Today, I want to talk a bit about a concept most value investors, for one reason or another, ignore: growth.
To clarify, most value investors don’t actually ignore growth. Rather, they try not to incorporate any growth into their analysis, or only incorporate absolutely worst case levels of growth and then have any further growth serve as “gravy”.
Most investors are familiar with the maxim that growth is not always good. Growth consumes capital, and unless you have competitive advantages to protect that growth and have it come at more than WACC, a growing company is worth the same as a company that doesn’t grow but pays out all cash to shareholders (for further discussion, I’d highly recommend Value Investing. There’s a great discussion of this concept and how to value growth).
All that said… most investors would prefer their company to grow than shrink. Small amounts of growth normally provide for some operating leverage, which should naturally improve ROIC, if slightly. Shrinking firms face all sorts of horrific choices, including reverse operating leverage.
So some growth is good, right? And if some growth is good, shouldn’t explosive growth be great?
I’m not so sure. As a rule of thumb, when a company grows at a tremendous pace, it is normally a good thing. But that’s normally because explosive growth occurs fora company like Facebook or Ebay that is in a brand new market that has the potential to “tip” (see The Tipping Point for further discussion on markets tipping”.
For traditional companies that most deep value investors invest in, I would argue that explosive growth is at best neutral and normally a bad thing (again, assuming there’s no huge franchise or competitive moat. Growth is always good with a moat or franchise). In fact, for net-nets and other beaten down companies, explosive growth can actually be a terrible thing.
The reasoning is simple- growth consumes cash. A growing business without a competitive advantage is a cash hungry beast. Investors know that the safest asset on the balance sheet is cash because cash is always worth 100 cents on the dollar. When cash is converted into something else, that asset may or may not be worth 100 cents.
This “growth is bad” thing might seem counter intuitive. So let me show you what I mean with an example from a current holding of mine, Wireless Xcessories (WIRX).
As a quick refresher, WIRX is a company in a complete commodity industry- producing cell phone cases and accessories. They have absolute no competitive advantages, but they’re attractive because they trade for such a steep discount to NCAV.
The company has experienced absolutely explosive growth. Revenues grew 10%+ in 2011 and just a shade under 75% in the first nine months of 2012. And while the company is working on slim margins, the growth has taken them from ~(1%) (that’s negative 1%) to ~2% or so operating margins. That’s a pretty big turn around, and it amounts to a nice bit of money for a microcap on pace to do $30m+ in sales this year.
But I mentioned I invested in WIRX as a net net. So let’s take a look at their balance sheet for 2010 and 2011.
And now their most recent
All of that growth has consumed a lot of cash. Cash and investments has gone from $3.5m (almost $0.90 per share!) to barely over $1m. While the 4th quarter should see some build back of operating liabilities that will generate a bit of that cash back (though this is far from assured if the company continues growing at this rate), that is a big chunk of their cash balance gone. Looking at the NCAV value, it’s gone up a bit from $1.83 per share to $1.95 (though a lot of that gain has come from interest income and gains on investment, not from the actual business generating profits).
The conclusion is pretty obvious- WIRX has made a transition from a cash rich net-net to a business trading at a discount to NCAV. It’s gone from a stock trading below liquidation value to a stock trading below on going business value.
In other words, WIRX was a safer stock back in 2010. You didn’t really need the business to do anything. All you needed was for management not to do something incredibly stupid with the cash and you’d be ok.
Today, WIRX is still cheap. And it still trades at a big discount. But it’s no longer as cheap. You need management to perform here. If the business tanks, an investor today will have much more to worry about than an investor in 2010. You need to be confident that inventory and accounts receivable are worth close to what they’re stated at.
Does WIRX have more upside today then it did 2 years ago? Sure- it’s got more net assets, and in an acquisition a competitor might be willing to pay a bit more of a premium because of a larger customer list.
But you don’t normally invest in a net-net for the upside. You invest for downside protection. That’s why I initially bought WIRX. And while I still really like the stock, the fact is WIRX has a lot less of downside protection today than it did two years ago.
And that’s why growth isn’t always a good thing.
Disclosure- Long WIRX
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