Growth is a crucial factor that investors consider when evaluating a company's potential for generating returns. However, not all growth is created equal, and not all strategies for achieving growth lead to long-term value creation.
In this new series of 3 articles, we will explore the different drivers of growth and how each driver can create more or less value depending on the situation. The second post will focus on innovation as a key source for developing competitive advantages, and not just necessarily to launch new products. Finally, we will examine growth stalls and how they can lead to the deterioration of companies.
“If you're not growing, you're dying”
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When we talk about growth, the first thing we need to do is differentiate between organic and inorganic growth, although it may seem obvious, the day-to-day of markets and social networks seems to make many forget. When a company reports its results, the headline goes to the revenue growth percentage. I rarely read the comment: the company grew 18% YoY, but only 3% was organic and 15% was inorganic. In this case, the company just generated 3% of "real direct" value for the shareholder, which, discounted for inflation, may mean that organic growth was actually negative. It is surprising to see that many people assume that inorganic growth generates the same value as organic growth. But this is another topic.
In the end, when I think about it, there are 3 different big areas in how to achieve new revenues:
Inorganic growth with M&A: a company achieves growth when it buys revenues through acquisitions. It is well known most acquisitions destroy value, but we have a whole series talking about it here for those interested: Part I, Part II, and Part III.
Organic growth via CAPEX or R&D: investing in the company for growth. Costco opening new stores in new geographies, Meta investing massively in developing the metaverse, and Netflix buying the rights to the next TV show hit. These are risky, they require new capital, our capital, hence we must make sure we get the appropriate returns. This is where we would focus today and where we would see that not all investments necessarily have the same return.
Organic growth (without/with little new capital): These rare companies that can achieve new revenues with little investments. Those beautiful and scarce moats. These are the ones creating the most value. Imagine Apple gaining market share not because they are making price reductions, investing in marketing, or because of the new features of their last iPhone. Just because Apple is Apple. Microsoft Office's change of business model to a subscription one. What was the investment required? None or very limited. However, the impact on the growth rates has been remarkable. This growth is more related to innovation, not only in products but in customer experience, in business models, etc. This will be the topic for the second post of this series.
Not all growth is created equal
In the fantastic McKinsey’s Valuation book, Koller et al (2020) describe how different new sources of revenue typically create more or less value.
They claim that being in fast-growing markets is the largest driver of growth (and value creation). Market share growth is generally less important, yet managers tend to focus most of their attention on gaining a share in their existing product markets. While it's necessary to maintain and sometimes increase market share, changing a company's exposure to growing and shrinking market segments should be a major focus according to Koller et al (2020).
Given the significant strategic importance of revenue growth for companies, it is worth considering each of the previous categories and why each one generally generates more or less value for shareholders. The reasoning behind is not complex and simply requires applying a bit of logic. What type of growth will create the most value? The answer lies in growth that requires the lowest capital investment (but which will probably leave the door opened for new competitors) or capital intensive but with high returns on that capital (more difficult to achieve but with higher barriers to entry), and that can sustain that growth over time.
Sustainable growth at high rates of return. Thank God nobody is paying me for saying it. Even if it might sound trivial, let us explore this further.
1. Developing new markets through new products or services
This is not simply about creating new products or services, which is the strategy most commonly employed by companies to diversify their product portfolio. Instead, it involves opening up new markets and unlocking new proposals that create previously unexplored markets. The stronger the competitive advantage that a company can establish in the new product category, the higher the return on invested capital and value created. For instance, AWS has generated spectacular value for Amazon, despite being a capital-intensive service, due to its attractive return on capital and high intrinsic growth rates. AWS has an overwhelming competitive advantage over traditional on-premise stack deployments, and although competition in cloud services is increasing, the potential oligopolistic structure due to high capital requirements and natural market growth means that value creation is still in its early stages. Similarly, traditional music retailers have been almost entirely outcompeted by online music sales giants like iTunes and Amazon, and later by consumers taking up online streaming services for mobile devices offered by Spotify, Amazon Music, Apple Music, and others. However, competition in the new digital-entertainment category is fierce, so the value created per dollar of revenue in this sector is unlikely to reach the levels that AWS once generated. Therefore, it is essential to understand how untapped and newly created markets will lead to growth with high-value generation due to the competitive characteristics of the new industry, or whether it will become an ultra-competitive arena that will simply consume an enormous amount of capital.
2. Persuading existing customers to buy more of a product or related products + attracting new customers to a market
Apple’s successful strategy and cash cow. Analyze what happened and the way Apple entered the smartwatch market with its Apple Watch. Rather than simply competing with other watch companies, they integrated the watch with their iPhone and Mac ecosystem, attracting a different set of customers who may not have been interested in traditional watches. This allowed Apple to enter a new market and compete with traditional watch companies that could not simply compete with Apple's ecosystem integration.
By creating a product that was not just a watch, but an extension of the iPhone and Mac, Apple convinced its own customers + attracted a new customer base. This strategy allowed Apple to tap into a growing market for wearable technology, and to compete with traditional watch companies in a new way. The integration of the Apple Watch with other Apple products also helped to create a sense of loyalty and dependence on Apple's ecosystem, making it more difficult for customers to switch to other competitors, locking in further the numerous clients in their increasing ecosystem, while cross and up-selling some new services.
The capital required to develop and market this new product was definitely low. While we can argue that Apple is leveraging its brand and all the previous investments and products, that's the point and the highly lucrative growth of this dimension. With around 60% gross margins in a new product that Apple could sell to its current clients and new potential ones that they are not stealing from a competitor, Apple can bring something new to the market.
