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Why Growth Is Overrated

Timothy is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Investors have a tendency to flock to companies which grow at extremely high rates. The logic goes that if the company grows by x% per year than so too will the stock. Using that same logic, many investors avoid companies which grow slowly. Again, the logic is that if the company can only grow by, say, 5% per year, then surely the stock won't grow any faster.

Two examples of this type of magnetic attraction to high-growth stocks are Netflix (NASDAQ: NFLX) and Chipotle (NYSE: CMG). Both companies have seen a dramatic rise in revenues over the last decade.

<img src="http://media.ycharts.com/charts/daa3c73f20c4e22439e9b8d31fe9ed10.png" />

NFLX Revenue Annual data by YCharts

Netflix saw revenue grow from $153 million in 2002 to $3.2 billion in 2011, and annualized rise of 35.5% per year. Chipotle grew its revenue from $205 million in 2002 to $2.27 billion in 2011, and annualized gain of 27.2%. The stock charts of both have a similar feature.

<img src="http://media.ycharts.com/charts/417f21ef2f5b232221ac3009d4160a0f.png" />

NFLX data by YCharts

Both saw meteoric rises as investors piled into the stocks. The stocks kept rising, luring more investors to buy shares. Growth estimates and stock returns blinded them of the reality of the vastly overpriced companies they were buying. And then, the inevitable crash as growth ended up being slower than their sky-high expectations.

This is one reason why growth and stock performance are not exactly correlated. Price matters. If you bought and sold either one of these stocks at the right time and the right price you did extremely well. If, instead, you chose the wrong price, you did abysmally.

Why Slow Growth Is Fine

Meanwhile, slow growing, boring stocks get ignored. Cisco (NASDAQ: CSCO), once a growth stock itself, has slowed down dramatically in recent years. The company's annual growth target is 5-7%, a far cry from its past growth rates. The slowing growth has prompted calls that Cisco is "dead money," that slow revenue growth will lead to poor stock performance.

But those calls are wrong. Two things work in favor of the slow-growth stock.

  1. Buying at the right price
  2. Retained Earnings

Let's say that you think Cisco is fairly valued at about $20 per share, about where it's trading today, so you buy a bunch of shares. Cisco generates about $10 billion in free cash flow per year, some of which goes to dividends and some of which goes to buybacks. For the sake of simplicity, let’s assume that Cisco stops all of this and simply keeps the FCF as cash on the balance sheet. 10 years go by. Cisco grows FCF at 5% per year.

How much is the stock worth now, assuming that your expectations are the same about future growth? Well, FCF has increased by a total of 62.9%. So, naively, one would think that the stock would appreciate at the same rate. But there are retained earnings to consider.

All of the cash which Cisco generated during the decade adds to the value of the company. Over the course of ten years the cash balance would have increased by $132 billion. With a share count of 5.4 billion, that's $24.44 per share in added cash.

So, the new fair value of a share of Cisco would be about $57. $32.50 of this comes from the original fair value increased by 62.9%, and the rest comes from the additional cash. The fair value thus increased by 185% over the course of the decade, or at an annualized rate of 11.04%, more than twice the rate of earnings growth.

The Price Is Right

What happens if you were able to buy the stock below fair value? Let's say you bought shares of Cisco a few months earlier for $16.25 per share instead of $20 per share, unable to pass up such a bargain. How does that affect the calculation above? Your return would now be 250% over the course of the decade, or 13.37% annualized. All from a measly 5% annual growth rate.

The Bottom Line

The myth that fast-growing companies offer the best returns is simply not true. In fact, if your timing is bad, they could very well offer the worst returns. Retained earnings allow companies to increase in value even without earnings growth. And getting in at the right price will have an enormous effect on your performance. Cisco is a great example of a company which can provide exceptional returns even with a low single-digit growth rate. Obviously, Cisco will spend a lot of their profits on buybacks and dividends, but the net result is the same. Slow and steady wins the race.

TheBargainBin owns shares of Cisco. The Motley Fool recommends Chipotle Mexican Grill, Cisco Systems, and Netflix. The Motley Fool owns shares of Chipotle Mexican Grill and Netflix. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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