Growth: Obsession and Confusion

Growth. Growth. Growth. For a stock investor, there is nothing quite like sustainable growth in earnings. Furthermore, growth in the economy helps too.  Growth is what every investor wants to see, or so they believe, both in the economy as well as in their stocks as it should lead where they want to go – higher returns.

Growth is the name of the game for politicians too. They need to engender a general sense of economic well being, fostered by a growing economy, to make an electorate happy and satisfied enough to vote for them again. In any democratic market economy, in particular, it is vitally important to generate a climate of economic success, and the most crucial time is a few months prior to an election.

The growth constituency is substantial, and so compelling is this idea that it almost  becomes an obsession. But is this really the one way street that everyone seems to imagine, or do we need a more balanced view? Investors can end up paying far too much for it, or the growth that exists may not be as profitable as hoped. Politicians must do whatever it takes to produce growth, or at least the perception it still exists, but they can easily produce temporary growth that takes risks with the long term health of the economy. 

While growth is in general a good thing for investors, as always, the devil is in the details. So often it seems that once investors have perceived some growth, they lose interest in further information. Somehow it is believed that the growth they see can solve any other issues there may be. The reality is, however, that we need to be far more discriminating if we are going to be successful investors.

Airline investing

Perhaps the best example of growth failing investors is the airline industry. No one can dispute that over the last hundred years the airline business has grown from zero to an enormous worldwide business. Yet despite this enormous growth, it does not seem to be widely known or understood that investors have lost money on a consistent basis all the way. Growth and losses is the name of the game here.

Warren Buffet recently admitted the difficulty of investing in airline stocks during an interview on CSFB. He joked by saying that whenever he I thought about buying an airline stock he called a 1-800 number and said “My names Warren Buffet and I’m an airline investor.”

No-one quite knows why it is so hard to consistently make money in airlines, but here are some likely explanations. Running an airline involves substantial capital outlays, but the pay back is only a low margin business, so the return on your capital may take a very long time and is very uncertain. In addition competition is fierce as everyone can see the general business growth, and it is very hard to distinguish yourself from your competitors, and so protect your earnings power.

So growth alone won’t do it for you. You need more than just growth for a successful investment.

High growth (often technology) stocks  

Investors have forever been attracted to high growth stocks. It is easy to see why - they are so exciting. A new invention can quickly become fashionable and often the possibilities seem endless. Momentum generates more momentum and everyone wants to be a part of it, even though no one seems to know what the right price is or really analyses how it generates the bottom line.

Nicholas Taleb, the author of “Fooled by randomness”, explains that as much as we think of ourselves as rational animals, when it comes to risk taking our actions are often not governed by reason, cognition or intellect. Rather, it comes chiefly from our emotional system.

          The traps are endless in high growth stocks. Do accelerating page views, subscriber growth or any other metric really lead to earnings growth? How many other competitors will also provide the same service or product? Will this new product really take on or will it soon become obsolete? Can you really make any useful projections at all or are they meaningless given so many variables? 

Satellite Radio

One of the latest “hot” growth areas is Satellite Radio. Let’s take a look.

Often stocks are valued at a multiple of earnings, but XM Satellite Radio (XMSR) has only losses. So Wall Street has to invent another metric and so they often use a price-to-sales multiple, which conveniently ignores the whole issue of how they will make money from their revenues.

Once we allow for convertible shares in their capital structure XMSR trades at a multiple of 37 times sales!!! Even during the internet heyday we never saw internet stocks trade much above 25 times sales. It would take 37 years for investors to get their money returned assuming that XMSR had no costs. Satellite TV companies trade at around 1.5 or 2 times sales. Get the picture! So you have to assume monumental growth and ultimate profitability far into the future to justify paying this price.

