Monday, June 8, 2009

The Growth Myth

I wrote about return on capital (ROC) and its influence on long-term returns in this previous post. More recently, in an interview with Morningstar, Jeremy Grantham talked about the importance of ROC and the widely accepted myth that high growth is correlated with high investment returns.

Grantham: Value Matters In Everything

Intuitively, it seems reasonable that high growth should be correlated with high investment returns but, like many other things, what is intuitive is often not correct. In the short run high growth rates tend to inflate equity values but generally the long-term returns can suffer. This idea is widely misunderstood.

Some excerpts from the interview:

"...in the end, returns in a stock market are overwhelmingly to do with return on capital (ROC). It isn't about top line growth. Nobody believes this but it's true. Growth stocks simply don't beat value stocks. Growth countries, for the record, have no history of reliably beating slower growth countries. Although everyone thinks it's the case it won't stand the test of analysis." (Emphasis added)

He goes on to say that:

"I'm very bullish that China will grow fast."

"I'm very confident they'll put pressure on raw material prices. But I'm not very confident that their earnings per share will be exceptional. And therefore you have to be careful. When you run an analysis of growth rate by country, you find no correlation between growth and return on the market. But when you run a correlation on a country based on starting PE, there is of course a very handsome correlation."

So value matters in everything including the country you choose. Don't expect high GDP to translate into stock returns. Starting point value is the key.

Long-term returns in investing come down to durable high ROC and the price you pay relative to intrinsic value....not growth.

Some investors make the mistake of assuming that an investment in a high growth business (or country) will produce above average long-term investment returns.

Growth, of course, will often have a favorable impact on value. It just happens to be a mistake to think that it always has a favorable impact.

In fact, growth can actually reduce value if it requires capital inputs in excess of the discounted value of the cash that will be generated over time. Sometimes, the highest growth opportunities attract lost of capable competition and capital that ruins the long run economics. Sometimes, high growth requires expensive yet necessary capital raising that dilutes existing shareholders and reduces per share returns.

Finally, even if growth that materializes does have favorable economics, some investors tend to pay a large premium upfront for those growth prospects. That hefty price paid may turn attractive long-term business results into not so attractive investment results.

Adam

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