Growth | Rising Prices of Stock

Now THAT WE have the basic tools of financial statement analysis in hand, "we can start tearing into companies. Because this can be a daunting task, I suggest that you break down the process into five areas:

• Growth: How fast has the company grown, what are the sources of its
growth, and how sustainable is that growth likely to be?

• Profitability: What kind of a return does the company generate on the
capital it invests?

• Risks/hear case: What are the risks to your investment case? There are ex
cellent reasons not to invest in even the best-looking firms. Make sure you
look at the full story and investigate the negatives as well as the positives.

J. Management: Who's running the show? Are they running the company for the benefit of shareholders or themselves? This is such a critical topic that I've devoted an entire chapter (Chapter 7) to it.

One word of caution: In this chapter and the next, "we'll be concerned only with evaluating the quality of the company. However, this is only half the stoiy because even the best companies are poor investments if purchased at too high a price. We'll cover how to evaluate stocks in Chapters 9 and 10, where I'll show you how to estimate the right price to pay for a company's shares.

The allure of strong growth has probably led more investors into temptation than anything else. High growth rates are heady stuff—a company that manages to increase its earnings at 15 percent for five years will double its profits, and who wouldn't want to do that? Unfortunately, a slew of academic research shows that strong earnings growth is not very persistent over a series of years; in other words, a track record of high earnings growth does not necessarily lead to high earnings growth in the future.

Why is this? Because the total economic pie is growing only so fast—after all, the long-run aggregate growth of corporate earnings has historically been slightly slower than the growth of the economy—strong and rapidly growing profits attract intense competition. Companies that are growing fast and piling up profits soon find other companies trying to get a piece of the action for themselves.

You can't just look at a series of past growth rates and assume that they'll predict the future—if investing were that easy, money managers would be paid much less, and this book would be much shorter. It's critical to investigate the sources of a company's growth rate and assess the quality of the growth. High-quality growth that comes from selling more goods and entering new markets is more sustainable than low-quality growth that's generated by cost-cutting or accounting tricks.

In the long run, sales growth drives earnings growth. Although profit growth can outpace sales growth for a "while if a company is able to do an excellent job cutting costs or fiddling with the financial statements, this kind of situation simply isn't sustainable over the long haul—there's a limit to how much costs can be cut, and there are only so many financial tricks that companies can use to boost the bottom line. In general, sales growth stems from one of four areas:

The easiest way to grow is to do whatever you're doing better than your competitors, sell more products than they do, and steal market share from them. Mobile-phone giant Nokia, for example, increased its share of the global mobile phone market from around 15 percent in the mid-1990s to around 35 percent today by simply doing a better job selling phones.

Raising prices can also be a great way for companies to boost their top lines, although it takes a strong brand or a captive market to be able to do it successfully for very long. Anheuser-Busch, for example, has historically been able to raise prices by 1 percent to 3 percent per year because it has a strong portfolio of popular brands such as Budweiser, Bud Lite, and Michelob.

Cable companies have also used pricing power to increase their top lines, though it's due more to monopoly power than strong brands. Throughout the 1990s, most markets had only one cable provider for any given consumer, so cable firms were able to push through annual price increases of 6 percent to 7 percent.

If there's not much more market share to be taken or your customers are very price-sensitive, you can do what Wal-Mart did and expand your market by selling products that you hadn't sold before. In the mid-1980s, founder and then-CEO Sam Walton saw that the firm's growth was likely to hit a wall at some point in the ensuing decade, so he began investigating new markets. After a trip to Europe , where European retailers had begun to build hypermarkets that sold everything from clothes to toys to ketchup under one roof, Walton figured that groceries could be Wal-Mart's next big market. Fifteen years later, Wal-Mart is the largest seller of groceries in the United States , and super-centers that include food sales account for an ever-larger percentage of its sales.

Remember, the goal of this type of analysis is simply to know why a company is growing. In Anheuser-Busch's case, you'd want to know how much growth is coming from price increases (more expensive beer), how much is coming from volume increases (more beer drinkers), and how much is coming from market share growth (more Budweiser drinkers). Once you're able to segment a firm's growth rate into its components, you'll have a much better handle on where that growth is likely to come from in the future—and when it may tap out.

The fourth source of sales growth—acquisitions—deserves special attention. Acquisitive firms are often darlings of Wall Street because they're major consumers of investment banking services. They're often looking to either raise capital for a new acquisition or find a new target, which means they constantly have folks in suits lining up at their door trying to pitch them on deals. It shouldn't come as any surprise, then, that the analysts that follow acquisition-hungry firms usually have nice things to say.

Unfortunately, the historical track record for acquisitions is mixed. Most acquisitions fail to produce positive gains for shareholders of the acquiring firm, and one study showed that even acquisitions of small, related businesses—which you'd think would have a good chance of working out well—succeeded only about half the time.

There are a host of reasons for this. For one, acquisitive firms have to keep buying bigger and bigger firms to keep growing at the same rate—and the bigger a target firm is, the harder it is to check out thoroughly, which increases the risk of buying a pig in a poke. Even Warren Buffett found this out when Berkshire Hathaway bought GenRe, a huge reinsurance firm, in 1998. Buffett knows more about insurance than almost anyone alive, but the GenRe purchase turned out to be less than stellar. Buffett himself said some time after the deal that GenRe was in worse shape than he'd thought when he bought it. Not even the sawiest of CEOs can know all the skeletons that may be lurking in a huge target firm.

