According to the investment calculator on Wal-Mart's (NYSE: WMT) investor relations page, folks who plunked down $10,000 for shares on this date in 1980 would now have a stake in the company worth $4,922,262 ... and that doesn't include reinvested dividends.
Success stories like these are an awe-inspiring thing. They also provide the key justification for what's come to be known as growth investing, in that picking such winners provides the highest possible returns.
Paying 50 cents on the dollar for a mediocre business can work out very well, but making five or 10 times your money on such an investment is often a remote prospect. Paying closer to 100 cents on the dollar for a stake in a business that can earn high returns on incremental capital year after year, even as it gets bigger and bigger, can net you a fortune over the span of 20 years. Paying 200 cents on the dollar for a company with great-sounding prospects is always a bad idea.
That middle path can lead you to great profits, but the smaller the discount to your estimate of intrinsic value, the more reliant you are on the future turning out as well as expected. Pay above fair value, and you need more luck than good sense. There are obviously tremendous pitfalls to success in this realm, or else everyone would own a professional sports team and companies like EZCORP (Nasdaq: EZPW) and Portfolio Recovery Associates (Nasdaq: PRAA) would be out of business. Our inability to see the future makes growth investing one tough gig.
Now, a lot of great things have been written on this site about how to find the next home run stock and how to avoid the dreadful ones. The trait I'm going to key in on today is one that's common to dream stocks and duds alike. While this is a feature that everyone should have an eye on, growth investors in particular need to sit up and pay attention.
Guilty until proven innocent
In my CFA program curriculum, I came across a very interesting warning in a reading on identifying low-quality financial reporting: "Your presumption should be to treat all asset growth as bad and impose a tough standard to reject that hypothesis."
At first, that might sound crazy. How can a company become a world-beater without significantly increasing its net operating assets over time? Wal-Mart has certainly experienced massive asset growth over the years:
|
Fiscal Year |
Operating Assets (Total Assets-Cash and Marketable Securities), in millions |
Operating Liabilities (Total Liabilities-Total Debt), in millions |
Net Operating Assets (Operating Assets-Operating Liabilities), in millions |
|---|---|---|---|
|
1989 |
6,347 |
2,118 |
4,229 |
|
1999 |
48,117 |
18,271 |
29,846 |
|
2009 |
156,154 |
55,909 |
100,245 |
Data provided by CapitalIQ, a division of Standard & Poor's.
In Wal-Mart's case, asset growth was a good thing, as the company was able to continually earn high returns on capital as money was reinvested in the business. But keep in mind that we're talking about one of the biggest winners in the business world over the past few decades. Countless other companies have aggressively grown their asset bases, only to meet with unexpected headwinds and poor returns on investment. Past examples would include the old AT&T's (NYSE: T) spending over $100 billion to purchase various cable companies, and ConocoPhillips' (NYSE: COP) top-dollar acquisition of Burlington Resources. A more recent case is LDK Solar (NYSE: LDK) and its costly foray into polysilicon manufacturing.
Good growth, bad growth
The challenge for growth investors, then, is to separate good asset growth from bad asset growth. That is an extremely difficult task, and one that requires a solid grasp of the firm's growth prospects, competitive positioning, and management quality. I don't have a neat formula to apply here, but I do have a few suggestions.
If a firm has a dominant position in an emerging growth market, as Intuitive Surgical (Nasdaq: ISRG) has in the field of robotic surgery, then asset growth is probably not a bad thing. If a firm enjoys a duopoly or oligopoly position in any market, even one as mundane as salt, asset growth should work out OK. Contrarily, if the business is one of countless competitors vying for market share, even in a market with terrific "blue sky" potential such as renewable energy, asset growth may be questionable.
Here's where investors get tripped up
Successful growth investing does not stem from catching a few years of astronomical sales growth rates. Rather, it appears to hinge on identifying a durable (i.e., multi-decade) competitive advantage that allows the subject company to get bigger and better.
This advantage could result from a pristine intellectual property portfolio, or simply being the lowest-cost producer. Just look for the wide moat, regardless of what form it takes, and then figure out what could narrow it in the future. No moat, and you've got to question whether a company's asset growth is going to deliver the goods in terms of future shareholder returns.
