Orbis Investments: Why revenue growth is not necessary for good returns

Growth has an almost irresistible allure for investors. Whether it’s a rapidly growing economy or an exciting start-up, investors are naturally drawn to opportunities that seem to offer the greatest long-term growth. However, when it comes to long-term investing, chasing growth may be misguided.

If we look back over more than a century of data and across 19 countries, there is actually a slight negative correlation between real economic growth per capita and real equity returns. For example, between 1900 and 2009, Japan’s annualised economic growth rate was more than 50 per cent higher than the UK’s, yet the UK’s annualised equity returns were approximately 30 per cent higher than those of Japan over the same period.

There are several reasons why economic growth and investment returns don’t necessarily move in tandem. In particular, competition may reduce profitability and excitement about growth may drive up company valuations, both of which are likely to reduce returns for shareholders. It may sound intelligent to comment on the latest GDP figures, however the relationship between economic growth and stock returns is tenuous at best.

Trying to forecast industry trends isn’t much better. Imagine if you could go back in time to the early 1970s. Armed with perfect foresight, you would know that computers, smartphones and all sorts of technology would become ubiquitous. You would also know that smoking would eventually be banned in many public places and the tobacco industry would be subject to costly lawsuits and onerous regulation. With that in mind, would you have invested in technology or tobacco stocks?

It would seem to be an easy decision, but you may be surprised to learn that the largest tobacco stock at the time would have been a massively better investment than that era’s largest technology company. A $1,000 investment in IBM on 1 January 1975 would have grown to $48,000 at the end of 2016 – not a bad result. But a similar investment in Philip Morris – now known as Altria – would now be worth about $1.2m.

Industries touted for their growth will attract new talent and more competition. IBM grew complacent and failed to anticipate the boom in personal computing. In contrast, the low-tech and litigation-prone tobacco industry experienced a considerable decline in competition, leaving the incumbents to make substantial profits as existing competitors left the business.

The lesson here is not to ignore new markets or industries, but rather to apply a healthy dose of scepticism. Many other investors are chasing the same growth stories, and stock prices will likely reflect that appeal. Furthermore, revenue growth and an exciting story are not sufficient, or even necessary, conditions for good returns. Cash generation and the ability to reinvest at high rates of return are far more important.

We believe a more reliable approach is to focus on individual company valuations. Rather than trying to guess which countries or sectors will offer the best growth prospects, we take a bottom-up approach, performing in-depth research on a wide range of companies, seeking to understand their intrinsic value based on our view of their cash flow potential and reinvestment opportunities.

The beauty of a bottom-up approach is that you don’t need to wait until a whole stockmarket is cheap. Instead, you can select individual shares that appear to trade at a discount to their intrinsic value. This allows you to spend more time understanding individual businesses – and less time trying to divine the fortunes of entire economies.

Dan Brocklebank is head of Orbis Investments UK, Orbis Investments