Here’s a news flash to all the unwavering “value” investors out there…

The stock market loves growth.

The higher and more consistent the growth, the better. Consider the following…

There are roughly 5,500 publicly traded companies in the U.S. with market caps of at least $50 million. Over the past five years, the top 10% of these companies have averaged annual revenue growth of more than 20%.

The bottom 10% of the bunch have seen their revenues decline on average (or annual revenue growth of less than 0%).

For that five-year period, shares of the fastest-growing stocks have more than doubled on average, with total returns of 103%.

Shares of the no-growth bottom-dwellers averaged 8% declines in total returns.

The stock market really loves growth.

But sometimes, that obsession can lead to trouble…

No business leader in recent history knows this better than Kevin Plank, the founder of athletic apparel maker Under Armour (UAA).

Plank was notoriously hyper-focused on his company’s growth rate as he worked to make Under Armour “the best sports brand on the planet.” In October 2016, the company recorded its 26th consecutive quarter of at least 20% sales growth. Plank explained the importance of that streak in an earnings call…

Our financial results are an incredible accomplishment for any brand and something that we believe separates us from others in our business. I don’t know if there’s ever been another model like ours with the growth we’ve seen over the last 6.5 years, particularly in [the] consumer [sector].

Unfortunately for Under Armour and its shareholders, that quarter marked the last time the company would ever grow anywhere close to 20%. The following quarter, sales growth dropped to 11.7%. Over the next three quarters, it averaged just 3.6%. In 2019, it averaged sales growth of just 1.4%.

Under Armour shares dropped, too… from a high of $47 in 2016 to just around $10 today.

So what happened? How did the sales growth drop so much, so quickly? And what can Under Armour’s mistakes teach us about how to invest in successful companies?

A major contributor to the abrupt shortfall was Under Armour’s practice of “pulling forward” sales orders. That’s when you claim revenue now that you would have otherwise earned in some later period.

Knowing how important sales growth of at least 20% was to Plank, executives at Under Armour made every effort to hit that mark each quarter. Per the Wall Street Journal, an unnamed former sales executive admitted…

It was a pretty common practice to pull forward orders from the month after the quarter to ship within the quarter in order to hit the number or close the gap.

That was fine at first – and not illegal – as long as the pulling forward only occurred occasionally and the customers willingly approved placing their orders early.

But problems began to mount when the pull-forwards became more frequent. The same executive explained: “We found ourselves pulling forward sales every quarter.”

At the end of 2016, the pull-forward tactics collapsed when Under Armour’s largest customer, Dick’s Sporting Goods, abruptly stopped taking products early. Its management team was upset by Under Armour’s decision to sell lower-priced products through discount channels like T.J. Maxx and Kohl’s. And just like that, the jig was up.

As Harvard Business School Professor Ethan Rouen explained after researching the company’s pull-forward strategy, “If you’re mortgaging the future, it’s eventually going to catch up.”

The Under Armour pull-forward strategy is a great example of why we at Stansberry Research are so focused on not only seeing robust growth in revenue, but also in free cash flow (“FCF”)…

FCF is the profit left after a company pays all expenses, including capital expenditures. The more FCF a company produces, the more cash it can return to shareholders through dividends and buybacks. Sales growth alone can power stocks higher for a while. But over the long run, growth in FCF generation is what’s most correlated to outsized shareholder returns.

Therein lies the issue with a company like Under Armour. Just look at the seven-year period from 2009 to 2016, before the company’s pull-forward strategy went bust. Sales grew by more than 460%, but profit margins fell. This led to earnings growth of just over 300%, but a decline in FCF.

As investors, we want to find businesses with scale advantages that improve margins and FCF rates over time. We want businesses that become more capital efficient as they grow… in other words, businesses that get better as they get bigger.

The stock market loves growth, and for good reason. But to invest in sustainable growth over the long term, make sure you keep your eye on the metrics that matter…

Good investing,

Austin Root

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Source: Daily Wealth