The Downsides of Growth

 

I love companies that can grow for decades – writes the Undercover Fund Manager.

 

The best sort of growth reinforces the business model, which in turn makes future growth more likely. Network effects and economies of scale from greater purchasing power, or leveraging fixed distribution networks, are good examples.

However, pursuing growth for growth’s sake is one of the biggest mistakes I see companies make.

When is growth not the right strategy?

 

Growth that generates poor returns

 

Any money a company spends beyond maintaining its existing operations should earn reasonable returns. What is ‘reasonable’?

To me, it’s the opportunity cost of money in someone else’s hands. In other words, if I can earn a high-single-digit return by investing in the stock market (even in a tracker), a company should be targeting at least that, and preferably more, on any investments it makes. Otherwise, it should just return the money to me. Fairly simple and obvious – but not how a lot of companies operate.

Many companies tout earnings accretion as a reason to do deals; the returns seem to be an afterthought. Earnings accretion is a terrible reason to do acquisitions. With interest rates this low, virtually any deal, whether funded with cash or debt, will enhance earnings.

Every deal is different and must be appraised on its own merits, but as a general rule, if a company can’t generate a double-digit return within three years, I’d rather they didn’t do it.

In addition to generating good returns, acquisitions should at least maintain, and preferably enhance, the overall quality of the business.
 

Growth for diversification sake

 
Diversification is normally a bad reason to grow.

Not always – companies like Amazon have done a great job of diversifying into completely new areas – but this is a rare skill and should be seen as the exception rather than the rule.

Like investors, companies are usually better off sticking squarely to their circle of competence. 
 

Growth that distracts from the core business

 
You see this a lot in roll-outs (shops, restaurants, cinemas, hotels, etc): the core estate gets neglected because all capital and management attention is directed to expansion.

Over-expansion can lead to sales at existing stores being cannibalised. Instead of spreading greater sales over a fixed cost base, you get almost the opposite effect – higher fixed costs from extra stores, but little in the way of additional sales to compensate, leading to falling margins and returns on capital. Not a great combo.
 

Pursuing the wrong customers

 
Banks and lenders are very prone to this. In good economic times, they relax their lending standards and take on riskier borrowers. This makes growth look great for a few years, but when the economy turns, impairments skyrocket.
 

Taking on too many customers

 
Some companies are very scalable, meaning they can take on new customers without incurring much additional cost (these can make brilliant investments). However, most companies don’t work this way.

If most businesses doubled customer numbers in short order, they’d incur significant operational difficulties and existing customers would get a far worse service. In the short term it looks great, but over time customers get fed up and leave, meaning the long-term value of the business is eroded.

Companies should aim for measured customer growth that enables quality of service to be maintained. 
 

Growth leading to organisational complexity and diseconomies of scale

 
Be wary of companies in too much of a hurry to grow. Fast growth is often hard to sustain because it puts undue pressure on the back office operations of a business.

Companies must be choosy when it comes to growth projects. Taking on additional business volume might not make sense, especially if it dilutes margins or uses up resources that would be better directed elsewhere.

An acquisition may look brilliant on paper, but involve big integration risks or cultural challenges, meaning it probably shouldn’t be entertained.
 

Growth through price increases

 
Price increases are often sticky in the short term, because it can be a pain for companies to switch supplier, but in the long-term, excessive pricing can erode a company’s moat.

I like companies with scope to raise prices, but they must provide enhanced value to customers. It can be a difficult balance to strike, which is why the best businesses usually err on the side of caution when it comes to raising prices, even if it means growing a bit more slowly.
 

Bad contracts

 
Any time you have a business reliant on big, complex, multi-year contracts – beware. The temptation to prop up revenues and profits by bidding aggressively is high and we’ve seen many firms get into trouble, especially in the outsourcing and construction space.

The accounting for these contracts can be complex and problems can take years to manifest. The implied margin often leaves little room for error and it only needs costs to increase a bit more than expected for a contract to become loss-making.
 

Growth that imperils the balance sheet

 
Leverage is a great way to juice returns, but also a great way to get into difficulty when shocks occur.

With debt being so cheap, taking on more of it almost always looks like a good idea. Enter the expected returns into a spreadsheet, layer a few turns of leverage on top and you’ve created value out of thin air. Magic!

The benefits of having a strong balance sheet are much more difficult to quantify, but often far more important. Customers in some industries will often favour suppliers they deem most financially secure, especially if they’re reliant on an ongoing relationship. A strong balance sheet in this instance can be an enormous competitive advantage.

Even if that isn’t the case, the advantages of not being beholden to bankers or equity holders when the economy turns down, and maintaining investment through downturns, are massive.

Unfortunately, most company finance directors don’t seem to agree, which speaks a lot to how they are compensated (short-term earnings growth usually). 
 

Growth that sacrifices resilience

 
Protecting the existing business and maintaining resilience should come before the pursuit of extra profits.

Examples include ensuring redundancy in the supply chain (eg, dual sourcing of components), investments in cyber security, regulation, IT, risk monitoring and so on. These are pure costs for businesses, so taking shortcuts can be tempting.

In good times, companies will often run quite lean or become more vertically integrated (eg, through less reliance on outsourcing). While this can support profits in the short term, it usually decreases business resilience.

Vertical integration works great in upswings, but in downturns it can kill you, because it increases fixed costs and operational gearing. Maintaining a degree of flexibility in the cost base, especially for cyclical, capital-intensive businesses, is prudent.

It’s a lesson most companies only learn after the event. But for the best-run businesses, protection and resilience of existing operations is always front of mind.
 

Summary

 
Growth can be a good thing for a business and its shareholders, or a bad thing. Investors must try and distinguish between the two.

Growth projects are usually worth pursuing when they don’t imperil the core business or balance sheet, generate good returns, and – ideally – reinforce the moat and business model.

Business strategy is all about trade-offs. There are no free lunches and if you want to grow quickly, there are probably sacrifices to be made. Measured growth, sustained over the longest time possible, is what most companies should be striving for. The tortoise always beats the hare in the end.
 

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About The Undercover Fund Manager

Professional fund manager specialising in UK equities across the market cap spectrum. https://theundercoverfundmanager.com @FMUndercover