The other day my cousin – noserunnin – mentioned that he recently bought shares of Under Armour. I asked him why. He said because they were growing earnings 30% annually. I said, yes, but is that growth good or bad? He looked at me like I had four ears. He said what do you mean is it good or bad?
Here’s a transcript of our conversation.
EARS: Suppose I told you that the earnings in my savings account has been growing at 30% per year for the last five years.
NOSE: What interest rate are you getting?
EARS: One half of 1%.
NOSE: How is it possible that you can grow earnings at 30% per year if you are getting less than 1% interest?
EARS: The first year I put in $1,000 and earn $5 in interest. Every year thereafter I put in an additional $200. At the end of the fifth year I have $4045.18 *.005 = $20.15 earnings, which is 30% annualized growth from my beginning earnings of $5.
NOSE: This is some sort of trick.
EARS: You’re right…sort of. The key is the cash I’m adding each month to finance my growth in earnings. That money has to come from somewhere. If I’m borrowing that money at 4% to stick in my savings account to earn less than 1% then I’m destroying value. Of course that would be stupid, I would never do this, but that is an example of how growth can be bad. Even though my earnings are growing 30%, I’m destroying wealth. Not only would I be destroying wealth, but I’d be destroying it at a faster pace each year because of the growth.
NOSE: But companies don’t do that.
EARS: Sure they do. Companies borrow money or sell equity so they can finance growth. If the return they get on their financing is greater than the cost of their financing, then their growth is good. If their return on the financing is less than their cost of financing then their growth is bad – they will be destroying wealth at an increasing rate. In that case the growth is making things worse, just like it would have with my savings account.
NOSE: Give me a real life example of a company with bad growth that is destroying wealth.
EARS: How about Iconix Brand Group (ICON)? They have brands such as Mossimo, Joe Boxer, Danskin and others that you’ll probably never see at the Masters. But they have been growing earnings 13% per year for the last five years. The problem is that their cost of financing is about 7.5% and their return on that financing is only about 7%, so they are destroying wealth. And because they are growing, they are destroying it at a faster pace each year.
NOSE: Well, what about Under Armour?
EARS: Good news. UA’s cost of financing looks to be around 8-9% whereas they appear to be earning around 15% on that financing, so their growth is good. They are creating wealth at a faster and faster pace. Of course my numbers are just back of the envelope – you need to do your own research.
NOSE: How are you doing these calculations?
EARS: We can talk about that tomorrow.
Market commentators and investment managers who glibly refer to “growth” and “value” styles as contrasting approaches to investment are displaying their ignorance, not their sophistication. Growth is simply a component - usually a plus, sometimes a minus - in the value equation. – Warren Buffett, 2000 Shareholder Letter
Thanks,
Ears
Note: Obviously this was not a real conversation. My cousin wants you to know that he has no position in UA or ICON, and neither do I. The numbers were back of the envelope – please do your own research.
