Wealth = Quality x Quantity Part 2: investor expectations

‘The production of wealth,’ as 19th century philosopher John Stuart Mill observed, ‘has its necessary conditions’.

For senior executives and directors charged with growing the wealth of shareholders, few things could be more important to understand than the ‘necessary conditions’ for the production of wealth.

In this series of articles, we’ll share the findings of our research into wealth creation in Australian equity capital markets and layout a clear framework that describes the necessary conditions for the production of wealth.

In this article, we’ll look at the importance of investor expectations to wealth creation.

A quick recap
In the first article in this series, we looked at the findings of our research into why some companies create wealth, while others destroy it.  We showed that the creation of wealth is a function of ‘Quality’ and ‘Quantity’.  ‘Quality’ is the rate of return that the company is able to generate on the capital entrusted to it, calculated by its sustained (say 5 year average) Economic Profit Spread ie its Return on Capital Employed (ROCE) less its Weighted Average Cost of Capital (WACC).

‘Quantity’ is the amount of capital that a company can put and is the great magnifier of Quality.

BHP Billiton, the business that created more wealth than any other in our analysis, best exemplifies the impact of combining Quality and Quantity, not only enjoying a median return on capital employed 10% above the return required for risk over the past five years, but also employing an average of $83 billion a year at those rates, creating nearly $39 billion more profits than investors would have required for the risk associated with their investment.

But quantity can also magnify poor quality.  Newcrest Mining Limited 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 market valuation $10.6 billion less than what investors had poured into the business as at 30 June 2013.

The final ingredient: expectations
To complete the analysis of what creates wealth, we need to bring in expectations. Ultimately it is expectations of quality and quantity that drive the creation of wealth.

If a company is expected to generate high returns on capital and employ large amounts of money doing so, the value of the company will be bid up well above the amount originally contributed by investors and wealth will be created.

But the reverse is also true. If a company is expected to invest at low rates of return its value will fall and, absent of a takeover premium, it will trade at a discount to the book value of capital employed.

Our research found that the valuation that companies trade at is a function of expectations of the quality of future returns and the quantity of funds likely to be employed at those rates. But because the future is unknowable, with a few exceptions (like oil and gas exploration and development business Oil Search Limited (#14)), in forecasting the future quality of a business and the quantity of funds it will be able to put to work, investors tend to put great store in historical performance, meaning wealth often reflects historical performance, particularly for established businesses.

For example, Cochlear (#27) had created $2.9 billion of wealth as at 30 June 2013 and an average return above that required for risk over the five years to 30 June 2013 of 14%. Unpacking Cochlear’s valuation into quality and quantity expectations shows that investors were expecting the Group to continue to enjoy returns significantly above the cost of capital even as it grows invested capital well into the future.

Contrast this with Qantas (#196), who by 30 June 2013 had destroyed $3.5 billion with an average return 3.5% below that required for risk over the past five years. Unpacking Qantas’ 30 June valuation shows that investors were expecting returns to stay well below the cost of capital no matter what growth scenario is envisaged.

In the next article we return to the themes of Quality and Quantity, examining the link between wealth created and Economic Profitability.