Investors are obsessed with growth. Articles and investor reports constantly hold a microscope to growth rates and how they are changing. The attention seems to be on revenue, rather than gross profits, EBITDA, and net income. Why does everyone marvel at growth analysis when investor returns can be equal or better from steady, repeatable cash flow?
The companies I like generate relatively consistent levels of EBITDA and cash flow from year to year (in other words, they are boring). They may grow a little or fall a little (gasp) but they have healthy profit margins, strong balance sheets, and have created a niche in their market. Historical growth and future prospects are important, but don’t get my attention like sustainability of the existing revenue stream. Will the business keep its historic revenue and profitability for many years to come? If so, it’s a quality company offering a service/product that people want and growth will take care of itself.
I think growth is generally overvalued. For example, in the early stage tech sector, barely-profitable businesses are being valued at many billions of dollars, with astronomical multiples. The only way investors are making outsized returns is unprecedented growth or the “greater fool theory” (investors manage to sell their holdings to another round of even more bullish investors). Meanwhile, the blue chip tech companies like Microsoft, Intel, and others are very modestly valued.
Maybe people focus on growth because they think it’s the only way to make outsized returns. I don’t buy it (pun intended). A pretty simple analysis can prove my point. Say an investor buys a middle market business that has been around for 20 years making relatively steady results. He pays 4x EBITDA, keeps this identical profitability for 5 years, and then sells it for the original purchase price. The result is a 20%+ annual compounded return from dividends. If moderate leverage is used (provided by Catalus of course) it becomes 30%+. Add some normal business growth and the return accelerates further. The assumptions can vary, but the opportunity to make substantial returns remains.
