Value

1. Value creation is driven by return on invested capital and growth

The faster companies can grow their revenues and deploy more capital at attractive rates of return, the more value they create.

ROIC and growth drive value. Return on invested capital (ROIC) and revenue growth are the twin engines of value creation for companies. High ROIC allows companies to generate more cash flow from their existing capital base. Meanwhile, growth enables companies to invest more capital at attractive returns, compounding value over time.

The relative importance of ROIC vs. growth depends on a company's current performance:

• For high-ROIC companies, accelerating growth creates the most additional value
• For low-ROIC companies, improving returns should be prioritized before pursuing growth

Different types of growth create varying amounts of value:

• New products typically create the most value (1.75-2.00x revenue)
• Expanding existing markets is next most valuable (0.30-0.75x)
• Acquiring businesses tends to create the least value (0-0.20x)

2. Conserving value means focusing on increasing cash flows

Anything that doesn't increase cash flows doesn't create value.

Cash flow is king. The conservation of value principle states that financial engineering and accounting manipulations do not create real value - only increasing cash flows does. Many executives fall into the trap of pursuing actions that boost short-term earnings or EPS without actually improving the underlying economics and cash flows of the business.

Common value-destroying pitfalls to avoid:

• Financial engineering like complex debt structures
• Accounting changes that boost reported earnings
• Acquisitions justified by EPS accretion alone
• Repurchasing shares solely to increase EPS

Instead, executives should focus relentlessly on initiatives that genuinely improve cash flows through higher revenues, margins, capital efficiency, or lower costs. This requires discipline to resist short-term pressures and make decisions based on long-term value creation.

3. The expectations treadmill challenges sustained outperformance

No company can perpetually outperform the stock market's expectations.

Expectations rise with performance. As companies deliver strong results, the market's expectations for future performance rise accordingly. This creates an "expectations treadmill" where companies must continually accelerate performance just to keep up with ever-increasing expectations embedded in their stock price.

The expectations treadmill explains several market phenomena:

• High-performing companies can see stagnant stock prices despite continued strong results
• Turnaround situations often see dramatic stock price gains as expectations are reset higher
• Sustained stock outperformance becomes increasingly difficult over time

To navigate this dynamic, executives should:

• Focus on long-term value creation rather than short-term stock moves
• Understand the expectations embedded in their current stock price
• Avoid setting unrealistic expectations that can't be sustained
• Consider relative performance vs. peers rather than absolute stock returns

4. A company's value depends on who owns and manages it

Different owners will generate different cash flows for a given business based on their unique abilities to add value.

The best owner maximizes value. A business has no single inherent value - its value depends on who owns and operates it. The "best owner" of a business is whoever can generate the highest cash flows from it over time. This principle has important implications for corporate strategy and M&A.

Ways owners can add unique value:

• Synergies with other businesses in their portfolio
• Superior operational or functional capabilities
• Better insight into industry trends and opportunities
• Improved governance and incentive structures
• Distinctive relationships with key stakeholders

The best owner for a business changes over time as industries evolve. Executives should:

• Regularly assess whether they remain the best owner of their various business units
• Divest businesses where another owner could create more value
• Acquire businesses where they have a unique ability to improve performance

5. Understanding investor types helps navigate the stock market

The market isn't a monolith, and the interaction of investors creates volatility that isn't necessarily driven by new information.

Different investors drive different behaviors. The stock market comprises diverse investor types with varying strategies, time horizons, and decision-making processes. Understanding this landscape helps executives interpret market movements and focus on the investors who matter most.

Key investor types:

• Intrinsic investors: Focus on long-term fundamental value (20% of assets, 10% of volume)
• Traders: Seek short-term price movements (35% of assets, high volume)
• Mechanical investors: Follow strict formulaic approaches (e.g. indexers)
• Closet indexers: Closely track market indexes despite claiming active management

Intrinsic investors ultimately drive long-term valuation levels, while traders create short-term volatility. Executives should prioritize communication with intrinsic investors who have the greatest impact on sustainable value creation.

6. Stock market performance aligns with real economic factors

Once we factor in the effect of inflation and interest rates, this performance will make sense.

Economic fundamentals drive markets. While short-term stock movements can seem random, long-term market performance aligns closely with real economic factors like GDP growth, corporate profits, inflation, and interest rates. Understanding these relationships helps put market movements in context.

Key drivers of stock market returns:

• Corporate profit growth (real growth of ~3-3.5% annually)
• Dividend/buyback yields (~3-3.5% annually)
• Changes in valuation multiples (driven by interest rates/inflation)

Over the very long term, real stock returns have averaged 6.5-7% annually, closely matching the sum of profit growth and dividend yields. Shorter-term deviations from this trend are often explained by changes in interest rates and inflation impacting valuation multiples.

7. Long-term stock returns reflect fundamental business performance

Adjusted for inflation, large U.S. equities have earned returns to shareholders of about 6.5 to 7 percent annually.

Fundamentals win in the long run. While short-term stock movements can be driven by changing expectations, technical factors, or irrational behavior, long-term returns ultimately reflect the underlying economic performance of businesses. This reinforces the importance of focusing on fundamental value creation.

Components of long-term stock returns:

• Real profit growth: ~3-3.5% annually
• Dividend/buyback yield: ~3-3.5% annually
• Total real return: ~6.5-7% annually

This long-term return is remarkably consistent and can be explained by fundamental economic forces. Significant deviations from this trend are unlikely unless there are radical changes in investor risk preferences or the structure of the economy. Executives should be wary of expectations for sustained returns significantly above this level.

Last updated: September 10, 2024