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The end of the g-word: greed had its day in Gordon Gekko’s 1980s. Is growth no longer good in Gordon Brown’s 2008?

An unchecked dash for growth is a serious danger to long-term financial wealth. Investors have always looked to fast-growing companies as a means to underpin sustainable profits long into the future, and companies take little convincing to jump on the bandwagon, yet this passion is turning into a dangerous obsession, one that leads to a never-ending boom-and-bust cycle.

In his book Growth Fetish, the Australian socio-economic thinker and commentator Clive Hamilton spells out his own damning verdict, arguing that even though we’ve enjoyed 60 years of post-war consumer capitalism, meaning we have materially never had it so good, escalating waste, excess consumption and environmental damage mean people are still no better off in terms of their own personal happiness.

The director of the Australia Institute’s challenge that we should take a step back and pursue what he terms ‘a richer life rather than a life of riches’ will produce no more than a collective snort of derision from the world’s trading floors. Nor is it likely that Hamilton’s critique of the Blair-ite third way, whereby following the collapse of communism in Eastern Europe the Left embraced Thatcherite free-market economics as the basis of its own policies, will attract anything more than glazed eyes.

Yet the accusation that a dangerous obsession with growth can have deleterious consequences should resonate, particularly with those bankers who could be about to lose their jobs in the fallout from the ongoing global credit crisis. Had the world’s leading banks not got involved in an alphabet soup of credit derivative obligations (CDOs), special investment vehicles (SIVs) and varied disastrous debt holdings in an ultimately failed quest for new sources of earnings growth, those positions might look a lot safer today.

Growth fetish

The management teams of Northern Rock, which went bust last year and is now effectively in state ownership, and Bear Stearns, which is about to be sold off for an eighth of its stated book value to JP Morgan, have both attracted plenty of criticism in recent weeks. Yet no such objections could be heard a year ago, when Northern Rock and Bear Stearns were still trading at £11.50p and $150.35 respectively, prices less than 10% below their all-time highs.

Both firms were, to quote from last July’s Financial Times interview with former Citigroup head Chuck Prince, ‘still dancing’ as the credit market music played on. No-one seemed to care until the debt market game of musical chairs stopped the global equity markets were dumped on to their backsides as a result.

These recent failures seem to confirm the cynical view of equity markets as short-term profiteers. The lessons of the last stock market downturn, which began a mere seven years ago and lasted until as recently as early 2003, do, depressingly, appear to have already been forgotten.

Then it was not banks and financial stocks that took the UK market over the precipice, but the bursting of the technology, media and telecommunications (TMT) bubble. The fortunes of two firms in particular were key here, as one offered a painful lesson in strategic execution, the other in the importance of valuation.

The first was Marconi. Known as GEC between 1900 and 1999, the firm became one of the UK’s industrial powerhouses after Arnold, later Lord, Weinstock took the reins in 1963. By the time Weinstock retired in 1996, GEC had built up leading positions in the global defence, infrastructure, telecommunications equipment and medical industries and had accrued a net cash pile of around £2.5 billion.

Yet toward the end of the Weinstock era, GEC was largely dismissed as a plodder by the UK equity market, which crabbed the firm’s GEC-Alsthom and Siemens-GPT joint venture structures, criticised the firm’s cash-laden balance sheet as flabby and inefficient and bewailed its lack of earnings growth. The stock had begun to underperform by the time Weinstock stepped down, to be replaced as managing director by George Simpson, later Baron Simpson of Dunkeld. Simpson brought in John Mayo as deputy chief executive and the two men were swiftly given a mandate to shake up the supposedly ossified behemoth by shareholders, brokers and bankers alike

Simpson, who had previously sold Rover to BMW and then merged Lucas Industries with America’s Varity, and Mayo, who has as an SG Warburg banker had spun Zeneca out of ICI before joining the pharmaceuticals firm as its finance director, swiftly got to work.

