Tuning in for higher return

This might sound a little strange, but growing companies do not always make for good long term investments. And I know it’s even stranger to talk about growing companies when there aren’t many, the TSX down 23% since the summer highs of 2014. But this week’s note is for the forward thinkers. It’s for the people that are looking at today’s market as an opportunity for long term reward. It’s also for the people that just saw their wealth decline by 23% and want to make better choices next time. I want to help them understand that most stocks go up for two reasons. And one of those is far more riskier in the long term than the other. Here we go:

I believe one of the keys to long term investment success is being able to understand the difference between profitability and growth. Most people assume profits and growth are the same thing, but they’re wrong. Understanding that difference means no longer riding the cyclical ups and downs of the market, and instead earning a positive above average long term rate of return.

In simple terms, growth is when a company sells more product than it did the year before. Although most shareholders get very excited to hear their companies are growing, that growth can actually mask a real long term problem. To understand why, let’s look at the history of television manufacturers. From the thirties to present day, the number of television sets in the US grew from about 8,000 to at least 325 million, no doubt a “growth” industry. You would expect with such growth that a large and thriving group of TV set manufacturers would be leading the market today. Yet over the decades, and in spite of that growth, the number of TV manufacturers fell from about 220 to 23, a decline of 89%. 

The reason growth in and of itself is not a good enough long term investment proposition is because it doesn’t take into account profitability. The issue most of these TV manufacturers encountered is that for all their growth, they couldn't generate profits and cash flow from their businesses. In simple terms, cash flow is what's left over after selling all the products and paying all the expenses. Yes their factories were getting bigger and they were selling more TVs than ever before, but their costs and intense competition prevented them from making enough money to stay open.

So cash flow, not growth, is the real lifeblood of business. In some cases we see the stock of a company with lots of cash flow but little growth outperform the stock of a company with lots of growth but little cash flow over time. If a business has good cash flow, just that can be enough to keep shareholders very happy. But if a business has ample cash flow and growth over the long term, then you’ve found something truly exceptional. 

Back to the TV manufacturers, if a business is getting bigger, but still has negative cash flow (the costs of making TVs outweighs the proceeds from selling them) then ultimately that cash flow problem just gets bigger too. That means it’s very rare to see a company grow its way out of a cash flow problem over the long term. The fix is in setting a higher selling price and/or controlling costs better than your competitors.

This matters for Canadian investors because businesses with slim or negative cash flow tend to be in mature industries, industries with many established competitors, and industries that sell commodity products. I think I just named two thirds of the TSX. Companies like that have little to no control over what they charge for their products, or the ability to lower costs below their peers. They end up riding the cyclical ups and downs of the product they produce, which is why they are called cyclical companies.

All-star investor Peter Lynch has noted these cyclicals are the hardest companies of all to invest in. Not only does the product they sell have to rise in price, but the company additionally has to figure out a way to produce it for less than their competitors or face losing market share. In the earlier years of Warren Buffett’s Berkshire Hathaway investing he wrote about how he avoided these types of companies altogether. 

Putting this all in context, yes the energy and mining companies along with the rest of the TSX will one day rise again. But this time when the recovery takes hold, keep in mind that growth will only be a fair weather friend. Cash flow is there to the end. 

Ben Kizemchuk is a Portfolio Manager & Investment Advisor with Altus Securities Inc. in Toronto. He offers financial planning and investment management for high net worth Canadian investors. Ben focuses on high quality investments, the Growth and Income Portfolios, low risk investing, and reducing tax.