I know it sounds absurd. Technically speaking, one should always seek out a business that is going to grow in the future (whether you’re a value investor or not). There is a difference between businesses that are profitable and those that create wealth for shareholders. Of course, investors are usually looking for companies that will be larger at some point in the future than they are today. Even value investors may require some amount of future growth to justify a potential investment. But experienced investors have learned the hard way that a growth-at-all-costs mentality can be a major negative for shareholders. We must avoid this pitfall – which may be easier said than done. Main stream media and Wall Street tend to hype growth which it makes it all that much harder to ignore.
High growth names can be very tempting in that they offer potentially high rewards. Just to be clear, not all growth is negative. However, there is a segment of growth that ultimately destroys wealth, not creates it. This is a tricky concept for new investors to grasp. It is fairly basic to understand that a company which grows its revenue at a fast pace, but that isn’t able to generate profits is eventually losing proposition. What is much more difficult to digest is that even though a company may be generating bottom line profits, it may actually be destroying shareholder wealth. How is this possible?
This is explained by the difference between return on capital and cost of capital. Return on capital is a fairly basic calculation of after-tax operating earnings divided by invested capital. The cost of capital is simply the opportunity cost for the use of a company’s capital. This applies to both debt and equity financing. In academic terms it is defined as the weighted average cost of capital or WACC. The cost of debt financing is easily determined by taking the average fixed interest charge on all debt outstanding. Arriving at the cost of equity is more difficult because there is no stated charge. Some investors choose to ignore the equity charge all together – which is a mistake. An equity cost of capital can be estimated, however, it is an inexact science. Generally speaking, the greater the perceived risk of the company - the higher the cost of equity.
How does a company create value? The Return on capital must exceed the cost of capital on a sustained basis. For example, if a company can sustain a 15% return on capital with a 10% cost of capital, wealth is created. However, if it can only sustain a 7% return on capital wealth is destroyed. So that a company that is profitable may not always create wealth for its shareholders. If company’s management pursues aggressive growth on low ROC endeavors, eventually it will suffer the consequence. It has been my experience that many company managers don’t understand this basic concept – but all investors should.
