The Risk of Low Growth Stocks Part 1: Stall Speed
“When you stop growing you start dying.” -William S. Burroughs
According to the conventional wisdom, so called “growth stocks” are riskier than stocks of companies with stable but low growth. There is some truth to this idea. A company that is currently growing at 20% per year might grow the following year by 30% or 10%, a wide range of potential outcomes. On the other hand, a company that is currently growing at 5% is unlikely to have such a wide range of outcomes and instead a good year might mean growing 7% while a bad year is growing 3%. Over the long term, the fundamental risk of owning a stock is related to the range of potential future outcomes. So in this way “growth stocks” can be riskier investments.
But over the years, we’ve come to appreciate what we think is a pernicious risk associated with investing in companies that exhibit slow growth. What we’ll show in this post is how once a company’s long term, sustainable growth rate begins to fall below the rate of the overall economy, risk jumps much more than you would intuitively expect. While the high growth stock has risk related to whether next year’s growth is 30% or 10%, the low growth stock has risk related to whether long term growth is 5% or 4% or 2%. The difference between those growth rates might seem slight, but the impact on an investor’s returns can be very, very large.
The most basic way to value a cash flow stream is the Gordon Growth Model.
The formula simply says that if you assume a perpetual growth rate, than the return an investor will earn is the current cash flow divided by the investor’s desired rate of return minus the growth rate. Or you can rearrange the formula to show that an investment’s rate of return is the cash flow yield plus the rate of growth.
So a company that generates $100 of current cash flow that grows perpetually at 5%, is worth $2,500 to an investor who is happy earning 9% per year.
$2500 = $100/(.09-.05) or rearranged to show that the fair value is a cash flow yield of $100/$2500 = 4%
Simple! And exactly correct. The only problem is in the real world growth rates fluctuate.
Historically the S&P 500 has averaged a free cash flow yield of about 4% and cash flow has grown at 5% per year (or about the rate at which the economy has grown). This is why the stock market has had an average rate of return of about 9%.
Here’s a chart of the free cash flow yield of the S&P 500 going back to 1990 (the oldest data available on Bloomberg).
You can see how the free cash flow yield was around 4% in the first half of the 1990s. It then trended down towards 2% as the Dot Com bubble took off and investors started incorrectly believing that growth would be much higher going forward than it had in the past. The market got cheap again after the crash, but then got rather expensive again heading into the financial crisis. The market crash that followed caused the market to get extremely cheap. Despite all the worries about a new stock market bubble we only recently saw the free cash flow yield return to more historically average levels last year, before the sell off last quarter brought it back to cheaper levels again.
This is not to say that we are suggesting at all that this simple measurement can be used to exactly measure the fair value of the stock market. Free cash flow can be a volatile metric and all we’re trying to establish is that not only does the basic Gordon Growth Model make good theoretical sense, it also accurately describes how stocks as a group are valued in practice. When the market gets cheap, say at a 8% free cash flow yield, as it did in the years shortly after the financial crisis, investors might expect a total return of 8%+5% (or whatever growth ends up being) for a 13% total return. And guess what? Since 2010 the stock market has returned almost exactly 13% per year.
While individual companies come and go, collectively the economy and companies as a group have shown highly persistent, you could even say “perpetual” growth, making the 4% free cash flow yield a very stable average valuation.
This next chart is one of the most important charts for investors to understand. It shows that if you group companies at any point in time into five groups ranging from those posting the highest current growth rate to the lowest, each of those groups of companies all pretty quickly start gravitating towards the average 5% rate of growth. The chart shows that even very quickly growing companies on average see their growth rate decline to near 5% within just 3-5 years. But it also shows that on average, companies that are experiencing negative or no growth see their growth rate pick back up towards 5% within 3-5 years.
Source: Valuation, by McKinsey
So on average, assuming a company will generate growth of about 5% over the long term is a pretty good assumption, regardless of whether it is currently a fast growing business or is struggling to grow. But in this post we’re talking about the risk of owning certain specific stocks, not groups of stocks or the market overall. And that leads us to the risk of assuming a company will grow 5% when in fact it only ends up growing 4% or 3% or less.
If a 5% growing business requires a 4% cash flow yield (a free cash flow multiple of 25x, the inverse of 4%) for investors to earn 9%, you can easily do the math to figure out what sort of cash flow yield a 3% growth business or a 1% growth business requires. While a 4% yield plus 5% growth gets you to 9% total return, if a business is only growing at 3%, it needs a 6% cash flow yield. If it is only going to grow at just 1% per year, it needs an 8% cash flow yield.
