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 position, facilitates the attraction of competent people at all levels and generates value for shareholders. On this last point, the relationship is direct not only with the company's history of expansion, but also with the expectation of growth in future years, since the estimated value of a business depends, fundamentally, on its growth rate and profitability. expected. 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 that was half man, half bull. So that the secret of the labyrinth would never be revealed, after the completion of its construction, King Minos imprisoned Daedalus and his son, Icarus, in a heavily guarded tower. Determined to escape, Daedalus constructed wings made of bird feathers and wax so that Icarus and he could flee.
Before they left, Daedalus instructed Icarus not to fly too high, as the heat from the sun could melt the wax and thus destroy the wings. At first, everything went according to plan and both escaped the tower through the air. However, the euphoria of being able to fly caused Icarus to climb higher and higher, ignoring his father's warnings about the danger. Already too high, the wax that held the 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, being guided by ambition and ignoring prudence, making the mistake of trying to exceed the limits imposed by one's own reality, was as valid in ancient Greece as it is today. We will discuss the topic applied to the context of business and investments.
Why business growth is limited
A company's revenue growth in a given economic sector comes from two possible factors: an increase in demand, either through an increase in volume or price, or a gain in market share. The latter is always a temporary growth accelerator, as it is not possible to gain market share forever. At the extreme limit, there would be no more growth to capture when the company conquered the entire market and became a pure monopolist. In the practical world, the limit arrives much earlier than this, due to the actions of competitors or antitrust bodies, which prevent the formation of monopolies and stimulate competition. Demand can grow forever, but not so fast.
The growth in demand can be broken down into some factors: demographic growth, the increase in per capita income and the increase in the representativeness of the product or service in total consumption (share of wallet). As demographic growth and per capita income are necessarily slow, stories of accelerated growth are always associated with increased adoption, by the consumer public, 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 extend over long periods in embryonic sectors, but is unlikely to be seen in traditional sectors, which have already reached a point of stable balance between supply and demand.
At the risk of stating the obvious: no company can grow rapidly forever in the same economic activity, as the gain in market share and share of wallet are inherently limited and population and income growth are slow. The expectation of maintaining high growth rates indefinitely, just doing “more of the same”, is unrealistic. From the point where there is no more room for a company to grow quickly in its economic segment, its shareholders are at risk.
What happens when a business reaches its limit
There are some alternatives to what a business that can no longer grow efficiently can do: The first is not to recognize that its market is saturated and continue trying to find some way to accelerate its growth, an act that usually leads to wasting capital in investments, aiming to increase the quality or volume of supply without there being demand for it. In a simple example, imagine that the food sector insisted on trying to sell more than humanity is capable of consuming or tried to convince people to spend an increasingly larger portion of their budget on food. The error is not so simple because the point at which growth is inefficient is not well defined. It is usually found empirically, when efforts to continue growing fail to generate results, always depending on the interpretation of shareholders and executives, attributing this difficulty in growth to failures in strategy or execution, which are solvable problems, or to intractable market saturation.
The second alternative is to expand business activities to new sectors or economic segments in which there is still room to grow quickly. When it is a segment close to the activity in which the company has historically had success, which takes advantage of its market positioning and competencies, it can be a strategy with a good chance of success. However, there are cases of companies that 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 bring good returns to their shareholders.
The third option is to recognize that expansion attempts are no longer efficient and start 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 objective of maintaining a high return on investors' capital, however it is not usually the alternative chosen by executives and shareholders.
The difficulty of not seeking to grow
Abandoning the goal of growing quickly is not 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, the successful execution of which has great potential to advance their careers. Furthermore, their individual compensation does not necessarily have a high correlation with the return on invested capital, so it may be objectively more profitable for them for the company to continue growing even if the profitability of the business 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 maximum 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 seek growth can be even greater. Very successful people in the business world tend to be highly competitive, ambitious and confident. These characteristics are desirable most of the time, but they are risk factors for falling into the trap of the Icarus legend: being dazzled by your own success, getting carried away by ambition and ignoring prudence.
The market contributes negatively to this dilemma. Most stock analysts want to hear growth stories, about talented leaders who will lead their businesses on expansionary campaigns where the sky is the limit. Under this culture that puts growth above everything, sometimes even profitability, saying that the plan is to grow at vegetative rates, even if it is to keep the business highly profitable, almost sounds like an admission of failure.
The case of Sees Candies
To illustrate how the topic is not trivial, even Warren Buffett and Charlie Munger had their learning curve on it. 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 still maintains a reputation for high quality in all its products, which makes Sees one of the region's favorite brands for gifts and special situations. The quality premium also translates into a price premium that makes the operation very profitable.
Having a simple to manage and highly profitable business in hand, the legendary duo drew up a national expansion plan for Sees Candies products and began a movement to open 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 California currently has around 230 stores, nearby states (Washington, Oregon, Nevada and Arizona) have ~55 stores and the rest of the United States has only ~40 stores.
