Forum Archive Index - June 2001

["Andrew Smith" <smith5@free.net.nz>]

I found this interesting.

Question: Return on Invested capital(ROIC), is IC the share price less debt?

 Is this not likely to effect companies such as BCH?

 

FOOL ON THE HILL
Three Things to Know About Growth

You need to know three things about growth if you're thinking about investing. First, growth isn't always good. Second, it doesn't make sense to talk about growth and value separately. Third, fast growth can create high risk.

By Richard McCaffery (TMF Gibson)
June 28, 2001

The cheetah, the world's fastest land animal, can run 70 miles per hour. Yet the stress of running this fast drives the animal's body temperature to near-fatal levels, which means the chase ends quickly whether the cheetah gets dinner or not.

The parallel here to the world of investing is growth. Few words are used as often or remain as misunderstood as growth. This is why I hope the cheetah story helps. There are two sides to growth: It's a wonderful thing to see a company growing quickly, but growth comes at a price and isn't the whole story.

Growth creates stress on the enterprise managing it. It creates high expectations for investors. And growth isn't the same thing as value. 

How good is your growth?
Start by wiping the slate clean if you think growth is universally good. Forget what you hear about growth projections, at least for a moment. Like most things in life, growth must be qualified. Growth, like speed, is not an end in itself. For the cheetah, speed is a good thing if it yields dinner, especially one other predators can't catch. For investors, growth is a good thing if it yields increased value. That's the bottom line. As investors, we're looking for growth that adds value.

Unfortunately, the kind of growth we hear about most often -- growth in earnings per share based on Generally Accepted Accounting Principles (GAAP) -- usually doesn't tell us whether a company is creating value or destroying it. We have to dig deeper for this, which is why we spend a lot of time tearing apart financial statements and analyzing cash flows.

See, growth does not equal value. It's just one component of it. The other is a return measure such as return on invested capital (ROIC). (This concept is covered thoroughly in the McKinsey & Co. book, Valuation.) ROIC tells us what kind of return the company is generating from its invested resources -- retained earnings, debt, equity, the whole package. Imagine a company that borrows $100 at a 10% interest for one year to fund a onetime project. If that project yields less than $110 in cash flows or fails to produce some future benefit, then the company has destroyed value. It has taken $110 and turned it into less than $110. We don't give money to companies to watch them do this. 

You can understand the concept of ROIC by expanding this example from a single project to a company as a whole. If a company isn't creating $1 of wealth for every dollar of invested capital, then it's destroying value. You don't want to be invested in a company that takes dollar bills and turns them into $0.90. This isn't creating wealth, it's consuming it, and, unfortunately, it isn't as uncommon as you might think. AT&T (NYSE: T), for example, destroyed a lot of wealth last year. 

Once you put growth and ROIC together, however, you've got the two drivers of value. Find a company that's growing, and that earns a return above the cost of its invested resources (often called the cost of capital) and you have liftoff. That's another way to think about it. ROIC, like an aircraft wing, creates lift, and growth creates thrust.

Growth and value investing nonsense
Therefore, if you think about growth and ROIC as the two components of value, you see how silly it is to use the words "growth" and "value" separately to describe different styles of investing. You think a "value" investor doesn't want the value of their investment to grow? Bill Ruane, manager of the Sequoia Fund, is viewed as a value investor, yet the mean 10-year growth rate of the stocks in his portfolio is about 18%. Ruane wants it all -- companies trading at low prices, earning superior returns, and growing at a healthy pace.

So-called "growth investors," on the other hand, can supposedly ignore the price of a security and look for stocks likely to grow quickly. As we've seen above, however, companies can grow without creating value. How do we know if this is happening? There's only one way to be sure. The company must be mature enough to be profitable. Once a company is generating positive cash flow, investors can examine its profits to determine the return it's generating and the underlying cash value of the business relative to its trading price.

This means that if you buy shares in a company that doesn't have a track record of sustained profitability, well, you've got no idea what kind of value you're getting. All you have is a rough idea of how fast it's growing, and a free-floating stock price attached to hopes and dreams. This isn't enough paint to finish the portrait. Beginning investors can eliminate an entire category of investment mistakes by avoiding unprofitable companies. This means you will miss opportunities. You might not land the next Intel (Nasdaq: INTC), but that's OK. You don't have to own high-profile market leaders to invest successfully.

High growth, high expectations
This brings us to the final point. Very fast growth can lead to high risk. Why does Bill Ruane care about the price he pays for a security if it's generating good ROIC and growing quickly? Because stock prices look into the future. They provide estimates of how much value investors think a company will create. The higher the stock price, the faster the company will have to grow and the longer it will have to earn a superior ROIC. Unfortunately, there are two constants in business: Companies cannot grow at high rates forever, and competition -- over time -- reduces ROIC.

So we must be realistic, even skeptical, when thinking about stock prices. The better the company, the more likely people have high hopes for its future. Of course we must invest in high-quality companies to make money in the stock market, but high-quality companies are often priced to very speculative levels.

In The Intelligent Investor, Ben Graham writes about the volatile history of the Great Atlantic and Pacific Tea Co. (NYSE: GAP). In 1938, eight years after the company went public, it sold for just 12 times its five-year average earnings. By 1961, after years of growth, it sold for about 30 times earnings, far above the multiple of 23 for the Dow Jones that year. The expectation of fast growth burdened the company with a multiple it couldn't live up to, and the stock fell to $18 from $70.

"There are two chief morals to the story," Graham writes. "The first is that the stock market often goes far wrong, and sometimes an alert and courageous investor can take advantage of its patent errors. The other is that most businesses change in character and quality over the years, sometimes for the better, perhaps more often for the worse."

So, don't be confused by growth. Keep on the lookout for the better companies, which create value, and guard against the worse, which only promise it.

Regards
Andrew