Another reason to be skeptical of acquisitive firms is simply that buying other companies takes time and money. Targets have to be investigated, investment bankers have to be paid, and acquired firms have to be integrated into the new owner, all of which steals resources away from running the core business. If executives are spending all of their energy looking for ways to make the firm bigger, rather than better, the wheels are sure to come off the cart eventually.

From the investor's perspective, however, the biggest reason to be leery of a growth-by-acquisition strategy is even simpler: It makes the company more difficult to understand. Acquisitive firms usually post many merger-related charges and often wind up restating their financial results, which means the results of the acquiring company can be obscured in all the merger-related confusion. As a result, two things can happen:

• An unscrupulous management team can use the fog created by constant
acquisitions to artificially juice results, and this financial tinkering can
take a long time to come to light because it's buried in the necessary fi
nancial rejiggering that comes "with any sizeable acquisition.

• The true growth rate of the underlying business may be impossible to fig
ure out, especially if management is evasive about giving out information
on the firm's organic growth rate.

Bottom line: If you don't know how fast the company would have grown without acquisitions, don't buy the shares—because you never know when the acquisitions "will stop. Remember, the goal of a successful investor is to buy great businesses, not successful merger and acquisition machines.

As you might have guessed, I generally view acquisitions as a very low-quality way of generating growth. Unfortunately, there are plenty of other ways of making growth look better than it really is, especially when we turn our attention to earnings growth rather than sales growth. (Sales growth is much more difficult to fake.) Although the list of tricks that companies can use to boost earnings growth even as sales growth falters is a long one, there are a few basic areas to watch out for: Changing tax rates, changing share counts, pension gains, one-time gains (often from selling off businesses), and rampant cost cutting are among the most common. (I'll show you the full spectrum of earnings-management tricks in Chapter 8.)

In general, any time that earnings growth outstrips sales growth over a long period—for example, 5 to 10 years—you need to dig into the numbers to

IBM Growth Rates	1995	1996	1997	1998	1999	2000	2001	2002
Revenue %	12.3	5.6	3.4	4.0	7.2	1.0	-2.9	-5.5
Operating income %	51.7	13.2	5.8	0.7	30.2	-2.5	-20.1	-26.9
Earnings per share %	43.7	41.4	118	9.3	25.2	7.8	-2.0	-28.0

see how the company keeps squeezing out more profits from stagnant sales. A big difference between the growth rate of net income and operating income or cash flow from operations can also hint at something unsustainable.

IBM is a classic example of what I call "manufactured growth," because it used almost all of the previously mentioned techniques to pump up its bottom line during the 1990s. As shown in Figure 6.1, Big Blue's earnings per share growth looks pretty good since the Lou Gerstner-led turnaround began in the early 1990s—close to double digits most years, which is not bad for a company of this size.

But when we look at operating income, it looks as though the company was growing much slower, while sales growth was stuck around 5 percent on average. As a double-check, take a quick look at cash flow from operations— unfortunately, this also looks pretty stagnant from 1995 through the end of the decade (see Figure 6.2).

So what was driving those great earnings-share results that Gerst- ner's IBM kept turning like clockwork? A whole host of items: For one, the firm's tax rate plunged from 46 percent in 1995 to around 30 percent by the end of the decade. For another, the firm cut overhead spending substantially during the 1990s—a laudable accomplishment, given the bureaucratic nature of the firm.

Finally, IBM bought back about a quarter of its shares during the latter half of the 1990s—fewer shares outstanding meant more earnings per share— and benefited from an overfunded pension plan that boosted earnings. As you can see, a simple comparison of IBM's earnings per share relative to its

IBM	95	96	97	98	99	00	01	02
Cash flow ($bil)	10.7	10.3	8.9	9.3	10.1	9.3	14.3	13.8

operating income and cash flow raised many red flags—enough that any investor looking at the company in the late 1990s could have been skeptical about the quality of the firm's earnings growth. (Note: Low-quality growth doesn't imply that a company is cooking the books, merely that the growth rate isn't likely to be sustained over the long haul.)

You should also keep an eye out for one-time gains and losses that can distort a historical growth rate. A big gain from the sale of a division, for example, can make growth look better than it really was. Large losses can also affect growth rates—if a company's earnings were depressed in the first year of a three- or five-year period, the firm's growth rate will be overstated because growth will be calculated from a depressed base. So don't take the trailing three-year and five-year growth rates that you see as gospel—always check to see "what's behind the numbers.

In general, any time you can't pinpoint the sources of a company's growth rate—or the reasons for a sharp divergence between the top and bottom lines, as was the case with Big Blue—you should be wary of the quality of that growth rate. Paying less taxes and buying back shares are good things for shareholders, no question, but they're short-term fixes rather than long-term sources of earnings growth.

A word on cost cutting: All things equal, I'd rather own a more efficient firm—one with lower overhead costs—than a less efficient firm. However, cost cuts are not a sustainable long-term source of earnings growth, and if you're looking at a firm that's been slashing costs, you should be aware that at some point there won't be any more costs to cut. Earnings growth will eventually slow unless sales growth speeds up.

At some point, a cost-cutting firm is going to find that it has become as efficient as possible, and sales and earnings growth will converge unless the firm manages to boost revenue growth. So when you see a firm with earnings gains being driven by cost cutting, make sure you think about the sustainability of those cost cuts because they "won't be around forever.