Now that’s scary. And seriously risky. Because an 8% cash flow yield means a stock is worth exactly half of what it would be worth if it was trading at a 4% cash flow yield. We’re talking about a $100 stock that needs to fall to $50 if the company is only going to grow at 1% rather than 5%. Even a small change, like a 5% business slowing to 4% (in perpetuity) requires the cash flow yield to jump from 4% to 5%. This means a change from 25x cash flow to 20x or a 20% decline in the price. Ouch.
And I don’t just mean it might exhibit some volatility, I mean it will perpetually be worth 20% less than you expected. This is real risk. The risk of permanent impairment to the value of your investment.
Think about the consumer staple type businesses we’ve warned investors about over the past couple of years. In the past, these consumer packaged good and health product companies have generated solid 5% growth as they’ve grown volumes as well as raised prices. They traded for 25x free cash flow multiples because the 5% was very steady. While they didn’t grow quickly, they grew dependably, and remember it is the perpetual growth rate that drives valuation.
But in recent years these companies have seen their moats breached. They have been losing volumes to start up brands. While they’ve continued to increase prices, they haven’t seen much in the way of growing volumes and so their growth rates have generally declined from around 5% to 2%-3%.
That might not seem like such a big deal. 3% and 5% are pretty similar numbers. We’re not talking about the wide swings of growth that high growth businesses experience. But it may well be that the era of consistent 5% growth for these businesses is over. That instead they won’t go into decline, but they will only grow at 2% or 3% per year. What many people don’t appreciate is just what a large risk that represents.
“But wait!” some deep value investors will exclaim, “you can still buy a slow growing stock without much risk if you pay a cheap enough price.” In theory that’s true. But it brings us back to the quote that opens this post.
“When you stop growing you start dying.” -William S. Burroughs
That perpetual 5% growth rate? Remember it is descriptive of the market as a whole. But under the surface, individual companies are experiencing large swings in their growth rate. The market as a whole keeps returning to about 5% growth because that’s approximately the growth rate of the overall economy. But many companies find that while they might be able to reverse temporary periods of decline, once their ongoing growth rate slows down they hit what might be thought of as “stall speed”. In aerodynamics, the stall speed is the minimum speed at which an aircraft must travel to remain in flight. If it slows to a speed below this rate, it will stall and eventually crash.
For companies, if they stop growing as fast as the economy they start slowly losing share of their customers’ wallet. They start losing relevance and as they are left behind by new competitors, their customers start thinking about them less and less and growth continues to slow before finally going into decline.
Look at the companies today in your portfolio and try to find a single one that has neither grown nor contracted over the past decade or two. This situation barely exists in the real world. Once a company stops growing it starts dying. The market gets that, which is why stocks that enter periods of very low growth are sold down very aggressively. The market knows that dying companies get trapped into a cycle they can’t escape and so once growth slows markedly, the opportunity to sell and move on with your capital intact has slammed shut.
The fact is, we’ve made this mistake at Ensemble. In the past we’ve owned companies like Prestige Brands and DistributionNow. Each of these companies had once grown at 5% or better and in each case, we mistook a slowdown in their growth as a temporary phenomenon and ended up taking losses on our investment when we came to the conclusion that the slow down in growth was more permanent.
Every company in every sector is subject to this potential risk, which is why over the years we’ve focused more and more on making sure we believe that the companies in our portfolio can grow at least at the same rate as the overall economy for the foreseeable future. There is no easy way to be certain you avoid companies that hit stall speed and go into decline. Even the fastest growing business of today may end up growing very slowly much sooner than you expect. But we think it is critical for investors to recognize how large of a danger is presented by even small declines in the long term growth rate of a company once it stops keeping up with the growth of the overall economy.
All stocks have risk. Fast growing companies can see rapid changes in their growth rates that send their stocks into a tailspin. But when investors see stable, slow growing businesses, they often feel like while they might not be exciting, they will be safe investments. Some of them may be. But the safety does not come from the lack of high growth, it comes from a stable and steady rate of growth. If that stable growth slows in a way that appears to be permanent, that safe stock you thought you bought can quickly reprice with a 20% to 50% decline that is entirely justified if the slowdown is here to stay.
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