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October 10, 2008

Can Residual Income Distinguish between Earnings Growth Derived from Productivity Improvements and Investment-Driven Growth?

Differentiating between productivity-driven growth and investment-driven growth leads to a profitable trading strategy.


The Idea

Differentiating between productivity-driven growth and investment-driven growth leads to a profitable trading strategy.

The Research

The market places a high value on a company’s growth. Companies generally grow through productivity gains or through investments, such as an acquisition. The market doesn’t appear to discriminate between these different types of growth, even though expansion from investment is often agglomeration and not organic growth.

Professors Sudhakar Balachandran and Partha Mohanram investigated whether there is a way to differentiate between these sources of growth and to see how the market reacts to each. In their study, the researchers drew on the concept of residual income, which takes into account the cost of capital for an investment. For example, if the cost of capital for a company is 12 percent, the return on any investment must be greater than the 12 percent threshold for the investment to be considered value-enhancing. If the return is less than 12 percent, the company may have experienced growth, but not value-enhancing growth.

Using data from more than 1,500 companies from 1975 to 2004, the researchers found that in the long run the market does place a higher value on productivity-driven growth. However, the market also places a positive value on investment-driven growth. The researchers further found that productivity growth is undervalued and that investment-driven growth is overvalued.

Balachandran and Mohanram used these findings to develop a trading rule ¾ essentially, going long on companies whose growth is driven by productivity gains and going short on those whose growth is driven by investment. The researchers found that this trading rule delivers average annual hedge returns of 9.2 percent. 

 

Practical Applications

Investment managers

You can use this trading rule as a profitable investment strategy. In 25 of the 30 years covered in the researchers’ study, the rule would have generated positive hedge returns. You can also use this strategy to screen out genuine growth companies from companies that are growing purely by investment or agglomeration.

 

CFOs, boards of directors, compensation committees

You can evaluate your firm on the basis of growth, while understanding that not all growth has the same value. You can also use this information to guide company strategy ¾ for example, evaluating whether investment-driven growth would be truly profitable, given the cost of capital. Some market observers have suggested that many firms' willingness to add assets without worrying about their inherent profitability was a potential contributing factor in the current financial crisis; this research can be used to help firms focus on the core profitability of their assets. Additionally, you can consider these findings when determining how much to compensate managers for their growth strategies.

 

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