Earlier this week, we published a blog about the rising concentration of profits in India amongst a handful of companies – the 20 most profitable firms in India now generate 70% of the country’s profits, up from 14% thirty years ago. In response, one of our readers shared this piece from Mckinsey which shows similar findings from a study of the world’s 2,393 largest companies.
“At its heart, business strategy is about beating the market—in other words, defying the power of “perfect” markets to push economic surplus back to zero. Economic profit (the total profit after the cost of capital is subtracted) measures the success of that defiance by showing what is left on the table after the forces of competition have played out. Our study found that from 2010 to 2014, the average company made $180 million a year in economic profit. Plotting those averages demonstrates a power law—the tails of the curve rise and fall at exponential rates, with long flatlands in the middle….You see a big gap between the middle and the top—the average economic profit on the top quintile is 30 times greater!”
The blog resonates well with Marcellus’ investment philosophy about why economic profit (the excess returns over cost of capital) matters as perhaps the ultimate measure of value creation for the firm and why competitive forces are always at work to erode this. Therefore, assessing a firm’s competitive advantage and sustainability of the same and hence sustainability of these excess returns is the central focus at Marcellus.
“Market forces are pretty efficient. The average company generates returns that exceed the cost of capital by almost 2 percentage points, but the market is chipping away at those profits all the time. That brutal competition is why you must struggle just to stay in place. For companies in the middle of the Power Curve, the market takes a heavy toll. In those flat lands, all the hard work amounts to little more than the ability to pay the rent.
The curve is extremely steep at the bookends. Companies in the top quintile capture nearly 90% of the economic profit created, averaging $1.4 billion annually. This is a hall of fame for business, with the top 40 including household names such as Microsoft, China Mobile, Merck and Exxon. In fact, those in the top quintile average some 30 times as much economic profit as those in the middle three quintiles, while the bottom 20% suffer deep economic losses. In smartphones, for example, the top two companies—Apple and Samsung in the period we studied—earned virtually all the economic profit while the other mobile phone makers in aggregate actually destroyed value.”
The blog brings out the other aspect that alongside excess returns over cost of capital, if these excess returns can be reinvested back into the capital employed, absolute levels of economic profit grows.
“Size isn’t everything, but it isn’t nothing, either. Economic profit reflects the strength of a strategy based not only on the power of its economic formula but also on how scalable that formula is. Compare Wal-Mart, with a moderate 12% return on capital but a whopping $136 billion of invested capital, with Starbucks, which has a huge 50% return on capital but is limited by being in a much less scalable category, deploying only $2.6 billion of invested capital. They both generated enormous value, but the difference in economic profit is substantial: $5.3 billion for Wal-Mart versus $1.1 billion for Starbucks.”
The study shows that certain industries simply don’t lend themselves to building moats with the industry making economic losses on an average.
“Industry matters, a lot. Our analysis shows that about 50% of your positioning on the Power Curve is driven by your industry—highlighting just how critical the “where to play” choice is in strategy. Industry performance also follows a Power Curve, with the same hanging tail and high leading peak…There are 12 tobacco companies in our research, and nine are in the top quintile. Yet there are 20 paper companies, and none is in the top quintile. The role of industry in a company’s position on the Power Curve is so substantial that you’d rather be an average company in a great industry than a great company in an average industry. In some cases, you’d rather be in your supplier’s industry than in your own. For example, the average economic profit of airlines is a loss of $99 million, while suppliers in the aerospace and defense category average a profit of $453 million.”
The blog also shows why investing in mediocre companies expecting them to become better have such poor odds.
“Mobility is elusive. We found that the odds of a company moving from the middle quintiles of the Power Curve to the top quintile over a 10-year period are 8%. Consider that number for a moment: it means fewer than 1 in 10 companies make such a leap. To give yourself the best chance, you must choose the right businesses in your portfolio to back. Their chances of showing real improvement are also 1 in 10.”
If you want to read our other published material, please visit https://marcellus.in/blog/
Note: the above material is neither investment research, nor financial advice. Marcellus does not seek payment for or business from this publication in any shape or form. Marcellus Investment Managers is regulated by the Securities and Exchange Board of India as a provider of Portfolio Management Services. Marcellus Investment Managers is also regulated in the United States as an Investment Advisor.
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