Not all growth is created equal

TAKING on a growth objective should be based on how much capital is needed, the expected returns, and the time taken to achieve those returns. Business growth is often celebrated. Yet, not all growth is good for shareholders.

Tom Murphy, the former chief executive of Capital Cities, once summed up this approach with a metaphor: “The goal is not to have the longest train, but to arrive at the station first using the least fuel.” Here, the train symbolises a company’s size, while the fuel represents the capital required to grow.

The essence, then, is not about building a business empire, but making prudent decisions about capital investment to achieve optimal returns.

The price Starbucks paid for growth

Starbucks’ aggressive push for growth in the 2000s serves as a poignant case study.

The coffee brewer’s rapid growth led to internal competition among its stores for the same customers, diminishing returns, and also eroded the unique Starbucks experience.

Things came to a head in 2008 when Starbucks announced the closure of over 660 outlets, or 4 per cent of its store base, leading to restructuring costs of US$267 million.

In another sweeping move, the company temporarily closed all 7,100 outlets for extensive employee training.

Shareholders paid a steep price for its haphazard pursuit of growth, as Starbuck’s stock price plummeted 54 per cent in 2008 due to concerns over its overexpansion and a looming global recession.

Unfortunately, that was not the end of Starbucks’ bad capital allocation decisions.

In 2012, the company attempted to diversify – or rather “diworsify” (diversification that makes things worse) – into other business lines.

This initiative included a US$100 million acquisition of La Boulange, only to shutter the brand three years later. Similarly, a hefty US$620 million was spent on Teavana, which led to the closure of all 379 locations by 2018.

These decisions to grow and “diworsify” despite diminishing returns is a timely reminder that shareholders would have fared much better had the coffee chain concentrated on its core competencies – coffee and customer experience.

Buffett’s one-dollar test

Starbucks’ missteps serve as a prelude to Warren Buffett’s one-dollar test – a critical tool for assessing whether management’s decision to reinvest retained earnings actually improves shareholder value.

Buffett’s test is based on a simple idea: A company should only retain earnings if they can create at least a dollar of market value for every dollar retained.

This criterion ensures that the money kept by the company works as hard as, or harder than, it would in shareholders’ hands.

Suppose you own a 10 per cent risk-free bond with an unusual feature: Each year, you are given the option to either take the 10 per cent coupon in cash or reinvest it in more 10 per cent bonds.

Assuming that you do not need the money, your decision to take the coupon in cash or reinvest it should be based on one factor – what is the latest interest rates offered by these risk-free bonds today?

If the prevailing rate falls to 5 per cent, then reinvesting into your existing 10 per cent bonds is the better move because this 10 per cent interest rate is more than what the market currently offers.

However, if the prevailing rate rises to 15 per cent, then you would not want to reinvest in the 10 per cent bond. Instead, you should take your coupons and invest them in new bonds with a 15 per cent interest rate.

This bond analogy applies to a company’s earnings too. If the profits can be reinvested at higher returns than the shareholders could earn themselves, then the earnings should be retained.

On the flip side, companies should return these earnings to shareholders through dividends or share buybacks if they are unable to deliver better returns.

Henry Singleton’s masterclass in capital allocation

Another example to follow is Henry Singleton, the former CEO of Teledyne Technologies. He exemplified exceptional capital allocation, earning praise from Buffett as the business leader with “the best operating and capital deployment record in American business”.

In the early 1960s, during a time of market exuberance, Teledyne was well-regarded as a disruptive player in the semiconductor and aerospace industry. Hence, its share price soared.

At this point, Singleton could have bought into the narrative that the laws of valuation do not apply to his company, similar to dozens of CEOs of “disruptive companies” today. But he did not.

Instead, he recognised the inflated valuation of Teledyne’s stock, which was trading as high as 50 times earnings back then. Astutely, he used the overvalued stock to acquire other companies, effectively building Teledyne’s diverse portfolio at a fraction of the cost.

However, when market sentiment shifted and conglomerates fell out of favour, Teledyne’s stock price plummeted.

Adapting to these new circumstances, Singleton initiated a massive share repurchase programme when its stock was trading below 10 times earnings. From October 1972 to February 1976, Teledyne’s shares outstanding decreased by 64 per cent. By 1984, Singleton had retired about 90 per cent of Teledyne’s stock.

This strategic shift in capital allocation paid off handsomely. Investors who bought Teledyne stock in 1966 would have enjoyed an annual return of nearly 18 per cent over 25 years, or got back 53 times of their investment, versus less than seven times for the S&P 500.

The end result is a testament to Singleton’s unparalleled capital allocation skills.

Key to steady compounding: wise capital allocation

Increasing shareholder value is not just about growth, but also about judicious capital allocation. The Starbucks and Teledyne case studies are a reminder that growth is not an end in itself, but rather a means to an end – with the desired result of the creation of shareholder value.

We should always scrutinise management’s capital allocation decisions, applying Buffett’s one-dollar test: Are they creating at least a dollar of market value for every dollar retained?

Take note – our returns are inextricably linked to these capital allocation decisions. As Buffett quipped: “Over time, the skill with which a company’s managers allocate capital has an enormous impact on the enterprise’s value.”

In the end, it is how efficiently capital is used to pursue growth that drives shareholder value, and not the size of the company alone.

In the absence of good reinvestment opportunities, shareholders are better off if management simply returns excess capital via dividends or share buybacks.

The writer does not own any of the stocks mentioned. He is the founder of Steady Compounding (https://steadycompounding.com) a website that aims to empower investors with lessons from super investors, stock analysis and market insights.