Monday, July 16, 2012

Why Growth May Matter Less Than Investors Think

"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." - Warren Buffett in the 1992 Berkshire Hathaway (BRKaShareholder Letter

In the long run, investor returns are not primarily driven by growth. 

They are, instead, mostly driven by long run return on capital and the price paid relative to intrinsic value. Here's a recent article by Brett Arends that does a good job of explaining why the returns for investors often have little to do with GDP growth. From the article:

"Wall Street's obsession with these things is institutional, not rational."

I've covered variations of the "growth myth" in previous posts. I realize some take it as a given that something like above average GDP growth should lead to better than average returns for investors. As it turns out, there is actually rather little correlation.

"The fastest-growing countries should give you the highest return. They simply don't. But, there's only four of us— that— that believe that story. Everyone else in the world believes that if you grow fast like China, you'll outperform in the stock market." - Jeremy Grantham on CNBC

At the very least, real evidence to support that accepted dogma is rather weak. When something counterintuitive comes along, it's usually worthwhile to give it real consideration instead of just treating it as some strange anomaly. The most useful insights are sometimes not far from what at first seems contradictory, paradoxical, or counterintuitive.

It's at least a good habit to explore what's against conventional wisdom. Of course economies with high levels of growth will generally have more desirable investment outcomes, right? As it turns out, not really.

Oh, and it's not just GDP growth. Fast-growing industries and businesses have a whole range of possible investor outcomes with above average returns far from being probable.

"...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." - Warren Buffett in the 1992 Berkshire Hathway Shareholder Letter

It'd be easy to conclude it applies to only something as historically troubled as airlines, but any industry or business that required sustained low return on capital investments to compete will result in subpar returns for investors over the long haul.

Unfortunately, sometimes it's the fastest growing, most promising, dynamic, and exciting areas of opportunity that will produce modest (or worse) returns and a wide range of outcomes for the typical investor.

Growth usually attracts (or often requires) lots of capital. All that supply of capital ends up financing plenty of new capable competition. It's the new competitors that leads to the lower return on capital (less pricing power, a supply glut etc.) and reduced long run investor returns (even though the overall opportunity may, in fact, remain rather large). It's the newly raised capital that might dilute per share returns. There's plenty of growth to go around but, for the investor, big winners and losers. If certain investors can actually pick the winners and avoid the losers consistently, then it might work out. That's usually easier to do in theory though some can clearly do it well. Those that try to need a realistic assessment of their capabilities and limits.

"A money manager with an IQ of 160 and thinks it's 180 will kill you," he said. "Going with a money manager with an IQ of 130 who thinks it's 125 could serve you well." - Charlie Munger in San Francisco Business Times

So lots of innovation and change is often very good for society, but not necessarily good for per share investor returns. Extreme change can mean that today's apparent leader is anything but further down the road with adverse consequences for investors. The result may be dramatic and hard to foresee differences in the core economics of the business even though today the business seems just fine.
(Consider Research in Motion: RIMM five years ago versus now. They seem an easy target now, but not too long ago they were highly profitable and viewed as a strong player.)

Where there's less industry growth and change, there's less fresh capital financing capable new competitors, and a narrower range of investment outcomes for the typical investor. If an established leader with sound economics in that industry has emerged, investor returns can end up being more predictably between good and better if an appropriate price is paid. So the typical investor may do just fine.*

Less downside, less upside, and naturally less excitement. In my book investing is not about the adrenaline rush, it's about getting above average results at the lowest possible risk.

I'll cover this subject more -- why high growth and high returns often have little to no correlation -- in future posts.

Adam

Long position in BRKb established at lower prices

Related posts:
Ben Graham: Better Than Average Expected Growth - Mar 2012
Buffett: Why Growth Is Not Necessarily A Good Thing - Oct 2011
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

* I just think it is better to adopt an approach that doesn't require exceptional ability just in case the individual investor overestimates his or her own ability. In other words, an approach where nothing good has to happen to get a nice result (then if something happens to surprise on the upside...no problem). Think of it as an insurance policy. We can't all be above average. Again, it is a realistic assessment of abilities and limits that counts most for an investor. Demosthenes said: "What a man wishes, he will believe." Well, remember the survey of drivers in Sweden as explained by Charlie Munger: "...in self appraisals of prospects and talents it is the norm, as Demosthenes predicted, for people to be ridiculously over-optimistic. For instance, a careful survey in Sweden showed that 90% of automobile drivers considered themselves above average. And people who are successfully selling something, as investment counselors do, make Swedish drivers sound like depressives. Virtually every investment expert's public assessment is that he is above average, no matter what is the evidence to the contrary." - Charlie Munger speaking to the Foundation Financial Officers Group in 1998
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