I often read arguments about which is better, investing in growth or value stocks. Unfortunately much of what is written on the subject is simply wrong. By definition, value stock
s have low market to book ratios and growth stocks often have high market to book ratios.
However, there isn’t a lot of difference in the sales growth rates between growth and value because sales growth isn’t what defines them.
The defining factor is in their return on invested capital (see here by Jiang Koller 2007). The process is simple, firms with great opportunities to invest at above average rates of return (high ROIC), receive capital, invest and grow. So why don’t growth companies have more sales growth than value companies? Because many high ROIC firms don’t have attractive places to invest capital and many low ROIC firms don’t need outside capital to continue to grow.
Bennett Stewart in his book “The Quest for Value” defined firms into three basic categories, X firms had returns near the cost of capital, Y firms had returns above the cost of capital but had limited options for investing capital, Z firms also had returns above the cost of capital but had many options for investing capital and grew quickly. Stewart also said there were X-minus firms that didn’t earn the cost of capital and pre-Z firms that grew quickly on outside capital with the thought they’d have a Z level of ROIC later. I like this approach to classifying firms – it is clearer about the status of the business and adds clarity to strategy.
| Return on Capital | Opportunities | |
| X-Minus | Below Cost | N/A |
| X | Near Cost | N/A |
| Y | Above Cost | Limited |
| Pre-Z | Below Cost | Many |
| Z | Above Cost | Many |
X and X-minus, Low ROIC
Firms with returns equal to the cost of capital (and even less than the cost of capital) or “X and X-minus“ can still have sales growth, but they won’t get the high valuations (market to book ratio) of the high ROIC firms. These firms grow because they retain earnings, which even if low, they can reinvest in the company. With low interest rates, firms can borrow to continue to grow. A CFO I once met said that as long as he could borrow at 4% and invest at 7% he was going to continue. The market cost of capital is higher than the bank cost of capital and consequently the firms stock price took a nose dive (although the bankers LOVED him).
Theoretically the right choice for these firms would be to return capital to the investors so that it could be invested at higher rates of return. However, CEO’s and CFO’s rarely think that they should return capital, and it is often the board or an activist that pushes the issue. This is the agency problem, where management and shareholders aren’t always on the same page. Management incentive programs have to be carefully drawn to balance growth and return to shareholders. Too much on sales or profit growth, then the capital becomes “stuck” in low performing investments. Too much on return to shareholders and the management team underinvests and damages the firm long term.
X and X-minus firms shouldn’t grow, but they do by retaining cash and investing in projects that generate weak returns.
“Y” Firms – High ROIC, Constrained by Operations
Most firms with good ROICs that are constrained by other the factors are called Y” firms by Stewart. The firms have good returns on capital but are limited in how fast they can invest. My rule of thumb on retailers was that sustained unit growth rates above 25% always and everywhere resulted in a blowout. Over a 15 year period every retailer who grew at this rate, blew up. Eventually the growth retailer I was with that grew at over 25% a year for 7 years blew up too. The causes of the blow ups vary, but usually it was a lack of talented staff, poor controls or the firm continued to grow after returns declined. All problems that could be foreseen.
Growing at 25% a year for a retailer means opening a lot of new locations, and you need to locate, hire and train a staff. Growing during a downturn when good talent was being laid off helped ease some of the hiring pressure. Although central office and distribution staff grew at a fraction of the sales growth rate, every year staff count would need to grow at 15% or better to keep up.
Growing fast also stresses controls. Ebay used to reorganize 3-4 times a year because as the company grows, the management challenges, controls and processes have to be updated. Nothing is static. What you could get by with at $100m in sales won’t work at $200m in sales.
If you are successful managing the growth, the best markets will eventually be addressed and you reach the point of diminishing returns where further investment turns the above average returns to average returns. (See here for a recent discussion of this same phenomena by Fisher, Gaur and Kleinberger). Niche retailers run into this but also big firms such as Wal-Mart, Home Depot and Best Buy. (This was a great source of short ideas, as there is nothing like a management team with their foot mashed on the growth gas pedal while new store returns are tanking.)
A great deal of consumer product firms are constrained by opportunity. They cannot further invest at similar ROIC levels. New strategies (panini’s at Starbucks?) often decrease profit rate and require large investments in process and product that don’t generate a solid return.
A lot of auditing and consulting firms are extremely profitable, but as long as they can capture new clients at full rates. You can follow a low price strategy, but in the end, you end up with low priced customers and low returns of capital.
Growth can destroy shareholder value – that is what I call dumb growth. Capital allocation requires discipline and a set of metrics and standards that are appropriate to the strategy. Investments must earn their cost of capital. But there are often strategies that offer lower (but still above average) ROIC’s, that should be explored. The Ansoff Matrix I mentioned earlier can be of help looking for opportunities.
“Z” Firms Grow Fast
A great deal of internet software and services qualifies as “Z”, above average returns, with lots of above average places to invest capital. Sales growth is a function of reinvesting profits and raising outside capital. This was perhaps captured best by the HBR article in 1996 by W. Brian Arthur “Increasing Returns and the New World of Business”, where he outlines the shift from decreasing returns on capital (like a retail chain that over expands) and increasing return on capital (the internet) where more users increase the value of the product.
A firm with attractive places to invest capital and is unconstrained will grow quickly. Ebay grew over 60% for a dozen years, although they’ve grown 5% over the past five years. Eventually that happens to every “Z” firm, they reach diminishing returns (yes, even Facebook) and growth slows.
“Pre-Z” Fast Growth and Low ROIC
There are a few pre-Z’s that have gone public, Snapchat lost $520m in 2016, and $380m in 2015. Revenue in 2016 was less than “cost of revenue”, so the customers paid actually less than it cost to deliver the service. They are growing fast, and losing money fast. Maybe Snapchat’s numbers improve although usually great growth companies make money right away.
Amazon has survived for years where the return on capital has been paltry, with the thought at some time it will turn for the better (and perhaps it has). Amazon’s operating profit from 2011-2015 totaled to $3.8b (no interest, no taxes) but the asset investment has grown $35.7b. In 2016 operating profits were $4.2b, more than previous four years added together. Amazon continues to invest to grow market share, and as long as they’ve got the cash and a 185x p/e they can continue.
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Dr. John Zott is the CFO for Carlson Wireless Technologies, and Principal consultant at Bates Creek Consulting. John is the chair of the Careers Committee at FEI Silicon Valley, a senior adjunct professor at Golden Gate University and comments regularly on issues that affect consumer businesses. If you are a former student, colleague or would just like to connect – reach out.