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Beat the Market - Part II

By Roger Montgomery

Beat the Market - Part II

Growth is an important component in any strategy designed to beat the market.  But you may be surprised to hear that there is good growth and bad growth.  Read on to find out more…

Is growth always good?

Many years ago the world’s wealthiest man Warren Buffett said that growth was not always a good thing.  What?  Aren’t companies of the western world doggedly pursuing growth?  If our economy has two quarters of negative growth, we call it a recession and recessions are bad.  More sales, more profits, more products.  It is all about ‘more’. 

But growth is not always good.  They might not know it but for some investors, growth has destroyed wealth both quickly and permanently.

Remember ABC Learning Centres? It’s April 2006 and the shares are trading at more than $8.00.  Profits are growing at a fantastic rate - rising from about $11 million in 2002 to over $80 million in 2006.  The problem is return on equity is declining. 

Return on equity contraction foretold the demise of the company, which was accelerated by the increase in debt.  It is return on equity that will help you identify the great companies to safely invest in. And it is return on equity that will save your portfolio from permanent destruction. 

To understand what Warren Buffett was talking about when he said not all growth is good.  You need to know something about return on equity.

Imagine you have a business, even a good one.  You invested $1 million dollars in it, bought a shop and in the first year, produced a real cash profit after tax of $400,000.  That’s a 40% return.  Now suppose another shop came up for sale in another area for $400,000 and you decided to buy it.  As it happens you are really good at running the first store you bought but you have found running the second store a little harder.  Traveling between them has been challenging and so you decide to bring in a manager for the second store.  The result is that after a year of owning the second store it produces a profit of $20,000.  Meanwhile the first store produces another $400,000.  The second store has generated a return of just 5%.  Many business owners – and I know one or two – would say this is still satisfactory, because profits have gone up.  In the first year your business made $400,000 and in the second year, profits have gone up to $420,000.  Profits of your new ‘group’ grew by five percent. 

Thinking about this situation another way reveals what a poor investment the second shop is.  You first have to remember that you gave your business more money, so profits should have gone up.  A rocking chair and a bank account is all you need to make profits go up.  Invest $1 million in a bank account and then put in another $400,000 the year after and the interest you earn in the second year will be higher than in the first.  You have grown the profits and it has been no effort at all. 

So when a company increases its profits it is nothing spectacular if the owners have invested more money in the company.  This is purchased growth.  Shareholders have funded the opportunity for the directors to look good.  The situation is even worse if that additional money generates a return that is less impressive than the rate available from a bank account. And if a higher return can be earned for the same risk or the same return for less risk, somewhere else, then the reality is that you don’t want to put more money into the business.  You don’t want it to grow.  It is better that the $400,000 is taken out of the business, rather than employed to purchase another shop.  The $400,000 should be invested elsewhere at a higher rate or even at the same rate in a bank account, which has a lot less risk. 

If, each year, you invested the $400,000 from the original shop into a new one that produced a return of five percent, the business would eventually have many more shops earning five percent. And each year the business would be worth less and less even though profits would be growing.

Many investors don’t understand this – that there is growth that will destroy wealth.  They happily allow the management of a company to keep the money “to grow the business” and willingly accept a low return.  That low return is actually costing you money because you could have earned a better return elsewhere. It is called opportunity cost.  Investing the money in the business at a low rate of return has cost you the opportunity of earning more or earning the same, but with more safety, elsewhere.

For those who are visual, Table 1. shows that an investor in a company that generates a five percent return on equity and that keeps all the profits for growth rather than paying those profits out as a dividend, will lose half their money.

Table 1.

