Thursday, February 6, 2014

Asset Growth and Stock Returns

From this 2008 paper:

"ONE OF THE PRIMARY FUNCTIONS OF CAPITAL MARKETS is the efficient pricing of real investment. As companies acquire and dispose of assets, economic efficiency demands that the market appropriately capitalizes such transactions. Yet, growing evidence identifies an important bias in the market's capitalization of corporate asset investment and disinvestment. The findings suggest that corporate events associated with asset expansion (i.e., acquisitions, public equity offerings, public debt offerings, and bank loan initiations) tend to be followed by periods of abnormally low returns, whereas events associated with asset contraction (i.e., spinoffs, share repurchases, debt prepayments, and dividend initiations) tend to be followed by periods of abnormally high returns."

Paper: Asset Growth and the Cross-Section of Stock Returns

A recent Barron's article explained it this way:*

Barron's: Buy the Asset Sellers

"A 2008 study published in the Journal of Finance found that over the long term, U.S. stocks in the market's bottom decile ranked by recent asset growth outperformed those in the top decile by 13 percentage points a year."

The article also points out that...

"A 2012 paper that focused on international markets reported similar findings."

The paper's findings (on page 1610) reveal specifically the following gap in performance from 1968 through 2003:

Value weighted (VW) returns for firms with lowest asset growth: 18%

Value weighted (VW) returns for firms with highest asset growth: 5%

"...we find that raw value-weighted (VW) portfolio annualized returns for firms in the lowest growth decile are on average 18%, while VW returns for firms in the highest growth decile are on average much lower at 5%."

So there is the 13% gap but the paper also notes that "with standard risk adjustments the spread between low and high asset growth firms remains highly significant at 8% per year for VW portfolios and 20% per year for equal weighted (EW) portfolios."

I am highly skeptical of the "standard risk adjustments" but that's a subject for another day. Still, even using the most conservative numbers from this paper, the gap is not at all insignificant.

The paper concludes by calling this "a substantial asset growth effect on firm returns."**

I've mentioned the following quote before but, due to its relevance, I'll include it here for those who may not be familiar with it:

"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 (BRKa) Shareholder Letter

The bottom line is to avoid the misjudgment that exciting growth must necessarily lead to high returns. That growth might be a negative factor may or may not be counterintuitive, but understanding it is very useful and important. On occasion, the impressive growth prospects require so much capital that returns end up being poor for owners. Other times, fast growth attracts competitors, fresh capital, and possibly a disruption that changes what, for a time at least, looked like attractive economics. The list goes on. There are many variations of this that tend to be very industry specific.
(Consider how often growth is mentioned on a major business media outlet with at least the implied assumption that growth must be a good thing. Another way to think about it is this: In that context how often -- though, admittedly, a subtlety even if a crucial one -- is the potential negative implications of growth written about or discussed? I think we're talking, at best, about exceptions to the rule.)

In contrast, sometimes -- though it is far from assured -- the boring, stable, firms with only modest or low growth prospects establish themselves in a competitive framework that allows the strongest to maintain attractive return on capital for a very long time. Now, there's without a doubt many examples of growth being a very good thing for investors. The problems arise when growth is assumed to always be somewhere between a good and a great thing for investors; they arise when no consideration is given to the alternative implications of growth; they also arise when an extreme premium price is paid -- relative to approximate intrinsic value -- upfront for that potential growth.***

High growth rates and attractive long-term investment outcomes need not have much to do with each other.

The main point is that growth is too often treated as being always a good thing. Well, sometimes growth is of the low (or worse) return variety. Think airlines for many decades. That industry grew impressively for quite some time. In addition, sometimes too much is paid for the privilege of ownership due to the exciting growth prospects. The asset may end up performing well, but the owner doesn't get compensated sufficiently considering risks and alternatives.

The study above happens to focus on asset growth and returns.

Well, this is not necessarily limited to asset growth; it can apply to growth more generally (though certainly not a rule of some kind...there are plenty of examples of good growth). Below, I've included some related posts that may be of interest to explore further along these lines.

I happen to think it's not a bad habit to consider carefully things that conflict, contradict, or that might be inconsistent with what one is predisposed to think (or with prevailing wisdom). It's all too easy to quickly dismiss what's counterintuitive and just move onto the next thing. Some will run into an odd paradox, for example, and treat it as nothing more than an interesting anomaly. Too often -- or, at least, often enough -- that is a mistake. The biggest insights -- though, of course, not all -- are sometimes adjacent to what at first seems nonsensical.

Occasionally, the most useful discoveries are found inside or very near what initially seems unfamiliar, contradictory, and even uncomfortable.

"The thing that doesn't fit is the thing that's the most interesting, the part that doesn't go according to what you expected." - From The Pleasure of Finding Things Out by Nobel Prize winning physicist Richard Feynman

Another mistake is to "write off" or choose to ignore an investment idea due to some real, even significant, existing flaw. Well, sometimes the part that is right can be very useful (i.e. lucrative) while the downside (or cost) of what's wrong is very small. In the real world, at least often enough to matter, important insights will exist alongside things that are somewhat messy, incomplete, and inconsistent.

"When I was young everybody was excited by Gödel who came up with proof that you couldn't have a mathematical system without a lot of irritating incompleteness in it. Well, since then my betters tell me that they've come up with more irremovable defects in mathematics and have decided that you're never going to get mathematics without some paradox in it. No matter how hard you work, you're going to have to live with some paradox if you're a mathematician. 

