The most common incentive plan mistakes made by privately held companies #5: Payments made in full in one year

In this series of articles, we’ll review some of the most common mistakes that privately held companies make in approaching the question of incentives, before looking at a sketch of what I have seen work well.

Mistake #5: Payments made in full in one year

Because the financial calendar is 12 months long, it seems to make sense to tie bonus payments to annual performance. But most business owners will agree that one year is too short to get any real sense of the strength of a result. You need the perspective of three or more years to judge how sustainable and how repeatable the result was.

Yet, most bonus programs pay out in full each year and often with the benefit of hindsight, therefore, over pay.

Ironically, the consequence of this approach can be lower bonuses for managers, as owners are often reluctant to tie large amounts to single year performance, knowing what an unreliable indicator it is.

Next we’ll look at the final of our six most common mistakes, using the wrong performance measures.

The most common incentive plan mistakes made by privately held companies #4: All or nothing

In this series of articles, we’ll review some of the most common mistakes that privately held companies make in approaching the question of incentives, before looking at a sketch of what I have seen work well.

Mistake #4: All or nothing
The problems with tying bonuses to budget are exacerbated when the bonus is made on an ‘all or nothing’ basis, such as, ‘You hit budget you get a bonus, you miss budget, you get nothing.’

All or nothing bonus plan

This structure puts further pressure on budget preparation as negotiating the budget down by just one dollar could make tens of thousands of dollars difference to the take home pay of the manager.

When performance is close to budget in an all or nothing plan, managers are encouraged to do any of the thousand short term things that are at their discretion to improve performance. You may have seen some of these before:

  •  cutting back on training;
  •  cutting back on or research and development;
  •  cutting back on advertising;
  •  asking too much of their people;
  •  deferring the hiring of new people until the new financial year;
  •  discounting or providing generous payment terms to bring forward sales into the current financial year;
  •  deferring maintenance expenditure;
  •  arguing the interpretation of accounting treatments.

And so on. The list is only as long as the creativity of managers. But this is the key point: instead of spending time on sustainably growing the business, all or nothing incentive plans provide so much pay off for that last few dollars, it’s very tempting for managers to spend their time making decisions that boost short term financial performance and deliver them a bonus, and ignore what really matters to the business, its long term growth.

And of course, if performance is safely over the budget, there is no incentive to make the most of a good year in an ‘all or nothing’ bonus plan. The incentive scheme is effectively dead once budget is reached.

In fact the incentive is to hold back any more upside, as out-performing the budget by too much will weaken the manager’s negotiating position going into the next round of budget discussions. In this circumstance it pays to defer revenue till next year. It pays to bring forward expenses. This is not the behaviour any owner would want, but the behaviour that is encouraged by an all or nothing incentive plan, especially one tied to budget.

Ultimately, an all or nothing plan does damage at a deeper level of the business. The bulk of managers who ‘short term’ the business gain no pride or sense of achievement from their behaviour and the employees who watch on and suffer the consequences become cynical and detached. It can be a very costly error to make in incentive plan design.

In the next article we’ll look at the problems with paying out all of an incentive in one year.

The most common incentive plan mistakes made by privately held companies #3: Bonuses based on performance against budget

In this series of articles, we’ll review some of the most common mistakes that privately held companies make in approaching the question of incentives, before looking at a sketch of what I have seen work well.

Mistake #3: Bonuses based on performance against budget
Given the short-comings of discretionary bonuses, an obvious solution for many companies is to base bonuses on performance against budget. Hit the budget, get the bonus. Simple. But there is a major unintended consequence of this approach– it pays people to lie.

The case of a client, I’ll call George, is illustrative. George owns a privately-held plastic injection molding business and he was sharing with me recently his frustrations with the sales forecasts put together by his sales team each year. While George feels the business is fairly stable and sales should be fairly predictable, each year demand has been under-forecast by the sales team, leading to under-resourcing in the production department, lost sales and damage to the firm’s reputation for reliability.

The sales team incentive plan runs on performance against budget and the budget is set with the involvement of the sales team each year. The sales team responds to this arrangement by maximizing sales and minimizing the budget.

While George is aware of the in-built conservatism of the sales forecasts, the sales team is closer to the customer base than he is and he feels unable to rigorously challenge their projections.

Not only does linking incentives to the budget reduce the reliability of George’s sales forecasts, it means sales managers are being paid higher incentives than what George feels they truly deserve.

In order to build ‘buy-in’ to the numbers, many owners will, like George, involve the managers responsible for performance in the preparation of the firm’s budget. And the final set of numbers usually involves some degree of negotiation between the ‘aspirational’ goals of owners and the ‘realistic’ goals of managers.

But while the benchmarks set in the final budget make no difference to the wealth of owners (what matters to them is the actual results), that is not the case with managers whose bonus is tied to performance against budget.

