Evaluating Quality Growth in Stocks

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Investors are naturally drawn to companies that are growing rapidly, hoping for exceptional returns as these businesses expand.

However, to determine if a company's growth will create long-term value, you need to understand these key principles:

In this post, we'll discuss these principles drawing from Michael Shearn’s 2011 “The Investment Checklist: The Art of In-Depth Research.” This will help you identify companies whose growth strategies will create lasting value rather than disappointing results.

Growth carries risks. When you purchase growing companies, you're generally paying for future growth in addition to current performance. This means you must determine (1) whether growth can continue, (2) for how long, and (3) at what rate.

Companies grow in three main ways, each with different risk profiles:

All three approaches can succeed, but acquisition-based growth inherently carries more risk because it requires paying premium prices, usually taking on debt, and successfully integrating different company cultures, systems, and employees.

There's often pressure on management teams to grow their business because top-line growth can increase the stock price.

This pressure can lead to mistakes, especially when the core business slows down and management seeks growth through new initiatives or acquisitions in unrelated areas.

For instance, when Jack Greenberg became CEO of McDonald’s ($MCD ( ▼ 0.07% )) in 1999, growth began to slow as the company faced market saturation overseas and growing health consciousness among American consumers.

Greenberg decided to pursue growth by acquiring other restaurant chains like Chipotle ($CMG ( ▼ 1.5% )) as McDonald's core business slowed. This led to McDonald's first-ever quarterly loss in 2001 and a stock drop from $45 to $15.

When James Cantalupo took over as CEO, he sold or closed these acquisitions and refocused on the core business, driving the stock back up to $70 by 2010.

For growth to add value, it must eventually translate to sustainable profits rather than just expanding revenues. Many rapidly growing industries fail to translate expansion into profits.

For example, when the internet industry first evolved, it grew extremely quickly, yet most businesses weren't profitable. This made it difficult to predict which companies would succeed.

To evaluate whether historical growth has been profitable, compare gross and operating margins to unit growth over a 3-5 year period:

Shearn provides an example with Western Union ($WU ( ▲ 1.2% )). As transactions increased from 2005-2009, its gross profit margin fell by 7.5%, operating margin declined by 20.8%, and profit per transaction dropped by 31%.

Clearly, Western Union's growth was becoming significantly less profitable over time – a concerning indicator that its expansion strategy wasn't creating proportional value for shareholders.

To evaluate growth potential, you need to determine how many years a business can continue growing, not just how fast it's growing right now. Every fast-growing business will eventually experience slowing growth.

Start by asking if the business model can be broadly replicated across markets, customer segments, and/or product categories. Some business models have natural limitations while others can expand almost indefinitely.

Be cautious about projecting past success into the future. Competition may increase or the company might cannibalize its own sales as it expands – meaning new locations and/or products take customers away from existing ones rather than attracting entirely new customers.

For less obvious cases, compare earnings growth to industry-specific operational metrics. For example, in a railroad business, if earnings are increasing while shipping volume is decreasing, earnings growth is likely coming from less sustainable sources like cost-cutting rather than true business expansion.

Secular growth trends are sustained patterns driven by demographic or social changes. Unlike cyclical changes (short-term ups and downs tied to economic cycles), secular trends continue through business cycles.

Companies riding secular trends see earnings peak at successively higher levels with each business cycle.

Examples of secular trends include:

Shearn cites investor Ron Baron, who has a successful track record of identifying these trends early. He looks for "industries that are positioned to have strong job growth over the next 5, 10, or 20 years" and then finds the best companies within those industries.

To identify these trends yourself, research demographic and social changes using resources like:

These resources can help you spot emerging trends before they become obvious to most investors.

A growing business must continually find new ways to sustain expansion.

To evaluate a company's innovation efforts, you must examine both the investment in research and development (R&D) and the results of that investment. In other words:

What separates successful innovators from others isn't just spending, but execution. As Harvard professor Clayton Christensen notes:

Thus, the best companies excel at course-correcting and converting R&D into marketable products.

It's very difficult to project demand for new products/services, especially those that transform markets. With no existing pattern to extrapolate from, even early sales data can lead to significant under- or overestimation.

Innovators like Apple ($AAPL ( ▼ 0.3% )) and Google ($GOOGL ( ▼ 0.2% )) are the toughest to forecast because their products create entirely new markets with no precedent.

Sometimes, even the companies themselves can’t predict their own success. Nintendo ($NTDOF ( ▲ 1.91% )), for example, failed to anticipate the popularity of their own Wii gaming console in 2006, creating product shortages.

So, how can you evaluate these companies? One approach is to survey target customers after they've used the product for at least three months. Early users of transformative products typically provide enthusiastic feedback that can help identify potential winners.

Many analysts assess growth potential using the total addressable market (TAM) approach – estimating the total market size and then calculating what portion the company controls.

However, be cautious about accepting market share estimates at face value:

Watch for these potential issues:

In the case of Darling Ingredients ($DAR ( ▼ 0.48% )), a rendering company that processes animal by-products, their market share appeared to increase yearly. However, the actual market was shrinking as larger ranches began handling rendering themselves. Darling was simply capturing more of a declining market with fewer customers.

Three key indicators often signal a business's growth may be slowing:

Ultimately, these warning signs often appear well before a company officially acknowledges growth challenges.

Growing companies command premium price-to-earnings (P/E) ratios based on expected future growth. If growth slows, both earnings forecasts and valuation multiples can drop sharply.

Google ($GOOGL ( ▼ 0.2% )) provides a clear example: from 2007-2010, its earnings nearly doubled from $13.50 to $25/share, yet the stock price remained flat because concerns about slowing growth caused its P/E to contract from 45x to 21x.

Conversely, sustained growth can eventually justify high initial prices. Shearn's firm purchased Whole Foods ($WFM ( ▲ 0.02% )) at $40/share (20x earnings), saw it fall to $8 during the 2007 recession, then watched it climb above $50 by 2010 when growth resumed. Though delayed, the earnings growth ultimately validated their original purchase price.

The bottom line is that buying growth at reasonable valuations matters. Moreover, strong growth can eventually justify premium prices, but expect significant volatility if market expectations shift.

Investors often mistake fast-growing businesses for good investments. In reality, businesses growing too quickly are among the riskiest investments because the growth may not be controlled or sustainable.

Here are four key signs of undisciplined growth:

1. Financing Growth Beyond Means

Companies that use internal cash flow to grow are more stable than those relying on debt or equity. Calculate the cash conversion cycle (CCC) to assess this:

The lower the days in the CCC, the faster a business can redeploy internal free cash flow into growth.

Industry cash conversion cycles vary dramatically across sectors. For example, software companies maintain short 10-day CCCs (minimal inventory, quick payments), funding growth internally. Homebuilders, conversely, operate with lengthy 200-400 day CCCs, necessitating constant borrowing for expansion.

2. Infrastructure Limitations

Growing businesses need four key infrastructure components to scale successfully:

USAir (now part of American Airlines ($AAL ( 0.0% ))) demonstrates what happens when infrastructure falls behind growth.

After acquiring Pacific Southwest Air ($385M) and Piedmont ($1.6B), their information systems couldn't handle the tripled size. Computer failures, scheduling errors, and poor customer service resulted in profitability dropping from 6-7% above industry average to 2.6% below it.

3. Human Capital Constraints

Fast-growing companies need to rapidly expand their workforce.

If revenues grow 30% annually and staffing must keep pace, employee count needs to double every ~2.5 years – creating major training and quality challenges.

Another airline example shows what happens when growth outpaces hiring capabilities.

Spirit Airlines ($SAVEQ ( ▲ 0.43% )) expanded quickly, adding up to 13 destinations in a single year, but couldn't staff properly. In 2006, Spirit had only 61 employees per aircraft while competitors averaged 77, resulting in more customer complaints than any other airline.

4. Location Selection Pressure

For retail companies specifically, growth quality depends heavily on site selection.

The best retail companies grow opportunistically rather than setting arbitrary store number targets. When management mandates a specific number of new locations, quality suffers.

Whole Foods ($WFM ( ▲ 0.02% )) exemplifies this disciplined approach. It took them 10 years to find a suitable site for their first San Francisco store. As Jim Sud, VP of Store Development explained:

This patient, selective approach explains why Whole Foods has maintained consistent quality and profitability across all locations.