I love companies that can grow for decades.
The best sort of growth reinforces the business model, which in turn makes future growth more likely. Network effects and economies of scale from greater purchasing power, or leveraging fixed distribution networks, are good examples.
However, pursuing growth for growth’s sake is one of the biggest mistakes I see companies make.
When is growth not the right strategy?
Growth that generates poor returns
Any money a company spends beyond maintaining its existing operations should earn reasonable returns. What is ‘reasonable’?
To me, it’s the opportunity cost of money in someone else’s hands. In other words, if I can earn a high-single-digit return by investing in the stock market (even in a tracker), a company should be targeting at least that, and preferably more, on any investments it makes. Otherwise, it should just return the money to me. Fairly simple and obvious – but not how a lot of companies operate.
Many companies tout earnings accretion as a reason to do deals; the returns seem to be an afterthought. Earnings accretion is a terrible reason to do acquisitions. With interest rates this low, virtually any deal, whether funded with cash or debt, will enhance earnings.
Every deal is different and must be appraised on its own merits, but as a general rule, if a company can’t generate a double-digit return within three years, I’d rather they didn’t do it.
In addition to generating good returns, acquisitions should at least maintain, and preferably enhance, the overall quality of the business.
Growth for diversification sake
Diversification is normally a bad reason to grow.
Not always – companies like Amazon have done a great job of diversifying into completely new areas – but this is a rare skill and should be seen as the exception rather than the rule.
Like investors, companies are usually better off sticking squarely to their circle of competence.
Growth that distracts from the core business
You see this a lot in roll-outs (shops, restaurants, cinemas, hotels, etc): the core estate gets neglected because all capital and management attention is directed to expansion.
Over-expansion can lead to sales at existing stores being cannibalised. Instead of spreading greater sales over a fixed cost base, you get almost the opposite effect – higher fixed costs from extra stores, but little in the way of additional sales to compensate, leading to falling margins and returns on capital. Not a great combo.