When I learned how to ski, my teacher thought trial by fire would be a good, if not entertaining, way to teach me. Somehow, that day I managed to find the small creek on the side of the slope, spent about 30 minutes under a chairlift searching for my yard-saled skis and poles, and managed to stop the lift by getting off "too early." I was out over my skis, no question.
One of the most common factors I get asked about in my travels is Sales Growth. One would think that investing in companies with massively growing sales is a great idea. Maybe they just signed a huge contract, or that new product toy was a holiday favorite. Unfortunately, companies whose sales are growing the fastest tend to be about as likely to succeed as this inexperienced skier circa 2004.
The graph below shows the result of investing based on a company's Sales Growth (change in sales over the previous one year). Imagine breaking the S&P 500 into buckets of about 50 stocks each from lowest to highest Sales Growth. The blue bars show the excess returns relative to the S&P 500 from 1964-2015. Stocks with the highest year over year Sales Growth underperform the S&P 500 by 2.3% per year.
As an investment factor, Sales Growth misses the mark on a few fronts. Stocks with the highest Sales Growth tend to elicit high valuations because investors associate high Sales Growth with high future earnings. In other words, they have very high expectations for the future. Just as a poll of U.S. drivers would result in 80% rating themselves above average (a mathematical impossibility), investors tend to be OVER-optimistic.
The graph below shows average percentile scores for each of the Sales Growth buckets mentioned above based on the theme of valuation. I'll define valuation as an aggregated score based on a company's sales, earnings, cash flows, and shareholder orientation relative to price. The scores can range from 1 to 100, with 1 being the best (cheapest) and 100 the worst (most expensive). Using the High Sales Growth bucket as an example, that bucket is on average more expensive than 62.4% of stock in the index. We know from mountains of academic research that the more expensive a stock, the more likely it is to underperform the overall stock market over time. The fact that high Sales Growth companies are priced at high valuations puts them at a long-term strategic disadvantage for generating strong stockholder returns.
So why is it that investors are so optimistic?
Herein lie the trappings of a classic Growth Trap. Growth Traps exist when investors believe a company will “grow into” a more reasonable valuation. They say, “I don’t mind paying 50x earnings because sales and earnings next year will double, resulting in a forward PE of 25x.” This rarely comes to fruition. Using this logic, Sales Growth would seem like a good factor. The problem is that most investors have never run a business and underappreciate the true cost of scale.
Ironically, you see this most often in M&A activity. Acquisitions are about as de facto rapid sales growth as exists. Acquirers believe they have the ability to create “synergy” by acquiring firms and cutting costs. A late 1990’s KPMG study found that 82% of respondents to the study "believed" the deal they were involved in had been a success. Practically, value creation almost never works out because costs almost always end up scaling up with a firm’s size. 83% of M&A transactions in the study cited above were unsuccessful, and 53% of them destroyed shareholder value.
Still not convinced that rapid sales growth can be bad? Keep reading...
Here’s the second level reasoning why extreme growth can be bad. Often when you see rapid sales growth, the cost of that growth is so high that it negates the benefits. In some cases, there is the extreme, a la the tech bubble, when a company like eToys spends $2 on “customer acquisition” for every $1 of revenue. That’s obviously a losing proposition.
Posed another way, a growing business that lands a massive sales contract that stretches its current infrastructure is about to experience a giant operational cash drain associated with materials, inventory, personnel, etc. that it needs to fulfill that big contract. If you don’t believe me, watch Shark Tank for about 20 minutes and you are almost guaranteed to see an investor looking for capital to “expand” their business. Frequently in these cases, the Sharks don’t invest because they understand how difficult managing growth can be.
Here’s the research. When you look at those same buckets of stocks based on 1-Yr Sales Growth, but then look at the change in operating assets, you find that the burden for ramping up falls greatest on those companies with the highest sales growth. As I mentioned earlier, costs scale linearly with the size of the firm. It’s no coincidence in the chart below that the change in operating assets moves in lock step with Sales Growth.
The reality is that on average, margins actually end up shrinking because companies have to quickly dole out cash to build their working capital. Think of the cost difference between shipping a package overnight versus standard delivery. There is a substantial premium on expediency. You can see this in the chart below, which shows the average operating cash flow yield (EBITDA to Enterprise Value) for the same Sales Growth buckets. Operating margins tend to shrink as you get to the higher growth buckets on the right.
Recap: Avoid Growth Traps. Growth Traps are companies that are rapidly expanding their businesses. Rapid expansion requires investment in operating assets. That investment places strain on a firm’s infrastructure and results in declining margins. Because investors were overly optimistic for the stocks prospects, it is likely that these high flyers will not grow into their valuations and shareholder returns will suffer.