Creating value by growth.

For buy and hold investor in public companies, it is important to make sure company has additional avenues for growth in it's line of business. It is often easy to overlook this important aspect while reviewing Warren Buffett's investment criteria. Lets first take a minute to review Warren Buffet's investment criteria.

To put it simply, buy businesses with sustainable competitive advantage(s), run by honest and competant managers and selling at a fair price. Warren adds that to evaluate these qualities, the company needs to be within one's circle of competance.

I would add that in addition to these qualities, it is also important for buy and hold investor in public companies to also look for potential growth opportunities that the company has in it's line of business.

It is instructive to look at a question that was asked in May 2008 Berkshire share holder meeting. The question was whether Warren would prefer a company like See's candy (with moat and high profit margins) but not many opportunities for growth or a candy company with 14% profit margin but lots of growth. Warren replied that he does not mind either. He has no preference between the two. This implies that growth is not necessarily that important in an investment. This is true but Berkshire business model is different from other companies and it is worth looking at that closer.

If a company like See's candy generates lots of cash without growth opportunity, the best course of action is to distribute that cash to shareholders. In the case of Berkshire, Warren would deploy the profits from See's candy in other businesses that have opportunities for growth. But most companies operate in single line of business and are forced to either distribute the capital to shareholders or to allocate capital within the current line of business. Since management is paid for growth, returning capital to share holder is not on top of their mind. So Management usually deploys the earnings in a lot of value destroying projects rather than returning the capital to share holders. Over long term this reduces return on invested capital and eventually share holder return.

To avoid this dilemma, pick a company with opportunities for further growth and management will at least have some place to meaningfully allocate capital rather than dream up meaningless projects. For buy and hold investor in a public company (unlike Berkshire), it is better to identify companies that have good growth potential in addition to competitive advantage.

A company having sustainable competitive advantage can protect it's turf but if it operates in a saturated field without opportunities for further growth, it will likely not create long term value for the stock owner. Don't mistake me here. There is a possibility of making one time excess return if the company is under valued. But after that, it does not create long term value. Based on DCF, if discount rate of 10% is assumed and if company distributes all it's earnings and does not grow it's earnings, it is valued at 10 times earnings. So if you buy at 5 times earnings, you may make a great one time return but after that it does not create excess return.

But to truly create value over long term, a company must not only have sustainable competitive advantages but also have room to grow. Or in other words, it needs to be able to use it's advantages to deploy retained earnings at a very high rate of return. Sustainable competitive advantages are very important. But for buy and hold investors in public companies, future opportunities to grow using those advantages are equally important. Thus one must also evaluate how much growth opportunities exist for the company's products before investing. Otherwise the company's moat may not result in long term share holder value.

I recently read Jack Welch's book 'Straight from Gut' (Ex-chairman of GE). One of the mantra's of Jack was to only own businesses in GE that were number one or two. The reasons are obvious. If they are No.1 or No.2, those businesses obviously have some inherent competitive advantage. But there was an unintended consequence. That is, the business leaders started to define categories so narrowly that their products were No1. or No.2. Essentially this narrow definition limited future growth because of fewer opportunities to further expand. Or in other words, it is not only important to have competitive advantage but also to have opportunities to use those advantages to expand further. That creates true long term value.

One of the reasons for Warren buying Coke in late 80's apart from it's low valuation was because of it's huge international opportunities. To be sure, this is not a new concept and has been documented in Phil Fischer's book 'Common stocks and uncommon profits'. But when reviewing Warren's criteria, this aspect could be easily missed by part time investors like me.

In the next article, we will try to dwelve deeper into what growth drivers one could look at. If I get an opportunity to ask Warren, I would ask a list of growth drivers that he usually looks for. Until then, lets come up with a few that can help us. See you next time with a list of growth drivers.