Sales and Distributions
How revenue growth and distributions drive equity returns
Last week, we introduced a method for decomposing equity returns. We found that revenue growth is the largest driver of equity returns, followed by changes in valuation multiples and net distributions to shareholders, with changes in multiples driving the vast majority of the year-to-year volatility. Below we show a simplified version of last week’s decomposition.
Figure 1: Average Annual Returns for US Stocks, Revenue-Weighted, 1996–2020
Source: Capital IQ, Verdad. For stocks with > $300M of market cap, ex biotech, financials and REITs.
This simplified aggregate conceals a significant diversity in how investors earn money in the equity market. To take one extreme, Amazon has compounded at over 20% per year, with returns for shareholders made entirely through revenue growth with negative distributions (i.e., the company has borrowed and issued equity to grow). On the other extreme, Kimberly-Clark has barely grown at all but has provided investors with stable annual distributions, leading to a healthy long-term return.
Figure 2: Return Decomposition for Kimberly-Clark and Amazon, 2000–2020
Source: Capital IQ, Verdad
These represent two successful equity value creators. But not every company is an Amazon or a Kimberly-Clark. Indeed, the market is also rife with failure and value destruction.
The worst-performing segment of the market is dominated by failed Amazons: they can purchase revenue growth, but it never exceeds the capital invested. A classic example of this would be the electric scooters that once littered many major cities. These companies briefly grew revenue at astonishingly high rates, but the aggregate revenue generated never exceeded the capital deployed to buy and maintain the scooters.
We can divide the equity market into four broad types of companies: those that grow revenue at rates above and below the market average, and those that are creating or destroying economic value, defined as the sum total of revenue growth and distributions. Value creators have a positive combination of sales growth and net distributions. Either component can be negative, but the combination must be positive. Value destroyers have a negative combination of sales growth and net distributions. Either one component is more negative than the other or they are both negative. We summarize this in the matrix below:
Figure 3: The Four Types of Company
Source: Verdad
Amazon is an example of a profitable growth company, and Kimberly-Clark is an example of a low-growth value creator. These two types of companies are most of the market, and companies tend to reside in one or the other quadrant with some persistence. Unprofitable growth companies would include the scooter companies and many oil and gas companies prior to the oil selloff in 2015. Low-growth value destroyers include many oil and gas companies after 2015 and several struggling retail companies. Both value-destroyer quadrants are a smaller part of the universe, and there is far less persistence as companies either move to value creation, restructure, or disappear.
These four types of companies perform very differently. Below we show returns from 1996 to 2020 for each of these four categories of stock. We divide the companies each year based on the prior year’s growth and value creation and then show the return decomposition the following year. The data is revenue weighted because it better shows the underlying dynamics. The market cap–weighted returns are noted and reflect the same pattern.
Figure 4: Return Decomposition by Quadrant, 1996–2020
Source: Verdad, Capital IQ. Data is market revenue weighted, ex companies with acquisitions > 10% of sales.
The perhaps unexpected result is that the highest-returning segment is the low-growth value creators. While sales growth is a large contributor to returns in the aggregate data set, it turns out that when earnings distributions impact returns, they impact them a lot. The segment of low-growth value creators only grows revenues at 3%. But it has a net distribution return of 4% and is helped by multiples expanding. Profitable growth has much higher revenue growth, but that is offset by multiples contracting and no contribution from distributions.
The unprofitable growth segment is the most interesting. It has companies with extremely high revenue growth and multiples, but these companies are burning investor capital. On average, these valuations fall dramatically, and the return on a strategy that continually invests in this kind of company is negative. It is also the smallest segment as it is difficult for a company to persist here. Low-growth value destroyers do not suffer the same fate, if only because of their low starting multiples. On average, multiples actually expand for this quadrant, but they are still consuming investor capital and on average have lower returns with much higher volatility.
The below chart shows the market cap–weighted returns of each of these four types of companies.
Figure 5: Market Cap–Weighted Return Decomposition by Quadrant, 1996–2020
Source: Verdad, Capital IQ
While sales growth may be the largest component of stock returns, it is uncertain and comes with high multiples that are also uncertain and have more room to fall. The history of growth versus value investing would suggest that investors have traditionally overpaid for growth from sales relative to growth from distributions, which are much more predictable. Even within the value-destroyer category, a category which should have terrible returns, the low-growth stocks do better, perhaps because they start at less than half the multiple of the unprofitable high-growth stocks. In our decomposition, the only difference between the two categories is that the low-growth value destroyers have rising multiples, on average.
Value investing is premised on the idea that multiples drive the majority of market volatility and that multiples are mean reverting, with low-multiple stocks tending toward increased multiples and high-multiple stocks tending toward multiple contraction. This phenomenon explains why the segment of low-growth value destroyers above does surprisingly well, despite bad fundamentals.
Over the long term, ignoring everything else and just focusing on multiples turns out to be the most profitable strategy, even more profitable than investing in companies that distribute profits or profitable growth firms, though it does require annual rebalancing into the cheapest companies. Below we show the exact same dataset as in Figures 4 and 5 with returns for naively defined value (lowest 20% of Sales/TEV) versus growth (highest 20% of Sales/TEV).
Figure 6: Naively Defined Growth vs. Value, Market Cap–Weighted, 1996–2020
Source: Verdad, Capital IQ
Low multiples turn out to be an extraordinary predictor of returns, although with much more volatility, periodically experiencing dramatic drawdowns. Note the sharp fall off in returns of value as compared to growth over the past few years. This resulted from valuation multiples for both value and growth failing to mean revert as they usually do. For the past three years ending June 2019, changes in multiples have reduced growth returns by just 0.6% (versus a long-term average reduction of 8%) while changes in value multiples have increased returns by the same 0.6% (versus a long-term average of 6%). Below we show historical spread between value multiple expansion and growth multiple compression. When above zero, growth has higher returns from multiple changes than value does.
Figure 7: Difference in Return from Multiple Changes, Growth Minus Value
Source: Verdad, Capital IQ
Over long histories, multiple changes are averaged out, but in any shorter periods, the volatility of multiples can lead to significant distortions.
It is true that returns come mostly from sales growth, but that does not mean that the best path to making returns is to try to capture that sales growth. It is often expensive and unpredictable, and while it can deliver spectacular returns, it turns out that earnings and value often deliver higher and less-volatile returns.