‘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 impact competition has on returns on capital employed and 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.
In the second article we argued that it is actually expectations of ‘Quality’ and ‘Quantity’ that are the key determinants of wealth creation, but that for most businesses, the history of the business is a good guide to the future and hence Quality and Quantity expectations.
In the third article we looked at the macro picture and showed that the top quartile of Wealth Creators combined both Quality and Quantity. The second quartile had Quality without Quantity, the third quartile had low Quality and Quantity and the bottom quartile, those that destroyed wealth combined low quality with large quantities of capital.
Competition can be hazardous to wealth
Why are some businesses able to achieve and sustain high returns on the funds entrusted to them and create wealth while others languish with low returns?
High returns on capital are a rare achievement – just 26 of the 200 businesses we studied enjoyed average returns 10% or more above the cost of capital over the five years to 30 June 2013.
Like most of the businesses in our set, these businesses are professionally managed, offer compelling value propositions to their customers and play their part in the communities in which they operate.
The difference is the competition that they face.
For most businesses, the competition for sales, supplies or employees forces returns down to a level that just compensates investors for the risk that they take on. A short period of high returns attracts the attention of competitors and in the absence of a hard to replicate product or cost advantage, returns fall away as new players enter the market.
But a small group of businesses has been able to avoid these pressures and maintain high returns. Some, like Cochlear (#27) invest hundreds of millions in research and development and enjoy the protection of patents, allowing them to reduce competition over the life of the patent. Others, like BHP Billiton (#1) enjoy cost advantages over their competitors and pricing power in some of their businesses, while others like Reece Australia (#40) leverage brand recognition and distribution networks.
In each of these instances, the advantages have proven durable, giving investors confidence that high returns can be maintained well into the future, even in the face of competitive pressures. When these advantages can be maintained, wealth will be created, limited only by the size of the capital investment opportunity.
The production of wealth has its necessary conditions. For many businesses this can be simplified into the concepts of ‘Quality’ and ‘Quantity’. Boards and senior managers can help their business create more wealth for shareholders by focusing attention on these two simple drivers and ensuring all strategic, as well as day-to-day decisions are made with this in mind.
More on how businesses can be engineered to create wealth can be found here.