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2/6/14 – The Assumptions of Growth

Written by Brad McMillan, CFA®, CFP® | Feb 6, 2014 4:04:44 PM

It is hard to think of two companies that are more different than General Motors and Twitter. One deals in heavy metal, is both an American industrial titan and an icon of business history, is a recovering bankrupt, and is everything to do with manufacturing real assets that last a long time. The other is a new company that deals in the deliberately short and ephemeral, employs relatively few—especially when compared with GM—and is a titan of the new social media era. The fact that both are actually successful American businesses gives a look at the scope of what our economy actually covers.

And, yet, even given their diversity and scope, these companies do have something in common—both have seen their growth prospects come into question, as previous assumptions of strength are proving false.

In the case of GM, fourth-quarter profits were down, as the company restructured many areas outside the U.S., cutting capacity and getting out of markets. Although these are one-time costs, the reductions in capacity and the decisions to abandon some markets speak to a realization that the company will need less in the way of production in the future and will be competing in fewer markets—all of which will mean slower growth. Even as many things continue to go well, growth will be lower. Shares are down more than 12 percent as I write this over the past month.

For Twitter, the damage is even more substantial—at least in the short term—with share prices getting hit today for more than 20 percent, as reported growth-in-views actually went negative on a period-to-period basis for the first time. Fourth-quarter growth-in-users was down to 3.8 percent, from the previous quarter’s 6.4 percent. The stock is now down by about a third from its peak.

What is interesting is that the focus has now moved, in many cases, from earnings to growth. In other words, how much a company is making is not the issue as is how much it will grow.

This shift reflects, in my opinion, the reality of how the market has been trading. P/E ratios reflect a number of factors, but one of the major ones is the expected growth of a company. If, for example, you expect a company—like Twitter—to grow quickly, you are willing to pay much more than if you expect that same company to stay the same. We see the same thing in sports, where players who are expected to be superstars (i.e., to grow) are paid more than those who are expected to quietly fill particular roles in the same ways for much of their careers.

The current high (by historical standards) P/E ratios reflect an expectation of earnings growth that again is above the expectation typically seen and that has been based over the past several years on high levels of stock buybacks, refinancing existing debt, and issuance of new debt at very low (by historical standards) interest rates that have left profit margins at or close to all-time highs. Current growth expectations roll up many of the positive factors that have been obtained over the past several years—and implicitly assume that they will continue.

I was at a great conference the past couple of days. One of the quotes I took away was, “the greatest errors in investing are based on extrapolation.” When we look at the extrapolated expectations of growth, and the potential consequences of slower-than-expected growth (e.g., Twitter), perhaps we should examine those extrapolations and see whether, in fact, things will really end up as rosy as expected. The Twitter and GM experiences suggest that, if they do not, the consequences could be substantial.