The trains to power stations business GEC-Alsthom was spun off and listed on the Paris bourse, under the new name of Alstom, in 1997. The defence business, bulked up by the 1998 acquisition of US firm Tracor, was spun out and sold for £7.7 billion to British Aerospace, creating BAE Systems, in 1999. Medical Systems was sold to Dutch technology giant Philips in 2001.

The vast amounts of cash released by these deals were not left in the bank. Simpson and Mayo latched on to the potential of GEC’s telecommunications unit, which had a technological edge in broadband transmission technologies such as synchronous digital hierarchy (SDH) and dense wavelength division multiplexing (DWDM), and moved to rapidly expand it.

GEC was renamed Marconi in 1999 to reflect the shift in emphasis, which was confirmed when the new entity spent £5.3 billion buying in the 40% of Siemens-GPT it did not own and acquiring Fore, Reltec, Bosch and Mobile Systems International. The spree spent all of the cash fostered by Weinstock and more, leaving the group with an indebted but supposedly more ‘efficient’ balance sheet.

Investors lapped up the strategy, driving Marconi’s share price from £4 to £12 and the firm’s market cap to over £30 billion. Shareholders’ total returns were further boosted by a special dividend paid out at the time of the British Aerospace deal.

Yet by September 2001, all had gone sour. The build out of broadband capacity, using fibre-optic technology such as DWDM, managed to even outstrip demand growth and swamp the telecoms equipment market with overcapacity. As demand for its cutting-edge kit plunged, Marconi issued a pair of profit warnings, which culminated in 2001’s £5.7 billion loss and the ejection of Simpson and Mayo from office.

Both men were vilified for bringing down a UK institution. Weighed down by its debts, Marconi eventually had to be recapitalised in a 2003 rescue rights issue that wiped out existing shareholders. After a restructuring programme under Mike Parton, the firm was finally put out of shareholders’ misery when it was sold for just £1.2 billion to Sweden’s Ericsson in 2006.

Yet all the new management team had done was what investors, brokers and bankers had told them to, and initially rewarded them for, right down to getting rid of all of that cash. After all, the shares had soared and provided excellent short-term total returns, in the form of capital gains and that special dividend.

Had Simpson and Mayo funded their acquisitions in stock, rather than sterling, Marconi may well have survived the downturn and emerged as a global player in its field, rather as Vodafone did after its end-of-century acquisition spree

The mobile telecoms giant avoided the debt trap into which Marconi fell; it bought America’s AirTouch for $85 billion in 1998 and then Germany’s Mannesmann for $195 billion in 2000. Such prices may have been vastly inflated by the TMT bubble, but at least then chief executive (now Sir) Christopher Gent shrewdly paid in what turned out to be overvalued paper. As a result, Vodafone still had ample liquidity when times got tough, which they did shortly after the Berkshire firm got sucked into the UK’s 3G spectrum auction in spring 2000.

Thirteen participants slugged it out over 150 rounds of bidding for five 3G licences, and paid out £22.5 billion between them. TIW, which became known as 3, paid £4.4 billion for Block A and Vodafone £5.96 billion for block B. BT coughed up £4 billion for Block C, before spinning off its mobile arm, which ultimately became known as O2 before its acquisition by Spain’s Telefonica for £18 billion in 2005. One2one, which has since been rebranded T-Mobile, clinched Block D with a £4 billion bid and Orange, which is now owned by France Telecom, won Block E for £4.1 billion.

All of the winning quintet would come to repent the prices paid at their leisure, but there is no doubt Vodafone did what management felt was strategically correct: bid and bid hard enough to make sure it would get a chance to cash in on the growth opportunity offered by 3G mobile services. Yet Vodafone’s share price set its all-time peak of 399p in March 2000, just as the auction began, as the market began to smell trouble and baulk at the prices that would be paid for the 3G spectrum.

Ultimately that UK 3G auction, a mechanism copied in Germany and elsewhere, had the devastating effect of filling Gordon Brown’s coffers at the exchequer while draining vital liquidity from the equity markets and helped tip them over into a bear market that only bottomed two years later.

