Finding true growth – how some businesses fake it

Is it really so easy to separate growth and value investment styles? Growth in particular is a challenging concept this year.  Investors should think harder about what it means.  Genuine cash generative growth is valuable, but rare. Investors need to know how to spot it and what they should pay for it.

Often, analysts need look no further than earnings per share to estimate growth rates, but this has become a risky approach. It is not just that accounting treatments, profits adjustments and share buy-backs flatter earnings per share. Some so-called ‘growth’ stocks are actually businesses whose customer base is shrinking physically. Investors need to look deeper into organic growth comparisons, and separate out pricing and volume effects.

Longer term performance means finding companies with true growth; weeding out the imposters. If companies have been exaggerating their growth, any shock to that can hit the share price hard. Not only are immediate profits forecasts cut, but future growth rates are revised down and  a greater risk factor might be applied to discount longer term prospects. And for some, more capital might be needed to address the problems or restructure. Changing prospects may even suddenly make bank debt look like a bigger problem if goodwill has to be impaired. Managements typically have a bias to optimism, and are reluctant to address asset valuations until they are forced to. All this even seems to surprise lenders, who set covenants that can overly rely on intangible assets. If investors want to keep one step ahead of share price collapses, they need to think of growth in down to earth physical terms.

Printing money has boosted consumer and business confidence, and restored economic growth. But that growth in western economies is now much lower than historic levels, and disguises a lot of business disruption. Many traditional businesses face challenges from new business models but are responding with cosmetic changes that only temporarily flatter reported growth. These can include rolling-up a business by buying smaller competitors, or pruning lower margin areas. Accounting treatment can flatter these moves. And many retail businesses have continued to expand their floor space or units, even as their business model has been called into question. This roll-out usually distracts management and investors alike from the problems at the core of the business proposition.

It seems that investors do not look closely enough to see if activity in older units is slipping back. Management may be incentivised to focus on keeping up appearances in the short term.  Should we be surprised, in a world where ‘shrinkflation’ cuts the size of consumer products to preserve prices and margins? Investors should be no more convinced than consumers that this disappearing act does not compromise brands and business value.

Sadly, many businesses have simply raised prices, misunderstanding their power and believing that they are in a semi-monopoly position. The failure of these strategies often comes as a total surprise to investors. It is an area where analysts need to do some work themselves. They should start by questioning some of the metrics that company managements put out. There are accounting standards for earnings per share, but not for some of the earnings per share adjustments, or for the ‘organic growth’ metrics put out by managements.

Extracting more profit from a declining base of customers or shrinking product hardly merits a growth rating. These challenges are not just about technology and consumers moving online. Many tobacco and branded food businesses are being hit, alongside high street retailers.

The psychological impact of priming is powerful – we are typically influenced unconsciously by context and framing. A ‘growth stock’ label, combined with rising earnings per share and management excitement, influences subsequent analysis. The halo effect, as management claim credit for share price performance, is added to the social endorsement of seeing other investors pile into the shares. A powerful cocktail of biases spares many growth companies from close scrutiny.

In a world where true growth is scarce, it should be prized. Superior returns on capital can persist for several years, meriting a premium rating. Indeed, some new strategies may merit a very forward-looking approach; digital businesses can scale rapidly. And, even older economy businesses, such as Fever-Tree Drinks, have developed capital-lite business models. But even for those businesses, the cost of customer acquisition and unit costs matter.

Undoubtedly, this year will see many established businesses fall from their growth pedestal. Portfolio performance may depend on side-stepping these disasters. It can be hard to overcome some psychological biases, and those linked to growth are harder than most.  But, looking at the trends in physical like-for-like customer demand is a good start

Disclosure: The opinions expressed in this article are my own, and may not represent the views of any firm or entity with which I am affiliated. The information presented in this article has been obtained from sources believed to be reliable, however, I make no representation as to their accuracy or completeness and accepts no liability for loss arising from the use of the material. Articles and information do not represent investment advice. I am a manager of actively invested equity funds. Clients own shares in Fever-Tree

Image credit: rights reserved; source Bloomberg. Published on April 9 2018

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