Let’s look at it another way. Assume XMSR becomes a mature business and trades at 2 times sales, how many subscribers would it need to justify this amount of revenue. At $13 a month XMSR would need 35 million subscribers, against a hoped for 6 million at the end of this year. So you have already discounted several years of projected growth on this basis. If you are buying this stock you would presumably be betting that 35 million subscribers is a significant underestimate, in order for you to achieve an attractive return. Who knows? But this stock hardly seems like a bargain, and the risks are substantial.

Since doing this analysis the stock has continued to trade higher as the company exceeded expected subscriber growth in the second quarter. Our analysis is ignored for the time being, as the stock trades only on subscriber growth right now.

It is my contention that for the most part stocks like this, where the valuation is hard to fathom, are essentially trading stocks which require trading discipline, and a great deal of focus on the company’s news flow. Investors that like to passively own stocks should avoid this kind of issue as for the most part long term returns on excessively valued stocks have been very poor to put it mildly.

  The “growth” economy

So how about investing in strong economies?

The Asian “Tigers” as they came to be known achieved remarkable growth from the mid 1980’s  to the mid 1990’s and over a decade the Malaysian stock market did nothing but go up. Then in just one month 10 years of gains were wiped out.

In the late 1980’s Americans seemed to accept the dominance of Japanese corporations and the miraculous growth and performance of the Nikkei index. But in the last 16 years the stock market has collapsed and the Japanese economy has been locked in deflation.

There are many similar examples of cases where it seems that spectacular growth is assured, only to find that suddenly and dramatically all the returns disappear. Investors need to be very careful not to fall victim to examples like this. Really the only way is to determine the sustainability of growth by understanding the mechanism that produces the growth, as well as some sense of valuations.

In the US today we are used to the idea of growth and tend to believe that policy makers have always found a way of managing to produce it. However, we don’t really look at the details of how it is generated. Is the growth in the US really something we can count on?

 Today, US economic growth is generated in the main by a massive expansion of credit growth, based primarily on an explosion of house prices. As a nation we no longer save at all but are very ready to increase our debt levels if we are given an incentive. When General Motors decide to sell a huge amount of their inventory at a loss we are very ready to take advantage. This activity boosts the growth statistics, but is this really what you would call healthy and sustainable?

Asset prices or incomes?

The other main driver of the economy is the housing market itself. As the chart below shows the average house price in the US has almost doubled in the last 6 years. Building, selling houses and mortgages have all experienced boom conditions and this year house price rises seem to have accelerated.

Rising assets prices, equities in the 1990s and houses in the 2000s, have been enormous drivers of growth. They have also enabled Americans to maintain their standard of living through debt accumulation as real incomes have failed to make any progress and the US has become uncompetitive internationally, as demonstrated by the explosion in the trade deficit over the last decade.

The burden of debt accumulation has so far been eased by consistently falling interest rates, but as the chart below shows debt accumulation has been so dramatic that even at current low interest rates, the burden of debt is becoming harder to bear.

Politicians and economists are quick to celebrate the “dynamic, resilient and flexible” strength in the economy. But what has been driving growth is the incredible willingness of consumers to increase debt levels while real incomes which service the debt are not rising at all. Growth in the US economy therefore depends crucially on house prices continuing to rise to generate yet further activity and collateral for yet more debt, at a time when house prices are extended, incomes are flat and interest rates are continuing to rise relentlessly to curb this growth.

In the end economies which are internationally competitive and are based on healthy income growth are far more sustainable than an economy driven by asset prices and debt.

Summary

Growth is an important characteristic in investing but we need a broad and balanced approach to what it means for our investments. We have shown above that remarkable growth in the Airline business has not stopped investors from consistently losing money.

High growth stocks like XSMR need a great deal of care when it comes to investing and very often should be treated as trading stocks only.

Finally, an economy may produce strong economic growth statistics, but if it depends or never ending asset price appreciation and debt expansion, at a time when incomes are no longer increasing to service that debt, then economic growth is more likely to represent the speed of ruination than a strong sustainable economy. 

As interest rates are likely to continue to rise until the current process comes to an end, this is a particularly dangerous time to believe in a durable economic expansion.     

 

 

 

 

 

 

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