For them, where the budget lands can make tens of thousands of dollars difference to their pay that year. And the higher the budget, the lower the probability they will be paid a bonus. So incentive schemes that use performance against budget to determine incentive payments encourage managers to negotiate for the lowest, most ‘realistic’, budget they can get away with. The problem is so widespread we even have a name for it: ‘sandbagging’. But what it really is, is lying.

Tying incentives to budget encourages a swag of dysfunctional behaviour, including:

  •  Low-balled budgets, leading to under-resourcing and in turn missed sales and missed profits.
  •  Hoarding of information by managers (sharing it with owners will weaken their negotiating position), which reduces the quality of decision making at the top.
  •  Time wasting: with meaningful amounts in bonuses at stake, it’s not surprising that the preparation of the annual budget is often drawn out over months as each layer of management negotiates with the next. Owners, of course, pick up the tab for this massive time wasting exercise.
  •  Money wasting: if a manager has negotiated and won some expenditure in his budget but fails to spend it, he weakens his negotiating position for that and other expenditure in the following year. Better to spend it on useless activity than loose the money for future years. Far from encouraging managers to trim their costs, tying bonuses to budget encourages them to pad their costs, building a buffer for the year when performance is sailing close to budget and they need to ‘pull out all stops’ to get their incentive.

And of course, by negotiating budgets annually, much of the risk of non-payment is taken out. Annual negotiation allows targets to be reassessed for their ‘reasonableness’ so that projections that were made for that new market or acquisition, can be reassessed 12 months in and ratcheted down to ‘realistic’ levels, ‘given what we now know’. And bonuses can still be paid, despite the woeful returns to investors.

Perhaps worst of all, tying incentives to budget and then negotiating the budget puts the vast bulk of honest, hardworking managers in an unenviable position. It forces them to either lie about what they think the business is capable of and benefit their families, or be truthful and watch as the rewards flow to others.

It generates a high degree of cynicism or a low degree of morale. It does not encourage managers to sustainably grow wealth for shareholders and it makes bonus payments made in this way very poor value for money for owners.

Next we’ll look at the dangers of cliff-payoffs in incentive programs.

The most common incentive plan mistakes made by privately held companies #2: Bonuses based purely on the owner’s judgement

In this series of articles, we’ll review some of the most common mistakes that privately held companies make in approaching the question of incentives, before looking at a sketch of what I have seen work well.

#2: Bonuses based purely on the owner’s judgement

Work out a sum to share with managers and divvy it up based on how you think they’ve performed during the year. Its simplicity is appealing, but there are a few problems with this approach.

First, people talk, leading to sibling-like rivalry: ‘Why did he get more than me?’ The amounts no longer matter, if what gets paid differs due to a subjective assessment, someone is going to feel hardly done by. The business ends up aggravating their staff and making them more vulnerable to poaching. And paying for the privilege.

Second, discretionary bonuses like this discourage open and frank discussions about personal performance. When the employee knows that his boss’ impression of his performance makes the difference between a holiday for his family to Dubbo or Disneyland, the incentive plan encourages him to hide problems, rather than discuss them.

Third, the value of discretionary bonuses is discounted by employees because they know that there is no guarantee of delivery, no matter how good the results they achieve. In the market for talent, a $50,000 bonus opportunity decided on discretion is not worth as much as one objectively determined, except of course, to those skilled at creating the impression of good work.

Finally, the day-to-day behaviour encouraged by discretionary bonuses can be damaging to the performance of the company. Imagine two sales people, one on a discretionary bonus and one on a flat 10% commission. It pays the former to spend time in the office ensuring the boss knows just what a good job he is doing, it pays the latter to get out of the office and make the next sale.

In our next article we’ll look at the dangers of linking incentives to budgets.

The most common incentive plan mistakes made by privately held companies #1: No incentive plan

In this series of articles, we’ll review some of the most common mistakes that privately held companies make in approaching the question of incentives, before looking at a sketch of what I have seen work well.

Let’s start with mistake #1: no incentive plan

My experience is that most privately-held businesses in Australia would say that they do not use any sort of structured incentive plan; they just pay their people a fixed salary which is subject to some kind of annual review. But this approach can have a number of unintended consequences.

No incentive opportunity means higher fixed costs…

Offering no incentive plan usually leads to higher levels of fixed pay, to allow for the lack of bonus opportunity. A competitor’s offer of $180,000 salary with a bonus opportunity of $50,000 may need to be countered with a $215,000 salary with no bonus opportunity, for example.

And it doesn’t stop there. In the absence of an incentive plan, if the employee has a good year, he or she will often expect some recognition of that in the form of a raise. But this again locks in higher fixed costs that will survive long after the employee’s performance has returned to normal levels.
Higher fixed pay means higher fixed costs that put more pressure on the bottom line when business inevitably turns down.