But perhaps clearer cases appear when we think of more traditional products like Nivea, a brand owned by Beiersdorf. When they accelerated growth in sales of skin-care products by convincing men to use its Nivea products, competitors didn’t retaliate because they also gained from the category expansion. Men’s skin-care products aren’t much different from women’s, so much of the research and development, manufacturing, and distribution cost could be shared. The major incremental cost was for marketing and advertising.
3. Gain market share in a fast-growing market
When a company aims to gain market share, it's important to consider the nature of the market itself. In a fast-growing market, the absolute revenues of competitors may also be increasing rapidly, making it less likely that they will retaliate against the company trying to gain share. However, in a mature market, competitors are more likely to respond aggressively.
Let's return to the example of the cloud market. In recent years, Google and Microsoft have been rapidly gaining market share in this space, although it's worth noting that this has been at the expense of other players rather than at Amazon's. However, the fact that the overall market is still growing at a rate of around 20% per year makes Microsoft's market share gains "less threatening" to Amazon than if the market were stagnant. This results in more moderate competitive strategies between the players, with fewer price wars and a greater focus on specific services tailored to each niche market.
4. Gaining share from incremental innovation
Incremental technology improvements are unlikely to generate sustained value or maintain a competitive advantage for long, particularly in industries where competitors can quickly copy innovations. Think of the automotive sector, where hybrid and electric vehicles are not fundamentally different from traditional gas or diesel vehicles in the eyes of consumers, making it difficult to command a significant price premium.
Tesla, which has been a clear early winner in the electric vehicle market, faces a challenging environment as traditional automakers invest heavily in their own electric vehicle models. While Tesla has the advantage of being a first mover, it must continue to innovate and differentiate itself to remain ahead of the competition.
Ultimately, the total number of vehicles sold will not increase due to the adoption of electric vehicles, meaning that gaining market share in this space will be a zero-sum game. Competitors will try to take market share away from each other, and Tesla will need to continue to innovate in order to stay ahead. While the company has a head start, it is important to remember that the industry has not fundamentally changed, it is still cyclical, competitive, and capital-intensive. Tesla will need to compete in a crowded market in order to maintain its dominance and returns.
5. Gaining share through product pricing and promotion
The beer market is an example where gaining market share through pricing and promotion can be challenging. Large international brands such as Heineken, Corona, and Budweiser dominate the market, and each has a strong financial position. If one of these companies tries to gain market share through a price reduction campaign, the others can easily respond, leading to a cycle of market share give-and-take without any significant advantage for any one company. Additionally, craft beer breweries are gaining popularity and taking a larger share of the market. In response, the larger beer companies have tried to acquire or partner with craft breweries to capture their market share. However, this strategy has not always been successful as craft beer consumers value authenticity and uniqueness, which may be lost under the larger companies' control. Ultimately, in mature markets, gaining market share through pricing and promotion may not create much value, as competitors can easily respond and maintain their positions.
An interesting “counter” case are retail giants Costco and Walmart. Costco has gained market share by offering bulk products at lower prices, but Walmart responded by reducing prices on key products such as video games and game consoles, leading to a cycle of price wars that drove down margins across the segment. While Costco's business model is built around low prices, Walmart's competitive response illustrates that price wars rarely lead to permanent market share gains/recovery. Therefore, it is not that Costco intended to enter into any pricing war, it is just part of a business model and strategy centered around low prices. While Walmart's incremental return on capital during the last decade has been negative, Costco's was around 18%. More about this particular case, here.
6. Price increases
Price increases are extremely tricky and dependent on the industry and the competitive position. As an average, new value from price increases is short-lived. Very very few companies can apply price increases without resulting decline in sales volume is significant.
Furthermore, price increases can have unexpected consequences and may need to be adjusted or reversed in response to customer feedback or market conditions. In 2016, Mylan, a pharmaceutical company, faced backlash and public scrutiny when it raised the price of its EpiPen, a life-saving allergy medication, by more than 500%. The company was accused of price gouging and profiteering at the expense of patients who relied on the medication. The negative publicity and public outcry ultimately led to Mylan backtracking and offering a generic version of the EpiPen at a lower price. In 2018, Starbucks raised the price of its coffee and other drinks in response to increased labor and rent costs. However, the move caused some customers to switch to cheaper alternatives or reduce their frequency of visits. As a result, the company's sales growth slowed, and it had to reevaluate its pricing strategy.
Note this might not be applicable to specific industries with different dynamics, such as luxury products. Veblen goods are luxury items that have a higher demand as their price increases. In this case, increasing the price can actually create more value for the company. This is because the high price of the item is seen as a signal of its quality and exclusivity, which in turn increases its desirability and demand. For example, the luxury brand Hermes has been known to increase the prices of its handbags regularly, which has not hurt its sales or profitability. Similarly, luxury car manufacturers such as Ferrari and Bugatti are also able to increase the prices of their high-end vehicles without losing demand from their wealthy customers. In this case, the high price is seen as a status symbol and a marker of exclusivity, which actually increases the value of the product for the consumer.
Analyzing a growth strategy
Analyzing different growth strategies is not a trivial task, as it often depends on the industry being analyzed. However, while history may not repeat itself, it often rhymes. Understanding the different paths to growth available to a company or management team, and how they can create (or destroy) value depending on the industry, can help inform investment decisions.
The logic explaining why growth from product market expansion creates greater and more sustainable value than growth from taking share is compelling. Nevertheless, the dividing line between the types of growth can be fuzzy.
In our next post, we will explore different innovative areas that can drive growth and are not as straightforward as we might think. We hope to see you there.
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References & bibliography
Koller, T., Goedhart, M., Wessels, D. (2020) Valuation: Measuring and Managing the Value of Companies. Wiley. 7th edition
Con tu substack, soy como Warren con Howard marks ;)