Rapid
growth in revenue and earnings may be top priorities in corporate boardrooms,
but these priorities are not always best for shareholders. We are often tempted
to invest large amounts in risky or even mature companies that are beating the
drum for fast growth, but investors should check that a company's growth
ambitions are realistic and sustainable.
Growth's Attraction
Let's face
it, it's hard not to be thrilled by the prospect of growth. We invest in growth stocks because we believe that these
companies are able to take shareholder money and reinvest it for a return that is higher
than what we can get elsewhere.
Besides, in traditional investing wisdom, growth in sales earnings and stock performance are inexorably linked. In his book "One Up on Wall Street," investment guru Peter Lynch preaches that stock prices follow corporate earnings over time. The idea has stuck because many investors look far and wide for the fastest-growing companies that will produce the greatest share-price appreciation.
Besides, in traditional investing wisdom, growth in sales earnings and stock performance are inexorably linked. In his book "One Up on Wall Street," investment guru Peter Lynch preaches that stock prices follow corporate earnings over time. The idea has stuck because many investors look far and wide for the fastest-growing companies that will produce the greatest share-price appreciation.
Is
Growth a Sure Thing?
That said,
there is room to debate this rule of thumb. In a 2002 study of more than 2,000
public companies, California State University finance professor Cyrus Ramezani
analyzed the relationship between growth and shareholder value. His surprising
conclusion was that the companies with the fastest revenue growth (average
annual sales growth of 167% over a 10-year period) showed, over the period
studied, worse share price performance than slower growing firms (average
growth of 26%). In other words, the hotshot companies could not maintain their
growth rates, and their stocks suffered.
The Risks
The Risks
Fast growth
looks good, but companies can get into trouble when they grow too fast. Are
they able to keep pace with their expansion, fill orders, hire and train enough
qualified employees? The rush to boost sales can leave growing companies with a
deepening difficulty to obtain their cash needs from operations. Risky,
fast-growing startups can burn money for years before generating a positive cash flow. The higher the rate of spending money for
growth, the greater the company's odds of later being forced to seek more
capital. When extra capital is not available, big trouble is brewing for these
companies and their investors.
Being Realistic About Growth
Being Realistic About Growth
Eventually
every fast-growth industry becomes a slow-growth industry. Some companies,
however, still pursue expansion long after growth opportunities have dried up.
When managers ignore the option of offering investors dividends and
stubbornly continue to pour earnings into expansions that generate returns
lower than those of the market, bad news is on the horizon for investors.
For
example, take McDonald's - as it experienced its first-ever losses in 2003, and
its share price
neared a
10-year low, the company finally began to admit that it was no longer a growth
stock. But for several years beforehand, McDonald's had shrugged off shrinking
profits and analysts' arguments that the world's biggest fast-food chain had
saturated its market. Unwilling to give up on growth, McDonald's accelerated
its rate of restaurant openings and advertising spending. Expansion not only
eroded profits but ate up a huge chunk of the company's cash flow, which could
have gone to investors as large dividends.
CEOs and managers have a duty to put the brakes on growth when it is unsustainable or incapable of creating value. That can be tough since CEOs normally want to build empires rather than maintain them. At the same time, management compensation at many companies is tied to growth in revenue and earnings.
However, CEO pride doesn't explain everything: the investing system favors growth. Market analysts rate a stock according to its ability to expand; accelerating growth receives the highest rating. Furthermore, tax rules privilege growth since capital gains are taxed in a lower tax bracket while dividends face higher income-tax rates.
The Bottom Line
CEOs and managers have a duty to put the brakes on growth when it is unsustainable or incapable of creating value. That can be tough since CEOs normally want to build empires rather than maintain them. At the same time, management compensation at many companies is tied to growth in revenue and earnings.
However, CEO pride doesn't explain everything: the investing system favors growth. Market analysts rate a stock according to its ability to expand; accelerating growth receives the highest rating. Furthermore, tax rules privilege growth since capital gains are taxed in a lower tax bracket while dividends face higher income-tax rates.
The Bottom Line
Justifications
for fast growth can quickly pile up, even when it isn't the most prudent of
priorities. Companies that pursue growth at the cost of sustaining themselves
may do more harm than good. When evaluating companies with aggressive growth
policies, investors need to determine carefully whether these policies have higher
drawbacks than benefits.
by Ben McClure
No comments:
Post a Comment