Growth that goes nowhere

Summary: Fast growth can be one of the most powerful signs of a successful business, but it does not always translate into wealth for shareholders. This story looks at the overlooked difference between companies that grow meaningfully and those that simply get bigger.

In any workplace, there is a hyperbusy person who gets nothing done. We’ve all met this person, and some of us might even be them! They are always busy; their days are always full; they go to a lot of meetings and as time passes, they get busier and busier. However, when it comes to actual accomplishments (projects delivered, goals achieved), the list is always short. Such people are always in motion but not getting anywhere.

What is interesting today is that this isn’t true only of people, but also of many companies. I’m not talking about businesses that fake success for IPOs, etc but those that are genuine. These are the ones that really grow revenues and profits rapidly but, paradoxically, bring no great benefit to shareholders in terms of actual money made. To fund all that growth, the company holds back money that might otherwise reach the owners. If the returns generated by the funds deployed within the company are less than what the owners might have gotten elsewhere, then that growth does not make anyone richer.

So what I’m describing here is high growth in a business which is useless for investors. This will sound strange to most of you. The entire world of business and investing worships growth, and yet here I am trying to convince you that growth can be bad. Your instinct is correct: most of the time, on average, companies that grow faster are the winners and their shareholders make lots of money. However, this general trend conceals many exceptions. Within the set of fast growers, many companies grow just as fast but deliver poor returns for shareholders.

The single number that growth-obsessed investors focus on, the headline growth rate, cannot be used to distinguish between these two types of companies. What separates the two types of businesses is not how fast they grow but what it costs to generate that growth. A business that can add a rupee of profit by spending 50 paise more will make its shareholders richer, but the one which needs to spend 90 paise to add a rupee of profit is just round-tripping money through its books without creating any wealth.

Over the years, a constant underlying theme in my writing has been that bad investments that have some characteristics of good ones are far more dangerous than outright bad ones. High-growth companies that don’t generate returns for shareholders are a particularly severe case of this problem because growth is such a strong signal of a good business, and it makes for dramatic, attention-grabbing headlines. In contrast, the return that a company earns on capital is a dull detail that will be buried somewhere deep and will have to be dug out by a determined analyst.

As we’ve seen earlier, good investors think of growth and value as two sides of the same coin, not opposing philosophies. Growth adds to a business’s intrinsic value only when it exceeds a certain level of capital efficiency. This sounds like an academic or a PowerPoint kind of idea until you realise how much money has been wasted (or even lost) by ignoring it.

I’m not making a point against growth investing. Growth investing works, and most of the time it works well. My point is that looking at a single number and thinking that you have a case for investing is a mistake that growth investors are more prone to. High growth becomes a mental shortcut that bypasses the work of observing and understanding what is going on in a business.

This month’s cover story is about distinguishing the two kinds of growth: the one which will make money for you versus the one which just keeps a company occupied with more and more activity that does nothing for you. It’s not something talked about often, and I’m sure it will be useful for all our readers.

Also read: A fall is not a loss