Research Affiliates found a disconnect between internal investment, as measured by growth of total assets, and growth in earnings. Companies that invest aggressively to expand their sales and assets despite a low return on capital tend to perform poorly because, according to Brightman, “growth in the size of a company does not produce wealth for the investors in that company.”
The researchers attributed the poor performance to negative EPS growth, and were able to correlate low levels of investment with positive EPS growth: When businesses attempt to rapidly grow scale, it often results in a dilution of EPS and lower returns for shareholders.
“One explanation is that investors mistake growth in assets for wealth creation,” says Brightman. “Encouraged by investor enthusiasm and the compensation incentive for growth, management invests aggressively, thereby creating a low or even negative return on the marginal new capital invested. A low marginal return on capital lowers average EPS and destroys wealth for investors.”
For example, on the eve of the dot-com bubble in July 1999, Compaq, Yahoo and WorldCom were all considered growth stocks, posting high levels of investment, but low returns on equity and earnings yields. Yahoo, the sole survivor of the trio, went on to post negative returns over the next 10 years.
In July 1999, smart growth stocks like Coca-Cola, Exxon and Kellogg had low levels of investment and high ROE, and went on to post subsequent 10-year total returns of 20 percent or more.
On the eve of the global financial crisis in July 2007, Wachovia, Merrill Lynch and Lehman Brothers were all similarly positioned with relatively high levels of investment as they loaded their balance sheets with mortgage-backed securities, and low ROE. At the same time, Kellogg, Exxon and Coca-Cola continued to generate high ROE with relatively low levels of investment.
As of July 2016, Research Affiliates identified Tesla, Facebook and Netflix as potential dumb growth stocks, noting that each continued to post high levels of investment with low or negative returns on equity. Historically, companies with those characteristics provided poor returns, according to the report.
In some cases, investors are falling victim to management more interested in empire building than in creating a sustainable business, according to the authors, and such behavior can be linked to compensation incentives for CEOs who rapidly expand company sales or assets.
Such companies seem to fail the tests of many ESG and socially responsible investors, says Brightman, as companies who grow rapidly may not be environmentally or socially sustainable, and companies expanding at the expense of shareholder interests could be examples of poor corporate governance.
“Reckless growth seems environmentally irresponsible, (but) this is a subject for further research,” says Brightman. “Because CEOs of larger companies are paid more than CEOs of smaller companies, CEOs have a financial incentive to grow the size of their companies regardless of whether or not growth creates or destroys wealth for investors.”