How much growth should we expect from publicly traded companies? Probably not as much as they hope.
In chapter 27 of "More Than You Know: Finding Financial Wisdom in Unconventional Places," Michael Mauboussin dug into some of the issues affecting growth rates and expectations.
First, he noted that growth is considered an “absolute good” by managers and investors alike. Managers use growth and its metaphors to inspire employees and impress their shareholders. Growth investors look for companies promising quick and sustainable sales and earnings increases.
As we might expect after a statement like that, there is a “but” coming, and Mauboussin expressed it this way: “But most investors do not intuitively understand the power, and onus, of compounding.” After noting the power of compounding—Albert Einstein famously called it the “eighth wonder of the world”—he followed up by saying that the challenge for investors is to make compounding work for them, and not against them.
Turning to promises and performance, the author reported on research by Chris Zook. In his book, “Profit from the Core,” Zook created a sample of 1,800 companies operating in the 1990s, all of them with sales of $500 million or more. There were three modest hurdles for growth:
- 5.5% inflation-adjusted sales growth.
- 5.5% real earnings growth.
- Total shareholder returns that were greater than the cost of capital.
As Mauboussin observed, these targets are well below the goals of most strategic plans. Indeed, two-thirds of those companies planned for double-digit (nominal) growth rates.
For most companies, double-digit goals turned out to be castles in the air. Only 27% managed to get over the first hurdle, sales growth. And only 12.5%, one in eight, was able to get over all three hurdles—and this was the 1990s, a decade of exceptionally strong economic growth.
Mauboussin followed with his own study, using a sample of companies operating in the decade between 1997 and 2006, and again with annual revenues of at least $500 million. Projections of the growth rate, the expectation, averaged 13.4% per year. The reality turned out to be 6.2%, and that was a conservative estimate (for organic growth) since acquisitions were not factored into the data.
He observed, “As companies get larger, sustaining double-digit rates becomes very difficult. So if past is prologue, the expected growth rates for many companies will have to come down.”
Still, he wanted to make a distinction here: In a distribution of company sizes or city sizes, scientists have learned that average growth rates are not a function of size, but the growth rate variance declines with size. Presumably, there is less variation in growth rates among larger companies and more variation in growth rates among smaller ones.
That appears to be borne out with this chart from the author. An explanation follows:
This chart shows the 10-year compounded annual sales growth rate for more than 2,600 American companies. It shows that average growth rates for small and large companies are about the same, and there is a lower probability that a large company will grow or shrink as fast as a small company.
The author added, “Investors often call this the law of large numbers—big companies can’t grow as fast as small companies—but it’s more accurate to say that big company growth doesn’t vary much from the average growth rate.”
Does all of this make companies with high expectations poor investments? No, said Mauboussin:
“Nothing could be further from the truth! The problem is that while we know that some companies will grow rapidly in the future, spurring upside revisions and attractive shareholder returns, we have no systematic way to identify those companies. Therein lies a great opportunity.”
In his book, “Stocks for the Long Run,” Jeremy Siegel analyzed a group of leading growth stocks in the early 1970s, the “Nifty Fifty”. All 50 were expected to generate high growth rates and all had price-earnings multiples of more than 40.
Siegel asked if these stocks had been overvalued in 1972 since stocks in the group fell deeply during the bear market of 1973-74. In his analysis, he found that some companies did far better than the market (Philip Morris PM, Gillette and Coca-Cola KO), while others did worse (Burroughs, Polaroid and Black & Decker SWK). Importantly, as a group, they delivered a return that was consistent with that of the overall market, and “on average the P/E was just about right.”
The idea that there is a gap between expectations and reality will come as no surprise. But Mauboussin wanted to add that the situation had worsened in recent years because of the “earnings expectations game,” which he described as: “Executives work to meet or beat Wall Street’s forecasts, which encourages analysts to increase their expectations, and compels the executives to deliver even more growth—by whatever means possible.”
He concluded:
“Investors and managers must have reasonable expectations. The evidence shows that sustaining rapid growth is very difficult, especially for large corporations. Furthermore, while there is nothing wrong with growth stocks, the indications are that it is very difficult to know which companies will exceed expectations and which will disappoint. Investors should continue to focus on investment ideas where the expected value is favorable—where the upside opportunity outstrips the downside risk.”
Conclusion
It’s a good idea for investors to look for companies that are growing, but they should keep their expectations in check. Many of the companies they’re buying for their expected growth profile will disappoint and fail to compound growth as much as expected.
One of the basic messages here is that companies, large companies in particular, will find it hard to sustain aggressive growth rates. But in assessing corporate growth rates, look to the variance rather than the capitalization of the company as the source of dampened growth.
Finally, there’s wise advice in Mauboussin’s final sentence of the chapter, which I will repeat here for emphasis, “Investors should continue to focus on investment ideas where the expected value is favorable—where the upside opportunity outstrips the downside risk.”
GuruFocus 15-year anniversary promotion
The holiday season is here, and so is GuruFocus’s 15-year anniversary! In order to celebrate, we are offering an exclusive holiday discount of up to 30% off on our GuruFocus Premium Membership.
Join now to get GuruFocus Premium membership for only $399/Year! In addition, save an extra $100 when you upgrade to our PremiumPlus Membership, and enjoy $100 off the price of each additional region you add to the subscription.
Don’t miss out on this once-in-a-decade deal! You can sign up for the discount price by clicking this link. Happy holidays!
Read more here:
