Join our community of smart investors
OPINION

On growth risk

On growth risk
April 29, 2015
On growth risk

His policy is to do the bare minimum necessary to keep the club in the Premier League, thus reaping the lucrative TV rights while spending as little as possible on players. Tony Evans in The Times has described the plan as "minimum effort, minimum expenditure, maximum profit without dangerous investment".

This recognises that investment carries big risks. There are many clubs now languishing in the lower leagues that spent a fortune on players in the hope of achieving great things only to fail horribly; Leeds United under Peter Ridsdale is perhaps the most spectacular example, but there are many others.

Football is not unusual in this. Investment carries dangers for all businesses. It often means taking on more debt. It can leave you vulnerable to diseconomies of scale such as being slow to respond to new rivals. The new facilities you build might turn out to be worth less than you paid for them if demand falters: writedowns of the value of big out-of-town stores were the main reason for Tesco's recent £6.4bn loss. Investing overseas might mean having to deal in countries with less than perfect respect for property rights, as BP discovered in Russia and Rockhopper and Falkland Oil and Gas might be finding in the South Atlantic. And big investment projects are hard to manage: the planning fallacy means bosses under-rate the time and expense they take, while the effort of overseeing expansion can distract managers from the day-to-day running of the business.

Expansion, then, is difficult and dangerous.

This might help explain one of the strongest anomalies in investing - the tendency for momentum stocks to do well.

A big reason why a share might rise a lot is that its growth options improve: for example, if commodity prices rise, miners will see previously unprofitable projects become viable. But taking advantage of these options is dangerous; a lot can go wrong. Such shares are therefore riskier than others. Some investors might therefore avoid them for fear that the expansion will go awry. This means momentum stocks are underpriced and so should offer higher returns than other stocks to those who are brave enough to take on the risk. Timothy Johnson at the University of Illinois has said that momentum's profits come as a reward for taking growth rate risk. And Columbia University's Andrew Ang has shown that momentum's returns might be partly a reward for taking on extra downside risk.

You might object here that growth risk is idiosyncratic - if one company screws up its expansion there's no reason why others would - and economic theory tells us that idiosyncratic risk should not generate higher returns because it can be diversified away.

I'm not so sure. There is a systematic element to growth risk. If the market anticipates an economic downturn companies that are expanding could do especially badly because the risk of having excess capacity has increased, and because it might well become more expensive to carry lots of debt. This is consistent with a finding by the LSE's Victoria Dobrynskaya, that momentum stocks tend to have a higher downside beta than others; they do especially badly in downturns. And investors must be rewarded for taking on this systematic and nasty risk.

But, of course, there are also risks in not investing: the company that avoids capital spending will end up with outdated equipment that can't compete against more efficient rivals. With Newcastle still at risk of relegation, Mr Ashley is taking this danger. In business, there is no such thing as a risk-free venture; there are just different types of risk.