Even at last month’s analyst meeting, Vodafone’s chief technical officer Steve Pusey acknowledged average capacity utilisation of the telco’s 3G network across the EU is just 20%, even if this figure reaches 50%-60% in busy urban areas. So 2000’s dreams of 3G growth were way off beam and, as this realisation began to dawn, earnings estimates for Vodafone plunged and took the stock with it, to a new low of just 81p in September 2002.

Same old same old

This may seem like ancient history but the recent experiences of Mitchells & Butlers and Bear Stearns show the lessons of not chasing growth, particularly at any price, remain every bit as relevant today.

Mitchells & Butlers finance director, Karim Naffah, resigned in January after the managed pubs, bars and restaurant operator unveiled £274 million in losses related to a failed property venture. The group tried to set up a joint venture last August with property investor Robert Tchenguiz and at the same time Naffah took out a hedge to protect the scheme against interest rate changes and inflation, only for credit crunched banks then to refuse to fund the venture at all.

Chief executive Tim Clarke offered to fall on his sword as well. This was rejected by the board, but the firm has since been ejected from the FTSE 100 and seen putative plans for a merger with Punch Taverns come to naught.

Mitchells tried to embrace the ‘Operating company-property company’, or ‘OpCo-PropCo’ model, which stirred up a lot of speculative interest across the leisure and retailing sectors last year. Its shares have since more than halved from last summer’s £9 peak and perhaps the Sainsbury family should be given more credit for refusing to follow this fad last year.

The supermarket chain’s share price has admittedly also crashed, following the failure of last year’s Qatari-backed bid. But it has not received the opprobrium heaped upon Mitchells after the pub firm’s disastrous attempts to engineer fresh sources of growth, or upon Mayo and Simpson seven years ago after they gave the market the ‘efficient’ balance sheet it craved.

For all the talk, not one OpCo-PropCo deal got done in 2007, even when credit was free and easy, suggesting they may not be such a good idea after all. Lending money to people with dubious credit histories at premium rates and expecting to be repaid in full does not sound so good either, but this is where the sub-prime mortgage crisis had its origins.

Just as Vodafone, from a stock market perspective, felt that strategically it simply had to bid for the 3G spectrum in 2000, Citigroup’s Chuck Prince highlighted his dilemma with that infamous ‘still dancing’ quote. Prince implied he would have been pilloried for not letting Citigroup take part and make profits from the boom in slicing and dicing up sub-prime and other forms of credit, even if the risks were clear, simply because so many of his banking peers and rivals were doing so.

Prince was unseated from office anyway, and Marcel Ospel of UBS, Stan O’Neal of Merrill Lynch and Jimmy Cayne of Bear Stearns have all since shared his fate, paying the penalty for their banks’ multi-billion dollar credit write-downs..

Prince and O’Neal got hefty payoffs, worth nearly $300 million between them, and the vested interest given to managers by share or stock-option-driven packages means it is not just brokers, fund managers or activist investors who can be seen baying for growth.

Some managers too have an interest in driving short-term growth as hard as they can, to get the share price going as fast as it can. The severance package of around £750,000 of Northern Rock’s Adam Applegarth is small beer compared with O’Neal’s or Prince’s awards, but his bank’s dash for market share in the UK mortgage arena was initially rewarded with a soaring share price and performance bonuses for management.

Stock-based compensation packages, usually introduced to better align the interests of shareholders and managers, do not have to take the form of a pact with the devil, however. Reed Elsevier changed the terms of its executives’ long-term incentive plan (LTIP) in 2007, from an earnings growth measure to a total shareholder return (TSR) metric.

This appears to have focused management’s minds on the longer-term creation of shareholder value, judging by their recent strategic moves. Late last year, Reed sold its US Harcourt Schools publishing arm for $4 billion and used this cash to fund a special dividend payment of 82p per share, which was accompanied by a share consolidation. Reed then further reshaped its business in February by buying US data analytics expert ChoicePoint for £2.1 billion. A proposed sale of Reed Business Information’s print magazine titles further reduces the firm’s exposure to the vagaries of the advertising cycle.

