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.

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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.

 

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.