Is this the most misunderstood word in investment? – with David Holland

Unless they actively aim to destroy value, company directors should only look to grow their business if their chosen growth strategy will deliver a return on invested capital that is comfortably above the cost of that capital. So corporate strategy expert David Holland, tells his clients – and yet, is this advice not a lot easier to offer in theory than follow in practice?

In our experience as professional investors, companies and their investors can all too often become obsessed with pursuing growth simply for growth’s sake. That being so, we take the opportunity to ask Holland, how does he set about discussing this issue with clients and encourage them to think more clearly about the viability of future projects?

“‘Growth’ is probably the most misunderstood word in the investment community,” he replies. “It is like when we were talking earlier about what probability you would attach to the word ‘likely’. In the same way, the word ‘growth’ does not pass the clarity test because, when investors and corporate managers talk about ‘growth’, the implicit assumption is everyone is talking about growth in earnings.”

Two types of earnings growth

The problem there, Holland goes on to explain, is there are two ways to grow earnings and so, when company executives are discussing the subject, it is important to press them on what exactly they mean. “On the one hand, there is efficiency growth,” he continues. “That is where you grow earnings by having higher margins, higher returns and thus a higher return on capital.

“That is running a better business – that is going to grow earnings but it is hard work. Alternatively, you can grow earnings by investment. If you have a company with a track record for trying to grow earnings, however, or being very aggressive about growth and focusing on earnings, it will start leaning into mergers and acquisitions – and, all too often, using debt and so increasing its probability of financial distress.

“If I am making expensive acquisitions and not properly understanding the value – if I am being overly optimistic about the future – that is not good growth. So you really have to understand where the earnings growth is coming from – although my second point would be that earnings growth does not really matter because it is about the quality of the earnings.

Return on capital

“This is where return on capital is important. Whether it is ‘return on invested capital’ or ‘cashflow return on investment’ or whatever – and all these metrics have their pros and cons – the basic idea is you want to invest if your return on capital is greater than your cost of capital, and you want to sustain that return for as long as possible. That way, you will be growing your economic profit streams.”

In Holland’s experience, however, what underperforming companies will often do is conclude the only way to grow their earnings is by undertaking some grand project – to which he offers some simple advice: “The first law of holes is, when you are in one, stop digging.” “If you are generating returns below the cost of capital, then stop ‘growing’”, he continues. “Fix the problem, then focus on growth in economic profit, not earnings.

“The key connection people need to make is that the value of an asset, and especially the value of a company, is your invested capital – your book value – plus the present value of all economic profit streams. As such, any incentive programme should be based on increasing economic profit streams. Even if this is negative, as long as it is improving, that is a good thing and the faster it can improve.

Economic profit targets

“Now, whether business leaders choose to make that part of their incentive programme is a different matter but, if you talk about setting economic profit targets, they will get it. Take the example of mergers and acquisitions – how many companies see share price falls after they announce a big acquisition? It is just the market saying it believes the net present value or ‘NPV’ on that acquisition is negative.”

At heart, Holland argues, company executives need to adopt the mindset whereby, every time they make a positive NPV decision, they should add that NPV to the value of the business and, every time they make a negative NPV decision, they should subtract that NPV. “That is why, of course, the share price can react quite quickly to both external events and internal announcements,” he adds.

“People do understand this in the end although it is better to communicate the idea by using ‘economic profit’ and then building that connection between project finance and corporate finance – that economic profits and NPV are actually the same thing. What then follows is that, as long as you are taking on the right projects, and doing so in a smart way, it will show up in your economic profits – and that is how you should get paid.”