Money & Investing
Whats the Hurry?
Daniel Fisher, Forbes, 04.14.03

Rapid growth may be the mantra in the executive suite, but a new study suggests it isn't necessarily good for shareholders.

For a few years in the early 1990s Merisel seemed to be doing everything right. Sales grew at a blistering 50% annual rate between 1989 and 1994 as the computer distributor bought competitors, opened overseas operations and rode the personal-computer boom to $5 billion in revenue.

Then the motherboard shorted out. Manufacturers slashed PC prices, eliminating margins for middlemen like Merisel (nasdaq:
MSEL - news - people ). The overseas expansion didn't work out and a complex SAP software installation, designed to cut costs, turned into a disaster. From a split-adjusted peak of $220, Merisel shares plunged below $3, where they remain today.

Could investors have seen trouble coming? A study of thousands of companies throughout the 1990s suggests they could. That study, by California Polytechnic State University finance professor Cyrus Ramezani, finds that companies that grew the fastest (in revenue and earnings) generated less shareholder wealth than their slower peers. In other words, the hotshots had dizzying growth that they couldn't sustain, and their stocks often suffered.

"The implication for the 1990s is that chasing growth per se, in terms of earnings and revenue, really was the wrong thing to do," says Ramezani, lead author of the study, which appeared in a recent issue of the Financial Analysts Journal.

Ramezani isn't the first to suggest that slow-and-steady wins the investment race. Warren Buffett built one of the world's biggest fortunes on a similar premise. But Ramezani's study of thousands of companies from January 1990 to December 2000 provides intellectual ballast.

Ramezani divided the companies into four groups each quarter over the 11-year period, according to sales and earnings growth. Companies in the fourth quartile showed the fastest growth. He then examined the relationship between growth and shareholder returns using a measurement known as Jensen's alpha, which represents the difference between a company's stock performance and the return of a diversified portfolio of risky stocks.

Ramezani used this measure to correct for the fact that high-growth companies also tend to collapse more often, making it impossible to compare portfolios with different growth characteristics over a number of years. This so-called "survivorship bias" skews returns simply because more losers are eliminated from the sample.

What Ramezani found was that companies that are consistently in the third quartile of growth--stalwarts like Wal-Mart, AutoZone and Intel--had stocks that far outperformed their faster-growing cohorts in the fourth quartile, such as Merisel, Limited and Toys "R" Us. The difference in risk-adjusted returns averaged 7.5% a year, based on a subgroup of 2,300 firms that reported sales and earnings growth sufficient to put them in one of the two quartiles for at least three years in a row. The laggard first-quartile companies, which reported that sales shrank on average by 3.4% a year over the period, included such problem children as 7-Eleven, Unisys and Owens-Illinois.

"When companies get on the treadmill beating the drum for more earnings growth, it's very tempting to invest too much capital in unrewarding, mature or risky businesses," says Bennett Stewart, senior partner at the Stern Stewart consulting firm.

The study didn't dismiss growth entirely. Fourth-quartile stocks, which expanded revenue an average 167% a year over the decade, included such winners as Williams-Sonoma. But picking them instead of fourth-quartile losers such as Bombay Co. or Books-A-Million is largely a matter of luck. Investors would have been better off in the third quartile, where sales rose a still-impressive 26% a year. Hardware supplier Fastenal was in the third quartile and rose fourteenfold.

Now, no academic study is perfect. Martin Whitman, manager of the Third Avenue Value Fund, notes that Ramezani's findings are biased toward large-cap growth stocks like Wal-Mart, which began the decade cheap and ended it expensive. Well, the study at least did encompass the 2000 down year.

Skeptics also dismiss studies that use adjustments like Jensen's alpha, citing the adage: "You can't eat risk-adjusted returns." True enough.

So Ramezani ran the numbers to determine raw returns for four portfolios with holdings adjusted yearly according to growth rates, bypassing the alpha calculation. The results didn't disturb his conclusion that fourth-quartile speedsters are not the best place to put your money, although the order of finish for the race changed a bit. Second-quartile stocks did best with an 11.2% compound annual return through January 2002, followed by the third quartile at 9.1%. The hot-growth fourth quartile showed an 8% return, slightly better than the skanky first quartile's 7.5%.

Footnote: The market-cap-weighted S&P 500, burdened by tech outfits that didn't exist in 1990 and later crashed, returned just 5% on average.

Slower Is Better

Companies that ranked in the third quartile of growth actually had higher shareholder returns.








SLOW-AND-STEADY WINNERS (third quartile)

















Wal-Mart Stores




FAST-GROWING LAGGARDS (fourth quartile)

Briggs & Stratton




Limited Brands








MGM Mirage




Toys "R" Us




*First trading date 4/2/91. Source: Bloomberg Financial Markets.