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.