Wednesday, October 5, 2011

Buffett: Why Growth Is Not Necessarily A Good Thing - Berkshire Shareholder Letter Highlights

Warren Buffett wrote the following in the 1992 Berkshire Hathaway (BRKashareholder letter:

"Growth is always a component in the calculation of value, constituting a variable whose importance can range from negligible to enormous and whose impact can be negative as well as positive."

Some may find the idea that growth could ever be a negative thing for an investor a bit odd.*

If nothing else it's not necessarily intuitive.

In fact, listen or read carefully someone touting an investment and you'll hear growth potential mentioned in a way that implicitly suggests all growth is good growth.

Buffett later in the same letter added the following:

"...business growth, per se, tells us little about value. It's true that growth often has a positive impact on value, sometimes one of spectacular proportions. But such an effect is far from certain. For example, investors have regularly poured money into the domestic airline business to finance profitless (or worse) growth. For these investors, it would have been far better if Orville had failed to get off the ground at Kitty Hawk: The more the industry has grown, the worse the disaster for owners.

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 over a dollar of long-term market value. In the case of a low-return business requiring incremental funds, growth hurts the investor."

So why would anyone running a business pursue growth strategies that do not produce high returns for shareholders besides poor judgment or incompetence? Well, as Buffett points out above, some industries just don't have favorable economics. So even solid execution results in not great investment outcomes. There are other reasons. The desire of a CEO to expand the business empire, so to speak, even if, in pursuit of that growth, it happens to not produce much in the way of long-term returns (though short-term it may look okay especially with clever use of accounting) is one example.

Growth for growth's sake, the financing of low return (or worse) growth, happens plenty in the world of business and investors end up getting hurt by it.

I've covered variations of the "growth myth" in other posts. If interested, I've included some links to examples below.

Think about this the next time you hear growth prospects at the center of some investment thesis. Growth prospects do tend to be, at least often enough, an overrated component of long run value creation for shareholders.

So, even if not deliberate, growth is at times pursued at shareholder expense and, as part owner of the business, healthy skepticism when it comes to aggressive growth strategies involving the use of shareholder funds is often more than justified.

Now there's obviously nothing wrong with high return growth when you can find it at a fair price. Just keep in mind that dynamic high growth frequently invites competition. It is the potential for intense competition that makes the crucial question of whether a business can sustain its high return on capital characteristics (or generally favorable long run economics) tougher to answer.

Growth for growth's sake often ends up producing lousy rates of return for shareholders. The question becomes this. Will a particular growth opportunity involving incremental capital make shareholders wallets fatter or just make the domain the business happens to occupy larger with returns an afterthought?
(I say only somewhat sarcastically that words like "strategic" or "synergistic" -- when used to justify a large but ill-conceived capital allocation decision -- are, at times, just code for something like: "we're investing to get bigger fast though possibly at the expense of long run shareholder returns".)

The expensive pursuit of market share at subpar or negative returns is another variation of this.

Some businesses, over an extended period, can put large quantities of incremental capital at high rates of return to work. Unfortunately, that is a rare business. Since most cannot do this, it's preferable for the excess funds to be used for buybacks (when the stock sells below -- ideally nicely below -- intrinsic value) or dividends.

Also, for a business structured like Berkshire Hathaway, the businesses that produce excess capital can send it to Warren Buffett for deployment into some other high return investment (that's precisely the role that See's Candies has played for decades).

The reality is most high return businesses like See's need little capital and generate lots of it (relative to its size, of course). Keeping those funds inside a business like See's is an invitation for poor use of capital.

Finding businesses with durable high returns on capital, with management that knows how to wisely deploy funds, then paying a nice discount to a conservative estimate of intrinsic value determines long-term returns for investors...not growth.

Adam

Long BRKb

Related posts:
Grantham: High Growth Doesn't Equal High Returns - Nov 2010
Growth & Investor Returns - Jun 2010
Buffett on "The Prototype Of A Dream Business" - Sep 2009
High Growth Doesn't Equal High Investor Returns - Jul 2009
The Growth Myth Revisited - Jul 2009
The Growth Myth - Jun 2009

* 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 lots of capable competition (and fresh capital) that, over time, converts what looked like attractive economics into something much less so. Other times, high growth ends up requiring expensive but needed 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.

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