…a risk-adverse culture…

A lack of incentive opportunity also influences the type of people attracted to a position: a well structured bonus plan will attract someone that is prepared to back their skills and abilities, someone that is more comfortable with a little risk. But a position that offers a higher level of fixed remuneration, with no bonus will attract risk adverse managers more interested in peace of mind than performance.

…and a resistance to change

With no upside, managers with no incentive opportunity often advocate against change. As one manager put it to me when the owner wanted to expand internationally, ‘How do I explain all the extra hours away from home to my wife and kids? There is absolutely no upside in it for me.’

But even those companies that do use incentives often make costly mistakes. In the next few articles we’ll look at some of the worst to watch out for.

Incentive plans for privately held businesses

Attracting, motivating and retaining key staff is a challenge for every business. Incentive plans can play a big part in achieving that aim, but many privately held companies shy away from using incentives, wary of experimenting with something as sensitive as pay.

But with care, a powerful and highly attractive incentive scheme can be designed for managers of privately held companies; one that focuses attention on sustained gains in the value of the business, while offering meaningful, competitive rewards for successful mangers.

In this series of articles, we’ll review some of the most common mistakes that privately held companies make in approaching the question of incentives, before looking at a sketch of what I have seen work well.

Download this article in full by clicking here

 

 

 

 

 

 

But to start, it’s worthwhile looking at the basic framework of modern executive remuneration.

Modern remuneration practice

Traditional remuneration practice in Australia and New Zealand has seen the majority of rewards for managers paid in fixed remuneration, such as a salary. Then, if the business or manager has a particularly good year, he or she may qualify for a ‘bonus’.

Modern remuneration practice is different. At its heart is the concept of ‘at-risk pay’. Employees have a meaningful part of their pay at-risk, subject to loss if performance is disappointing, but capable of significant upside if performance exceeds expectations.

This is nothing new to anyone who has ever worked in sales. Most sales positions have an element of ‘at-risk’ pay, usually tied to sales performance (eg sales commission). If sales targets are met, the commission earned when added to base salary, combines for an attractive total remuneration package. But if sales are low, it makes for a tight year all round.

Owners like this kind of pay structure, because costs are more variable and good sales people like it, because they can usually earn significant amounts if they beat their sales targets.

Modern remuneration practice applies the same approach to managers. If targets are met, the at-risk component when added to base salary combines for a market competitive total remuneration package. But if performance is poor, the executive will be paid well below market. And of course, if performance is above expectations, rewards can be substantial.

Within that framework, remuneration for senior executives today comprises three parts: fixed remuneration, short term incentives and long term incentives.

The three parts of modern remuneration

3 parts of modern remuneraiton

Fixed remuneration is the employee’s salary and any additional perks, such as superannuation or a car allowance that do not vary with performance.

Rewards that are linked to performance measured over one year (or less) are called ‘Short-Term Incentives’ or STI, the most common example being an annual bonus paid to employees.

‘Long-Term Incentives’, or LTI, reward multi-year performance. LTI plans are most common in public companies and usually comprise equity based rewards such as shares or share options.

Equipped with an understanding of the structure of modern remuneration, we can now look at the most common mistakes made by privately held companies in the use of incentive plans.

Wealth = Quality x Quantity Part 4: Competition can be hazardous to wealth

‘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.

Key takeaway
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.

Wealth = Quality x Quantity Part 3: The macro picture

‘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 macro picture and how Economic Profitability links 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.

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.

The macro picture
Grouping the two hundred businesses in our research set into four quartiles further reinforces
the importance of quality and quantity to wealth creation.

Figure 1: Cumulative Wealth Created by Quartile

table

The total wealth created by the top 25% of businesses we analysed was $488 billion, more than 18 times as much as the next quadrant. These businesses fit the description given by Warren Buffett in his 1992 letter to fellow Berkshire Hathaway investors as the best businesses to own:

‘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.’

That is, they invest large amounts of capital at high rates of return.

Indeed by 30 June 2013, the top quartile, including the likes of BHP Billiton, Commonwealth Bank, Telstra, CSL and Woolworths, had invested $678 billion – nearly three times as much as the other quadrants put together – at the highest average returns, 3.8% above what investors could expect to earn elsewhere at comparable risk.

The second quartile created a very credible $27 billion of wealth. Their average returns were close to those in the first quartile (2.6% above the cost of capital, versus 3.8% enjoyed by the first quadrant), but these businesses, including the likes of software developed IRESS Limited (#61) and retailer, Oroton Group (#96), were not able to put large amounts of capital to work at those rates (just $62 billion in total at 30 June 2013). With the accelerator of wealth creation missing, the second quadrant created a fraction of the wealth of the first.

