If you read Valuation:Measuring and Managing the Value of Companies or Value Investing: From Graham to Buffett and Beyond, you learn the shockingly well hidden financial truth that growth can destroy value…let me say that again. There are points in time when growth in net income can destroy value. Amazing! but very logical.
In Value Investing, Greenwald contends that the only value creating growth is growth within one’s franchise. That’s because you have a competitive advantage and can reliably create ROICs above the cost of capital. In Valuation, the Mckinsey authors emphasize the same point that growth destroys value when ROIC of incremental investments is lower than cost of capital and creates value when ROIC of incremental investments is higher than cost of capital. According to this book, value is maximized when a company invests as much as it can into opportunities with ROIC higher than cost of capital.
The issue I’m struggling with is in Value Investing by greenwald. Greenwald emphasizes to an extreme degree that “the only profitable growth is growth within the franchise”…you read that like 9 times when reading through the book. However, in one or two sentences he mentions that this is because of the reason that Valuation mentions, because the franchise achieves a ROIC higher than cost of capital. What I don’t understand is why he doesn’t think growth can be created outside of the franchise.If ROIC outside of the franchise is greater than cost of capital, it should still create value shouldn’t it? One possibility is that maintenance of ROIC outside of the franchise is unlikely, so after ROIC converges back to cost of capital, you’ll start breaking even or losing value with growth. A real scenario, but I figure if a company is either 1) wise enough to stop investing capital once the ROIC spread begins eroding, or 2) finds a competitive advantage outside of the core franchise, the company could benefit significantly(obviously more in the case of #2). After all, wasn’t Amazon originally a bookseller? Their “franchise” probably didn’t have any real value at that point. Branching out, Amazon was able to realizze a ROIC higher than cost of capital in the online store business, and instead of eroding, ROIC maintained due to a competitive advantage that was being realized. Major value creation.