The price of ambition

Dear investors,

A maxim in the business world is that every company plans to grow. In most cases, the objective is well-justified: it brings economies of scale, improves competitive positioning, facilitates the attraction of competent people at all levels, and generates value for shareholders. This last point is directly related not only to the company's expansion history but also to its expected growth in the coming years, since the estimated value of a business depends fundamentally on its expected growth rate and profitability. However, does this expansionist ambition always make sense?

According to an ancient legend from Greek mythology, King Minos of Crete commissioned the inventor Daedalus to build a labyrinth to imprison the Minotaur, a mythical creature half-man, half-bull. To ensure the labyrinth's secret would never be revealed, upon completion of its construction, King Minos imprisoned Daedalus and his son, Icarus, in a heavily guarded tower. Determined to escape, Daedalus constructed wings from bird feathers and wax so that he and Icarus could flee.

Before they departed, Daedalus instructed Icarus not to fly too high, as the sun's heat could melt the wax and destroy his wings. At first, everything went according to plan, and they both escaped the tower through the air. However, the euphoria of being able to fly caused Icarus to soar higher and higher, ignoring his father's warnings about the danger. Already too high, the wax holding his feathers together began to melt, and Icarus's wings disintegrated, causing him to fall from the sky into the Aegean Sea, where he drowned.

This metaphor about the risk of being dazzled by one's own success, guided by ambition and ignoring prudence, and falling into the trap of trying to exceed the limits imposed by reality, was as valid in ancient Greece as it is today. We will discuss the topic applied to the context of business and investment.

Why Business Growth Is Limited

A company's revenue growth in a given economic sector comes from two possible factors: increased demand, whether through increased volume or price, or market share gains. The latter is always a temporary growth accelerator, as market share cannot be gained forever. At the extreme limit, there would be no more growth to capture once the company conquered the entire market and became a pure monopolist. In the practical world, the limit arrives much earlier, due to the action of competitors or antitrust agencies, which prevent the formation of monopolies and encourage competition. Demand, on the other hand, can grow forever, but not so quickly.

Demand growth can be broken down into several factors: demographic growth, increased per capita income, and the increased representation of the product or service in total consumption (share of wallet). Because demographic and per capita income growth are necessarily slow, stories of accelerated growth are always associated with increased consumer adoption of the product or service offered directly by the company or by the final link in the production chain in which it participates. This type of rapid growth can last for long periods in nascent sectors, but is unlikely to be seen in traditional sectors, which have already reached a stable equilibrium between supply and demand.

At the risk of stating the obvious: no company can grow rapidly forever in the same economic sector, as market share and share of wallet gains are inherently limited, and population and income growth are slow. The expectation of maintaining high growth rates indefinitely, simply doing "more of the same," is unrealistic. Once there is no longer room for a company to grow rapidly in its economic segment, its shareholders are at risk.

What happens when a business reaches its limit?

There are several alternatives for a business that can no longer grow efficiently: The first is to ignore the saturation of its market and continue trying to find a way to accelerate its growth. This often leads to wasted capital investment, aiming to increase the quality or volume of supply without realizing the demand for it. To give a simple example, imagine that the food industry persisted in trying to sell more than humanity could consume or tried to convince people to spend an ever-increasing portion of their budget on food. The error is not so simple because the point at which growth becomes inefficient is not well defined. It is usually found empirically, when efforts to continue growing fail to produce results, always depending on the interpretation of its shareholders and executives, whether to attribute this growth difficulty to flawed strategy or execution—which are solvable problems—or to intractable market saturation.

The second alternative is to expand the business's activities into new sectors or economic segments where there is still room for rapid growth. When the segment is close to the activity in which the company has historically been successful, leveraging its market positioning and competencies, it can be a strategy with a good chance of success. However, there are cases of companies that have expanded into sectors completely different from their original activity, forming business conglomerates without any operational synergy between them. Most business groups that followed this course of action did not generate good returns for their shareholders.

