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Seeds of destruction
By Bob Tattersall
January 13, 2003
At Saxon Funds, we are value investors, so our portfolios are typically widely-diversified and full of dull companies. With the exception of the occasional "busted" technology stock, there is little evidence of high tech or glamour and most of our companies produce everyday products for existing markets.
This state of affairs is just fine with our long term clients, but potential investors frequently observe that the portfolio should contain more top-ranked companies and industry growth leaders if it is to achieve their return objectives. In other words, they assume that companies with superior operating performance will deliver superior stock market returns. Our practical experience tells us that the opposite is true, but that's what you would expect a value investor to say. So, I was happy to note a couple of recent academic articles which support our viewpoint.
In the Journal of Financial Research, Scott Bauman, Mitchell Conover and Don Cox evaluate the investment performance of companies listed in "Hot Growth Companies - The 100 Best Small Companies" published annually in Business Week. This study is of particular interest to me because of its focus on smaller growth companies. As you can imagine, these companies all exhibited superior operating and investment performance prior to identification and inclusion in the Business Week listing. Unfortunately, the authors found that both operating and investment performance fell off dramatically in the period following publication of the list. In fact, stock market returns lagged the benchmark indexes in the range of 6 per cent to 16 per cent on an annualized basis.
For the companies in this study, the sequence of events appears to have been
- Overly optimistic growth projections
- The bidding-up of growth stocks to unrealistic levels
- A decline in corporate operating performance (reversion to the mean)
- A collapse in the stock price
The authors conclude that "any attempt to find winning investments from a “hot growth” listing… appears futile."
The second study appeared in the current issue of the Financial Analysts Journal and is authored by Ramezani, Soenen and Jung. Theirs was a two step analysis. First, they investigated the link between sales or earnings growth and corporate profitability metrics such as return on investment or economic value added (EVA). The second level of analysis was to determine if there is a link between maximizing corporate profitability measures such as EVA and maximizing shareholder wealth.
The first part of the analysis is of interest because it will tell us whether or not management with aggressive growth targets can bring this growth to the bottom line. After a lot of number-crunching, the authors conclude that there is a U-shaped relationship between growth and corporate profitability. In other words, profitability increases with the growth rate of sales or earnings up to a certain point, and then there is a distinct pattern of decreasing returns to rapid growth.
No numbers are provided to indicate when "good growth" turns into "bad growth," but the rule of thumb seems to be that the top 25 per cent of growth stocks contains the value destroyers.
The second part of the analysis is of greater relevance to investors because it addresses the widely-held belief that a portfolio of companies with superior operating characteristics will deliver above-average stock market returns. The good news is that there is a positive relationship between higher profitability (EVA) and higher risk-adjusted stock market returns. The bad news is that these excess returns are highly-sensitive to market conditions and the persistence of sales and earnings growth rates. The authors conclude, "Our empirical results indicate that maximizing growth does not maximize corporate profitability or shareholder growth."
What practical lessons in portfolio strategy can we learn from these two academic articles? For a start, it is fairly clear that buying growth stocks on the basis of a list published in any business periodical is likely to be disastrous. This makes intuitive sense, anyway, as these companies and stocks must have enjoyed explosive, and probably unsustainable, growth in order to qualify for the list in the first place.
The second article confirms that explosive growth is a value destroyer both for the corporation and its shareholders. A management strategy of pursuing moderate growth seems to increase the odds of maximizing corporate profitability as well as shareholder return, although the connection between growth and EVA remains shaky. As a value investor, I think it makes more sense to start with a statistically inexpensive stock price and treat growth as an unexpected and unearned bonus.