Five elements to make managers think and act like owners #1: Reward sustained improvements in profitability

In this series of articles, we’ve looked at some of the most common mistakes that privately held companies make in approaching the question of incentives, and we’ve sketched out the common themes that owners tend to look for in an incentive plan.

Let’s now move to see how those themes can be realised in practice, by including five key elements in the incentive plan design that will make managers think and act like owners.

#1  Reward sustained, multi-year improvements in profitability
Ultimately an ‘ownership-like’ incentive plan must have financials at its heart, as it is sustained gains in financial performance that power the value of a business. Single period spikes in performance are unlikely to grow the value of the business a great deal however – buyers look for high levels of ‘repeatable earnings’. The more reliable the profit flow, the higher the premium buyers are likely to pay for a business.

I’ll discuss how to reward sustained gains in element #4, but it is worth focusing on how ‘profit’ is defined first, because, as we have seen, the most common profit measures, such as EBIT and EBITDA (or Net Profit, Earnings Per Share, Return on Equity and so forth) can actually encourage decisions that reduce, rather than grow, the value of the business.

One measure of profit that can be relied on to drive decisions that will grow the value of the business is ‘Economic Profit’. Economic Profit is the only metric that can be measured as easily as EBIT or Net Profit and yet ties reliably to wealth creation for owners. It’s measured like this:

Economic Profit calculation

Most owners know that ‘Profit’ is what is left over from sales revenue once all the costs of running the business have been taken out.  But accounting profit forgets one very important cost – the cost of using shareholder funds.  And by failing to put a price on the equity used to fund the business, accounting profit effectively says it’s free.

Pay managers to grow accounting profit and they will be encouraged to use as much of the shareholders’ money as they can put their hands on, after all its free and if they invest it at just 1%, accounting profits – and their bonuses – will grow.

But by charging for the owner’s capital used in the business at a rate that reflects what could be earned elsewhere at similar risk, managers are encouraged to treat capital like the scarce and valuable thing every business owner knows that it is.

Economic Profit puts into practice what anybody starting a new business has to think about from day one: if I put my savings into this business, will it generate more profit than I could have got elsewhere at similar risk?

For managers on an incentive plan linked to Economic Profit it forces them to think the same way: not just will this decision be profitable, but will it make enough profit to justify the owner’s investment?

In the next article we’ll discuss how to align the payoff profile of managers to that of owners.

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 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.

 

Glossary of commonly used terms

For the sake of clarity, here are definitions for some of the technical terms used on this site.

Wealth Created
We define Wealth Created as the difference between the Enterprise Value of a business and the Capital Employed in the business as at a specific date.

For the purposes of our published research, Enterprise Value is calculated at 30 June and Capital Employed is based on the financial year-end closest to that date, adjusted for any significant capital raisings between year-end and 30 June, were applicable.

Capital Employed
The total funds invested in the business by lenders and shareholders as at the most recent balance date to 30 June.

Adjustments are made to book values to establish a better picture of the underlying performance of the business including capitalising non-cancellable operating leases, capitalising significant items, capitalising research & development expenditure and reversing goodwill amortisation.

Enterprise Value
The market value of the company’s debt and equity as at 30 June. Where debt is not publicly quoted, the book value of debt is used.

Weighted Average Cost of Capital (WACC)
The weighted average cost of debt and equity capital. This is equivalent to what investors could expect to earn elsewhere over the long term at similar levels of risk.

Net Operating Profit After Tax (NOPAT)
NOPAT is the underlying operating profits of the business. Adjustments are made to statutory results to calculate NOPAT, including adding back interest and significant items, capitalizing research & development expenditure and reversing goodwill amortisation.

Return on Capital Employed (ROCE)
ROCE is calculated as the NOPAT of the business divided by the two year average Capital Employed.

Economic Profit Spread (EP Spread)
Calculated as ROCE – WACC, the EP Spread tells us about the quality of the business. A high quality business is one that can consistently put investor funds to work at a rate greater than what investors can earn elsewhere at similar risk (the WACC).

