The Secret to Great Growth

Charlie Munger, a master investor who has had a profound impact on Warren Buffett as vice chairman at Berkshire Hathaway (NYSE:BRK-A), has famously said, "All intelligent investing is value investing."

You're intelligent, right? You want your investments to make you wealthy, right? Then according to Charlie, you need to be a value investor.

The biggest reason Charlie believes value investing is smarter than growth investing is because growth is a part of value. Therefore, growth investing cannot produce better returns than value investing over the long term.

What would Buffett say?
But don't take my word for it. Here's what the Oracle of Omaha, Warren Buffett, had to say about the subject in his 1992 Chairman's Letter:

"In our opinion, [growth and value] are joined at the hip: Growth is always a component in the calculation of value, constituting a variable whose importance can range from negligible to enormous and whose impact can be negative as well as positive."

The positive aspects of growth are pretty straightforward. If a company can generate more sales over time, it should be able to generate more profits as well. To see those benefits, let's take a quick look at Coca-Cola (NYSE:KO), a Motley Fool Inside Value recommendation and quintessential Buffett investment.

So if the stock price increased faster than both sales and EBIT, each sale must be generating tons of value. No wonder Buffett invested in Coca-Cola!

There's bad growth?
It's not intuitive, but growth can destroy value. In that same Chairman's letter, Buffett teaches us:

"In the case of a low-return business requiring incremental funds, growth hurts the investor."

Growing firms require capital investments. Those investments can take many forms, but the idea is to generate additional sales. However, those sales also have to generate returns on the invested capital that will compensate shareholders for letting management use their capital. If the returns don't deliver, the company's growth destroys shareholder value.

Charlotte Russe (NASDAQ:CHIC) and Hot Topic (NASDAQ:HOTT), two fashion retailers, are interesting examples. The table below shows their performance against the market's evaluation of that performance.

Stores and sales grew nicely at both companies. Unfortunately, as they grew, ROIC fell. That won't cut it over the long term. Sooner or later, the market recognizes this.

And there's good growth
If growing sales across falling ROIC is bad, then increasing sales with increasing returns has to be good, right? Let's look at another example.

As arts and crafts retailer Michael's Stores (NYSE:MIK) grew, its ROIC improved. Thus, the capital that shareholders supplied created more value over time. See the difference in the stock price? This is what Buffett meant when he said:

"Growth benefits investors only when the business in point can invest at incremental returns that are enticing -- in other words, only when each dollar used to finance the growth creates [more than] a dollar of long-term market value."

To hammer the point home, here's a look at Nike's (NYSE:NKE) performance over the past few years.

Then there's great growth
Quality Systems (NASDAQ:QSII) has been a fast-grower lately, and it's rewarded its shareholders handsomely.

Clearly, the market loves a business that can generate huge amounts of value with very little incremental capital requirements. Quality Systems currently trades for almost $70. Now that's a value-generating business model!

Three important points about growth
So, with regard to growth and value creation, take a page from our Motley Fool Inside Valueanalysts and look for three things in value-oriented growers:

1. Don't focus solely on sales growth.
2. Make sure a company earns more than its cost of capital. Otherwise, it's destroying value.
3. Find companies with high incremental ROIC.

Be an intelligent investor
Referring back to the Coca-Cola example, the important thing was not that Coca-Cola grew its sales and operating income. Rather, the company's ROIC grew from about 19% in 1988 to 27.2% at the end of 2004 while sales and operating income grew. Coca-Cola created value because of all three, not simply because of its high sales growth.

Philip Durell, advisor/analyst of the Fool's Inside Value newsletter service, heeds Munger's words: All intelligent investing is value investing. If you'd like to learn more about value-creating companies, or if you'd like full access to our lineup of more than 30 buy reports, we invite you to join us with a free, 30-day guest pass. Without a doubt, it will be an intelligent investing decision.

For more on value creation, check out:

• The Sweet Smell of Money
• Stock Up on "Discounted" Value
• Put Time on Your Side

Fool David Meier owns shares of Nike but does not own shares in any of the other companies mentioned. Quality Systems is a Motley Fool Stock Advisor recommendation. The Motley Fool has a disclosure policy.