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The Fallacy of the Growth Imperative

12 April 2016

Capitalism is often said to have a growth imperative. On a macro level, politicians have made promises that can only be paid going forward if economies grow, whilst at the micro level businesses which do not grow are expected to fall prey to creative destruction. Whilst the macro topic is interesting, and the likes of Kenneth Rogoff make some compelling challenges to it[1], my business is companies, so that’s what I’m going to focus on.


Let me start by stating plainly that we like growth, provided the business is riding the tailwinds of rising demand, be that online fashion or consumer goods in emerging markets. However, focusing on growth in mature industries, where demand is stable, is a recipe for disaster. Neither statement is really ground-breaking stuff, but my next assertion is more controversial: in developed markets, most industries are mature, with growth only eked out thanks to inflation and meagre population and productivity growth.


To put it simply, we are not going to consume more baked beans; a pay rise will not translate into an increased number of laundry washes; and we’ve seen all too recently what happens when banks chase growth in new markets such as subprime. Even sectors like automobiles, where you might expect some long term growth, have in fact been static, as can be seen on the chart below.

US Auto sales

And this despite a 50% growth in the population of the USA since 1976.

Source: Bloomberg, Ward’s Automotive Group, 28 June 2016

Yet most companies’ annual reports will have, within the first five pages, some comments from the CEO about the growth in sales. The growth imperative is entrenched. The result is the cyclicality we see in so many industries: as the market expands, CEOs get busy investing to grow capacity only to find that the much anticipated demand from consumers wanting to concrete over their garden doesn’t materialise. They all suddenly realise the industry is in over-capacity, leading to price competition and the weakest players going under. At which point capacity gets more balanced, prices start to rise and the whole cycle starts again.

So are CEOs complete idiots? Well, let’s just say they’re caught in classic game theory. Investments tend to lower the cost of production, thanks to technological advancements which improve plant productivity. Therefore, if they do not invest whilst their competitors do, when the downturn comes they will end up being the high cost producer and be taken out. This can even happen in growing industries, as we’ve recently witnessed in the iron ore mining industry. Even the most bullish CEO did not realistically believe that the demand from China would match the entire production coming online. However, faced with the option of being a higher cost producer or investing to lower cost of production further, they all decided to invest.

World Iron Ore

China is big, but… Want to guess the direction of spot prices in the last two years? And the share prices have followed.

Source: Bloomberg, The World Steel Association, 28 June 2016

So where am I going with all this? I believe there is a better way. And, somewhat counter-intuitively, it is emerging from one of the least cyclical, best performing sector of all: the consumer staples industry. The new model’s best known pioneers are probably 3G Capital and Reckitt Benckiser. But before we go and look at what it is they are doing that is so revolutionary, let’s have a quick look at the industry they operate in.

The consumer staple industry also suffers from the growth imperative

The Fallacy Of The Growth Imperative Chart3 The Fallacy Of The Growth Imperative Chart4 The Fallacy Of The Growth Imperative Chart5

Now, those are just excerpts – what you can’t quite see there is that in every single one of these cases growth was reported ahead of profits.

And who can blame them? If we look where value has come from in the Western consumer stocks, we find the largest chunk of returns since 2005 has been topline growth, followed by dividends, which together account for almost two-third of the value generated for shareholders.

The Fallacy Of The Growth Imperative Chart6

But… what happens if we look at the top half in the sector? We find that margin has been a slightly larger factor than growth.

The Fallacy Of The Growth Imperative Chart7

So what about the bottom half – have they really underperformed because of margin destruction? The answer is yes.

The Fallacy Of The Growth Imperative Chart8

So what do we find if we go further up the value scale – does the margin story still hold? And the answer is again yes, in fact increasingly so.

The Fallacy Of The Growth Imperative Chart9

And the answer is still yes when we wonder if this still holds true for the top decile.

The Fallacy Of The Growth Imperative Chart10

Source for all the above: Bloomberg, 28 June 2016. Calculations by THS Partners


So, what does one make of all this? Yes, of course growth does matter to an industry’s return, the charts above are pretty clear on this. But if you want to invest in the winners, invest in those who focus on the margin, not those who focus on growth. This is good news as margin improvement is also easier for a company to achieve than growth; costs, the largest part of margins, are largely under their control. Note that the growth seems to follow – the top quartile stocks have also experienced significantly higher growth than their pedestrian peers. Why should that be? There are many reasons, but M&A is one of the top ones; those with materially improved cash flows have been able to buy out weaker companies, or part of their product lines.

And this is exactly what the Reckitt Benckiser and 3G Capital of this world have done – they have first and foremost focused on operational efficiency. They then used the cash flow generated from their improved operations to buy other companies or product lines in areas where they could see interesting things happening – be that another opportunity to improve margins or higher growth.

Reckitt Benckiser embarked on this path after their merger in 1999, and look at the margins:

The Fallacy Of The Growth Imperative Chart11

Margins expanded from 11% to 25% over 17 years has made shareholders 13.5x their money, or 17% IRR (including re-invested dividends). The EM exposure has been modest (~25%). Source: Bloomberg 6 July 2016

Then observe the invested capital discipline, which has only risen due to acquisitions:

The Fallacy Of The Growth Imperative Chart12

Source: Bloomberg, THS Partners commentary, 6 July 2016

Naturally, there will be pushback against this assertion from many parties who will say margins improved thanks to growth, not the other way round. Though my charts above pretty much disprove this, the best way to comprehensively debunk this idea is to look at volume growth. That’s obviously harder to do – product mixes change the whole time, volume numbers aren’t consistently reported, etc. But we can look at single companies in more commoditised product areas – e.g. the beer volumes of AB Inbev in North America.

The Fallacy Of The Growth Imperative Chart13

ABI has managed to grow earnings every year since the Inbev takeover (and cash flows even more), despite falling volume. The fall in 2015 was due to a revision to cost assumptions in the post-retirement healthcare benefits as well as a modest increase in brand investments – brands still matter.

To summarise, we argue that:

  • Growth is a good thing at industry level
  • But the winners within an industry are those that focus on operational efficiency (margins)
  • The cash flow generated by efficient operators will enable them to have their pick of growth-focused less efficient operators. They will therefore outgrow the industry via M&A

This new model to prioritise efficiency over sales growth has been pioneered by Reckitt Benckiser and 3G capital. Margins do not however grow to the sky, as eventually competitive pressure will put a lid on them. Until then, significant shareholder value will be created by those who prioritise operational efficiency over growth.




[1] Rethinking the Growth Imperative, Kenneth Rogoff, 2 Jan 2012



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