. “The secret sauce has always been fulfillment and the scale advantage here,” says Armbruster.

But here’s one you may not know about: SiteOne Landscape Supply SITE, +0.60%, a wholesale distributor of landscape supplies to residential and commercial landscape businesses. SiteOne is five times the size of the next largest player. “That scale allows them to buy materials at lower cost and fulfill demand better than local players,” says Armbruster. It also creates the financial strength to build out a digital ordering and delivery service that smaller companies cannot provide. SiteOne is growing by purchasing smaller local competitors, in what is still a highly fragmented business. A similar holding, Pool POOL, +2.58% takes the same approach in the pool supply and equipment business.

3. Strong brands: Brand power gives companies pricing power, and it helps lower customer acquisition costs. Here, Armbruster cites Monster Beverage MNST, +2.95%. Coca-Cola KO, +0.02%, Pepsi PEP, +1.15% and others have come out with good competing energy drinks. But Monster has defended its market share because it’s done a good job of cultivating its brand.

4. Sustainably differentiated business models: “Differentiated” can be tough to define, but you know it when you see it. From the outside, New York-based Signature Bank SBNY, -1.18% looks like just another bank. But when you study it, you notice something different.

Instead of growing by acquisition, which is typical of regional banks, Signature attracts and retains top banking talent by offering an entrepreneurial setting. Pay is tightly linked to performance. “Signature Bank incentivizes them more, and this creates highly productive teams. They attract an incredible level of banking talent and they stay because their compensation is driven by their performance. It is very differentiated model,” says Armbruster.

Global-E Online GLBE, +5.96%, another example, helps companies launch their e-commerce efforts in foreign countries, no easy task to do on your own because of language and cultural differences. Global-E Online helps with everything from websites, to delivery and customer support. Customers include LVMH Moët Hennessy Louis Vuitton LVMUY, +2.02%. Global-E Online helps partner Shopify SHOP, +18.65% expand its international reach. “The service they provide is differentiated and hard to replicate,” says Armbruster.

5. The network effect: This is a classic quality that helps create protective moats. Basically, it means the more people there are using a service the better it gets. Like Amazon.com, the Latin American e-commerce company MercadoLibre MELI, +3.17% is a good example, because the platform gets more valuable as more buyers and sellers join.

Don’t do this

Besides knowing what to buy, you also have to know what to sell. Here, Armbruster follows a basic rule that many growth company investors use. Add to your winners and cut your losers fast, when the fundamentals break down. “We don’t like to dollar-cost average down. It is hard to do in growth names because there is a lot of room for a growth company to fall before the value investors get in,” says Armbruster.

This approach among growth investors explains why stocks fall so hard and fast when they miss revenue or earnings growth targets by even a small amount. But there are exceptions. The challenge is to figure out whether the hiccup is part of a longer-term issue or a fixable problem.

For example, Virtus KAR Mid-Cap Growth Fund holding DocuSign DOCU, +9.45% recently blew up after it missed estimates. Growth was so hot at the company for two years that the company got complacent. “Their sales team did not have to prospect; they just had to pick of up the phone. It seems like they got over-confident,” says Armbruster. “When the phone stopped ringing, they did not have a sales pipeline to reinvigorate the sales rate.”

But DocuSign’s competitive strengths remain, and it can get the sales efforts back on track. So Armbruster is staying with the position. “Digital signatures seem easy but the regulatory hurdles are high. So their competitive position is intact, and the value of digital signature is there,” he says.

Michael Brush is a columnist for MarketWatch. At the time of publication, he owned AMZN, MELI and DOCU. Brush has suggested WDAY, AMZN, and KO in his stock newsletter, Brush Up on Stocks. Follow him on Twitter @mbrushstocks.