What Makes a “Good” Company? Revisited – Lessons for All

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SEE LAST PAGE OF THIS REPORT Graham Copley / Anthony Salzillo

FOR IMPORTANT DISCLOSURES 203.901.1629/203.901.1627

gcopley@/asalzillo@ssrllc.com

November 21st, 2018

What Makes a “Good” Company? Revisited – Lessons for All

  • We update the work done a year ago on what makes a company good. At that time, we were focused on GE, aiming to create a blueprint of behaviors that drove good investment returns.
    • Poor companies make capital deployment errors driving down returns and increasing write downs. Better companies make better allocation decisions and better deals.
    • Better capital allocations drive better returns and better cash flow. Dividend growth is a hallmark of good companies but is a consequence of being good not a determinant.
  • The important word with respect to capital is “appropriate”; no strategies should be the same and the key difference between good and bad appears to be corporate “self-awareness”
    • Capital is only allocated appropriately by those who truly understand their competitive strengths and weaknesses: Technology Edge; Production Cost Edge; Brand Edge; etc.
    • Companies that over-estimate the above invest with the wrong assumptions and generally sit in the lagging group in the analysis below.
  • We highlight GE and DWDP as companies trying to change – we would buy DWDP today. PX had been a champion in the past and we believe that LIN can be again.

Exhibit 1

Source: Capital IQ and SSR Analysis

Explaining Exhibit 1:

  • The blue group are the good companies (overweight) – the orange group the “bad” (underweight).
  • Good companies are those with more than 17 years of EBITDA growth in the last 20 or more than 14 years of outperformance – or both. The “bad” group have less than 11 years of EBITDA growth or less than 9 years of outperformance or both. Using this definition, the “bad” group is slightly larger than the good group.
  • The discount from normal value is a measure of relative value where we have long term consistent data. We have indicated where we have included companies for which we do not have useful “normal” models – usually because of limited or inconsistent history.

Overview

When meeting a prospective Institutional or Hedge Fund Client for the first time, we always ask what matters to them when working through their stock selection process. Generally, the answer is specific to the investment criteria of the fund, but invariably the subject of company/management quality comes up. This prompts the obvious second question “how you measure or define a good company or good management?” At this point the discussion becomes a mixture of the objective and the subjective; focusing on capital allocation, return hurdles, style and credibility.

So, what makes a good company in the eyes of investors?

A good company to invest in with a 6-month horizon may not be a good company for the longer term – there is a price of everything! What we are discussing in this report – as we did last year – is what are the characteristics of a successful company for the long-term.

The conclusion is that business “self-awareness” is critical.

Appropriate capital allocation decisions define the better companies; but for that to happen companies must know themselves and not pretend or hope that they are something they are not. Most companies think they are allocating capital appropriately and where it goes wrong is where the assumptions are wrong:

  • What are our REAL competitive strengths – things that allow us to drive pricing and margins?
    • How sustainable are they?
  • What are our customers and competitors doing that could disrupt our business?
    • How do we plan for and protect against?
  • Are we cost competitive – how do we stay ahead?
  • How wide is our technology moat – how do we keep it wide?

Whenever we are working for a corporate on a strategy related project our first question is always to ask the company to list what they are best in class at. Where are they number 1? How do they know that? How do they measure it? And what is it worth? It is staggering how many companies cannot answer some of these questions – especially the last one. Often the answers are based on opinion rather than data – if you can’t measure something, you can’t correct or improve it!

GE is turning out to be the most interesting case here: guilty of everything that defines a poor company for the last 10-15 years; saying all the right things for 18 months, yet still failing. In our view the issue remains “self-awareness” – GE can only develop appropriate strategies for its businesses if it correctly answers and understands the issues listed above. In a couple of recent pieces, we have questioned why the company does not yet appear to know what it is – concluding that this is a bad thing; and questioning whether perhaps the company does know the extent of its problems but is reluctant to disclose them – which would be worse.

Anecdotally, the Now Dow management team said all the right things with respect to appropriate use of capital in its recent analyst meeting and if it can stick with the strategy at some point the stock could be interesting – hard to make a call today as we do not know the technicalities of the spin and consequently the implied value – but we would buy DWDP. Separately, BASF stated this week that it has as new corporate objective of growing the dividend every year. The company will need to be a very good steward of capital through the cycle to achieve this consistently, but if successful the stock looks very attractively valued today.

In short, this analysis causes us to look positively on the companies with the best track record and negatively on those with the worst, but there must be a valuation overlay as there is a price for everything – a price to sell a great company and a price to buy a bad one. In Exhibit 2 we plot valuation for our better companies and for the worst – in the better group we would be most interested in KSU and Air Liquide, and while we would be concerned about DHR, it is interesting to see Mr. Culp’s old company at one end of the scale in this analysis and his new one at the other end. In the worst group FUL, EMN, IP and OI look cheap enough to buy and there is a small group of very overpriced “bad” names – ASH, HSC, BRC and AIN.

Exhibit 2

Source: Capital IQ and SSR Analysis

In Exhibit 3 we look at a return on tangible capital measure for each of the two sub-groups – the “bad” guys generally have low returns.

Exhibit 3

Source: Capital IQ and SSR Analysis

So, What Does All This Tell Us? And How Do We Identify The Next Opportunity

In the sections below, we outline the methodology behind the analysis in detail, but quickly conclude that Corporate optimism and, to a lesser extent, Complexity are the major culprits.

