How To Find Leaders In Sustainable Value Creation

Jan.23.13 | About: Polaris Industries (PII)

As a long term value investor, you know that, over time, market value and intrinsic value converge. A company with a positive performance spread (PS), that is a return on its capital greater than its cost of capital, a necessary condition for market value creation, will see it decreases to zero, if it is not able to embark on a new strategic value increasing trajectory. Another company, with a negative performance spread (PS), that is a return on capital lower than its cost of capital, will see it increases to zero, and eventually becomes positive, if it is able to embark on a new strategic value creation path. This dynamic is called competitive equilibrium, and you don't need to be a financial engineer to take advantage of this natural economic phenomenon and finding Alpha companies. To keep things simple, we will limit our observations to positive PS cases.

First, you need to know that there are positive PS companies in every industry. The idea that some industries are superior is erroneous. The data do not support it. The difference in returns within an industry-any industry-is several times greater than the difference across industries, no matter which ones. To get an idea, in the technology sector where there are 51 global companies with a market valuation of at least $9 billion, the average TSR (total shareholder return) from 2007 to 2011 for the first company of the top ten was 38% and for the tenth, it has been 14.1%. In this group, you have IBM (NYSE:IBM) at the eighth rank that is able, year after year, to generate a PS of around 10%. To take another sector, automotive components (with 45 global companies with a market valuation of at least $1.5 billion); the first produced a TSR of 61.3% and the tenth, 17.3%. The tenth one is BorgWarner (NYSE:BWA) that generates a PS of around 3%.

Second, you also need to recognize that commitment, i.e. the tendency of strategies to persist over time, is the prerequisite to sustained superior performance in most competitive industries. Businesses aspiring to sustainable superior returns must build their product market positions around commitments to some firm-specific resources. Remember that a choice a strategic if it involves significant sunk costs and that commitment is the only general explanation for sustained differences in the performance of organizations. Therefore we should look for companies that make every effort to develop capabilities and strategic assets that are hard to match. Creating such distinctive strategies is a difficult challenge and, only a few companies in any given industry are likely to be successful at implementing and sustaining them. The trend of their PS will indicate how successful they are.

It must be inferred from the above that companies (and leaders) that entertained the idea that they are in a bad industry and that better opportunity lies in wait nearby should be avoided like the plague. Changes in industry investment are negatively related to firm value. Corporate diversification destroys value. You should eliminate for consideration as Alpha potential investments, companies that practice flip-flop strategies and industries. These companies cannot make commitment value enhancing investments and they cannot produce positive PS.

An example of a company that obtains a strong positive PS year after year and that stay focused on its core market is Polaris Industries Inc. (NYSE:PII). This market leader in design, development and distribution of premium technical riding gear for snowmobile, off-road and adventure touring motorcycles have trailed PS of 14%, 4%, 10%, 17% and 24% for the respective trailing twelve months from September 2008 to September 2012. According to Scott Wine, its CEO, Polaris's "success is the result of being extremely focused on our strategic plan and executing against it meticulously". Also, they "found avenues into new markets that concurrently enhanced [their] core business". "We also concentrate on steadily building and refining our infrastructure to ensure we can sustain and improve upon our products and services-for customers, dealers, shareholders and all Polaris stakeholders" (Source: Annual report 2012). And they work with a 10-year strategic plan! What this commitment strategy combined with a positive PS on an up trend give as stock price appreciation over 1 and 3 years: 47%, 323% respectively. Year to date: 7.6%.

Disclosure: I am long IBM. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.