  Year 1 Year 2
Equity at Beginning $1,000,000 $1,050,000
Return on Equity 5% 5%
Net Profit $50,000 $52,500
Dividend $0  
Equity at End $1,050,000  
Price Earnings Ratio 10 10
Market Capitalisation $500,000 $525,000

Let me show you precisely how a company that is growing its profits but generating a low return on its owner’s equity, loses your money.  Table 1 shows a company listed on the stock exchange and whose shares are trading on a price earnings ratio of ten times. The price earnings ratio is simply the share price divided by the earnings.  So if the share price is $5 and the earnings are 50 cents, the price earnings ratio will be ten ($5.00/$0.50 = 10). If the price earnings ratio is ten, it means that buyers of the shares are happy to pay ten times the profits for the company.

In Year 1 when the company earned a profit of $50,000, the stock market was willing to pay ten times that profit or $500,000 to buy the entire company.  Another way of thinking about it is that the stock market thinks the company is worth $500,000.  What the stock market thinks the company is worth and what it is actually worth are very often two different things.  Don’t listen to what the stock market thinks.

The company begins Year 1 with one million of equity on its balance sheet and in the first year, generates a 5 percent return on that equity or $50,000.  Management decide that they need that money to “grow” the business and so decide not to pay any dividends.  As you are about to discover, that decision has cost shareholders a small fortune.

By keeping the profits, the equity on the balance sheet grows from $1 million at the start of the year to $1,050,000 at the end. In the second year, the company again earns 5 percent on the new, larger equity balance.  A five percent return on $1,050,000 is a profit of $52,500. 

So on the surface things look rosy.  The company is growing.  The equity has grown, the profits have grown and management are no doubt drafting an annual report that reflects their satisfaction with this turn of events.

But not all is as it first appears.  Indeed management have, perhaps unwittingly, dudded shareholders. 

As a shareholder your return is made up of two components – dividends and capital gains.  If two dollars is earned and you don’t receive one of those dollars as a dividend, then you should receive it as a capital gain. If, over time you don’t, it has been lost and management may be to blame.  Every dollar that a company retains by not paying a dividend should be turned into at least a dollar of long-term market value through capital gains. 

The company in Table 1 has not achieved this and unfortunately lost its investors money.  Even though the company appears to have grown – remember equity and profits are indeed growing – the reality is that as a shareholder you have lost money.  How?  The company ‘retained’ all of the $50,000 of the profits it earned in Year 1.  You received no dividends.  All you got was capital gain but the capital gains were only $25,000.  In other words the company failed to turn each dollar of retained profits into a dollar of market value.  And so investors have lost $25,000.  If the situation were to continue, you should insist that the company stop growing and return all profits as dividends and if that is not possible, the company should be wound up or sold.

CAPITAL ALLOCATION AND MANAGEMENT ABILITY

Table 1. showed us that by retaining money, the company was hurting investors as it expands.  The financial pain occurs because some of the profits were retained.  The reason for retention of profits is largely irrelevant because, either the money needs to be retained which makes it a poor business or management choose to retain which makes them poor decision makers.

Many investors don’t understand this very real way of losing money even when the company is reporting profits.  But investors aren’t the only ones upon whom this lesson is lost.  A very large number of company directors don’t understand this ‘loss’ either or, if they do, they apply their knowledge with a dose of schizophrenia. 

The above example demonstrates that a company with a low rate of return on equity will lose money for its shareholders if profits are unwisely retained and as Warren Buffett further observed, if profits are unwisely retained it is likely that management have been unwisely retained too. 

Roger Montgomery is the founder of The Montgomery Fund.  If you are keen to explore the detail, including how to identify high quality businesses and how to estimate the right price to pay for their shares, read Value.able.  It’s the best selling, value investors guide book, by Roger Montgomery and can be purchased at http://rogermontgomery.com/valueable-book/

 
Roger Montgomery
Roger Montgomery

Roger shares his stock market insights at his Insights blog, blog.rogermontogmery.com. Investors can also follow Roger on Facebook and watch media interviews at his YouTube channel. Grab your Second Edition copy of Value.able and learn how Roger Montgomery values the best stocks and buys them for less than they're worth. Grab the book now at special price!