Growth is key

Reed’s LTIP shows growth does not have to be the be all and end all, but most managers accept this is what makes the market tick.

‘It is the nature of the beast,’ agrees Mike Love, executive chairman of UK small cap IT consultant SciSys.

Small cap firms such as SciSys have suffered in recent months, as fund managers have liquidated their riskier positions, or simply been forced to generate cash to fund redemptions. Yet for all the market’s passing fads and fancies, Love embraces the market for the good it can do, and he should know, as he has has seen several cycles since he became chief executive of SciSys in 1986.

‘We would not wish to be a private company. It is very easy to undervalue the benefits of being a public company,’ he asserts. ‘We could not have bought CODA as a private company and we made an absolute bomb on that, and nor would we have been able to buy VCS last year, which is proving so good for SciSys in so many ways, as we were able to issue equity to the selling shareholders’.

Another small cap, Aim-listed Chinese mobile phone designer and assembler ZTC Communications only listed last year, via a reverse takeover of an unlisted cash shell. Chairman Frank Lewis also remains convinced that being a public company is best, even though his firm’s shares have halved since their listing.

‘The market is very short-term, and thank God we don’t have to report quarterly,’ he says. ‘But going to market has given discipline to management and I am pleased to say they run the company exceptionally well.’

Not all managers are quite so enthused about the market’s workings. Rob Lloyd, chief executive officer of property developer Eatonfield Group, says he believes the market is ‘obsessed to an unhealthy degree’ with short-term earnings, and adds net asset value is his preferred metric for measuring the company’s progress. That said, Lloyd accepts the benefits of going public means certain requirements have to be met.

‘Being a public company means you are put under the spotlight regarding numbers, and could mean you have to sell a part of your portfolio in a bid to hit the right numbers. Overall, though, we are in a comfortable arena’, he says.

Graham Stevens, chief financial officer of Aim-listed oil services expert Plexus Holdings appears to agree with Lloyd when he says: ‘If you weren’t public maybe you wouldn’t be so focused on out-and-out profit, you might invest more and take on more overheads. As a public company there is obviously more emphasis on delivering profits, but that is not necessarily a bad thing.’

Momentum is king

This quartet of executives, despite the considerable differences between their firms, all therefore accept growth is a key determinant of what is the market’s ultimate arbiter of performance: its share price.

Extensive work done on this subject by Nick Stevenson and his colleagues at the equity strategy think tank Mirabaud Securities suggests such pragmatism is sensible.

Mirabaud’s work on earnings growth shows the vital correlation between share price performance, and particularly price performance relative to the broader indices, and earnings. In particular, Mirabaud focus on changes in consensus analyst earnings forecasts as a means of spotting inflection points in share prices.

Firstly, a rolling EPS series is created for a stock, based on historic and two-year forward forecast numbers. Secondly, an earnings revision profile is then provided off the rolling EPS numbers. Finally, stocks, or indeed entire sectors, are then mathematically ranked, based on the magnitude of their earnings revisions.

A number of conclusions emerge. Firstly, and most simply, stocks with consistently better-than-average earnings revisions tend to outperform the broader market indices, while those with falling ones underperform.

This vindicates the market’s ‘growth fetish’, although it should be noted, in a recessionary environment, those stocks with better-than-average revisions can actually be seeing their earnings merely fall more slowly than those elsewhere.

Secondly, the system shows the second derivative of estimate changes and, by assessing whether a firm’s revisions are accelerating or decelerating, tackles the vital, if nebulous, concept of ‘earnings momentum’.

As Nick Stevenson puts it, ‘Commodity cyclicals such as steel, forestry & paper and semiconductor stocks are very sensitive to direction, tending to conform to the adage that “it’s better to travel than arrive”.’

The rate of growth rate is key short term...

It is not therefore simply growth in itself that drives a stock price: it is growth relative to the broader market’s fortunes, and also whether growth is accelerating or decelerating.