The third option is to recognize that expansion attempts are no longer efficient and begin distributing the cash generated by the business to its shareholders in the form of dividends or share buybacks. This is the most prudent course of action, given the goal of maintaining a high return on investors' capital, but it is not usually the option chosen by executives and shareholders.

The difficulty of not seeking to grow

Abandoning the goal of rapid growth isn't an easy choice for people with a successful track record at the helm of their businesses. Professional executives naturally want to be involved in large companies with sophisticated and ambitious business plans, whose successful execution has great potential to advance their careers. Furthermore, their individual compensation doesn't necessarily correlate strongly with the return on invested capital, so it may be objectively more profitable for them to keep the company growing even if its profitability deteriorates in the process.

Shareholders are in a slightly different position, as they are directly impacted by the lower profitability that an inefficient expansion plan can cause. However, the ambition to grow the business to its full potential is still present as an incentive. In the case of controlling shareholders who founded the business, and sometimes even have their own identity associated with the company, the impetus to pursue growth can be even greater. Highly successful people in the business world are often highly competitive, ambitious, and confident. These characteristics are desirable most of the time, but they are risk factors for falling into the Icarus trap: becoming dazzled by one's own success, getting carried away by ambition, and ignoring prudence.

The market negatively contributes to this dilemma. Most stock analysts want to hear growth stories, about talented leaders who will lead their businesses into expansionary campaigns where the sky's the limit. In this culture that prioritizes growth above all else, sometimes even profitability, saying that the plan is to grow at a vegetative rate, even if it's to maintain a highly profitable business, almost sounds like an admission of failure.

The Sees Candies Case

To illustrate how this topic isn't trivial, even Warren Buffett and Charlie Munger had their learning curve. In 1972, they purchased Sees Candies, a traditional manufacturer of artisanal chocolates and sweets on the West Coast of the United States. Founded in 1921, the company maintains its reputation for high quality in all its products to this day, making Sees one of the region's favorite brands for gifts and special occasions. This premium quality also translates into a price premium, making the operation quite profitable.

With a simple-to-manage and highly profitable business at their disposal, the legendary duo devised a national expansion plan for Sees Candies products and began opening stores in several American states. Although the same characteristics that made the brand so famous in California were preserved in other regions, Sees never achieved the same penetration outside the West Coast. While there are currently around 230 stores in California, neighboring states (Washington, Oregon, Nevada, and Arizona) have approximately 55 stores, and the rest of the United States has only approximately 40 stores.

The exact reason why Sees Candies failed to grow as much in other states is unclear. Whether due to the brand's lack of tradition in other regions, a greater presence of competitors, different consumer habits, or some other reason, the fact is that the business, extraordinary in California, proved not as replicable as initially hoped. After several failed expansion attempts, Buffett and Munger abandoned their ambition to grow Sees and began distributing all the cash generated by the operation as dividends, to be allocated to other investment opportunities. The company became an emblematic case, frequently discussed at Berkshire Hathaway's famous shareholder meetings, as an example of both the benefits of holding a good business in a portfolio for long periods and the limitations of growth.

The case of Sears, Roebuck and Co.

Despite the similar name, the outcome of Sears' story was quite different from the one we just recounted. In the 1950s, Sears was the largest retailer in the world. Despite its already dominant position, Sears continued to pursue aggressive growth over the decades, opening numerous stores throughout the United States and diversifying its investments into various other businesses, including insurance, real estate, shopping center development, and financial services.

In the 1990s, Sears entered a period of decline. While the company continued its strategy of investing in diversified businesses, competitors like Walmart and Target focused their efforts on optimizing their retail operations, allowing them to achieve greater efficiency and, thus, the ability to offer lower prices to end consumers, allowing them to gain market share.

In 2005, Sears was acquired by Kmart, another struggling retailer, and the two companies' operations were merged in an attempt to save both. After the merger, the new company attempted to regain profitability by closing underperforming stores, selling off real estate and other company assets, and undertaking financial maneuvers focused on generating cash. However, the focus on financial engineering was so strong that the quality of the retail operation was relegated to the background, with stores becoming increasingly outdated, experiencing inventory issues, and poor service.