In all our work on Optimism we have concluded that companies with poor self-awareness (leading to inappropriate capital allocation) only change direction with regime change. Whether that is a CEO turnover, the arrival of an activist – a hostile take-over bid – something that causes a corporate “slap in the face”. Overly confident CEO’s often don’t want to listen to any outside advise or only want to listen to outside advice that agrees with them rather than advice that challenges and makes them question either elements of strategy or the whole plan. Today we would put PPG in this category – the result has been a step up in optimism, although capital allocation has been fine – in part because the company cannot find anything to buy. We expect the activist o have an impact here and would own the stock on that basis.

It comes down to whether a CEO is open minded, willing to listen, and recognizes that he or she cannot know everything and that only seeking internal input leads to potentially dangerous group-think.

  1. John Flannery talked a very good game at GE but did not deliver – Larry Culp is more cautiously optimistic but has not really said much yet. If he is as self-aware as he sounds, GE could be as interesting once all the closets are emptied, as Tyco was when Ed Breen took over. We are not ready to buy this yet
  1. Which leads into DWDP. Two companies, previously chronically guilty of Optimism and very Complex which have turned themselves around dramatically over the three years since the merger was announced. The macro is hurting this story today, but the new strategies seem sound. We would buy DWDP today
  1. PX management has the strongest track record for focused cost control and capital allocation and would have been top of the blue list had we stopped the analysis in 2011 (the slower global economy had a magnified impact on the industrial gas industry). The PX/Linde merger is another story that has the right trajectory to us – not complicated and likely to be conservatively managed. We would buy new LIN today – remains our top pick.

While GE remains a risk – these are the types of stories/strategies that should work.

Methodology/Data Set

We analyzed 117 Industrials & Materials companies with 20 years of publicly traded history – 110 US, 7 European – with all market cap ranges considered. When we sum the number of years of EBITDA growth each company has seen over that 20-year period we get the approximate bell curve in Exhibit 4 and have chosen to define a first quartile as the 13 companies with at least 17 years of EBITDA growth. Those companies are listed in Exhibit 5.

Separately, we have done the same analysis for years of outperformance vs the S&P 500. We have taken the S&P 500 as a proxy for the European markets for the non-US stocks, which is clearly a simplification. We get the same shaped bell curve – Exhibit 6, but a different set of companies – Exhibit 7 – with the companies and the overlaps summarized for both sets of analysis in Exhibit 8.

Exhibit 4

 Source: Capital IQ and SSR Analysis

Exhibit 5

Source: Capital IQ

Exhibit 6

Source: Capital IQ and SSR Analysis

Exhibit 7

Source: Capital IQ and SSR Analysis

Exhibit 8

 Source: Capital IQ and SSR Analysis

If we do the analysis for an approximation to bottom quintiles (we are using a “number of years” to define our groups and consequently the group sizes are not the same) in the same way, we come up with the company lists and overlap shown in Exhibit 9, and when we index the two overlap group’s performance over the last 20 years we get the relative performance/return profile in Exhibit 10. Clearly you want to be in the better group! Note that the better group is not biased towards any specific sector and contains some large and smaller cap names – there is no overwhelming sector or size bias. We show the second line for the better overlap group as there are two outliers that started with low share prices and somewhat overwhelm the analysis. Without the outliers, the performance gap remains staggeringly large.

Exhibit 9

Source: Capital IQ and SSR Analysis

Exhibit 10

Source: Capital IQ and SSR Analysis

So, what do they have in common?

It’s Inversely Correlated To Acquisition Spend!

This is a clear example of poor capital allocation from the lagging group of companies. It is likely that the group fails to meet growth goals because of overly optimistic assumptions – see below – and consequently ends up either making more acquisitions or higher valued acquisition in an attempt to fill a growth shortfall – GE, DOW and DuPont were all guilty of this in the past. Had we shown the analysis and used 2014 as an end year, both old Dow and old DuPont would have been on the bad list.

GE bought Alstom’s power business among other things – Dow overpaid for Rohm and Haas and DuPont overpaid for Danisco.

Exhibit 11

Source: Capital IQ and SSR Analysis

Some R&D correlation for outperformers – No CapEx Correlation

Exhibit 12

Source: Capital IQ and SSR Analysis

Exhibit 13

Source: Capital IQ and SSR Analysis

Optimism IS The Key – Driving Overall Capital Allocation – And Complexity Matters

Optimism is, as expected given all our prior work, inversely correlated with success and is shown clearly in Exhibit 14. We define optimism as consistent over-estimation of performance by management, using January 1st sell side estimates for any company as a proxy for corporate guidance and therefore expectations. We have a large body of work on this subject, but, in summary, optimists are almost always poor capital allocators because they overestimate the expected returns on most investments – most have declining trends to return on capital and most underperform. Link to our last piece.

In Exhibit 15 we show the results for business complexity. The correlation is not as pronounced as it is for Optimism, but it is there. More complex companies are harder to manage when it comes to appropriate capital allocation. Hard to get an accurate assessment of businesses when you have too many. The complexity correlation was stronger with the data set we used last year – with data through 2016. In the piece last year, we had a slightly larger group of “good” companies as a result of how many companies fell in each year in Exhibits 4 and 6.

Exhibit 14

Source: Capital IQ and SSR Analysis

Exhibit 15

Source: Capital IQ and SSR Analysis

Yields on the Better Companies Not Necessarily Higher But Payouts Grow More

The lower yield is not unexpected as the better companies perform better and have higher multiples so yields decline as the TSR is coming from share appreciation. It is also not surprising that the better group has better dividend growth – they are the better capital allocators and have the free cash to increase payouts.

As indicated earlier we believe that dividend growth is a consequence of being better – not a cause.

Exhibit 16

Source: Capital IQ and SSR Analysis

Exhibit 17