Smart Corporate Growth Versus Irrational Growth
In general, growth is an investors friend. A growing company can create ever
higher earnings per share and which leads to ever higher share prices and (where
applicable) dividends.
But, there is a right way and a wrong way to grow.
How Smart Companies Grow:
Successful companies with smart rational management grow by investing
internally generated profits and cash flow as well as judicious amounts of
borrowed funds into new projects. This is called "organic" growth and includes expanding the business by
investing in larger production facilities, increased research and development,
increased advertising and sales efforts and similar initiatives.
In this scenario the company issues very few or (ideally) no new shares.
Therefore, increases in corporate earnings translate directly into increases in earnings
per share which (all else being equal) leads directly and inexorably to a
higher share price.
In addition, the company ideally issues only a limited number of stock
options so that its number of shares is held reasonably constant. In some cases
the company uses share buy-backs to offset the options and may even decrease its
number of shares outstanding.
Loblaw Companies Limited is an example. In the 5 years from the end of 1995
through the end of 2000, the company invested heavily in new stores and doubled
revenue. Meanwhile the number of shares grew by a modest 13%. Earnings per share
grew by 207% and the share price increased from $10.29 to $50.50.
CIBC is another example. In the same 5 year period it continued to invest and
grow. It actually decreased the number of shares outstanding by 10%. Revenues
and earnings per share doubled and the share price more than doubled.
It is extremely rational for companies to grow by investing retained earnings
in attractive projects because it is tax efficient (to investors) compared to issuing dividends
and because investors would not otherwise have an opportunity to invest in those
particular attractive projects.
There is a formula that tells us how fast a company can grow without issuing
new shares. The sustainable growth rate is equal to the Return on Equity times
the percent of earnings retained (as opposed to paid out as dividends).
Therefore a successful company that has an R.O.E. of 15% and which pays out 25%
of earnings as dividends retains 75% of the earnings and can sustain growth
at 15% * 0.75 = 11.25%. A company growing at a compounded rate of 11.25% per
year will increase earnings by 70% in 5 years and 190% in ten years. If no new
shares are issued then the Earnings Per Share will grow at the same rate.
A higher growth rate would require an increased proportion of debt or the
issuance of new shares. But rational managers know that increasing the number of shares outstanding
has the potential to dilute and decrease the growth in earnings per share.
How Irrational Companies Grow
Irrational company managers seek and congratulate themselves on absolute growth in revenues and disregard
the all important growth per share.
Nortel grew enormously from the end of 1995 through the end of 2000. But its
earnings went from positive to negative and the number of shares increased by
47%. In retrospect it seems clear that in return for the stock issued, Nortel
received grossly over-valued assets that often were ultimately worth little or
nothing.
It is "interesting" that during its glory days, Nortel would brag of 30% plus
increases in (pro-forma) earnings while not focusing on the fact that
(pro-forma) earnings per share were growing at less than about 20%. 20% is still
very robust, but the point is that the 30% on which management focused was
essentially irrelevant to the investor.
Another possible example is Telus. The company touts itself as a "growth"
company. In the five year period from the start of 1997 through the end of 2001,
I calculate that its share base has increased by 26% as it issued shares to fund
acquisitions. Meanwhile normalized earnings have also increased by 26%. This is a
compounded annual normalized earnings per share growth of just 4.8%. I also
calculate that even revenue per share grew by only 4.8%.
And yet by focusing on growth in number of customers, Telus considers itself
to be a growth company. Telus wanted to grow at a rate faster than its retained
earnings could fund. This growth came at the expense of diluting the share base,
cutting the dividend and also having to sell off valuable assets such as its
directory services and even its office buildings to raise cash. Possibly,
accelerated earnings per share growth in the future will result and this will
prove their strategy to be correct. But meanwhile the stock price was recently
down about 60% from its high and the strategy so far appears less than rational.
The Folly of Growing By Purchasing Other Companies with Shares instead of
Cash
In the great growth-by-acquisition boom of the late 90's it was often said
that a company could use its shares "as a currency" to buy other companies. And
this was accepted as a good thing.
But if company "A" doubles in size by purchasing similarly sized company "B",
but in the process doubles the number of shares outstanding, then I fail to see
how this represents real growth for shareholders.
In fact, the only time this makes a lot of sense is when company "A"s shares
are actually highly overvalued. In that case it might get exceptional value in
buying company "B" in return for a relatively few of its over-valued shares.
But, this should be a clear signal to investors sell their shares rather than
wait for the almost inevitable share price correction.
The Folly of Public Companies Buying Other Public Companies:
When a public company buys another publicly traded company, it is implicitly
saying that it is smarter than the market and its investors. After all if
company "A"s investors had wanted to buy company "B" shares , they were free to
do so in the market. Instead company "A" then buys company "B" at some premium
to the market and thereby forces its investors to become owners of company "B".
There is a certain arrogance in this.
In general, companies should instead invest in non-public assets and projects
that its investors are not otherwise able to access.
The Dangers of Issuing Shares to fund Growth:
Anytime a company issues shares for cash or assets it implies that it values
the cash or the assets more than its own shares. Typically shares are issued at
a slight discount to the prevailing market price in order to insure they are
sold. But this immediately suggests that this is (at most) what the shares are worth. The
immediate message is that the shares are either fully valued or possibly
over-valued since the company is willing to sell them for that price.
If a company thinks that its shares are under-valued then it should be buying
them in the market, not issuing new ones.
The Folly of excessively Promoting and Talking Up the Share Price:
Many growth oriented managers crave a higher share price in order to
facilitate acquisitions and will endlessly talk up and tout their shares in
an attempt to raise the price.
This is acceptable behavior as long as the higher share price is justified.
But if the share price is artificially raised too high, then new investors are
almost bound to lose money. Ethical managers should attempt to make money for
investors, not from them.
Exceptions to the Rules:
Sometimes it does make sense to issue shares to fund growth. If a company is
certain that it has a very attractive investment opportunity then the dilutive
impacts of a share issue might be quickly over-come.
For example Precision Drilling increased its share base by a hefty 69% in the
period from late 1996 through the end of 2001. But it also increased earnings
per share by 169%.
Conclusions:
"Organic" growth is often preferable to growth that is funded by share issues
since organic growth does not dilute earnings. Be very cautious of managements
that focus on absolute growth (to which their pay is usually tied) rather
than per share growth (to which your return is tied). Issuing shares
can be a rational growth strategy but be wary of companies that do so wantonly and then focus
on absolute growth. Always focus on earnings per share rather than on
absolute earnings. Be skeptical of companies that grow by buying public
companies, rather than by investing cash into new or private assets. Finally, remember
that the phrase "our shares are a valuable currency" is a clear danger signal that
often means -
"our shares are grossly over-valued, Sell!, Now!.
(c) Shawn Allen, Editor
March 1, 2002
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