Inflection points in this momentum appear to be key. This explains why even a firm with a bulging order backlog and booming earnings can see its share price fall, as happened when Wellstream Holdings’ stock plunged 8% after its figures three weeks ago. If the market fears the news simply cannot get any better, then, so goes the market’s logic, it can only get worse. If it is going to get worse – in the form of decelerating growth or even a fall in earnings – then it is time to sell and get out while the going is still good.

Holders of industrials stocks should certainly have been worried by Siemens’ March earnings miss. The German giant warned earnings at its power generation unit have been impacted by poor execution of turnkey projects taken on since 2004, but also by problems in its supply chain and also a shortage of experienced project engineers.

Such staff shortages are typical at the peak of an economic cycle. Applying the market’s usual chain of thought, a peak is always followed by a downturn, so it is little wonder Siemens’ stock took such a hammering after this announcement, falling from ?81 to an eighteen-month low of ?67 in just two days.

Such logic also explains why firms that are heavily loss-making and have no immediate prospect of profits can suddenly rocket, as the market concludes the news is so bad, it can only get better.

Barely a month ago, dynamic random access memory (DRAM) stocks seemed to be on the verge of such an inflection point, if recent market movements were any guide. Micron Technology stock had just jumped from $5.50 to near $7.

Over the long term, stocks such as Micron and Infineon spin-off Qimonda have an appalling history of losses, value destruction and cash consumption. Yet talk of Japan’s Elpida raising spot prices by 20% in April saw hot money return to the chip stock sub-sector, as investors scrambled for exposure to the operational leverage on offer from these commodity chip makers.

Long-term concerns over trend DRAM bit demand growth were briefly put aside in the scramble to buy DRAM stocks, as it appeared short-term capacity cuts could help stabilise the previously plunging commodity price. Yet the DRAM industry is just as structurally challenged now as it has been at any stage over the past ten years, when returns to shareholders have been atrocious.

DRAM demand has historically been driven by two trends: rising PC unit volumes and rising DRAM content per unit, as ever more complex machines require ever more memory to support their rising functionality.

Unit demand looks set to wobble as the economy stumbles, particularly as the financial services industry tends to be an aggressive adopter of higher spec machines and Microsoft Vista has still to inspire a wave of upgrades.

Worse, DRAM per box growth appears to be slowing to unusually low levels. Normally price declines, such as the 50% plunge in 1Gb DDR-II chips seen in the fourth quarter of last year, spur PC makers to buy more memory as a marketing tool in their own private dogfight for market share in a mature market. This may happen again short term, but work from Calyon Securities shows a major problem is developing.

Even if DRAM content per unit rises from the current 1.7GB to 4GB by 2012, this will only mean a 24% compound annual growth rate (CAGR) in DRAM content. This compares with the 46% seen in the period 2003-2007, according to Calyon, and since the 4GB per box limit cannot be exceeded until 64-bit operating systems become available, a development forecast for 2012 by Gartner, a major demand slowdown appears unavoidable.

Such concerns did not dissuade earnings momentum hunters from piling in, as history shows the share prices of Micron and its peers respond to inflection points in the commodity spot price, which can be tracked on www.dramexchange.com.

Yet the advances came to a rapid halt after last week’s profit warning from the world’s second largest microprocessor maker, AMD, last week. AMD blamed demand weakness across the board, including from the PC market, so it was perhaps not surprising DRAM stocks tumbled last week when Asian firms such as Samsung, NanYa and Powerchip, admitted they had failed to make any price increases for April stick.

Such a short-term setback should focus attention on the potential demand growth deceleration that bodes so ill in the long term for DRAM stocks and memory module makers such as the California-based but Aim-listed OCZ Technology, which has already disgorged three profit warnings in the past 12 months.

Sectors such as technology, biotech or media have generally been the haunt of ‘growth’ investors, yet Mirabaud’s Nick Stevenson argues the net should be cast much wider. ‘We identify “growth stocks” ex-post, by the extent to which they have beaten the index over periods of at least ten years,’ he says. ‘Our thesis is that being able to outperform the market over prolonged periods is a rare attribute and probably a reflection of the stock’s inherent advantages, such as superior technology, barriers to entry or regulatory favours, rather than simple luck.’

