Companies That Grow Fast Make Bad Investments

Growth sounds good. A company that is expanding, buying assets, opening facilities, acquiring rivals and raising capital is a company that is going places. The management team is on television. The story is exciting.

Michael Cooper, Huseyin Gulen and Michael Schill looked at what happened to the shareholders of such companies afterwards, and found something deeply unromantic: the faster a company grew its total assets, the worse its stock did. And this simple, crude signal, the percentage change in total assets on the balance sheet, turned out to be one of the strongest predictors of returns anyone had found.

The problem: an ugly number that beat the elegant ones

The signal is almost insultingly simple. Take the company's total assets this year. Compare to total assets last year. Compute the percentage change. That is it. No valuation model, no discounted cash flow, no forecast. Just: how much bigger did the balance sheet get?

Sort stocks by that number and the pattern is stark. The companies that expanded their asset base most aggressively went on to earn substantially lower returns than the companies that grew slowly, shrank, or stood still. The effect was economically large and statistically significant, and it held up against the standard factors.

What made the paper land so hard was the comparison. The authors showed this crude balance-sheet growth rate was a stronger predictor than many of the more famous and more sophisticated signals in the literature. It also subsumed a lot of them: a variety of previously documented anomalies involving share issuance, capital expenditure, acquisitions and accruals all turned out to be, in large part, the same effect wearing different clothes. They are all ways of measuring the same thing, a company that is expanding.

The key idea via analogy: the empire builder

Why would growth be bad for shareholders? There are several explanations, and the honest answer is that all of them probably contribute.

The empire-building story. Executives like running big companies. Bigger companies mean bigger budgets, bigger salaries, more prestige, more people at the annual conference. That gives management a standing incentive to expand, and to keep expanding past the point where the expansion actually creates value. Every good project gets funded first; the ones funded last are the marginal ones, and past a certain point the marginal project destroys value. A company on an acquisition spree is often a company that ran out of good ideas and started buying mediocre ones.

The overextrapolation story. Companies expand hardest when times are good, when their stock is high, when capital is easy to raise and everyone is optimistic. But "times are good and everyone is optimistic" is precisely the condition under which a stock is likely to be overpriced. Heavy asset growth is therefore a marker of a company whose shares the market currently loves. And loved shares earn poor returns. Under this reading, asset growth is a sentiment indicator dressed up as an accounting number.

The rational, theory-driven story. This is the one Hou, Xue and Zhang and the Fama-French five-factor model lean on. If a company's investors demand only a low return, then lots of projects clear the hurdle and the company invests heavily. So heavy investment does not cause low returns, it reveals a low required return. Under this reading nothing is wrong at all, and there is no mispricing: the low return on high-growth firms is exactly what should happen.

The paper does not fully settle which of these it is. But the fact that all three roads lead to the same prediction, and the data agrees, is part of why the effect is taken so seriously.

Why it mattered

• It became a standard factor. Both of the leading modern asset pricing models, the Fama-French five-factor model and the Hou-Xue-Zhang q-factor model, contain an investment factor. This paper is one of the main empirical reasons why. The academic factor named CMA, conservative minus aggressive, is a direct descendant.
• It unified a scattered literature. Share issuance predicts low returns. Big acquisitions predict low returns. High capital expenditure predicts low returns. Cooper, Gulen and Schill showed these are largely one phenomenon, which is a real simplification of a messy field.
• It gave investors a red flag that requires no judgment. You do not need to assess whether an acquisition is wise. You just need to notice that the balance sheet ballooned, which is a fact, not an opinion.
• It sharpened the meaning of quality. A high-quality company is not merely profitable. It is profitable and disciplined about deploying capital. The investment factor is what encodes that discipline.

The honest limitations

• Some growth is genuinely great. The signal, applied naively, shorts companies that are expanding because they have discovered something enormously valuable and are rationally building to meet demand. The strategy works on average and is wrong on many individual names, some of them the best investments of the era.
• The mechanism is unresolved. Empire-building, overpricing and rational discount-rate variation predict the same data. Without knowing which is operating, you cannot be confident about whether the effect persists, and the three stories have different implications for whether it should.
• It is entangled with value. Companies that have grown assets fast usually have high valuations and recently strong stock prices. Separating the asset growth effect from a plain value effect requires care, and how much is truly independent remains debated.
• Balance sheets are noisy. Total assets jump for accounting reasons that have nothing to do with real economic expansion: an acquisition, a lease capitalisation, a revaluation. The signal picks up all of it indiscriminately.

The one-line takeaway

Cooper, Gulen and Schill showed that the percentage change in a company's total assets is one of the strongest predictors of poor future stock returns, because aggressive expansion tends to mark either an empire-building management team, an overpriced stock, or both.