Thursday, 9 October 2014

Look at growth from the perspective of investment required to support the growth. Profitable Growth Occurs Only Within a Franchise.

Now to summarize about growth:
  1. growth at a competitive disadvantage destroys value,
  2. growth on a level playing field neither creates nor destroys value, and
  3. it is only growth behind the protection of barriers to entry that creates value.

The standard view of short term analysts is that growth is your friend. Growth is always valuable.  That is wrong!  
Growth is relatively rarely valuable in the long run. And you can see why with some simple arithmetic.  I am not going to look at growth from the perspective of sales, I am going to look at it from the perspective of investment required to support the growth. 
  • Now the investment required to support the growth is zero then of course it is profitable—that happens almost never (For Duff & Phelps or Moody’s perhaps). 
  • At a minimum you have A/R and other elements of working capital to support growth. 
Suppose the investment required is $100 million, and I have to pay 10% annually to the investors who supplied that $100 million dollars.   The cost of the growth is 10% of $100 million or $10 million dollars.   

1.  Suppose I invest that $100 million at a competitive disadvantage. 
  • Suppose I am Wal-Mart planning to compete against a well-entrenched competitor in Southern Germany, am I going to earn 10% on that investment?  Almost never.  In that case, I will be lucky to earn anything; perhaps I earn $6 million. 
  • But the net contribution of the growth is the $10 million cost of the funds minus the $6 million benefit which is minus $4 million dollars for every $100 million invested. 
  • Growth at a competitive disadvantage has negative value.  
2.  Suppose it is like the automotive industry or like most industries with no barriers to entry, it is a level playing field so the return will be driven to 10% cost by the entry of other competitors. 
  • So I am going to pay $10 million, I am going to make $10 million so the growth has zero value.   
3.  Profitable Growth Occurs Only Within a Franchise 
  • The only case where growth has value is where the growth occurs behind the protection of an identifiable competitive advantage. 
  • Growth only has value where there are sustainable competitive advantages. 
  • And in that case, usually, what barriers to entry means is there are barriers to companies stealing market share from each other.
  • There is usually stable market share which is symptomatic of that last situation that means in the long run, the company will grow at the industry rate
  • And in the long run, almost all industries grow at the rate of global GDP.   

So in these three situations, the growth only matters in the last one where its profitable (growing within a franchise) is.
  • And the critical issue in valuation is either management or the G&D approach will tell you the extent to which that is important or you have a good reliable valuation and there is no value to the growth because there are no barriers to entry. 
  • Or it is down here (growth is profitable) and there obviously you want to get the growth for free.
  • You could pay a full earnings power value and get a decent return. (Buffett with Coke-Cola in 1988).  

Introduction to a Value Investing Process by Bruce Greenblatt at the Value Investing Class Columbia Business School 
Edited by John Chew at                           
studying/teaching/investing Page 27

Notes from video lecture by Prof Bruce Greenwald

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