Street has an unending fascination with growth. Its world-view about businesses is to a significant degree shaped by how fast does the company in question is growing. Higher the pace, higher are the multiples generally with sometimes lower focus on how durable or sustainable that growth rate or revenue base is, especially during the seemingly ever lasting periods of optimism.
Though growth is a significant contributor to overall returns, unsustainably high growth rate – or even worse a fragile revenue base – is more of a bane than something to cherish. It hardly takes much time or efforts for markets to re-calibrate themselves to the changed reality in terms slowing rate or declining revenues.
This is what something which happened to economy as a whole back in 2007-08. And it is currently happening to Indian IT sector with growth rates coming down from 25-30% p.a. 2-3 years back to 8-12% p.a. today. And something which continues to haunt several companies every now and then.
This is not to say that this low growth rate is the new regime for Indian IT which is here to stay but thinking that 30% p.a. could stay so over a 10yr period, though possible, may not be probable. It could be a whole lot to expect from mere mortals 🙂 And this applies to entire economy and all its smaller constituents.
Good Business but a Bad Stock?
While growth is an important element to business returns, its importance diminishes when we were to look at overall stock returns over shorter chunks of time. True that over long term, business returns equate to stock returns but that is certainly not the case in short or medium term period. Two years back, I remember, Cera reported mid-teens earnings growth while stock tanked ~25% in a few days following it as company failed to deliver what people on the street were expecting!
As a value investor, what is important is not just how fast is a business is growing but what is priced into the stock and compare that with the rate we can conservatively think it can sustainably grow over medium to long term. Near term unsustainably high growth rates (and vice-versa) doesn’t count! And this is where we are at a position which is polar opposite to the street.
In markets, there are cases when short term stock returns from a slow growing business, for which market has depressingly low expectations, outperforms those from a fast growing one when all its glory is already priced in.
In fact, if the emperor fails to live upto the expectations of its citizenry, brutal bloodshed would follow for both – emperor and his supporters who elected him at his post in the first place 🙂
Thinking about long term growth
As an Analyst, people can have a very different world view about how a business grows. All those excel models sometimes only make it difficult for people to embrace reality and instead gets them tangled into a web of their own creation. As the saying goes, investing is simple but not easy!
In order to better insights about growth rates one needs to think how a businessman would think about it ditching out the coveted spreadsheet.
This is what a businessman, Anand Deshpande, MD of Persistent Systems, had to say about the topic in the company’s 2007 Annual Report which is quite interesting –
Growth is always discontinuous… I would like to compare the Company to the state of electrons in an atom. Just like atoms, to take the company to the next level, you have to inject new energy into the Company. You call these points of inflection, to use Andy Grove’s terminology.
At these points of inflection, new energy has to come in the form of one or more events such as a new business model, a new customer, a new senior executive, new funding, acquisitions, etc. These events will cause uncertainty and turbulence in the company. But these are necessary to move to the next growth level in the company.
Almost polar opposite to what a ‘spreadsheet king’ would say 🙂
As value investors, we need to avoid being too excited when these ‘energies’ are injected into the company and when Market as a whole is celebrating and tame our fears when turbulence first strikes and thereby trying to take an advantage of Market’s irrationalities without losing out our own sensibilities.
Stocks discussed in this post are for educational purpose only and not recommendations to buy or sell. Please contact a certified investment adviser for your investment decisions.