To beat the stock market you need to invest in the growth business. Growth plays very important role in any strategy designed to beat the market. But do you know that there is a good growth and the bad growth. To find out more keep reading….

Couple or maybe more decades ago one of the wealthiest man on the earth, Warren Buffett said, growth was not always a good thing. What? Aren’t companies in this whole world dodge to pursue growth? If our economy has two quarters of negative growth we call it a recession and recessions are bad (Many people are talking about recession in China and also in the US right now). We always talk about more sales, more profits and more products, it is always has been about ‘more’ that we want.

But growth is not always good. Investors might not know about it but growth has destroyed wealth quickly and permanently.

Remember Bharti Airtel? In June 2010 they bought the African assets for $10.7 billion USD from the Kuwait operator Zain. If you go through the media and what management said before acquiring that business about how profits will grow, the business is yet to beat its 2010 earnings. They still are making profits and their profits are growing every year since from the 2011 but the share price in June 2011 was in range of Rs 370 – Rs 400 and today at Rs 305. The problem is return on equity is declining.

Imagine you have a business, even a good one. You invested Rs 1 crore in it and opened up a shop and in the first year, you produced a real cash profits of Rs 40 lacs. That is a 40% return. Now suppose another shop came up for the sale in another area for Rs 40 lacs and you decided to buy it. As it happens, you are really good at running your first shop but now you are finding it a little bit hard to run the second one. Travelling between them is challenging and so you decide to bring one manager for the second store. The result is that after you owning it for a year the second store produces Rs 2 lacs as profits. Meanwhile your first store produces another Rs 40 lacs profits from it. The second store has generated a return of 5%. Many business owners (including my dad) – would say it is satisfactory result, because profits have gone up. In the first year you made Rs 40 lacs and in the second year you made Rs 42 lacs. Profits of your new group grew by 5%.

Thinking about the same situation in another way reveals what a poor investment is the second shop. You have to remember here that you gave your business more money, so profits should go up. In my opinion you only need a rocking chair and bank account for your profits to go up. Invest your Rs 1 crore in your bank and then put in another Rs 40 lacs the year after and you will see your interest earned in the second year had gone up. You have grown your profits by sitting on a rocking chair.

So if a company had increased its profits it is nothing spectacular if the owner have invested more money in the company. This is purchased growth. Shareholders have funded for this growth for the directors to look good. The situation is even worse if the additional money generates a return which is less impressive then the rate available from the bank account. If higher returns can be earned for the same risk or same returns for less risk, somewhere else, then reality is that you don’t want to put more money in the business (Read about our views in regards to DCB). You don’t want it to grow. It is better to take that Rs 40 lacs out of the business rather than employing it to buy the second shop. That Rs 40 lacs should be invested somewhere you are getting better returns or same returns.

If, each year, you invested Rs 40 lacs from the original shop to buy new shop that produced a return of 5%, the business will eventually have more shops earning 5% return. And each year the business will be worth less and less though their profits are growing.

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

Look at the table below who are visual, a company that generates 5% return every year and reinvest those profits back in the business to grow and earn same return, investor will lose half of their money.

  Year 1 Year 2
Equity at beginning 10,000,000 10,500,000
Return on Equity 5% 5%
Net Profits 500,000 525,000
Dividends 0 0
Equity at end 10,500,000 11,025,000
Price earnings ratio 10 10
Market capitalization 5,000,000 5,250,000

 

Let me show you precisely how company that is growing its profits but generating lower return on its owners’ equity, loses your money. Above table shows a company that is listed in the stock market whose price are trading on a price to earnings ratio of 10 times. The price earnings ratio is simply the share price divided by the earnings. So if the price of share is Rs 100 and earnings Rs 10 then price earnings ratio will be ten (100/10 = 10). If the price earnings ratio is ten, it means the buyers of the share are happy to pay 10 times the profits for the company.

In year 1 when company reported profits of Rs 500,000 the market was happy to pay ten times to its profit to buy the whole company. Another way of thinking about it is that company is worth Rs 5,000,000. 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 stock market thinks.

The company begins its first year with Rs 1 crore and makes profits of Rs 5 lacs. The management decides to keep that money to grow the business and decides not to pay any dividends to shareholder. As you are about to discover, that decision has cost shareholders a small fortune.

By keeping the profits in the business, the equity on Balance sheet had grown by Rs 5 lacs. The company generates again 5% return and report profits of Rs 5.25 lacs for the second year.

So on the surface things look rosy. The company is growing. The equity has grown and also the profits have grown and management are busy in drawing the annual report that reflects the satisfaction with this turn of events.

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

As a shareholder your returns are made of two components – dividends and capital gains. If Rs 2 is earned and you don’t receive one of those rupee as dividend, then you should receive it as a capital gain. If, overtime you don’t, it has been lost and management maybe to blame. Every rupee that company retains by not paying dividends should be turned into at least a rupee of long term market value through capital gains.

The company in the above table had not achieved this and unfortunately lost investors’ money. Even the company has grown its profits and equity the reality is that investors have lost their money. How? The company retained all of the Rs 5 lacs profit from the business but received back only Rs 2.5 lacs as capital gains. In other words investors lost Rs 2.5 lacs of rupees by reinvesting all the profits in the business. If the situation remains same then business should stop retaining all the profits and stop growing and start paying dividends to its shareholder. If that not possible, the company should wound up or sold.

The above example showed us that by retaining money and growing was hurting its investors return. This financial pain occurs because business retain the money. The reason of retaining the profits is largely irrelevant because, either the money has to be retained which makes it poor business or management choose to retain which makes them poor decision maker.

Many investors don’t understand this very real way of losing money even when company is reporting profits. But investors aren’t the only one but also many managers of the business don’t understand this loss, if they do, they apply their knowledge with dose of schizophrenia.

As Warren Buffett further observed, if profits are unwisely retained it is likely that management have been unwisely retained too.

Aziz Dodhiya is the chief investment officer for the Valueoperations funds which operates in the Indian market as an FPI (Foreign Portfolio Investor). We do not offer any personal advice to buy or sell any stocks and the views that are shared by Aziz might not incline to your personal investment strategy and this is the reason we advise to take professional advice before going ahead with our views.