Screaming newspaper headlines, voluble TV anchors and incessant email or sms "tips" are agog with seductive investment opportunities in "growth companies". I thought that I should share my perspective on growth and felt it best that I start with a few questions:
- What is the definition of growth?
- What is the quality of growth?
- What is the cost of this growth?
Definition of growth: That growth should be defined as increase in sales ("top-line" as it is flamboyantly called in investment circles) to me is dangerous. Is this a fair definition? When growth in sales is not accompanied by a commensurate increase in net profit, serious questions need to be asked. What finally does matter to the equity shareholder is net profit. Instead of just focussing on increase in sales numbers, the focus should be on expected increase in sales without commensurate variable expenses kicking in. In-fact, when growth in sales is accompanied by a non-linear exponential growth in profits it is a signal that operating leverage exists (i.e. fixed costs form a larger portion of expenses and can be spread over a larger sales base) in the business and massive upsides await if sales can be increased.
Quality of growth: A pertinent question about growth, is its quality. What percentage of sales (income) is real cash in hand versus accrued (an accounting term to reflect sales has happened, but cash has not yet been received)? Accrual accounting gives leeway to managers of a business to show income as accrued without actually receiving cash in the kitty. A consequence of this is that the balance sheet of the company begins to show a build-up of "account receivables" (an accounting term to reflect payments due to the company from external parties – customers included). When account receivables build-up is significantly higher than the increase in sales, one needs to probe into whether the company is "stuffing" the sales pipeline. An example for this is managers of a construction company can use the percentage completion method to lock in sales without actual cash coming in. i.e. they can say 70% of a project is complete so they can lock in 70% of the value of the project as accrued income. Cash has not come in and a massive dud of an account receivable is created on the balance sheet. There is large flexibility in determining percentage completion and hence investors who do not dig deep enough can be left holding just pieces of paper instead of genuine productive businesses.
The other and deeper aspect of quality in growth is on "how has it been created?". Is it, as Michael Porter would say through a "sustainable competitive advantage"? Growth created through genuine "sustainable competitive advantage" in an industry, captures a greater and sustainable share of the "value" rather than simply market share. I am no authority on this, however it is a useful yardstick to use when understanding growth in companies.
Cost of growth: We do know that growth can be created by simply dropping prices. As mentioned earlier, this is not a sustainable practice and it will reflect in "negative operating leverage". I.e. net profits increase slower than sales or even drop even when sales are increasing. This is one aspect of the cost of growth, which we have already touched upon under the definition of growth. An aspect that Michael Porter alludes to is that companies with a genuine sustainable competitive advantage are able to consistently generate superior returns on assets than their peers in the same industry. The key question therefore becomes, what cost does the company need to incur to sustain growth in its profits. If over the long run, operating assets (i.e. fixed assets + intangible assets + inventory + working capital) are growing at a pace faster than net profits, then it means the company is incurring a cost to its growth that is not sustainable. This sometimes can be overcome by taking on debt. Not only is debt available at a lower costs, it also provides a tax shield. This can lower the cost of capital and can be an efficient way to grow profits. Nevertheless, investors must be ever watchful for the cost of growth and its sustainability.
The cash flow statement provides insight into the long-term costs of capital and the impact of growth. In the cash flow statement, I like to see at-least over a moderate time period, operating cash flow (after adjusting for working capital) being greater than fixed assets purchases, interest paid and taxes paid. If a company is taking on unsustainable growth, then operating cash flow will not be able to sustain the requirements of fixed asset purchases + interest paid. This means the company is not generating enough funds to sustain its growth through internal accruals and will need to borrow to fund its growth. This is acceptable when capital requirements are in spurts – for example a capacity expansion that lasts over a one or two year period. However when this becomes a routine feature of the cash flow statement – the company is going down a slippery path.
Joan Magretta in her book "Understanding Michael Porter" provides thought provoking ideas on how Michael Porter's ideas can be implemented in practice. Look up this review on the book.