Phil Oakley 

Quality without growth is a bad mix

Phil Oakley

Quality without growth is a bad mix

If you are going to try to do better than an index tracker by picking individual shares, then buying those of quality companies is one of the best ways to go, in my opinion. Good companies, bought at the right price, can deliver market-beating returns without involving lots of risk. But just buying good companies is not enough on its own.

It’s not difficult to identify companies with high profit margins, high returns on capital, great cash flows and low debts. Understanding how they make them and how sustainable they are is a different matter. Then there’s the most important question: Can these businesses still grow?

Without growth, it’s hard to distinguish between a low-margin, low-return business and a high one. If you accept that the value of a business is based on the cash it will produce in the future then if neither can grow, neither should command a high price tag.

When you are researching a business you should try to spend a reasonable amount of time on trying to work out not only if it can grow but how it can. The quality of growth is also important. Not all growth should be treated the same.

In this article, I am going to look at this very important issue and use some real world examples of good companies with different types of growth.


Good-quality growth is based on sales not cost-cutting

Sales are the lifeblood of any business. They are its primary source of income. It cannot survive and prosper if it cannot persuade customers to keep on buying its products or services. Genuine growth companies grow by selling more not by cutting costs or buying back their own shares.

Yet sales (often referred to as turnover or revenue) growth can also be of varying quality. To identify high quality sales and ultimately profits growth you need to find a way of scrutinising the sources of a company’s sales growth.

A company’s sales growth can come from a variety of good and bad sources, such as:

  1. Like-for-like (LFL) or organic sales – selling more from its existing assets. This is usually a good source of sales growth, but not always
  2. Selling more goods and services on credit – companies can make themselves more competitive by offering more generous credit terms – giving them a longer time to pay their bills – to customers. Sometimes this is good business practice but at other times it can be a warning sign to investors that sales growth might be unsustainable..
  3. Investing in new assets – this can be good as long as the new assets improve or maintain a company’s returns on investment.
  4. Buying other companies – again this can be fine as long as a company can improve or maintain its return on investment. More often than not, returns go down.


Organic sales growth

This measures the increase in sales coming from a company’s existing operations. It is commonly used in industries such as retailing – where it is often referred to as like-for-like or same store sales – and consumer goods and is seen as a good measure of a company’s underlying sales growth.

Increases in LFL sales with retailers are usually taken as a positive development but some care is needed here. One area where LFL sales can be slightly misleading is in retailing. This is due to something known as the maturation effect.

Retailers can give the impression that they have very strong underlying sales growth when really what it happening is that stores that have opened during the last couple of years are just going through a natural maturation process.

This happens because new shops or outlets rarely reach their natural level of sales in the first year of opening. During their first year their sales are not included in a LFL calculation, but they are in their second year when sales may still be building up to normal levels.

This is why retailing companies with aggressive new opening schedules can post very strong LFL sales growth as lots of new stores are maturing at the same time. This tends to get investors and analysts excited and they often start predicting big growth in the retailer’s sustainable profits, which leads to a big rise in the share price.

When the company has built up to a large number of stores, the impact of new openings can begin to wane. In fact, new openings can be a problem as they start taking sales away from existing stores – a process known as sales cannibalisation. This is when LFL sales can fall off a cliff.

The retailing sector over the years has been littered with examples of strong LFL sales growth petering out when the size of the business has become too big. Consumer goods companies such as Diageo (DGE) and Unilever (ULVR) have been more successful at getting the value of their sales to tick upwards year after year. This has been done by a combination of selling more (volume) and increasing prices.

When looking at a company’s sales growth you have to be on the lookout for signs that it might not last. One of the biggest red flags is a rising ratio of trade debtors to sales. This is a sign of a company that might be having to offer greater amounts of credit to its customers to keep its sales growth. This is not a problem as long as sales are sustainable, but offering credit costs money and is an investment in a business just the same as investing in a new piece of machinery. The danger of course is that the sales growth is unsustainable.

The rising level of trade debtors to sales remains my chief concern regarding the health of the rapidly growing Fevertree Drinks (FEVR) as it has been on an upwards trend over the past few years.



Where’s the reinvestment opportunity?

Growing from existing assets or operations is highest quality growth provided a business does not have to invest too much in working capital (credit) or advertising to do so. The next best way to grow is to reinvest profits in projects with high returns on capital.

The best way to think about this is putting money into a high interest saving accounts and then keep on reinvesting the interest received at a high interest rate. This allows the magic of compound interest to do its work and create substantial increases in value for investors.

Identifying a business with the opportunity to keep on investing money at high rates of return is a skill that can allow you to identify long-term stock market winners. The thing is, these businesses are quite rare, or the high returns prove to be temporary due to increased competition. But as we shall see shortly, some do exist.

More often than not, companies will seek to grow by buying other companies that are either in the same or different business to them. This is often the worst way to grow as companies pay too much for the assets of others – known as goodwill. This often drags down a company’s impressive ROCE which sometimes cannot be recovered even when lots of costs are cut or the acquired business grows.

A good recent example of this happening in the real world is Reckitt Benckiser’s (RB.) acquisition of baby food company. Mead Johnson in early 2017. The high price paid combined with the poor performance of the acquisition has decimated RB’s ROCE, which was 22.7 per cent in 2013 and was just 12.8 per cent last year.


Case studies of quality companies and their growth

I’ve taken a selection of what I believe to be high-quality UK-listed businesses and looked at their sales and profit growth over the last five years and how much money they have had to invest to do so.