‘Our approach is obviously at odds with the conventional definitions of ‘growth stocks’, which generally combine a measure of high valuation with a measure of sales or earnings growth, but we’re sticking with it,’ Stevenson adds.

....But it is quality and sustainability of earnings that count long term

Warren Buffett once quoted Benjamin Graham to explain why at the turn of the last century he still preferred to invest in mature, cash-generative firms such as Coca-Cola (KO:NYSE) rather than tech companies: ‘In the short run the stock market is a voting machine, but in the long run it is a weighing machine.’

By this, Buffett highlighted his unwillingess to worry about trying to catch the inflection points in the earnings of cyclical, and ultimately cash-consumptive, stocks such the DRAM manufacturers. In the long run, Buffett argued quality of management, strategy and product will out, by dint of superior long-term profits and particularly long-term cashflow, which can then be returned to shareholders in the form of dividends to boost total returns.

Work by Nick Stevenson’s team at Mirabaud backs up this assertion, although finding firms that sustainably deliver the goods is not as easy at it looks. Just 83 firms across the whole of Europe tracked by Mirabaud have outperformed in each of the past ten years, including UK stocks such as Capita, Babcock International, Serco and AVEVA.

‘Generally speaking, we would expect competition to drive a “normal” company’s returns down towards the market average over time and – given the relatively small number of stocks that make the grade each year – the iron law of mean reversion appears very hard to cheat over periods much in excess of five years.’

Mirabaud’s list of ten-year outperformers did better than the broader European market indices in every year from 2001-2006. This again justifies the market’s focus on earnings growth, although in 2007 the list actually underperformed by 2%. Such an unusual lag was mainly because 102 stocks fell off the list last year. A host of mid-cap stocks, particularly those of Spanish and Irish origin or with their roots in the building industries, all came unstuck.

‘Were these companies genuinely advantaged relative to their peers, with the implication that they could soon bounce back, or were they just surfing a lengthy wave of credit-fuelled economic expansion that appears to be rolling over into a severe hangover?,’ asks Mirabaud’s Nick Stevenson, before continuing: ‘Are the enforced exits of several Nordic and Greek construction names simply evidence of a cyclical slowdown in building activity or do they point to more deep-seated problems in the Baltic and Balkan economies.’

It certainly seems as if a confluence of short-term factors, which helped builders across Europe, has now begun to unwind, prompting Stevenson to take the long-term view.

‘As we never tire of pointing out, staying on the performance high wire for several years in a row requires both incredible strategic positioning and flawless tactical execution.’

Long-term planning

Short-term growth may therefore get the market’s juices flowing, but it does seem as if it is long-term strategic and financial progress that ultimately generates the greatest rewards for all a firm’s stakeholders, be it shareholders, management or employees.

Dashes for growth, such as those launched by Simpson and Mayo at Marconi, Adam Applegarth of Northern Rock or Chuck Prince at Citigroup, can work well initially, but a lot of luck is needed if they are to pay off. If things go wrong, the results can be terminal. Nor can deals be done at any price, as Chris Gent and Vodafone found out, leaving Arun Sarin a legacy that still causes him trouble today.

However, Reed Elsevier is seeking to prove a business can be fundamentally reconditioned.

Reed’s share price has thus far responded enthusiastically to Sir Crispin Davis’s strategic manoeuvrings, as the stock has outperformed the FTSE All Share by 37% over the past 12 months. The focus upon total shareholder return has helped, but equally Davis’s thinking is clearly geared toward boosting Reed’s long-term growth potential, by increasing its internet capability and reducing the cyclicality of its earnings stream.

It will be several years before Sir Crispin’s strategy can be truly evaluated, and whether the timing and transaction valuation involved were appropriate. But if the plan does pay off, not only will Reed’s earnings (the ‘E’ in the PE) rise, but so will the ‘P’, as investors attribute that earnings stream a greater value, due to its greater stability.