Nov 23, 2007|
How good is 'good' growth?
'Growth benefits investors only when the business in point can invest at incremental returns that are enticing - in other words, only when each dollar used to finance the growth creates greater than a dollar of long term market value.' These words of the legendry investor Warren Buffet in his 1992 letters to shareholders of Berkshire Hathaway explains the importance of the nature of growth to the shareholders of the company.
In times as these when stocks, especially the heavyweights, are accorded valuations that are fundamentally unjustifiable by all means, investors try to reason them with the logic of 'higher multiples' for 'better' growth prospects. However, how 'good' is good and what makes it better is left unarticulated.
An investor likes to see his company grow because, if profits grow, so should his returns. The important thing for the investor, however, is whether the company increases the returns to its shareholders. A company that grows, at the expense of shareholder returns, is not really a good long-term investment. As Warren Buffet said in 1977 - 'Since businesses customarily add from year to year to their equity base, we find nothing particularly noteworthy in a management performance combining, say, a 10% increase in equity capital and a 5% increase in earnings per share.'
Does past reflect the future?
Although a consistent record of increases in earnings per share (EPS) is not of itself an absolute predictor of either further increases, or the rate of any increases, the same nonetheless is a factor worthy of consideration. In addition, it is logical to conclude that a company that has had regular and consistent increases in EPS over a protracted period is soundly managed. EPS growth and its ability to keep well ahead of inflation were some of the key factors in the investment strategies of Warren Buffet. Consistency in earnings growth without diluting the quality of the balance sheet (by over-leveraging) and return to shareholders are indicators of a soundly managed company with little susceptibility to cost pressures, commodity cycles and economic variables. This leads to predictability of future earnings and cash flows.
On the other hand, for a company whose earnings fluctuate and have a strong correlation to dynamic variables, future cash flows are less predictable. Further, the volatile earnings may also be due to poor and shortsighted management, cyclical products and weak pricing power.
In case of companies where the 'earnings power' is enhanced due to larger order book size or increased capacity, the same needs to be factored in, not without considering the execution risks. The case in point can be leading companies from the capital goods space, which have enjoyed high P/E multiples over the last 2-3 fiscals due to heavy accretion to their order books. So is the case with leading companies from the construction, retailing and media spaces that enjoy premium on the premise of exponential future growth prospects. However, what investors need to understand is that for a construction company to continue to command a P/E multiple of say 100 times going forward, the long term average growth in the earnings of the company should be 100% or if the company does not grow its current earnings then it will take 100 years for the investors to get back their money!
Average P/E ratio
Source: Equitymaster database
The compounding effect
Regular growth in earnings per share can have a compounding effect if all, or most of the profits are retained and reinvested for productive purposes. Of course, if the investor can do better with retained earnings than the company can, then his or her interests are better served by a full distribution of profits. Thus the compounded growth of the company should in effect deliver higher returns to the shareholders and not otherwise.
Having said that, while a temporary dip in margins and share prices could offer attractive buying opportunities to investors, provided the basic fundamentals of the company remain unchanged, it is necessary to identify whether there is something permanently wrong, or whether the problem has been isolated and resolved. Thus, it is pertinent for the investor to not just identify companies with good growth prospects but also evaluate the nature, susceptibility and sustainability of such growth.
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