“Not everything that can be counted counts, and not everything that counts can be counted.” - William Bruce Cameron, Sociologist
What’s the most dangerous thing in investing? Growth.
Wait, that doesn’t sound right. Aren’t multi-baggers that investors tout underpinned by exponential growth? Isn’t there an entire style of investing named after it? Don’t many funds have the exact word, if not a synonym, in their names? Not necessarily, yes, and yes. Some may even name their first born children in honor of growth (Cagr Iyer would fit right in with faddish new age names). Jokes apart, investors’ thinking around growth is as messed up as it can get.
First, there’s no such thing as growth. There’s only projected growth. Big difference. Buggy humans are poor forecasters in general. They’re disastrous, when it comes to growth. Analyst projections of earnings growth, company-wise and in aggregate, are embarrassingly wrong. Two reasons: recency bias and mean reversion. Investors get excited by rapid growth. They extrapolate this way into the future. Unfortunately, growth is generally mean reverting. Studies of companies over decades show that only a miniscule percentage sustain double digit growth over long periods. Statistically, high growth is likely to be followed by the opposite, in line with normal fluctuations around a modest long-term trajectory. Hypergrowth is especially unsustainable, as it likely arose from undue risk-taking in a fast-changing industry. Why fuss over an unknowable, that too with false precision?
Second, investors lie (about growth). A typical investor touts his best investment within the first five minutes of a conversation. You could know the same bloke for five years without knowing his net-IRR. His impressive winner narrative involves a handsome hero acting with great foresight in some underpenetrated category. This buggy human’s story is fraught with behavioural biases that go by names such as hindsight, survivorship, selection and self-serving. The whole truth involved a paunchy guy with receding hair who took a bunch of punts in anticipation of growth. It ended with a one in five hit rate and an unmentionable aggregate IRR. You’d have to use third-degree to get him to talk about the other four. Even then, they’d be categorised as ‘shit happens’ rather than ‘I screwed up’. For (projected) growth to be a useful input into an investment process, it has to work in aggregate, without benefit of hindsight. Trust me, it doesn’t.
Third, growth makes investors lose it. Charlie Munger said that the secret to a happy marriage is a spouse with low expectations. Nothing messes up an investor’s mind like high growth expectations. It blinds them to problems on more important fronts like governance, quality and risk. It makes them pay egregious prices, removing the only safety-lever they actually control. In an auction situation, growth ends up as a backfitted number to rationalize a winning bid. The abomination that is forward earnings often entails serious time travel. Inevitably, growth-chasing investors end up with a so-so business bought at a crazy price at a particularly inopportune time.
Fourth, compounding ≠ growth. Didn’t Einstein say that compounding is the most powerful force in the universe? Apocryphally, yes. Doesn’t Warren Buffett look for compounders? Emphatically, yes. But here’s the nuance: Compounding is NOT growth. Nor does it arise out of (chasing) growth. The similarity stops at semantics. A compounder is a strong business that gets stronger over time. That it also ends up bigger is incidental. Strength is knowable, in advance. It’s not mean reverting. In fact, it’s quite persistent. Unlike growth, it can be an input into an investment process. It should be.
Fifth, real ingredients of compounding lie elsewhere. Counter-intuitively, to find this mythical compounder, forget about growth. Anyway, except for rare cases of technology disruption, most industries grow adequately over a cycle. The material questions pertain to the real ingredients of compounding. An industry that allows companies to make money? A moat that holds off new entrants? A sense of equilibrium based on rational incumbents? A company special enough to gain within its industry? A prudent approach based on proven capabilities and familiar territory? No disruptive M&A? Responsible allocation of surplus cash? A sensible price for all this goodness? With satisfactory answers, we have our compounder construct: a fine business, playing to its strengths, steadily outpacing its industry, with cash to spare. As a bonus, there’s inbuilt resilience to tough times. And a virtuous cycle of increasing strength driving superior compounding and vice versa. Eventually, markets reward this low-risk construct, adding a valuation tailwind (if we didn’t overpay). There’s a good chance growth will follow. But, it’s an outcome. A sidekick really. The real heroes of our compounder movie are trust, focus, safety, quality, prudence, predictability, anti-fragility and cash. With this formula, even a sequel might work out!
Growth is a numerical outcome, knowable only with hindsight. It is singularly unhelpful, if not outright harmful in an investment process. Compounding is a holistic construct, controllable in advance. It is fuzzy and multi-faceted. It is imprecise and unmeasurable. Mixing up growth and compounding is one of the biggest mistakes investors make. Yes, compounders have delivered growth. No, (chasing) growth did not deliver compounding.
(Originally published this March at https://www.linkedin.com/pulse/growth-overrated-anand-sridharan/)