Well, if the mathematicians can't get the paradox out of their system when they're creating it themselves, the poor economists are never going to get rid of paradoxes, nor are any of the rest of us. It doesn't matter. Life is interesting with some paradox. When I run into a paradox I think either I'm a total horse's ass to have gotten to this point, or I'm fruitfully near the edge of my discipline. It adds excitement to life to wonder which it is." - Charlie Munger speaking at UC Santa Barbara


Investment always involves the weighing of various pros and cons; it's making smart trade-offs between alternatives; it's about opportunity costs.

When something doesn't sit well with what is preconceived, it's just generally not a good idea to ignore it. In fact, to me it's better to develop a tendency to do the exact opposite. Admittedly, this frequently leads nowhere but, at least, new things are learned. In fact, I'd argue it's best to study and try to learn from those kinds of things at least 2 or 3 times as hard as one might otherwise be inclined to do.

So expect to run into to some paradox and messiness during the investment process. Sometimes useful insights reside near a neighborhood where there's incompleteness and/or inconsistency; they reside where something just doesn't quite fit.

This all nicely complements the reality that perfect investments -- if they exist at all -- are few and far between while, at the same time, plenty of good but flawed ones exist.

Attractive return on capital that's sustainable long-term and purchased at the right price (i.e. plain discount to value) is a priority.

Growth, in a vacuum, isn't.

Sometimes growth leads to the creation of enduring value for business owners, but too often it leads to the exact opposite outcome: Reduced rewards for the investor at greater risk of permanent capital loss.

Now, whether the business happens to be publicly traded or not is irrelevant.

"Investment is most intelligent when it is most businesslike." - From Chapter 20 of Benjamin Graham's book The Intelligent Investor

Stocks are merely a convenient way to own part of a business and should be analyzed no differently than if the business is to be owned 100%.

Those who attempt to trade excessively are turning what should be a huge advantage -- the convenience partial ownership of a business -- into a disadvantage.

Excessive trading simply all too often leads to unnecessary frictional costs and mistakes.

Many, at great cost in terms of long-term results, will continue to ignore this reality.

Some final thoughts:

- Good businesses, over the long haul, tend to increase in terms of intrinsic value and that dynamic should be an ally. Of course, in the short run share prices do not necessarily follow, but the long run is a very different story.

- Increases to underlying intrinsic business value should be the primary driver of forward returns, not clever trading.

- Buy with a plain-to-see margin of safety -- only what is well understood -- to protect against what can't be foreseen and the inevitable mistakes. What's well understood is necessarily unique to the investor. If intrinsic value can't be estimated within a narrow enough range, the investment should be avoided. It's just not possible to buy with an appropriate margin of safety if what something is roughly worth can't be figured out in the first place.

- Developing sound judgment of long-term business prospects, and the discipline to never overpay should be the focus. Neither is necessarily easy to consistently do well. It also need not be terribly complicated.

- Know limits and stay well within them. A big part of the battle is learning to avoid most of what shows up on the radar.

A sound investment process and principles guarantees nothing but at least increases the chance of attractive long-term outcomes.

Adam

Long position in BRKb established at much lower than recent market prices

Related posts:
Buffett and Munger on See's Candies, Part II - Jun 2013
Buffett and Munger on See's Candies - Jun 2013
Aesop's Investment Axiom - Feb 2013
Grantham: Investing in a Low-Growth World - Feb 2013
Buffett: Stocks, Bonds, and Coupons - Jan 2013
Maximizing Per-Share Value - Oct 2012
Death of Equities Greatly Exaggerated - Aug 2012
Stock Returns & GDP Growth - Jul 2012
Why Growth May Matter Less Than Investors Think - Jul 2012
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

* An excerpt from an article with a title that pretty much says it all:

 "It may surprise most investors that firms experiencing rapid growth subsequently have low stock returns, whereas contracting firms enjoy high future returns. For example, a 2008 study found that a value-weighted portfolio of U.S. stocks in the top asset-growth decile underperformed the portfolio of stocks in the bottom decile by 13 percent per year for the period 1968-2003. A recent paper shows that the same is true internationally as well." 

Article: Fast firm growth doesn't mean great stock returns

** From the conclusion: "Over our sample period firms with the low asset growth rates earn subsequent annualized risk-adjusted returns of 9.1% on average while firms with highest asset growth rates earn - 10.4%. The large 19.5% spread is highly significant. Weighting the firms by capitalization reduces the spread to a still large and significant 8.4% per year." The 13% gap noted above is value weighted (VW) but not adjusted for risk. Take your pick. These all represent rather significant gaps in performance.

*** On the surface, estimating intrinsic business value on a per share basis isn't necessarily difficult. As Buffett has said: "Intrinsic value can be defined simply: It is the discounted value of the cash that can be taken out of a business during its remaining life." So just figure out what cash can be taken out of a business over the long haul then discount that cash appropriately, right? Not so fast. The definition is simple. The calculation itself is not. It's, in part, the assumptions (interest rates, future cash flows, how well future cash will be put to work, etc.), some of it hard to quantify but important stuff, that make the actual calculation more difficult and, inevitably, at best a range of possible values (even if the mechanics aren't that tough to learn). Buffett has also said there are good reasons "we never give you our estimates of intrinsic value." (The one explicit reason Buffett mentions being that not even Charlie Munger and himself will come up with the same intrinsic value estimate using the same facts.) Instead, he prefers to provide "the facts that we ourselves use to calculate this value." In the 2011 letter, Buffett explained that while they "have no way to pinpoint intrinsic value", a useful -- even if "considerably understated" -- proxy happens to be book value. This older post on how Buffett likes to specifically discount cash in order to calculate value might be of interest to some.
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