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.