Is your business engineered to create wealth? Part 1: Education

If the job of business is to create wealth, how strange it is then that so few managers really
understand how wealth creation works.

If you think this is unfair, try asking a manager this question, ‘How is it that Qantas has turned
the $15.2 billion entrusted to it into a business worth just $11.6 billion?’ Or, ‘How has
Cochlear been able to take $925 million and turn it into a company worth $3.8 billion?’

Shouldn’t every manager entrusted with other people’s life savings, be able to explain,
at least in high level terms, what has happened to these two companies and translate
those lessons into their everyday decision making?

If we expect our managers to create wealth, the first barrier we must address is education, by
giving all managers a clear and shared understanding of what is required to create wealth.

So what are the necessary conditions for creating wealth? Our research of Australia’s largest
listed companies summarised in the tables that follow, shows who has created (or
destroyed) wealth and the root causes. [1]

Figure 1: The 2013 Juno Partners Wealth Creators Report

1-5051-100101-150151-200

The data shows that, for example, BHP Billiton (ranked #1) at 30 June 2013 had taken $137 billion of capital from shareholders and lenders and turned it into a business worth $208 billion, creating a staggering $71 billion of wealth.[2]

By contrast, Newcrest Mining (#200) had taken $22.4 billion and turned it into $11.8 billion, destroying $10.6 billion.

How do businesses create wealth?
How does a business like BHP Billiton create $71 billion of wealth?

Being at the epicentre of the global mining boom would seem to help, but being a leader in the mining sector is not enough. OZ Minerals (#198) has managed to destroy $4.9 billion of wealth, turning every dollar entrusted to it into $0.20.

Wealth is also not just a matter of size. BHP Billiton is a very large company and created the most wealth, but Qantas (#196) is also a very large business, but its size did not save it from destroying billions.

Even growth per se does not matter. Both OZ Minerals (#198) and Westpac (#4) have grown their balance sheets in excess of 20% compound over the five years to 30 June 2013 but by the end of it, Westpac had turned $51 billion of investors’ funds into a business worth $90 billion, creating $39 billion, while OZ Minerals, turned $6.2 billion into just $1.3 billion, destroying $4.9 billion.

Instead, our research shows that the two most important conditions necessary for the creation of wealth can be characterized as ‘quality’ and ‘quantity’.

The importance of quality
Let’s look at the first condition: quality. Quality, of course, is a relative measure – it means something of a higher grade; better than the rest. If we apply that thinking to investing, a good quality investment is one that is capable of generating higher returns than what investors could achieve elsewhere, at similar risk.

To measure the quality of each of our sample of 200 Australian businesses, we calculated the return on capital employed (ROCE) of each and compared it to what investors could earn elsewhere at similar risk (the business’ Weighted Average Cost of Capital or WACC).

We call the net result, a business’ Economic Profit Spread, or EP Spread for short. Further explanation of these terms and others used in this article is included in this Glossary.

For example, Wotif, the on-line travel business (#57) earned 49.5% on the funds entrusted to it in 2013, compared to the 9.2% investors would expect, to justify the risks involved in the business, leaving an EP Spread of 40.3%.

Intuitively, generating 40% more than the return required for risk is good performance, but when you consider a little under three quarters of businesses covered in our research failed to generate more than 5% above what investors could expect for risk, then you begin to appreciate what a rare jewel Wotif is.

Quantity: the great accelerator of wealth creation
The second condition necessary for the creation of wealth is quantity, in this case the quantity of funds that can be invested at high rates of return. The more capital that can be put to work at high rates of return, the more wealth will be created.

This is best exemplified by BHP Billiton (#1) who not only enjoyed a median return on capital employed 10% above the return required for risk over the past five years, but also was able to employ an average of $83 billion a year at those rates, creating nearly $39 billion more profits than investors would require for the risk associated with their investment.

Quantity is the great accelerator of wealth creation. As good as Wotif’s returns are, the service nature of its business means that it does not organically generate large capital investment opportunities. It is hard to see how Wotif could ever employ $83 billion of capital in their business. Ultimately this restricts the wealth that the business is able to generate.

But quantity without quality is a recipe for wealth destruction
But while the ability to put capital to work is important, quality must always come first.

Investing large amounts of capital in low return, low quality businesses is a recipe for wealth destruction.

Newcrest Mining Limited (#200) is a good example of this. Over the past five years Newcrest suffered returns on average 2.3% below what investors required for risk. At the same time, it expanded its capital base, investing billions at low rates of return. The result was a valuation $10.6 billion less than what investors had poured into the business as at 30 June 2013.

Warren Buffett put it this way in his 1992 letter to fellow Berkshire Hathaway investors,

‘Leaving the question of price aside, the best business to own is one that over an extended period can employ large amounts of incremental capital at very high rates of return. The worst business to own is one that must, or will, do the opposite – that is, consistently employ ever-greater amounts of capital at very low rates of return.’

Key points

  • Competitive challenges make creating wealth difficult. That challenge can be made a little easier if all managers at least share a common and accurate understanding of how wealth is created.
  • Wealth is a function of Quality and Quantity. Can the business generate returns on the capital entrusted to it in excess of what investors could earn elsewhere (Quality), and how much money can be put to work at those rates (Quantity)?

Qantas (#196) has destroyed $2.9 billion of wealth because it has put large amounts of capital ($15.2 billion by June 2013) to work at low rates of return (on average 3.5% less than what investors require for risk) and is expected to do so well into the future.

Cochlear (#27) has created $3 billion of wealth because it has put the $925 million of capital entrusted to it to work at high rates of return (on average 14% above what investors require for risk) and is expected to do so well into the future.

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[1] For the purposes of this study, our database comprised the 200 largest Australian domiciled public companies as at 30 June 2013, excluding investment businesses, such as listed investment companies, insurance and real estate businesses, those with less than five years of publicly available financial reports and those who made losses in three or more of the past five years.

[2] Note that in the table of data we list the 2013 average Capital Employed balance, being the average of the year-end results for 2012 and 2013. The 2013 year-end values cited in the main text of this article and used to calculate Wealth Created, will usually be a little larger.