Growth and Value Creation
Growth and Value Creation
Growth and Value Creation
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An investment strategy for true wealth creation dictates shrewd investment analysis. Let's focus in on growth and its role within investment analysis. The business world as a whole tends to be consumed with growth. And growth and value creation are tightly linked, as is Return on Invested Capital (ROIC). As discussed in a previous post, growth and ROIC are the twin towers of value creation. The ability of any company to sustain both over time is going to drive a company's ability to create shareholder value. However, higher growth alone will not necessarily create the most value because the 3 drivers of growth do not all create value equally.
The 3 drivers of growth are the following:
- Segment Growth: organic revenue growth achieved by expansion within existing market segments.
- Market Share Growth: organic revenue growth achieved within the overall sector/industry in which it operates.
- M&A Growth: inorganic growth achieved through mergers or acquisitions.
According to research by McKinsey & Co, growth within segments of a company's portfolio and M&A explain more of the differences in growth of large companies than does market share. Increases in market share for large, well-established companies are rarely sustainable. This is because established competitors can retaliate against an increase in market share. And using price hikes to drive market share expansion may result in lost customers unless the company has a strong and durable competitive advantage. In this case too though, competitors can also retaliate. So new value created by price increases may not last long.
3 Growth Strategies with Greatest Value Creating Potential
Entering fast-growing product markets that take revenues from distant companies, rather than close, direct competitors or customers is said to have the most potential to create value. Doing so basically entails one of three growth strategies.
Developing Ground-breaking, Innovative New Products or Services
Think Apple creating the iPod or the iPhone. Think Microsoft when it created the Windows operating system and Office suite. You can also think about Crocs and its creation of shoes with superior comfort using its innovative Croslite material. Developing new products or services that are so innovative that new product categories are created has the highest value-creating potential. These types of innovations are also what tend to underly the durable competitive advantages of the companies that make them.
Persuading Existing Customers to Buy More of a Product or Related Products
As an example, if Starbucks is able to tout the benefit of increased coffee consumption, it can drive more revenues with coffee sales. It can also drive more growth via related products that we all have with our coffee. This would include Starbucks coffee-related drinks and other snacks like pastries. Direct competitors won't retaliate but instead follow suit. This is because they also benefit from the Starbucks strategy being employed. And the return on invested capital (ROIC) is likely to be very high because the supply-chain and distribution systems are already in place with little additional cost.
Drawing New Customers to An Existing Market
Lulu Lemon, for example, is actively engaged in this strategy. It is expanding its unique and branded gear with a line for men. By convincing men to use their products, the company can grow revenues while avoiding competitors retaliation. Competitors too will benefit from male consumers who begin wearing such products.
Challenges of Sustaining Growth
Sustaining high growth is much more difficult than sustaining high ROIC, especially for larger companies. In evaluating companies for potential money investment, growth is good but a high historical trend of ROIC is even better. Far too often, investors are focused on high growth. If a company is incurring high growth but operates with low ROIC, it could actually be value-destroying. Overall, companies with high ROIC can create value by increasing their growth rate, but companies with low ROIC should create more value by focusing on increasing ROIC instead. Of the two, ROIC is the more important metric versus growth.
If we look at Home Depot (HD) versus one of its main peers Grow Generation Corp (GRWG), we see this illustrated. Home Depot is much larger with a market cap of $302B while Grow Generation is a $255M company. As such, Home Depot has been incurring a lot slower levels of growth. In the past 3 years, Home Depot grew revenues at a compounded annual growth rate of only 9.30%. In contrast, Grow Generation has grown at a hefty compounded annual growth rate of 88.9% during the same period. The total return over the past 3 years for HD shareholders has been 31% versus a negative -20.8% for Grow Generation. The differentiating factor is ROIC: 31.1% for Home Depot and a negative -5.56% for Grow Generation. It would seem that Grow Generation may have a number of things that is leading to poor returns, but it should certainly focus on increasing it's ROIC before incurring growth.
Product Life Cycles
For larger, well-established companies like Home Depot, sustaining growth is difficult because most product markets have natural life cycles. First, a product proves itself to customers, thereby generating demand. That demand fuels growth that accelerates as more people buy it until it reaches a point of maximum penetration. This is the point of maturity. At this point, either sales growth falls back to the same rate as population growth rate or the economy's growth rate, or sales start to decline. The market for a product generally follows an S-curve over its life cycle until maturity.
Because of the natural life cycle of products, it can be very challenging for companies to sustain growth at high levels. The only way to achieve consistently high growth is to consistently find new product markets and enter them successfully in time to enjoy the more profitable high-growth phase. And, as stated previously, the most value creating growth comes with truly innovative products.
Success in investing requires strategic money management. When it comes to evaluating companies for money investment, don't necessarily focus on companies incurring high growth alone. Be sure that high growth is coupled with high Return on Invested Capital (ROIC). And/or make sure that companies incurring high growth are focused on the 3 growth strategies for value creation detailed above. The most value-creating growth will be based on truly innovative products. And these companies, if managed properly (i.e., high ROIC) will be the ones to establish durable competitive advantages within their industries. These are the companies that present as truly spectacular investment opportunities for long-term wealth creation.
The information provided on this site is based on my own personal experience, research, and analysis, and it is not to be construed as professional advice. Please conduct your own research before making any investment decisions. I am not a professional financial advisor, stockbroker, or planner, nor am I a CPA or a CFP. The contents of this site and the resources provided are for informational and entertainment purposes only and do not constitute financial, accounting, or legal advice. The author is not liable for any losses or damages related to actions or failure to act related to the content on this website.