The third quartile created $2.5 billion of wealth. This group has averaged returns over the past five years just above what investors could expect to earn elsewhere (their median Economic Profit Spread being 0.8%). Capital invested at 30 June is the lowest of the four quartiles at just $29 billion. With quality just above average and low quantity, this quadrant has done well to amass even $2.5 billion of wealth.

The bottom quartile has destroyed $55 billion of wealth by putting large amounts of capital to work ($158 billion by 30 June 2013) at low rates of return, averaging 3% below what investors could expect to earn elsewhere. Little wonder Buffett described these kind of businesses as the worst to own.

This quartile analysis shows the strong link between quality, quantity and wealth. The top 25% of wealth creators were also the businesses with the highest quality or EP spreads and the highest quantity of capital invested. The next 25% had good EP spreads, but less invested. The third quartile had breakeven EP spreads and the smallest amounts invested and the bottom 25% destroyed $55 billion of wealth by investing the second highest amount of capital at the lowest rates of return.

But where does accounting profit sit in all this? Given the emphasis placed on accounting profits by investment banks, the media and stock brokers, many managers would be forgiven for assuming measures like EPS, Net Profit and EBITDA are reliable indicators of wealth creation: more profit is always good for shareholders.

This is not borne out by our analysis. In fact accounting profit was shown to be a very misleading measure: while the top 25% of wealth creators also made more Earnings Before Interest, Tax, Depreciation and Amortisation (EBITDA) than any other quartile, the bottom quartile, who destroyed $55 billion of wealth, came second in terms of cumulative EBITDA over the five years to 30 June 2013.

The problem is accounting profit measures like EPS, Net Profit and EBITDA say nothing about the quality of the business. They do not take into account the return investors could earn elsewhere on their funds and so businesses that employ large amounts of money at low rates of return can grow their accounting profits handsomely, all the while destroying wealth for investors.

For anyone interested in wealth creation, the evidence is compelling: wealth is not a function of accounting profitability. Wealth = Quality x Quantity.

The link to Economic Profit
There is a measure of financial performance that neatly captures both quality and quantity: Economic Profit, or as it sometime referred to, Economic Value Added.

Figure 2: Economic Profit captures the key drivers of wealth creation

Economic Profit formula

In the final article in this series we’ll explore why some companies earn higher returns on their capital than others and the hazardous impact that competition can have on wealth.

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.

Wealth = Quality x Quantity Part 1: Our findings

‘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 basis of our research and present the findings of our research which highlights the importance of quality and quantity.

The basis of our research
So what are the ‘necessary conditions’ for creating wealth? We set out to answer this
question by looking at a group of Australia’s largest listed companies and asking who has
created (or destroyed) wealth and then digging deeper to find the root causes [1].

We used a simple definition of wealth creation being the difference between how much has
been invested in a company and how much it is worth as at 30 June 2013. This measure has
the advantage of being a dollar measure of wealth, as opposed to a percentage measure,
like Total Shareholder Return or TSR and hence shows the true impact the business has had
on the economy.

The Wealth Created results are summarised in the tables following, ranking the two hundred
businesses in our set by Wealth Created as at 30 June 2013 and show, for example that BHP
Billiton (ranked #1 in the table) 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].

Figure 1: The 2013 Juno Partners Wealth Creators Report

 

1-5051-100101-150151-200

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? If you were to believe the prospectuses, annual reports and investor briefings issued by many of our listed companies, you would be left with the firm impression that what matters in creating wealth is EPS growth and EBITDA.

But our research shows that is not the case.

In fact, these metrics are unreliable at best and dangerously misleading at worst. Managers that navigate with these measures risk running their businesses off course and destroying wealth.

Our analysis shows that wealth creation is also not a function of sector. For example, some miners performed well, but some destroyed billions.

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. The quality of a business is captured by the returns the business is expected to generate above what investors could expect to enjoy elsewhere at similar risk. We call this the company’s Economic Profit spread, or EP spread for short (for further detail on terminology, see our glossary of terms).

In assessing quality, we tend to give most emphasis to the EP spread the business has made over five years. This five year time frame helps iron out year-to-year fluctuations and gives a picture of sustained performance.

It shows, for example, the highest quality business in our set is Wotif.com Holdings Ltd (#57), which over the past five years has enjoyed an average return on capital employed of 56.5%, 45.5% above the rate investors could have expected to earn elsewhere at similar risk.

Intuitively, generating 45% more than the return required for risk is good performance, but when you consider a little under three quarters of the businesses covered in our research failed to generate more than 5% above what investors could expect for risk, then you begin to appreciate what are rare jewel Wotif.com 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.com’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.com could ever employ $83 billion of capital in their business. Ultimately this restricts the wealth 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, we found 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.’

In the next article we’ll discuss our findings regarding the importance of expectations.

______________________________________

[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.