Businesses with positive EP Spread are generating returns in excess of their WACC.

Economic Profit (EP)
The profits made by the company after charging for the expected return on all Capital invested – debt & equity. A number of adjustments are made to reported profits and Capital to see through
to the underlying performance of the business. Formulaically,
EP = (ROCE – WACC) x Average Capital,
or Quality x Quantity.

Is your business engineered to create wealth? Part 3: Capital allocation

Most CEOs would prefer to create more wealth for shareholders than less.

But most companies are not ‘engineered’ to create wealth – internal processes often act to hinder wealth creation, rather than encourage it.

In this article we look at how capital allocation processes can fail shareholders and some simple steps that can be taken to drive greater accountability into investment decisions.

The big capital spends, be they investments in new markets, new products or acquisitions, often represent the signature, transforming achievements of a CEO. And for shareholders, they often have a transforming impact on wealth.

So when faced with these opportunities, CEOs need clear, reliable tools to assess investment opportunities. Unfortunately, the tools that they are most likely to use are anything but.

If wealth creation is the goal of the business, then for any investment evaluation tool to be of use it must address the quality and quantity issues we saw in part one of this series as the key determinants of wealth creation.

This rules out using EBITDA and EPS growth, which both fail to capture the funds invested in a business and say nothing of the quality of the business. Sophisticated investors know this and mark down businesses that trumpet EPS accretion, if the investment fails to deliver reasonable returns on capital invested.

Other, more sophisticated tools, like Internal Rate of Return (IRR) and Discounted Cash Flow (DCF) address the draw backs of EBITDA and EPS by forecasting all the capital required for an investment and all the cash that will be generated by it and boiling them down to a single number; a percentage in the case of Internal Rate of Return (IRR) which can then be compared with the company’s hurdle rate, and a dollar figure in the case of Discounted Cash Flow (DCF), showing how much wealth will be created from the investment.

But while IRR and DCF can be used to accurately calculate the wealth impact of an investment decision, they are only ever as useful as the forecasts used and this is where IRR and DCF analysis fall down.

The best users of DCF look to key drivers, such as margins, volumes and inventory turns to assess the reasonableness of forecasts. If the acquisition requires industry best results across all key drivers to create wealth it’s time to negotiate a better price, or walk away.

But one key reasonableness test every CEO should ask is, ‘What is the forecast ROCE of this investment, in each year of the forecast period?’ If ROCE forecasts are beyond reasonable upper limits then warning bells should sound.

As the chart below shows, drawing on our research into returns achieved by Australia’s largest companies and summarised in the table in part one of this series, only the top 25% of companies are able to sustain returns 5% or more in excess of the cost of capital over any given five year period. This analysis probably understates how rare high returns on capital are in the broader economy, given businesses that have failed or who are yet to be consistently profitable are excluded from our research.

Figure 1: Returns significantly above the cost of capital are rare

Returns above the cost of capital are rare

 

In my experience, when DCF analysis is recut to include ROCE and Economic Profit data on an annual basis it often forecasts ROCE starting low and gradually growing larger and larger, past the 75th percentile and eventually into the top decile of what companies have historically been able to achieve.

Few companies are able to generate let alone sustain these returns, due to the competitive forces they face. If one player in a market is able to invest and generate such attractive returns, others will follow and unless the investment is made behind, as Buffett would call it, a deep ‘moat’ of a hard to copy competitive advantage, returns will begin to fall, not rise, as time goes on.

Given 75% of companies fail to make returns more than 5% above the cost of capital, the default assumption for DCF analysis should be that returns will revert to the cost of capital over time, in the absence of a very clear and proven set of competitive advantages that will keep competitors, suppliers and even governments at bay.

Equipped with the forecast annual EP Spread of the investment and a thorough knowledge of the competitive forces of the industry in which the business operates, a CEO is in a much stronger position to make career defining capital investment decisions.

The second and important step in this phase is to close the accountability loop for investment decisions. And that comes back to the performance measure chosen by the CEO. EBITDA and similar measures ignore the capital invested in a business and send a signal to all managers that capital is free.

