Growth – the Enemy of Value Stocks
4 MINUTES READING TIME
How can growth ever be a bad thing? Like most things in investing, it all depends on the circumstances. Growth is an important ingredient in the recipe of long-term value creation. But just like a single ingredient isn’t enough to make a tasty dish, growth on its own isn’t enough to create value. Other ingredients that are required include:
Why is growth often a bad thing for value stocks? Because these important ingredients are missing in a lot of value stocks. At the same time, most investors want companies to grow their sales and earnings. This combination – poor profitability a lack of suitable reinvestment options and pressure to grow earnings – creates the risk that value stocks will try to grow when they shouldn’t, destroying value in the process.
What is Economic Profitability?
Growth doesn’t appear out of thin air, it requires additional investment in both fixed and working capital.
All potential investments carry an opportunity cost. Imagine that you are the CEO of a company looking to allocate $100 million in retained capital. You could do one more of the following:
Acquire a business
Reinvest in your company
Hold cash or invest in short-term money market securities
Pay a dividend
How would you choose? The sensible way would be to rank each opportunity by its risk-adjusted return over and above a hurdle rate. In other words, you want to invest in opportunities that are economically profitable.
For example, it only makes sense to invest in your company if you are likely to earn a return higher than your shareholders could earn by investing their dividends in the stock market. Of course, you also need to consider the risks of the two options, which will vary with the level of operating and financial leverage.
Reinvestment return can be assessed using one or more measures of profitability, such as:
Return on Assets (ROA)
Return on Equity (ROE)
Return on Invested Capital (ROIC)
The problem for many value stocks is that many of them offer a poor risk-adjusted reinvestment return.
We can illustrate this using Finviz, one of my favourite free stock screening tools. I’ve created a bubble chart of the all the stocks in the S&P 500 ($SPX) with a price-to-book ratio of less than 3 (x-axis) and an ROE greater than -20% (y-axis). There were eight stocks with an ROE < -20%. I excluded these outliers so that we could zoom in on the ROE of cheap $SPX stocks
More than half of the cheap stocks (P/B less than or equal to 3x) currently have a ROE less than 10%. What’s magical about 10%? Its slightly higher than the 9.69% per annum long-term return of the $SPX (according to Jeremy Siegel’s Stocks for the Long Run). The table below shows the breakdown of ROE for cheap stocks in the $SPX.
The percentage of stocks with poor profitability is even higher if you weight stocks by their market capitalization. The larger the bubble, the larger the market capitalization of the stock. As you can see, most of the larger bubbles are currently sitting below an ROE of 10%.bubbles_2107_08949What do these charts tell us? That there are a lot of cheap stocks in the $SPX that are unable to earn a re-investment return that’s better than the long-term market return.
Unless the profitability of these companies improves, any additional investment is likely to DESTROY, not create, value. Investors in these companies would be better off if excess earnings were paid out as dividends. That way, they could re-invest the proceeds at a higher rate of return.
Its also important to remember that being profitable allows a company to grow by using retained earnings. For an unprofitable company to grow, it either has to borrow (reducing future profits by the amount of interest and principal repayments) or raise capital (diluting the returns of existing shareholders).
Means, Motive and Opportunity
Profitability provides the means to fund growth (through retained earnings). But growing shareholder value also requires re-investment opportunities. Otherwise retained profits can be used to:
Build up as cash on the balance sheet (lowering future returns)
Pay dividends (transferring reinvestment risk from the company to the shareholder)
Buy back shares (redistributing retained earnings between current and former shareholders)
None of which will increase the total “owner earnings” generated by the business.
The only way to grow the total pot of earnings is to re-invest. But the risk-adjusted return offered by the investment opportunity need to be equal to or higher than the return currently earned by the business. Otherwise, re-investing will eventually drag the return earned on the company’s assets lower.
Many value companies struggle to find profitable reinvestment opportunities. This may be because they are in an industry that is structural decline. Or it could be because they operate in a cyclical business that is prone to bouts of over-investment, over-capacity and low returns in invested capital.
Pressure to Grow
Company management are often reluctant to accept a no-growth strategy, even if profitability is low and there are few opportunities for re-investment. Worse still, shareholders often push no-growth companies into unsustainable growth strategies. For example, they might be tempted to seek growth through poor acquisitions and product line extensions rather than simply allocating retained earnings to shareholders via dividends.
The results can be disastrous for shareholders. For example, back in 2010 Roben Frazad wrote about Eastman Kodak in Bloomberg Businessweek, pointing out that the company:
blew upward of $15 billion on abortive acquisitions and product development in the 1980s and 1990s as its core film business shrivelled. The whole company is now worth just $1 billion; wouldn’t shareholders have preferred to get some of that $15 billion back?
In summary, growth is a bad idea for many value stocks. Low profitability and poor reinvestment opportunities make it hard for many value stocks to grow shareholder value over time.
This isn’t necessarily a problem. Value stocks can still be very profitable if they’re bought cheaply enough. But as we’ll see in the next part of the series, it’s becoming more and more challenging to find cheap value stocks.