Nothing Grows Faster Than the Average Forever or It Would Become Bigger than the World
The Date: Spring, 1985
The Place: Computer Lab (remember those?), Stanford University Graduate School of Business
The Situation: As a first year MBA at Stanford, I am taking the introductory finance class. My professor is William Sharpe, renowned for formulating the Capital Asset Pricing Model (CAPM), the fundamental theorem underlying Modern Portfolio Theory, and thus our approach to asset allocation. Five years later in 1990, Professor Sharpe would win the Nobel Prize.
The Assignment: Each student in the class had to pick a company and then apply each lesson from the class to their company. My company was Toys R Us and the lesson that week was the Dividend Discount Model (DDM). The DDM is a method for valuing stocks in which you estimate all the future dividends a company will pay and discount them back to the present using the appropriate discount rate (which was derived, of course, using Sharpe’s own CAPM).
The Problem: In 1985, Toys R Us, which had emerged from bankruptcy a few years before out of Interstate Stores, was a raging growth stock. Consumer spending was booming, and the company was opening stores at a rapid clip. Companies at the beginning of their growth cycle tend not to pay dividends because they need to retain all the cash they generate to fund future growth. So there was no prospect of Toys R Us paying a dividend any time soon, seemingly not in my lifetime. So how would you do a DDM on such a company?
The Conversation: So here is how the conversation went, pretty much word for word:
Me: Excuse me, Bill (he actually insisted we call him Bill), I am trying to do a dividend discount model for my company, but I am having a problem.
Prof. Sharpe: What is the problem?
Me: My company is Toys R Us.
Prof. Sharpe: So?
Me: Toys R Us is a fast-growing company. They are not going to pay any dividends for the foreseeable future. How am I going to do the DDM?
Prof. Sharpe: Nothing grows faster than the average forever or it would become bigger than the world.
Me: [ponders these profound words spoken by the Great One and the many-layered implications] Ok...I think I get it.
Besides the feeling that I had just climbed to a summit in Tibet to finally meet the Dalai Lama and have him explain to me the Meaning of Life (which turns out to be “make sure you floss every day”), there was a seminal finance and investing lesson in that one sentence.
No matter how fast-growing a company is and how much it may seem that the company will maintain that level of growth for years (if not decades) into the future, all companies must have a lifecycle. Eventually their growth must slow. It usually happens in stages, but at some point, they will grow no faster than the average. Or they would become “bigger than the world.”
I contemplated the mathematical implications of Toys R Us growing infinitely at 4% when the average is 3% and realized that eventually, the world would consist of one giant toy store encircling the earth. Then I went back to my computer, fudged some numbers and came out with a valuation for Toys R Us.
During every cycle there is always a new group of companies that are the fast-growers and lead the stock market. In the early 80’s, it was energy. In the mid and late 80’s, it was consumer stocks, including rapid-growth retailers like Toy R Us. Often, it is a new set of tech companies. Today, it is the FAANG stocks. And when they are in their glory it seems like nothing can derail them and they will continue to grow faster than the average forever. But history, experience, and simple math tells us that they simply cannot.
I have often flashed back on that conversation and that simple statement he made to me. And when we get in one of these environments when the Animal Spirits are flowing, it reminds me not to get caught up in the siren song of endless growth and return to the principles of diversification and risk management. These are the tools we use to manage portfolios every day. I’m just the lucky guy that got to learn the lesson from the Master himself.