To illustrate the intuition supporting the empirical evidence, we explore several examples of smart and dumb growth stocks. The stock of a company with a low return on capital and a management investing rapidly to increase its scale of operations is a dumb growth stock. In contrast, the stock of a company with a high return on capital with a management that demonstrates discipline and skill in capital allocation is a smart growth stock. Our examples look at three points in time: the height of the dot-com bubble (July 1999), the eve of the global financial crisis (July 2007), and more recently, July 2016.
Let’s begin with the dumb growth stocks.
We examine three dot-com stars—Compaq, Yahoo, and WorldCom—which, like many companies in the late 1990s, were aggressively investing for growth in the new internet-connected economy.
Compaq was the largest manufacturer of personal computers in the 1990s.5 To build scale, Compaq, despite (or because of) falling profits, invested heavily in a series of aggressive acquisitions.6 These acquisitions failed to produce the hoped-for economies of scale, while the rapid expansion caused quality control problems. We were not able, for example, to write this article on a Compaq machine, because the company was acquired at a fraction of its peak price by Hewlett-Packard in 2002.7
Yahoo, in the late 1990s, was expected by the stock market to attain a leading (if not the dominant) place in the exciting new field of web search. Despite little apparent profitability at the time, Yahoo invested aggressively to capture “eyeballs” and traffic. Although web search did become extremely valuable, Yahoo did not. Simply put, Google came along and did search much better.
WorldCom was the second-largest long-distance communication provider in 1999, a position achieved through aggressive acquisitions of technologies and networks. WorldCom financed its (loss-making) growth using rapid stock issuance, large amounts of debt, and some accounting fraud. When investors discovered that the industry had massively overinvested in fiber optic communication infrastructure, the game was up. WorldCom filed for Chapter 11 protection in 2002.
Financials, in the lead-up to the global financial crisis of 2008, are another example of dumb growth. Politicians, the media, and too many investors viewed securitization of mortgage debt as modern financial alchemy. Many of the banks that were among the most aggressive in stuffing their balance sheets with mortgage-backed securities have since failed or been acquired at fire-sale prices, leaving investors high and dry.
Now, let’s look at a few examples of smart growth stocks, in particular, Coca-Cola, Exxon, and Kellogg’s.
Over the three periods we examine, these companies have consistently ranked at the top of large companies sorted by high profitability and conservative investment. Each has cultivated its competitive advantage to dig a moat around its profitability. The managements of these companies have been careful stewards of their investors’ capital. All three slowly and steadily grew to global dominance in their industry.
Yes, of course, we cherry-picked these examples. Nonetheless, these vivid descriptions of dumb-versus-smart growth stocks illustrate empirical facts: companies with high investment, despite low profitability, fail to provide strong returns to shareholders, and in contrast, companies with high profitability, paired with low investment, deliver sustainably high returns.
More recently, Tesla, Facebook, and Netflix are examples of companies with an aggressive level of investment combined with a low return on capital. Are these companies poised to be the next Apple and Google, or will they go the way of Compaq, Lehman, and WorldCom? We have no specific information about the future prospects of these high-flying market darlings, but history teaches that, on average, companies with a low return on capital, paired with aggressive investment, have provided poor returns to investors.8