Growth is a challenging concept this year. Investors have been forced to think harder about what it means and, crucially, how much they should pay for it. Often, analysts need look no further than earnings per share to estimate growth rates, but this has become a risky approach. It is not just that accounting treatments, profits adjustments and share buy-backs flatter earnings per share. Some so-called “growth” stocks are actually shrinking physically. Investors are being forced to look deeper into organic growth comparisons, and separate out pricing and volume effects.
The challenge of 2018 may be less a rotation from growth to value, than a need to weed out the imposters in the growth universe. If investors want to keep one step ahead of share price collapses, they need to think of growth in down-to-earth physical terms.
Printing money has boosted consumer and business confidence, and restored economic growth. But that growth in western economies is now at much lower than historic levels, and disguises a lot of business disruption. Many traditional businesses face challenges from new business models but are responding by cosmetic changes that only temporarily flatter reported growth. These can include rolling-up a business by buying smaller competitors, or pruning lower margin areas. Accounting treatment can flatter these moves. And, many retail businesses have continued to expand their floor space or units, even as their business model has been called into question. It seems that investors do not look closely enough to see if activity in older units is slipping back. Management may be incentivised to focus on keeping up appearances in the short term. Should we be surprised, in a world where “shrinkflation” cuts the size of consumer products to preserve prices and margins? Investors should be no more convinced than consumers that this disappearing act does not compromise brands and business value.
Tragically, many businesses have simply raised prices, misunderstanding their power and believing that they are in a semi-monopoly position. The failure of these strategies often comes as a total surprise to investors, triggering sharp share price falls. It is an area where analysts need to do some work themselves. There are accounting standards for earnings per share, but not for some of the earnings per share adjustments, or for the “organic growth” metrics put out by managements. Extracting more profit from a declining base of customers or shrinking product hardly merits a growth rating. These challenges are not just about technology and consumers moving online. Many tobacco and branded food businesses are being hit, alongside High Street retailers.
The psychological impact of priming is powerful – we are typically influenced unconsciously by context and framing. A “growth stock” label, combined with rising earnings per share and management excitement, influences subsequent analysis. The halo effect, as management claim credit for share price performance, is added to the social endorsement of seeing other investors pile into the shares. A powerful cocktail of biases spares many growth companies from close scrutiny.
In a world where true growth is scarce, it should be prized. Superior returns on capital can persist for several years, meriting a premium rating. Indeed, some new strategies may merit a very forward-looking approach; digital businesses can scale rapidly. And, even older economy businesses such as Fevertree Drinks, have developed capital-lite business models. But even for those businesses, the cost of customer acquisition and unit costs matter.
Undoubtedly, this year will see many established businesses fall from their growth pedestal. Portfolio performance may depend on side-stepping these disasters. It can be hard to overcome some psychological biases, and those linked to growth are harder than most. But, looking at the trends in physical like-for-like customer demand is a good start.
A version of this article was published on Citywire on 26th March 2018.