Grantham: Investing in a Low-Growth World

In Jeremy Grantham's latest letter, he asks whether lower GDP growth logically leads to reduced stock returns.

Grantham answers that question this way:

"This is where I break ranks with many pessimists because I believe theory and practice strongly indicate that lower GDP growth does not directly affect stock returns or corporate profitability.

He adds, parenthetically, that their may be some effects of lower GDP growth that will lower equity returns in a minor way. This gets covered in more detail later in the letter. Otherwise, as far as stock returns go, growth is just not as big a factor as some might think.

All corporate growth has to funnel through return on equity. The problem with growth companies and growth countries is that they so often outrun the capital with which to grow and must raise more capital. Investors grow rich not on earnings growth, but on growth in earnings per share. There is almost no evidence that faster-growing countries have higher margins. In fact, it is slightly the reverse."

In fact, growth can be a negative factor. According to Grantham, it turns out that growth companies and countries underperform...

"The fact that growth companies historically have underperformed the market – probably because too much was expected of them and because they were more appealing to clients – was not accepted for decades, but by about the mid-1990s the historical data in favor of 'value' stocks began to overwhelm the earlier logically appealing idea that growth should win out. It was clear that 'value' or low growth stocks had won for the prior 50 years at least. This was unfortunate because the market's faulty intuition had made it very easy for value managers or contrarians to outperform. Ah, the good old days! But now the same faulty intuition applies to fast-growing countries. How appealing an assumption it is that they should beat the slow pokes. But it just ain't so."

While maybe not intuitive, that high growth rates will have a high correlation with investor returns is far from a given.
(Regular readers obviously know that this has been covered more than a few times on this blog.)

High levels of growth should, of course, generally lead to more desirable investment outcomes, right? As it turns out, not necessarily. If interested, here are some of the prior posts that deal with variations of this subject:

Buffett: Stocks, Bonds, and Coupons - January 2013
Maximizing Per-Share Value - October 2012
Death of Equities Greatly Exaggerated - August 2012
Stock Returns & GDP Growth - July 2012
Why Growth Matters Less Than Investors Think - July 2012
Ben Graham: Better Than Average Expected Growth - March 2012
Buffett: Why Growth Is Not Necessarily A Good Thing - Oct 2011
Grantham: High Growth Doesn't Equal High Returns - Nov 2010
Growth & Investor Returns - June 2010
High Growth Doesn't Equal High Investor Returns - July 2009
The Growth Myth Revisited - July 2009
The Growth Myth - June 2009

Fast-growing countries, industries, and individual businesses have a whole range of possible investor outcomes with above average returns far from being certain.

"Growth is always a component in the calculation of value, constituting a variable whose importance can range from negligible to enormous and whose impact can be negative as well as positive." - Warren Buffett in the 1992 Berkshire Hathaway (BRKaShareholder Letter

Wait, growth can be a negative thing?

Some might choose to treat all this as anomaly. Yet, it's often not a bad idea to explore in some depth what's against conventional wisdom -- what's not intuitive. Occasionally, that's where the more useful insights reside.

Growth, of course, can be a good thing but some seem to think, from an investor point of view, it is always a good thing. What gets in the way? Well, investors often pay too much for attractive future prospects. Also, high growth prospects invite in lots of capital and competition. Lots of well-financed capable competitors can lead to undesirable core economics and a wide range of unpredictable outcomes.*

The real question becomes whether growth will have a favorable impact on the per share value created over a very long time. Sometimes it does. Sometimes it does not.

The primary drivers of long-term returns is the price that's paid relative to well-judged intrinsic value, return on capital**, and whether real durable advantages exist.

A good business needs little capital. It can return the excess capital produced to shareholders. It can use it to finance opportunities at an attractive long-term return. It can do these things while maintaining or even increasing the size and strength of its economic moat (has no trouble defending its core business economics).

This just requires business leaders who do not choose growth for its own sake over per share returns for its shareholders.

Far from a certainty.

Unfortunately, sometimes the fastest growing, most promising, dynamic, and exciting areas of opportunity produce less attractive risk-adjusted returns and a wider range of outcomes.

Adam

* Growth will often have a favorable impact on value. It just happens to be a mistake to think that it always has a favorable impact. In fact, growth can actually reduce value if it requires capital inputs in excess of the discounted value of the cash that will be generated over time. Sometimes, the highest growth opportunities attract lost of capable competition and capital that ruins the long run economics. Sometimes, high growth requires costly yet necessary capital raising (to fund key investments, deal with competitive threats) that dilutes existing shareholders and reduces per share returns.

Finally, even if growth that materializes does have favorable economics, some investors tend to pay a large premium upfront for those growth prospects. That hefty price paid may turn attractive long-term business results into not so attractive investment results.
** The highest possible truly free cash flows relative to the ongoing capital requirements of an enterprise.
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Grantham: Investing in a Low-Growth World
Grantham: Investing in a Low-Growth World
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