McKinsey Global Institute published an important research paper on October 25. It depicts large global businesses, business sectors and cities, allocating some companies to superstar status (the top 10%) and some companies to value destroyer status (much of the bottom 50%). Its basic measurement was return on invested capital based on each firm’s imputed cost of capital—that is, assuming that cost of capital, does the firm earn an excess over its cost of capital or does it earn less than its cost of capital? A surprising percentage of firms in the study earned less than their imputed cost of capital.
The study included 5,750 firms, not all of which are publicly owned. It appears to have been truly global in scope.
The biggest lesson that I come away with is that in the 21st century, the biggest business sin is to be dependent on a large amount of fixed plant and equipment. By contrast, the most successful businesses have moats derived from intellectual property and are fabless and fab-lite. That is not a surprising contrast, but seeing it demonstrated makes it more vivid and believable. (German, Chinese, Japanese and Korean auto and parts manufacturers appear to be exceptions to this rule, suggesting perhaps that good management can overcome the difficulties of fixed plant and equipment.) It was a surprise to me, however, to learn that McKinsey’s superstar firms are more active in making acquisitions than firms further down the success scale.
The study also shows that the most successful firms, regardless of where they are headquartered, excel at international sales.
If these analyses are accurate, they tend to explain many things, including the recent relative lack of capital investment (if it destroys value, then why do it), the growing disparity between employee earnings at the most profitable companies and earnings of employees at older types of businesses, and why, perhaps, R&D should be entitled to accounting treatment that is more similar to capital investment. The analyses also suggest that barriers to international trade will make businesses as a whole less efficient and less able to deliver benefits to consumers. That should surprise no one.
The analysis also suggests to me that for long-term investors, the high-R&D companies are better investments than capital-intensive industries. It also suggests that companies that have high R&D expenses should be accorded higher p.e. ratios because the R&D is currently expensed but the earnings benefits are in the future. Indeed, the shift from capital-intensive industries to R&D-intensive industries might suggest that measurements such as CAPE should be modified to account for the difference in implied p.e. ratios. These differences may be difficult to compute accurately, but the trend may be strong enough to give one pause when applying historical data to current markets.
The most successful business sectors
Probably the most important chart in the study is the one below that indicates the business sectors that have progressed the most since 1995. You can see not only that “Internet, media and software” and “pharmaceuticals and medical products” lead the way by a considerable margin, but also that, with the possible exception of “real estate”, all of the growth sectors are fundamentally intellectual. None of them employs many people who do not have advanced degrees, except for the tellers that are employed by banks. And all of those types of business seek to build moats through intellectual property (internet etc. and pharmaceuticals etc.) or branded services that are of great importance to the businesses or people they serve (financial services and professional services). Not surprisingly, the most successful firms are located in the most global cities, whereas the less successful tend to be located in less vibrant cities whose populations are not as highly educated.
But companies are anonymous
I wish the authors had seen fit to tell us what companies were in the superstar category at different times and what companies had fallen from the top decile to the bottom decile over time (as some did, they say). But we are left to guess at such specifics. Some of that guessing should be easy. For example, banks (especially European banks) that may have appeared to be superstars before 2008 may well have destroyed value in succeeding years because they were undercapitalized and under-reserved in their apparently successful years. That is a shortcoming of using reported financial information. Perhaps other companies that fell far also had inflated accounting income that reversed itself when reality set in. That happens, for example, when a company carries a great deal of goodwill on its balance sheet that it eventually has to write off. In reality, the goodwill should have been written off earlier and should have impacted earnings earlier. That is a natural problem with acquisition accounting.
And I wonder how Amazon (AMZN) fits in. It has relatively meager earnings compared with its revenue but is building a great future. I also wonder how much of the changes over the period under study was due to companies that, like Apple (AAPL), existed but developed new products that vaulted them from ordinary to extraordinary. And how much was due to companies like Google (Alphabet) (GOOGL) that invented something essentially new? Both as an investor and as a commentator on public policy, I would love to know more about those things. But I guess McKinsey Global Institute will not tell us—maybe because McKinsey does work for so many of the big companies and would not want to demonstrate to the public that some of those companies are badly managed.
How the study may bear on some current hot-button issues
Does the study tell us anything significant about hot-button issues such as (1) whether business concentration is increasing, (2) whether that increase is detrimental to consumers, or (3) why the labor share of income is declining? Perhaps. The study tells us that there is considerable “churn” (their word) at the top, even as the top firms continue to grow and become more international. The study suggests that the firms at the top benefit from intellectual property. Thus, those top firms are able to maintain prices that a more competitive world would erode. Should patent and similar laws be weakened to allow for more competition? That is an age-old question, but it is one that should be revisited in each new era. And the study suggests that the erosion of labor’s share of income may be due to nothing more nefarious than the success of intellectual effort and its ability to tap international markets and to outsource many tasks that do not require heavy intellectual input.
Even long-term investors have to expect and prepare for change
As a long-term investor, an important takeaway for me is that the nature of successful companies changes fairly rapidly. One should expect that the successful companies twenty years from now will look vary different from today’s most successful companies. If that is true, then “buy and hold” has to have its limits. Thus, even for long-term investors, portfolio reevaluation should be a constant process. We should not look to time the market so much as we should ask ourselves whether each company that we hold is sufficiently forward-looking to remain successful.
In that regard, I think about my own investment in Alphabet. Google’s ad business throws off enormous cash at this time. But that business may not remain as successful for the next ten years. Its returns may be competed away or someone may come up with a better technology that wears away at Google’s ubiquity. But Alphabet is investing in numerous new technologies, some of which probably will bear fruit. The people at Alphabet almost certainly are better at guessing future winners in the technology race than I am. Therefore I am happy to have strong current cashflow being invested in future technologies. It is much like investing in Berkshire Hathaway (BRK.B). I do not know how Warren Buffett’s successors will use the company’s cashflow. But they can do deals on a scale that my pitiful little portfolio cannot even relate to. Thus, although it has to be hard for them to significantly change the composition of their overall portfolio of companies, they should be better positioned than an individual investor like me to foresee how to adjust to change.
Disclosure: I am/we are long GOOG, AAP,L BRK.B.
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.