Darden Professor Michael Schill set out to hunt down the answer to an odd phenomenon he noticed: Companies that were growing — with expanding assets — appeared to be a bad investment.
How could that be? Schill, an expert in corporate finance and investments, knew the observation seemed weird.
“It’s counterintuitive, but the market seemed to be enamored with firm growth to its detriment. So we began testing,” he says.
His research began with a simple question, “Do we see firms that are expanding their assets, expanding their balance sheets, doing any better or worse than those firms that are not or that are contracting? You’d expect that those expanding are the best investment and those contracting are the worst.”
“The headline finding is, that’s exactly wrong,” says Schill, “And it’s to the tune of big money.”
Schill’s research shows that, on average, from 1968 to 2008, high-growth firms that expanded their balance sheets earned about a 4 percent return annually — or just about the same as U.S. Treasury bills. Firms that expanded the least — or even contracted — earned the most — a whopping 24 percent annually. The stock market’s average yearly return is about 8 percent.
“So you’ve got this massive 20 percent spread if you bet on low-growth firms instead of high growth ones,” says Schill. “I’m not saying all growth is bad, but that the market systematically misprices it … the market gets too giddy about capitalizing a firm’s growth.”
Schill calls it “the absolute easiest trading strategy imaginable. Imagine starting a hedge fund and you work one day a year, on June 30. You download all the asset numbers for the firms in the U.S. You sort them into two baskets by comparing this year’s numbers to last year’s. Doing that over that 40-year window would get you fabulous returns. Just buy contracting firms and sell growing firms.”
Contracting firms often shrink for good reasons: because of efficiency, a reduction in inventory or just working to do more with less. Growing companies often grow for the wrong reasons.
“My view is that the market is enamored with growth. Investors systematically under-appreciate the incentive managers have to ‘empire build,’” Schill says. “Managers like to grow firms by acquisition or by green field investments — like building a new factory. The problem is, investors also like growth.”
Schill says that “the biggest variable to explain how well a manager is paid is how big the firm is. Size dominates anything else, including performance. Managers at big firms get paid more whether they do well or do poorly.”
“Certainly you get paid better if you perform better, but size dominates performance in corporations, so that creates this perverse incentive to grow your firm,” he says.
It’s well known that acquisitions are bad all around. It’s good for the target, bad for the acquirer. The reasons are usually simple. “If you’re a firm acquiring another, you’re probably paying too much or are too optimistic in how you think it will all pan out,” he says.
For example, earlier this year, Verizon grabbed Verizon Wireless from Vodafone for $130 billion using Verizon stock to make the buy. The German software company SAP paid $4.4 billion last year to acquire US Ariba so it could push into Cloud-based software solutions.
“Both firms appear to be trailing their respective index by a large margin post-acquisition,” says Schill. But Schill’s research shows that while growth by acquisition is systematically bad, it’s not uniquely bad. “That observation is true for any growth, including organic growth.
“Past research shows that acquisitions tend to be especially onerous if the acquiring company pays with stock or has a high valuation multiple. But what we find in reality, is these characteristics proxy for the size of expansion. If you control for asset growth, none of the other characteristics matter. Another way of saying it is, stock deals without much asset growth don’t tend to underperform.”
A market blinded by growth will be inefficient, a fact Schill wants to emphasize. “One of our research goals is to highlight this so that hedge funds learn to trade on it. And there’s some anecdotal evidence some already do. As they do trade on it, we hope the market gets better in pricing and removes this inefficiency.”
Schill’s startling findings can help the small investor, too. “It’s a good sorting variable. When considering an investment, check to see if the balance sheet is expanding. If it is, it’s a red flag.”