Case in Point: How lousy growth can make for a great stock
By Michael J. Schill,
The big idea: In April 2011, an equity investor can buy stock in America’s fastest-growing company, Ivanhoe Mines, or the most rapidly contracting company, Questar. For an investor seeking to maximize returns, which stock makes the better investment?
The scenario: In 2010, Ivanhoe Mines expanded its balance sheet from $1.53 billion to $3.22 billion in total assets as it poured money into the construction of a massive mining project called Oyu Tolgoi in Mongolia’s southern Gobi Desert. The vast open pit and underground mine promises to become one of the largest copper, gold, silver and molybdenum mines in the world and is expected to account for 30 percent of Mongolia’s future gross domestic product.
Concurrently, Questar, a Utah-based natural gas company, pursued a contraction strategy by shrinking its balance sheet from $9.02 billion in 2009 to $3.37 billion in 2010 as the company spun off its high-growth gas exploration and production businesses to focus on natural gas development. Following the spinoff, Questar maintains a more focused geographic footprint with an objective of providing natural gas distribution to customers in Utah, Idaho and Wyoming from local wells.
The 110 percent expansion
of total Ivanhoe assets put it at the top of the list for U.S. corporate expansion in 2010, and the 63 percent contraction of Questar’s balance sheet put
it at the bottom of that list.
With the ranking public in April 2011, an investor faces two alternative investment strategies: invest in the archetype for expansion or the archetype for contraction.
The decision prompts the question: Do investors have a good track record in pricing rapidly expanding or contracting companies? History tells us that investors tend to overprice expanding firms and underprice contracting firms. As an example, take a person who systematically invested over 35 years an equal amount of money in the stocks of firms whose balance sheet growth put them in the top 10 percent each year of U.S. public firms. That investor would find that the average annual performance of that portfolio would barely match the returns achieved by U.S. Treasury bills over the same period: about 4 percent. On the other hand, an investor who systematically bought the stocks each year of firms in the bottom 10 percent of balance sheet growth would be delighted to find average portfolio performance over the same period to be more than 22 percentage points above the returns achieved by Treasury bills: about 26 percent. The pattern suggests that expanding firms tend to be overpriced and contracting firms are systematically underpriced.
The resolution: From April 1, 2011, to April 2, 2012, the shares of expansionary Ivanhoe Mines declined from $26.28 to $15.76, a loss of 40 percent. Meanwhile, the shares of contracting firm Questar rose from $17.57 to $19.60, a total return of 15 percent. Following historical patterns, investing in the contracting firm dramatically paid off.
The lesson: The functional purpose of capital markets is to establish appropriate prices such that capital is efficiently allocated to those firms with good opportunities and pulled from those with bad opportunities. As this evidence shows, investors may be enamored with corporate growth to the detriment of their portfolios.
— Michael J. Schill
Schill is an associate professor of business administration at the University of Virginia Darden School of Business.