The 2000s were also a time when e-commerce began to gain traction, with companies like Amazon taking market share from traditional retailers. Sears even tried to compete in online retail, but was unsuccessful and continued to post losses until it filed for bankruptcy in 2018, after 126 years of operation.

This case illustrates how even a leading company in its sector can go from its peak to absolute failure due to excessive ambition and self-confidence. We intentionally chose a retail case. The sector is rife with aggressive expansion plans based on the premise that accelerating the pace of new store openings will simply result in the average profitability of the existing operation being applied to the new units. It's rare that the plan works as expected. By opening a large number of stores in a rush, location selection is less careful, teams are less trained, and executives lose the attention to detail that makes such a difference in retail. By wanting to grow too quickly, the business loses quality, profitability, and consequently, customers.

How to deal with growth risk in investments

While business expansion is always desirable for investors, any initiative seeking accelerated growth or in segments distinct from the company's original business represents additional risk. Investments related to the plan are under the company's control and will certainly materialize, while expected additional revenue and profits depend on the evolution of demand and the competitive environment, factors that are uncertain and uncontrollable. This doesn't mean that ambitious plans make a thesis bad; it simply means caution is warranted.

The first question that never has a definitive answer is assessing the plan's chance of success. A starting point is to assess the nature of the planned route. The closer it is to the company's core business, leveraging the knowledge and experience its executives already possess, the assets the company already holds, and the skills its employees already possess, the greater the chance of success. The problem with daring to explore new territories is that there are many unknown factors, and the cause of failure may stem from risks not even identified beforehand.

A second angle is to evaluate the planned change in growth rate. The more sudden the intention to accelerate growth—for example, a company growing at 5% per year intends to grow by 30% in the following period—the greater the risk. The execution capacity required to expand rapidly is not trivial. People take time to become proficient in their roles, processes take time to implement efficiently, and the compressed time available to achieve these goals makes everything more difficult.

The prognosis is more favorable when the intention for accelerated growth stems from a clear and unequivocal expansion of demand that the company is capable of meeting. Even so, the competitive environment must still be assessed, because when a growth opportunity is too large and obvious, the number of competitors seeking to capture it can be equally large, and the competitive dynamics become destructive. Typically, the sum of all participants' revenue growth plans results in aggregate revenue several times greater than is conceivable for the market size, even in the most optimistic scenarios. In other words, most deals will fail, and it is difficult to determine who will be the victorious competitor in advance.

When this demand expansion isn't underway and the company decides to try to accelerate its growth by stimulating consumption or gaining market share, the risk is substantial. Customers and competitors don't always behave as expected, and plans that seemed good on paper can completely fail.

Finally, it's necessary to estimate how much it's worth paying for the chance of growth. Since such initiatives are considerably riskier than maintaining a steady pace, the potential return implied by the stock price must be sufficient to offset the additional risk. This concept is basic and widely understood, but it's common to find market prices that assume non-obvious growth as virtually guaranteed, especially when eloquent executives are explaining their plans to analysts.

Why are we talking about this now?

It may seem strange to talk about growth risks while we're still under a contractionary monetary policy, but the most difficult scenario places us precisely in a situation where there's no expectation of major surges in demand on the horizon, which makes it risky to be overly ambitious. Eager to please a market still largely uninterested in stocks, despite the attractive prices of many, some companies have gotten creative and sought to develop non-obvious growth plans.

When demand is uncertain, we prefer companies that decide to focus on operational optimization and preparing for the next wave of opportunities over those that embark on an attempt to generate additional revenue precisely when doing so is most difficult. For example, it's inefficient to increase marketing investments during economic downturns because it's harder to generate additional sales when end consumers have less money. Not only is the success rate lower, but additional sales tend to be of low value, and the return on capital invested in marketing is often unsatisfactory.

Against this backdrop, we recently rejected some investment theses in companies with good business opportunities due to growth plans we deemed inadequate. Therefore, we took the opportunity to share our warning about these risks and to inform our investors that, even though we are optimistic about low stock prices on the Brazilian stock exchange, we remain vigilant to avoid making Icarus' mistake of getting too close to the sun.