** This article originally appeared in the Spring 2012 edition of Collective Insight which is published with Finweek magazine. To subscribe to Finweek please click here or visit Zinio.com and download in either English or Afrikaans.
By Adrian Saville and Andrew Newell
Adrian is an executive director and Chief Investment Officer of Cannon Asset Managers. He has experience in managing all of the major asset classes, including equities, bonds, property, cash and derivative instruments. Alongside his career in asset management, Adrian holds a Visiting Professorship in Economics and Finance at the Gordon Institute of Business Science.
Successful investing is the pursuit of an attractive investment return with a level of risk that the investor deems appropriate. It can also be said that, through time, the value of an investment will be guided by its ability to generate earnings or profits for the owner.
After the heydays of the early Noughties and the subsequent doom and gloom that has permeated the world, the question is asked as to where investors can find earnings growth, and how to capture it in the form of successful investing. These are two distinct questions, which are discussed below.
Identifying companies that are able to consistently grow earnings is no easy task.
On the contrary, it is extremely difficult. A company’s ability to grow is not determined by its size, ownership structure, primary market, level of concentration or diversification, industry or age. Also, investors are looking in the wrong place if they scan the landscape for evidence of the fastest-growing economies or regions.
Recent years have been witness to large sums of capital being allocated to the likes of China and India, the flag bearers for global growth, with many other emerging or dynamic economies also having received investor capital searching for growth. This is shown to be a futile approach: over the past three years, the S&P Index in the seemingly listless US economy has, in fact, generated a return for investors of 40%, and Shanghai’s equity index has shed almost 30% over the same period. This is at odds with the expectations of most investors.
Harvard Business Review (2012) published a study by Rita McGrath of Columbia University which shows us that of 4793 companies, each with a market value in excess of $1bn, only 8% were able to grow real earnings faster than world GDP without interruption between 2005 and 2009.
Admittedly, this was during a period of economic stress, but even between 2000 and 2005, when times were easier, that number is only 15%. Considering the full 10-year period 2000 to 2009, McGrath’s evidence is even more striking: just 10 firms in her 5000-firm sample achieved uninterrupted real earnings growth ahead of world GDP. Arguably, an even more intriguing result is the firms that make up this exclusive set of 10 which includes search firm Yahoo (Japan), Spanish construction operation ACS, Chinese brewer Tsingtao and Atmos Energy, a US-based gas business.
Against the backdrop of this result, which challenges many widely-held beliefs in investment finance about the sources of growth and the ease of sustainability, we extended McGrath’s research to include South Africa over the 10-year period to end-2011 to assess the application of her findings to our market. Notably, we too have a low success rate; just three firms have generated real earnings growth that also is ahead of South Africa’s GDP growth over this time.
They are Clientèle Life, Truworths and Mr Price. We are able to double the number to six companies when nine of the last 10 years are considered. WBHO, Bowler Metcalf and Famous Brands are then included. In contrast to McGrath’s research though, it is worth noting that the three South African firms identified above were relatively small at the start of the period. Thus, size may be a factor in the South African landscape that cor-relates with sustained profitability.
As noted, the commonalities across these successful firms, at home and abroad, are not the “usual suspects” of age, industry, size, diversification, ownership structure or whether market exposure is cyclical or defensive. In line with McGrath’s study, attributes that are consistent with sustained growth include agility and stability. More finely, agility refers to a business’s willingness to adapt and innovate quickly; to have a large number of small bets to build a diversified business portfolio; to make small and easily digestible acquisitions; and to support this with processes that allow for speed and flexibility. Stability, however, talks to a company’s strong central controls; a focus on shared values; retention of talent; steady leadership; and avoiding dramatic change in high-level strategy and sudden wide diversification.
Reflecting the global result, the South African firms that have been successful in sustaining growth provide evidence of agility and stability. Considering agility, they are quick decision-makers and innovators and strategically they fire a number of bullets, not cannon balls, to paraphrase Jim Collins. Acquisitions are in compar-able businesses and are not large in size. Mistakes are low cost and quickly recognised. Stability is evidenced by strong central controls and consistency of strategy.
Turning our attention from firms that have demonstrated an ability to generate earnings growth to building successful investment portfolios, different considerations must be recognised. If only three firms have grown earnings ahead of GDP growth over the last 10 years, obviously this is not a wide enough universe from which to build a diversified portfolio, assuming that one were able to identify these companies 10 years ago in the first place. Rather, investors need to couple their assessment of potential earnings growth with the price paid for those investments. If so few companies achieve this growth result, it follows then that the majority of firms must produce average growth in real earnings that is below GDP growth. In turn, this growth result ultimately will be reflected in the price of the underlying investment. This is not to suggest that most companies are of poor quality. The economic and business cycle is exactly that, a cycle, and consequently earnings growth is vulnerable to impacts such as economic cycles.
Research conducted by James Montier (2006) and more recently updated by our research team (2011), shows that the biggest explainer of investment returns is not just the earnings that companies generate, but the price applied to those earnings. Put simply, chasing elusive earnings growth is an unrewarding investment strategy.
Diagram 1 illustrates this well. Global equities have been divided into five baskets ranging from the lowest PE shares in Quintile 1 to the highest PE shares in Quintile 5. This highest grouping in Quintile 5 is explained by investors that expect strong earnings results from the constituent stocks and, accordingly, have pushed up the prices of the underlying investments. From our earlier arguments, we know that most companies are unable to sustain high rates of growth, which is evidenced by the red column. The blue column, which shows price performance relative to market, is therefore unsurprising as investors are disappointed by the result. Perversely, the cyclical nature of most companies’ earnings benefits investors in Quintile 1 as the improving earnings cause the constituent shares’ prices to be pushed higher.
This does not offer comment on the quality of the underlying firms, but rather suggests that successful investing is not about chasing growth. Instead, investors who pay the correct price for earnings enjoy better-than-market investment results. Certainly, the below data illustrate the aggregate result and do not show those companies that have been successful in consistently growing earnings and, indeed, those companies that go out of business also are not highlighted. However, as a whole, if most companies experience earnings volatility, it is important to recognise this in the context of the price paid to buy those earnings. Put differently, volatility in earnings is not an obstacle in itself. Instead, expecting stable or smooth earnings delivery is likely to lead to investor disappointment. The three companies identified above offer evidence of agility and stability and have generated healthy investment returns, all ahead of the aggregate market. In sympathy with investors being poor forecasters of growth, these three companies have traded on low earnings multiples too, suggesting that they were not the expected investment superstars of the future.
For decades, countries and whole economies have experienced conditions that have migrated from expansionary and upbeat to sluggish and depressed. In all environments, however, many investors will have attempted to figure out which companies have the best earnings prospects and will have invested accordingly. The evidence suggests that companies which generate sustainable growth in earnings are not those that are often touted as being superior by investment analysts. Rather, they are a set of firms that have a clear set of characteristics. Critically, only by paying an appropriate price for these earnings will investors be rewarded in the long term.