What do Mr Price, EOH, Wilson Bayly Holmes-Ovcon, Truworths, Famous Brands and Clientele Life have in common? They are the ‘exceptional exceptions’ that have managed to sustain and grow earnings between 1997 and 2013.
Their global counterparts, with a market cap of + $1 billion, are an equally eclectic group and include Yahoo Japan, India’s HDFC Bank, Spanish construction company ACS and Chinese brewer Tsingtao.
The reason these companies are ‘exceptional exceptions’ is that they have consistently managed to grow earnings ahead of nominal GDP – regardless of the economic cycle, says Adrian Saville of Cannon Asset Managers.
Saville has been touring the country, giving a presentation entitled Recession Proofing: understanding, harnessing and managing change, courtesy of Standard Bank. His presentation is based on research that examines the biggest drivers of corporate profits.
There should be no surprise in the news that across 25 countries surveyed, the economy has the biggest impact on corporate profits.
Context matters: world growth and company earnings:
Source: Adrian Saville
Of the 25 countries that were surveyed, the correlation between GDP growth and growth in real corporate earnings was strongest in France, with a correlation of 0.81. The US is midstream with 0.64 and in India, whose economy is less formal, the correlation is 0.42.
Regardless of the degree of variation, the results were a surprise. “More than industry, strategy, diversification, geography or globalisation, the evidence suggests that GDP growth has a bigger impact on company performance than anything else,” says Saville.
The same is true of South Africa. In 2013 when South Africa recorded barely any economic growth after inflation, just 50% of the top 220 companies listed on the JSE recorded real growth. South Africa’s correlation, like India’s, is lower than the global average, suggesting that South African companies are not as dependent on the local economy as, for example, their French counterparts.
If one assumes the economy matters, is this the case for all businesses?
Not so. One just has to look at South West Airlines, which has made a profit every year since its formation in the 1960s; yet it operates in an industry that hasn’t made a profit over its operating history.
“Is this just a once off idiosyncrasy, or are there businesses that can achieve velocity?” asks Saville.
In answering this he cites the research of Rita Gunther McGrath, an associate professor of management at the Columbia Business School who examined the top line and bottom line growth of 4793 companies with a market cap of over $1billion.
Between the years of 2000 and 2004, 15% of these companies grew their topline, each year without interruption, ahead of global GDP, while 7% grew their bottom line ahead of this, each year without interruption. When one looks at the more difficult economic period between 2005 and 2009, 8% of companies managed to achieve uninterrupted topline growth and 4% managed uninterrupted bottom line growth ahead of real GDP.
When you take the full period, 2000 to 2009, just ten companies were able to achieve uninterrupted topline and bottom line growth ahead of inflation and ahead of economic growth (nominal GDP). Aside from those mentioned above, they include US financial data company Factset, natural gas distributor Atmos Energy, Indian IT company Infosys, Slovenian generics player KRKA and Indra, Spanish technology company.
“Ten companies is a remarkably low number,” says Saville, “and runs counter to what executives say, to what is reported in board-packs, or budgets or pre-listing statements and is often contrary to investor expectations. The business of thriving, it seems, is a minority sport.”
The remarkable thing about these ten businesses is that their success has nothing to do with size, strategy, diversification or economic growth.
“Yahoo Japan has continued to grow in a horrible economy that has moved sideways for ten years; Spain has seen a boom and bust in the last decade; Infosys is a global business while Tsingtau is Chinese. There is no obvious correlation between these companies.”
The same research, using similar criteria produced an equally eclectic group of companies in South Africa. None of the usual suspects rank at the top of the list of companies that have produced sustained growth.
Evidene of exceptional exceptions in SA
Source: Adrian Saville
The common ingredients among all the firms are agility and absorption, Saville says.
Agility refers to operational, portfolio and strategic agility.
Operational agility is the capacity to seize opportunities to improve operations and processes within a focused model. “South West Airlines flies only Boeing 737s and the entire company is geared to keeping these planes in the air,” he says. “Average turnaround time is 40 minutes, compared to the industry average of 80 minutes – in the most unionized business in the industry.” Zara is another case in point.
Companies like Imperial, Bidvest, Barloworld locally, and GE, Proctor & Gamble and J&J globally display evidence of portfolio agility. “They can pick up and drop businesses and never take huge bets to reinvent themselves – acquisitions are usually less than 5% of market cap.”
Strategic agility is reflected in companies like Naspers and Apple where the leadership has the ability to take a vision and jump on company-changing opportunities. Mistakes, such as the expansion of Starbucks, are corrected equally quickly. Locally Clientele Life expanded into Nigeria where it had success in selling insurance policies, but failed when it came to collecting the premiums. “It wrote off the R17.5 million investment and returned home,” says Saville. “In comparison Telkom’s failed Multi-Links transaction in Nigeria cost it R7 billion. This shows little evidence of strategic ability.”
Absorption is the strength to withstand punishment and weather sudden shifts. Tools include diversified cash flows, low fixed costs, cash on the balance sheet, tangible and intangible assets, and locked-in customers.
Balancing agility and absorption is critical. Apple’s iPod is an excellent example of agility, but it was absorption—in the form of a small core of fanatical customers—that kept the company going during the 1990s, when its market share shrank dramatically. Those customers kept Apple alive until changes in context created its next golden opportunity.
Other absorptive skills include taking lots of small bets (Clientelè and Famous Brands) and nurturing the good ideas (bullets not cannons), strong central controls (Mr Price), constantly innovating (and asking what is going wrong), retaining talent (Truworths), stable leadership and good succession, bottom up business intelligence (unlike Sony which told its customers what they wanted), fat balance sheets and good organic growth.
The result, says Saville, is an elevated margin, ROE greater than the industry, a premium valuation and sustainable growth.
The challenge in South Africa is that when questioned on their agility and absorbtive capacity, a majority of executives believe they are in the top right hand quadrant, ie that they excelled in both areas. “That is mathematically impossible,” says Saville. Notably, whist this overconfidence is not unique to South Africa, “it is worth reflecting on how we tend to over estimate our agility and absorbtion.”
While the JSE-listed companies in the top right hand quadrant have been named, Saville is less inclined to name those likely to underperform. “There is a construction, IT firm, business services, chemical and platinum firm on the list. And African Bank … I can tell you that now.”
The research, says Saville, looks at the South African economy relative to corporate profitability over time, and doesn’t make a comment on stock market performance.
“The market is abnormally priced at the moment. Investors are looking past the economy.” But, he adds, there is an inherent logic to this.
One of the biggest drivers of South African economic growth is global economic growth. But South Africa has delinked itself from the global economy as a result of the platinum and metal-workers strikes.
The economy will recouple in time and South Africa will return to structural growth of 3%, which translates to 10% real earnings growth per annum, he says.
In the meantime companies should think hard about improving agility and absorption – and then ensure that ideas translate into action.