The cost of growing

Summary: Growth is the number markets love most, but this editorial argues it tells you little until you ask what it costs to produce. Using Buffett’s candy-company example, it makes the case that the best businesses for shareholders are often the dullest ones, and it points to the cover story for how to find them among Indian stocks.

Whether it’s a child or a city or a number on the screen, we have this reflex of always thinking of growth as something good, as proof of health. Stock markets operate on this assumption, and I feel it is even more so in India. The story that sells a stock most easily is always about how large the company will become and how quickly. Since almost every market participant believes this, it often becomes a self-fulfilling prophecy, at least for a while.

The problem is that growth alone tells us almost nothing. It’s an incomplete number until we also look at the cost of that growth – the amount of money needed to drive it. One business can grow rapidly and need little or no capital. Another can grow at the same pace but need more and more investment everywhere to keep the line pointing up. In the first, shareholders get richer; in the second, they’re happy for a while.

Warren Buffett demonstrated this by dividing businesses into three kinds: the great, the good and the gruesome. Surprisingly, many of the ones that were best for shareholders grew the least. His favourite example is See’s Candies, which hardly grew over decades, generated steady, healthy profits and required almost no additional capital. The numbers are almost unbelievable. Do read the cover story carefully for details of this miracle investment. In contrast, the exciting ones grew quickly, often because their industries grew quickly. Many of these companies failed, some more than once. You can see the same thing in many Indian industries, airlines, for example.

The attraction is hard to resist because of the growth-is-good wiring in our brains. The favoured industries keep shifting, from airlines to infrastructure to e-commerce to EVs and then to something else, but the lure of growth stays the same. Investors come to believe that for companies growing very fast, the normal rules don’t apply, but they always do.

So for investors, the first question about a business isn’t an exciting one like how fast it grows, but a dull one like what the growth actually costs. Watching the top line or the daily price is much more exciting (and easier) but won’t do anything for your investments.

This is why I’ve long disliked companies whose stocks are bought based on what might happen one day in the future rather than what is happening today. I’ve lost count of how many times I have warned my readers against ‘digital’ stocks that have never made money. It’s nice to hear pleasant promises, but cash already in the bank is much nicer.

I hope all this does not leave you with the impression that I see growth as an enemy, because that’s far from what I’m saying. The message is very simple: growth is great if it pays its own way. If it needs a constant subsidy from shareholders, then it’s not really growth at all.

There’s actually a big problem here for those of us who like to identify small caps that will become great businesses. This is where you make real discoveries. But it’s also the hardest place to distinguish future gems from empty, expensive promises. Managers of high-cost growth companies will always say this is just a phase that will pass, and, to be fair, for some companies it does. Real investing, the kind that takes skill and effort but gives big payoffs, is mostly done at this end of the market. It’s done not by reacting emotionally to high growth, but by looking at businesses with a cool head and a willingness to reject stocks.

This is what makes investing both difficult and rewarding. Our cover story, Good Stocks. Fair Prices, explains the three kinds of businesses and shows how to spot each of them among Indian stocks using Value Research Stock Ratings.