The exact reason why Sees Candies has not been able to grow as much in other states is not well determined. Whether due to the brand's lack of tradition in other regions, greater presence of competitors, different consumer habits or any other reason, the fact is that the business, extraordinary in California, proved not to be as replicable as initially expected. After several failed expansion attempts, Buffett and Munger abandoned their ambition of trying to make Sees grow and began distributing all the cash generated by the operation as dividends, so that it could 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 keeping a good business in the portfolio for long periods and the limitations of growth.
The case of Sears, Roebuck and Co.
Despite the similar name, the outcome of the Sears story was very different from the one we just told. In the 1950s, Sears was the largest retailer in the world. Despite its already dominant position, Sears continued to seek aggressive growth over the decades, opening a large number of stores throughout the United States and diversifying its investments into various other activities, including insurance, real estate brokerage, shopping center development, and services. financial.
In the 1990s, Sears went into decline. While the company continued its strategy of investing in diversified businesses, competitors like Walmart and Target put all their energy into optimizing their retail operations, which allowed them to achieve greater efficiency and thus the ability to offer lower prices to consumers. finals, which allowed them to gain space in the market.
In 2005, Sears was acquired by Kmart, another struggling retailer, and their operations were merged in an attempt to save both. After the merger, the new company tried to regain profitability by closing stores with weak results, selling properties and other company assets and carrying out financial maneuvers focused on generating cash. However, the focus on financial engineering was so great that the quality of the retail operation was left in the background, with stores becoming increasingly antiquated, with inventory problems and low-quality services.
The 2000s were also 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 in the initiative and continued to show losses until it went bankrupt in 2018, after 126 years of operation.
This case illustrates how even a company that is a leader in its sector can go from its peak to absolute failure due to heightened ambition and self-confidence. We chose a retail case intentionally. The sector is full of aggressive expansion plans based on the premise that accelerating the pace of new store openings will simply result in applying the average profitability of the existing operation to the new units. It is rare that the plan works as expected. When opening a large number of stores in a hurry, the choice of location is less careful, teams are less trained and executives lose attention to the details that make such a difference in retail. By wanting to grow too quickly, the business loses quality, profitability and consequently customers.
How to deal with the risk of growth in investments
Although the expansion of a business is always desirable for its investors, any initiative seeking accelerated growth or in segments different from the company's original activity represents an extra risk, as the 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, uncertain and uncontrollable factors. This doesn't mean that ambitious plans make a bad thesis, it just means that caution is needed.
The first question that never has a definitive answer is judging 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 activity, leveraging knowledge and experience that its executives already have, assets that the company already holds and skills in which its employees are already proficient, 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 can come from risks that have not even been identified in advance.
A second angle is to evaluate the change in the planned growth rate. The more sudden the intention to accelerate growth – for example, a company growing 5% per year wanting to grow 30% in the following period – the greater the risk. The execution capacity required to scale quickly is not trivial. People take time to become proficient in their roles, processes take time to implement efficiently, and the compression of the time available to achieve these goals makes everything more difficult.
The prognosis is more favorable when the intention of accelerated growth derives from a clear and frank expansion of demand that the company is capable of supplying. Even so, it is still necessary to evaluate the competitive environment, because, when a growth opportunity is large and too obvious, the number of applicants to capture it can be equally large and the competitive dynamics become destructive. Typically, the sum of all participants' revenue growth plans leads to aggregate revenue several times greater than is conceivable for the market size in even the most optimistic scenarios. In other words, most of the deals will be frustrated, and it is difficult to determine who the victorious competitor will be in advance.
When this expansion of demand is not ongoing and the company decides to try to accelerate its growth by stimulating consumption or gaining market share, the risk is substantial. Your customers and competitors don't always behave as expected, and plans that looked good on paper can fail completely.
Finally, it is necessary to estimate how much it is worth paying for the chance of growth. As initiatives like this are considerably riskier than keeping the business at cruising speed, the potential return implied by the share price must be sufficient to compensate for the extra risk. This concept is basic and widely known, but it is common to find prices in the market that assume non-obvious growth is practically guaranteed, especially when there are eloquent executives explaining the plans to analysts.
Why are we talking about this now
It may seem strange to talk about growth risks while we are still under a contractionary monetary policy, but the most difficult scenario puts us precisely in the situation where there is no expectation of large jumps in demand on the horizon, which makes it risky to have too much ambition. In the desire to please a market that is still not very interested in shares, despite the attractive prices of several of them, some companies have become 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 rather than those that embark on trying to generate extra revenue precisely when doing so is most difficult. In a simple example, it is not efficient to intensify marketing investments during economic recessions, as it is more difficult to make extra sales when end consumers have less money. In addition to the success rate being reduced, extra sales tend to have low value and the return on capital invested in marketing is often unsatisfactory.
With this background, we recently rejected some investment theses in companies with good businesses because of growth plans that we judged to be inadequate. Therefore, we take the opportunity to share the warning about risks of this nature and to inform our investors that, even though we are optimistic about the low share prices on the Brazilian stock exchange, we continue to be careful not to make Icarus' mistake, of getting too close to the sun.
Check out the comments from Ivan Barboza, manager of Ártica Long Term FIA, about this month's letter in YouTube or in Spotify.