Economic Profit by contrast, constantly reminds managers of the funds invested in their business and the need to generate sufficient returns. By holding managers accountable for sustained gains in EP, the rigour of investment proposals increases: managers know while putting together their forecasts that unless the investment generates and sustains high returns, the Economic Profitability of their business will fall.

As one client put it, ‘EP is like DCF with a memory’.

Is your business engineered to create wealth? Part 2: Performance measures

Most CEOs would prefer to create more wealth for shareholders than less.

But most companies are not ‘engineered’ to create wealth – internal processes often act to hinder wealth creation, rather than encourage it.

In this article we look at one of the most pervasive barriers to wealth creation: performance measures.

As we’ve seen in part 1 of this series, wealth is created when funds are invested at high rates of return and destroyed when funds are invested at low rates of return. But incredibly, the most popular financial performance measures in use today such as Earnings Before Interest Tax Depreciation and Amortisation (EBITDA) and Earnings Per Share (EPS) are silent on the rate of return, or quality of the business. And what’s worse, they actually encourage managers to destroy wealth by investing the money entrusted to them at low rates of return.

Consider a manager faced with an opportunity to add a new customer. If the business
goes ahead with the terms proposed by the customer, the impact on the Group’s financials
will be as follows.

Figure 1: Growing profits, destroying wealth

Growing profits destroying wealth

 

Any of the most popular performance measures, such as sales, margins, EBITDA and even ROCE improve if the manager takes this deal. But in doing so, they encourage him to invest the capital entrusted to the business at 8.2%, less than the 10% that investors could get elsewhere at equivalent risk – that is, these measures will encourage the manager to destroy wealth.

Indeed a manager can grow EBITDA or EPS, two of the most popular measures of performance in use today, by investing funds for a return as little as 1%.

As a consequence, all the creativity and hard work of a management team can unwittingly lead to wealth destruction if the compass that they use to guide decisions is a simple but misleading one, such as EBITDA.

Using EBITDA or any other measure that fails to capture quality and quantity of the business keeps the truth of the performance of the business back from managers and acts as an enormous barrier to the creation of wealth.

CEOs can remove this barrier by replacing EBITDA or similar measures with sustained gains in Economic Profit. Economic Profit is the only measure that captures both the quality of the business and the quantity of funds invested in it.

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

Economic Profit formula

 

Because EP goes down when funds are invested at low rates of return and up when they are invested at high rates of return, it guides managers, through all their efforts during a year, to create wealth, rather than destroy it. And it can be measured right down through the business, sharing responsibility for wealth creation throughout the management ranks.

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.

______________________________________

[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.

Is your business engineered to create wealth?

Most CEOs would prefer to create more wealth for shareholders than less. After all, in our society, we create different institutions for different needs: governments to create and enforce laws, charities for good causes and businesses as places to store and grow our wealth.
The job of business is to create wealth.

But most companies also face barriers to that goal. Even if you are able to create a great product or service that will improve the lives of customers, competitors will do all in their power to steal those customers, suppliers will squeeze higher prices for their inputs if they can and even governments will sometimes impose special taxes on businesses deemed to be too profitable.

To take on these challenges, every CEO must ask themselves, ‘Is my business engineered
to created wealth?’

In the five articles that follow, we’ll examine the most common internal barriers that businesses
face in trying to create wealth and how CEOs can remove them and in the process,
engineer their business to create wealth.

Figure 1: Barriers to wealth creation

barrier_large

In the first article, we’ll look at research into why some businesses create wealth, while others destroy it.

The second article looks at the impact internal measures of performance can have on decision making and wealth creation.

The third article addresses capital allocation and what can be done to close the accountability loop for investment decisions.

The fourth article looks at budgeting and planning, calling for a greater focus on how the business will create wealth and less on governance and accountability.

Finally, the fifth article addresses incentive structures, outlining some of the most damaging aspects of the more popular plans before outlining a different approach that is engineered for wealth creation.