Name5y ago TurnoverTurnover5y ago Op profitOp profit5y ago Capital empCapital emp
Ashtead Group1361.937062901037.51960.86086.6
Fevertree Drinks16.3170.23.656.47.6136.1
Spirax-Sarco Engineering661.7998.7136.2235.5576.91299.6


I’ve also looked at what the growth has done to three key profit ratios and quality hallmarks over that time:

  1. The profit margin – the percentage of sales turned into operating profits.
  2. The capital turnover – the amount of sales generated per £1 of money invested in the business.
  3. Return on capital employed (ROCE) – Trading profits as a percentage of money invested in the business.


Name5y ago EBIT marginEBIT margin5y ago Capital turnoverCapital turnover5y ago ROCEROCE
Ashtead Group26.631.40.80.620.320
Fevertree Drinks22.333.22.61.557.748.4
Spirax-Sarco Engineering19.520.11.212319.7


This may give us some insights as to how they might continue to try and grow in the future.


Ashtead (AHT) – a compounding machine but can it last?

Equipment hire company Ashtead is a great example of company investing lots of money at high rates of interest. The money invested in its business has more than trebled over the past five years on the back of a booming business in the USA  while maintaining its ROCE at a very impressive 20 per cent.

The ROCE has been maintained by rising operating margins as capital turnover has fallen back. Ashtead believes it still has plenty of scope to invest lots more money at high returns in the USA. The problem for investors is that equipment hire is a cyclical business. When the cycle turns down, profits and ROCE can fall sharply. As long as the US infrastructure market remains healthy, Ashtead will be confident of keeping its growth going.


Bioventix (BVXP) – needs very little capital investment to grow

Bioventix makes antibodies for use in medical testing. In many ways it is an investor’s dream business. It sells its antibodies to medical testing machine companies such as Siemens or Roche. Every time a Bioventix antibody is used in a blood test it receives a royalty. These royalties are small, but with millions of tests done every year they add up to a meaningful amount of money.

The great thing about Bioventix is that it is such a small company, with its products being developed by just a few people working out of a laboratory in Surrey. Virtually all its sales growth over the past five years has fed through to operating profits and has helped to create an exceptionally profitable business.

The investment needed to grow has been minimal with the increase in capital employed almost entirely attributable to the company’s rising cash balance. There are high hopes for its troponin antibody which can reveal if someone has had a heart attack. Competition is a concern from other types of antibody, but growth from new products could see big growth in future profits and cash flows that need little extra investment.


Diageo (DGE) – switching from capital to revenue investment in order to grow

Diageo is the biggest spirits company in the world. It is a big business in a competitive market. It has increased investment but profits have not kept pace and ROCE has come down slightly. Yet, recent results suggest that this company has got itself into a good place.

Its growth strategy revolves around focusing its marketing investment on its leading drinks brands in key markets. It is cutting costs and reinvesting the savings into higher marketing spend behind the brands. It seems to be paying off, with recent half-year results showing strong organic sales growth and an improvement in profit margins. Diageo is an example of a company switching its strategy to grow by revenue rather than capital investment.


Fevertree Drinks (FEVR) – Organic sales growth with working capital investment

Fevertree’s mixer drinks – especially its tonic water – are a phenomenon. So far, its rapid growth has been a triumph of marketing and branding and has required little physical investment in assets as its production and bottling have been outsourced to third parties.

Its growth has seen a big expansion in its profit margins, but ROCE has come down due to investment in customer credit and a swelling cash balance increasing its capital employed. The big question is can its growth continue and how much extra working capital investment will it need to do so?

It has a highly attractive, asset light business model which lends itself to high returns but its growth has to stretch beyond tonic water and beyond the UK. Cracking the market for brown spirits mixers in the USA and taking share off Coca-Cola and Pepsico will not be as easy as taking business of Schweppes has been in the UK.


Rightmove (RMV) – a licence to print money for very little investment

For me. Rightmove is probably the most outstandingly profitable business listed on the UK stock market. Its profit margins and ROCE have required very little capital investment.

High profits usually attract competition and can upset customers who think that they are paying too much. Rightmove’s stellar growth in recent years has been helped in no small part by it being able to increase the prices paid by estate agents' offices. However, there are signs that it might be having to rein this tactic in due to the growth of rival OnTheMarket (OTM), which offers much lower fees.

Rightmove’s improvement in ROCE has been very impressive and has come largely from a big improvement in capital turnover. It has gone from making just over £7 of sales per £1 invested to nearly £19.


Spirax-Sarco (SPX) – mix of organic growth and acquisitions seems to be working well

Steam systems and pump maker Spirax-Sarco has been one of the most dependable business own shares in over the years. The company’s products solve problems for its customers and this has allowed it to become deeply entrenched with them and win new business. It seems to have a defendable economic moat.

It has been able to deliver consistent levels of organic growth while maintaining profit margins. In recent years it has been buying businesses and is currently in talks to buy another one. This has dragged down ROCE very slightly but its still at a very high level. It remains a company to admire and looks well placed to keep on delivering with its proven strategy.


Unilever (ULVR) – is growth faltering and is it too reliant on cost-cutting?

Unilever has a great portfolio of brands stretching across food, beauty and homecare markets. These brands are bought regularly by consumers and have created a very dependable business with high profits and good cash flows.

The problem is that Unilever’s organic growth rates are slowing down. Its beauty products business remains robust and has defended itself well from own label competition while the high exposure to emerging markets has served the company well.

Unilever’s problems are that some of its food brands face tough competition, while there is very little growth coming from European and North American markets.

The company’s profit growth also seems to be increasingly driven by cost-cutting and strategies such as zero cost budgeting, but what happens when the cost cutting runs out?

It remains a high-quality business, but its growth potential is a cause for concern and explains why its shares have been rather lacklustre for the past year or so. They may continue to be so for a while yet.


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