If it seems too good to be true, it probably is.
That simple lesson can save you a lot of heartache. It'll also save you a lot of money. Let us explain why.
The high cost of high growth
Just in the past month, Freddie Mac (NYSE: FRE ) and Fannie Mae (NYSE: FNM ) were rescued by the U.S. government, Merrill Lynch has been bought out, AIG is engaged in "rescue talks," and Lehman Brothers is on a path toward liquidation as we speak. The collapse of these financial giants has been stunning in both its speed and severity.
These fallen companies were overlevered, overconfident, and too slow to either realize or admit that they were in serious jeopardy. But these companies all shared one additional trait that foreshadowed their downfall. They pursued a strategy of growth at any cost -- and it ultimately cost them dearly.
Year after year, these companies targeted double-digit growth, despite much slower growth in their core markets.
And they'd magically hit their numbers.
OK, it wasn't magic
What wasn't being asked strenuously enough was what risks the companies were taking to maintain this supranormal growth rate. This problem isn't unique to financial companies; they're just the most recent high-profile examples.
See, the stock market overvalues growth and undervalues high, sustainable returns on capital. It's ultimately extremely destructive for companies to pursue growth so vigorously, because what inevitably happens is that the companies take on new business that offers lower margins of safety, are outside of their areas of expertise, and carry a higher risk.
For a period of time, companies can grow at whatever speed they want, and their executives tend to win handsome rewards as the market nods its approval. But there is always a cost.
And it's often steep
The average company increases earnings only about 4% to 6% a year. That's far lower than most investors presume. Maybe the media devote too much coverage to the most rapidly growing companies; maybe we're just a bunch of eternal optimists. But perpetual earnings growth of 10% to 15% -- the kind of growth Wall Street analysts often assume -- is extraordinarily hard to find.
So again, we repeat: If it seems too good to be true, it probably is.
The 3 signs of unsustainable growth
There's even more truth to that maxim when you consider that earnings growth itself doesn't always add to a stock's value.
It can actually subtract from the value -- and often does. Whenever a company's return on invested capital (ROIC) is less than its weighted average cost of capital (WACC), the pursuit of growth will actually destroy value. But, afraid of "falling behind" the competition, many companies concentrate on empire-building rather than on maximizing shareholder value.
This simple truth is unfortunately lost on many investors -- and corporate executives. Don't be fooled.
As a cheat sheet for separating the good from the ugly, here are three warning signs that may indicate that a company's growth is coming at the expense of shareholder value:
1. The company is growing at a much faster clip than the rest of industry
Unless a company has a sustainable competitive advantage, growth rates that outpace the rest of its industry can be a signal of accounting shenanigans or aggressive business practices. Beware of ballooning accounts-receivable balances in excess of revenue or accounts-payable growth -- this could indicate that a company is extending favorable terms to its customers to perpetuate artificially high growth rates. In the insurance industry, keep an eye on premium volume. In frothy times, aggressive insurers have been known to write unprofitable policies to amass market share.
2. The company is branching out into noncore business lines
There's a reason the McPizza failed. McDonald's (NYSE: MCD ) is good at making burgers and fries -- not pizza pies. When companies deviate from a time-tested winning strategy to pursue bizarre new revenue streams, the results are typically disastrous. Even successful one-trick ponies tend to veer off course from time to time. Starbucks (Nasdaq: SBUX ) shares swooned in 1999 when the company launched an ill-conceived e-commerce venture. And Coca-Cola (NYSE: KO ) was flat for years while management squandered capital on water purification, shrimp farming, and even a movie studio.
3. Executive compensation is tied to the wrong metrics
Finally, the motive behind a company's aggressive growth can typically be traced back to the CEO's wallet. Analyzing a company's proxy statement can provide valuable insight into management's incentives.
Instead of concentrating on absolute compensation, focus instead on the metrics used to determine executive pay. For example, American Express' Ken Chenault is among the highest-paid CEOs in the world, but to realize the full value of his options package, he'll have to create some serious shareholder value.
Shareholder-friendly compensation structures reward management for boosting measures that will benefit shareholders, like ROIC.
Conversely, metrics like earnings per share (EPS) or earnings before interest and taxes (EBIT) may encourage executive malfeasance. These measures give executives incentive to repurchase shares or issue debt, when such capital decisions may not be in shareholders' best interests. Distributing options instead of restricted stock allows management to participate in a company's upside potential without any downside risk -- and this may encourage more aggressive growth plans.
Martyred on the altar of Saint Growth
In Lehman, Fannie, Freddie, Countrywide, Washington Mutual, and AIG, we've seen a pattern of companies that pursued growth at any cost. The final costs, in most of these cases, have been extremely high.
The takeaway here isn't restricted to financial companies -- it applies to every equity investment you'll ever make. If or when you encounter growth that appears unsustainable, run through the three points above, and honestly ask yourself what risks the companies may be taking on to do the impossible.
Keep up with Fool.com's ongoing coverage of this week's Wall Street chaos.
Bill Mann owns shares of McDonald's. Rich Greifner owns shares of Freddie Mac, Fannie Mae, and Starbucks. Bill Barker owns none of the companies mentioned in this story. The Motley Fool owns shares of American Express and Starbucks. American Express, Coca-Cola, and Starbucks are Motley Fool Inside Value recommendations. Starbucks is also a Stock Advisor selection. The Fool has a disclosure policy.