Most investors pose the question of quality vs. growth and boil it down Return on Equity (ROE) vs. growth, according to Harini Dedhia, head of research at Tamohra Investment Managers. However, thinking of these two as mutually exclusive numbers should be done at one's own peril. The sustainable ROE of a business also denotes the upper limit to the sustainable growth rate for a company, essentially denoting the upper limit to the long-term stock price performance for the company, which is inextricably linked to long-term earnings growth.
A growth rate above ROE comes at the cost of the balance sheet; either by raising more debt or diluting equity, as explained by Dedhia. The question remains: does the company's balance sheet have the strength to support this growth and for how long? No business illustrates this better than the retail sector, where growing faster than ROEs has resulted in the collapse of the largest companies in the sector.
The retail sector tends to overpromise on growth because it is easy to do so, with the capital cost to set up a retail outlet on rent not very high, making the temptation to chase growth high. However, accidents are the highest in retail because of this very reason of forgetting the mathematical connection between growth and ROE. Typically, an organisation in an aggressive growth phase loses sight of operating excellence at its retail assets, with operating margins being thin in any retail setup and all operating expenses being fixed in nature.
The case of India's largest modern retailer illustrates the dangers of growth without sustainable ROE. Five years preceding its death, the business looked promising with a record high ROE of 18% in year 3, though not a sustainable ROE. A closer look revealed a P&L propped up by aggressive sales and therefore receivables, with the year of propped-up ROE also being one of negative cash flow from operations. The company eventually collected ₹4000 crore of debt and an additional ₹4000 crore of working capital debt, with a business not making any cash profits.
When companies grow at 50-60% with significantly lower ROEs, investors must question how much time, after the funding dries up, does the company have to recalibrate. Businesses with high fixed costs and wafer-thin margins will die faster in such cases, as cash burn rates would be significantly higher. The retail sector's experience serves as a cautionary tale for all investors evaluating growth-focused investments.
