What Is Organic Growth, and When Is It a Smart Idea?

There are two main ways companies grow. They can buy other companies, which represents inorganic growth, or they can grow organically, which is what happens when a company invests its money to expand its product line, add a new service, or branch out into a new type of business. In this edition of Industry Focus, host Michael Douglass and Fool contributor Matt Frankel take a closer look at organic growth.

A full transcript follows the video.

This video was recorded on Oct. 9, 2017.

Michael Douglass: Let's finally turn to organic growth. Now, this one is really tough to get your arms around it, when it's effective to do organic growth. Generally speaking, that's the preference. Because what that usually means is that you know the people who are doing the work, and usually you know the work pretty well. If you're a bank and you're invested in single-family mortgages, and you're basically trying to write more business, you have a pretty good sense of what the trade-offs are there. If you're a bank and you usually do single-family homes since you're trying to move into multifamily, sure, you're moving into a new business, but generally speaking, you know what people you're putting on that business, so you therefore can really understand what that risk looks like on an initial basis as you really begin that ramp.

Matt Frankel: Sure. You said, all things being equal, organic growth is a preferred way to grow. And the right way to do organic growth is invest in something that's -- not necessarily immediately -- but going to add to your business, maybe open up a new channel of growth. Goldman Sachs (GS 0.22%) is one of my favorite examples of recent times. They have been pumping money into their new online lending platform. It's kind of like a Lending Club, but without other people lending money. It's Goldman Sachs lending the money. And it's already surpassed a billion dollars in loans, quicker than any of the other online platforms have. That's an example of good organic growth. They saw a market that they felt like they could do a better job of capturing, and have been pumping money into it and are willing to put money into it, because they have it, first of all, and because they want to grow it the right way to be a new permanent channel of growth for them.

Douglass: Right. I think that's really crucial. You can organically grow in businesses you're already doing. You can organically grow in businesses that are, let's say, pretty close to what you're already doing. Again, Goldman Sachs is a bank, so lending money is theoretically something they should be reasonably good at.

I think the third thing is when you can find ways to invest money to make what you currently do better, more efficient, more customer-friendly. A great example of this is the Starbucks (SBUX 0.53%) app. If you don't have it, personally, I think it's fantastic. Essentially, Starbucks recognized that they could make transactions go faster, they could really personalize offers for customers, they could drive more transactions and drive more business and drive more foot traffic if they really invested in their technology portfolio. So they did, and it's gone really well. While a lot of other food and drink establishments have struggled, Starbucks has been doing really well, and as a shareholder, I'm thrilled.

Frankel: Right. I don't know the numbers, but Starbucks invested millions into developing their mobile platform.

Douglass: Oh, I'm sure, and it's so slick.

Frankel: They capture people like me, who, if I see 28 people in line in front of me, I'll keep driving. But I can order before I leave my house, my coffee is there. That's a $5 sale they wouldn't have gotten.

Douglass: Right. It's interesting, because it's not something that on the surface on day one looked like it would drive a lot of money. Sure, it might make things a little bit faster, a little bit more efficient. Maybe it would capture a few people. But it's really making a big difference, even though it's not investing in a new business line, or investing in a different part of a current business line. It's really just something that, across the board, is making the entire business stickier.

Frankel: Yeah, it's just doing their business better, is how I would put it.

Douglass: Right, that sounds good to me. With all that in mind, there's a lot here about thinking about capital allocation. But the key thing here is that you want a management team that is good at capital allocation, because if they know what they're doing, they will make the right mergers and acquisitions, they will invest in organic growth when it makes sense, and they won't just be slavishly devoted to the dividend and the buyback. Those are important tools, but they are not nearly as important as investing in the business and making sure the business, long term, has a moat and is really successfully growing.  

Frankel: Right. If I can throw in one more example, Warren Buffett's Berkshire Hathaway (BRK.A 1.18%) (BRK.B 1.30%) is a great example of everything. That's why we keep bringing them up. But he's publicly prioritized the way that he will use Berkshire's cash, and No. 1 is always make sure the current business needs are met first, be that growth, capital requirements, whatever. No. 2 is to acquire new companies that will add value to Berkshire, kind of how Michael described buying a $1 billion company for $1.5 billion and sinking money into it. That's No. 2. A distant third and fourth are dividends and buybacks. So it kind of tells you that Warren Buffett doesn't feel that Berkshire is an overly mature company yet, even though it's worth about $400 billion.

Douglass: Right. And it's hard to argue with one of the world's best money managers and, frankly, business managers.