Sustainable growth – without the hot air

Equity investors will be aware of a phenomenon referred to as ‘the value trap’ – roughly a situation where conventional valuation ratios such as the price/earnings or price/book value suggest that a share is deeply undervalued. Alas, closer examination often reveals the company is trading cheaply for good underlying reasons.

Similarly, positive valuation signals reflecting growth prospects may mask a less exciting reality. An example is when future corporate earnings estimates are overly optimistic, even delusional. Unfortunately, such mirages are relatively common, leading to subsequent hubris in the private and public equity markets. The alchemy apparently linking exponential growth projections and stellar valuations is exposed for what it is – hot air!

A subtler danger associated with valuation and future growth is more fundamental than mere over-optimism and goes to the heart of what ‘growth’ means in an investment context.

This deeper danger is when so-called growth masks a deterioration in underlying asset quality.

Properly maintaining an existing asset base is a prerequisite for sustainable growth  in the overall economy, individual sectors and at the company level.

At the macro level, the economy is not just composed of its machinery and labour, but also of its natural and social capital. Such a holistic view presents an existential challenge for concepts like Gross Domestic Product (GDP) and derivatives such as GDP per capita, an alleged indicator of the wellbeing of each person. While the consensus purports to tell us how well a country is performing on the basis of its short-run GDP figures, the narrow focus fails to see the wood for the trees, quite literally.

How so? The clue is in the ‘G’ – it fails to account for the depreciation of assets, and the value of the overall asset base ultimately is what counts for our collective wellbeing. GDP leads to a focus on immediate consumption and gross investment, with no attention to the biosphere and other impacts on essential assets. The influential Dasgupta Review puts it this way: “The contemporary practice of using GDP to judge economic performance is based on a faulty application of economics.” UK Treasury, please take note!

Consider the pollution as a result of economic activity. The damage inflicted on all assets, for example, forestry, the atmosphere, the oceans and human health, should be recorded as a depreciation of the relevant asset. Done consistently, a lot of the improvement in wellbeing inferred in reported GDP statistics would be exposed for what it is – more hot air.

At the sector level, we see the danger playing out with the risk of tipping points in core infrastructure. In the UK, a contemporary example lies in the water sector, although the theme extends to all critical infrastructure including airports, railways, energy grids and now data centres. Management may focus on new asset delivery (the ‘growth’), but quietly forget the ageing of existing assets (the ‘de-growth’).

The economist Sir Dieter Helm puts it succinctly for Thames Water: “The main challenge is actually about how to turn around a failing company, how to transform its performance, how to get the assets properly maintained, and even more basically how to even understand the assets and the state they are in.” (italics mine).

Risks are particularly high with infrastructure assets because of the cascading effects involved in networks – the overall size of the system dictates its ability to meet demand, but its weakest link is what matters for overall system security.

Finally, this message is of relevance for companies and financial institutions also. Analysts will be aware that growth in free cash flow is one of the fundamental determinants of intrinsic value. If prospective returns exceed the cost of capital, the more investment-fuelled growth, the better, at least in terms of potential valuation.

Except, of course, there is a twist, one which is often ‘unseen’ in abstract modelling, until it is too late in practice. Growth that comes at the expense of failing to maintain the quality of the existing asset base is not growth, not just in the water sector, but in every other sector, regardless of their hugely diverse assets.

In more ‘modern’ companies, this may be devilishly hard to discern because of the quasi-invisibility of human capital impairment. Education to maintain the value of human capital today is as important as the maintenance of tangible assets was in the past. ‘Growth’ companies that fail to do it will simply create yet more hot air.

In short, the message when assessing growth is to make sure you don’t rise into the thin air in a balloon that is weak at the seams. The effect of gravity is unlikely to be pleasant when reality subsequently dawns. To revert to Helm once more: “If something is unsustainable, it will not be sustained.” Perhaps that should be a health warning attached to all commentary on growth – it is the sustainability that matters.

Further reading:

Dieter Helm: “The end(less) game for Thames Water.” Available at www.dieterhelm.co.uk