My friends Fred and Howard each penned “Lost Decade” posts that offered valuable perspectives on who the winners of tomorrow might be. Fred points to companies like Google and Apple, two winners of the past 10 years whose futures are likely to be bright. Howard emphasizes the importance of entrepreneurship, yet believes a strong core of under-invested in winners will emerge that will offer historic opportunities for capital appreciation. Both posts are worth a read; please do check them out.
However, there is an important facet of the discussion I’d like to explore more fully: the business dynamics of future winners. This is particularly relevant given the rapid changes in technology and restructuring of the global business landscape through outsourcing, cloud computing and other variable-cost solutions. One thing is for sure: the winners of tomorrow will look quite different than the winners of yesterday. But why?
I’d suggest that Return on Equity (ROE) is a good proxy for financial success. It is a very rich measure that embodies three critical elements of performance: Profitability (Net Margin), Efficiency (Asset Turnover) and Leverage. This decomposition of ROE is commonly called The Dupont Formula:
Net Income x Sales x Assets
ROE = —————- ———- ———- = Margin x Efficiency x Leverage
Sales Assets Equity
Consider the winners of yesterday, the manufacturing and materials companies that long dominated the Dow. In the early and mid-1900s, these businesses had attractive margins, poor efficiency and substantial leverage. This is because the businesses were neither global nor commoditized (so high margins were still available), but were also very asset intensive and, therefore, not very efficient. They did enjoy high leverage, but due to good margins were less risky than their leverage might indicate. As the 1900s came to an end and the 2000s began, these businesses came under significant pressure. Think autos, steel, and a host of other asset-intensive businesses that either became commoditized (e.g., chemicals, steel, bank lending) or were disrupted by cheap substitutes from abroad (e.g., toys, shoes). This had the result of depressing both margins and efficiency, while leverage remained high. In short, a formula for dying businesses and industries. Shrinking margins. Asset intensive. Reliant on leverage to generate even marginally acceptable returns. But with poor operating performance these businesses lack the cushion necessary to deal with sharp turns of the business cycle, as we’ve seen in the recent crisis. Banking is a prime example. ROE was artificially inflated by excessive leverage, masking problems in both margins and efficiency. And when the cycle turned and asset quality deteriorated, many have had life-threatening problems with little hope of extricating themselves through operating performance.
The winners of tomorrow will necessarily look different. Businesses that are not yet commoditized and, therefore, have high margins. Companies that heavily leverage technology and don’t require as much infrastructure as leaders of the prior century. Lower asset levels result in less leverage, making businesses less vulnerable to business cycles and liquidity shortages. Google and Apple, two companies mentioned in Fred’s earlier post, fit the bill. Companies whose principal asset is IP will necessarily perform well in the tomorrow’s economy. Those who leverage open source software, distributed computing and center their investments on people and products will have attractive operating characteristics. Manufacturing is and will always be necessary, but it is unlikely that these companies drive value creation in the next century.
High margins. Low asset intensity. Low required leverage. These are the hallmarks of tomorrow’s winners. Technology will be a key enabler in both identifying and making these winners, which is why investments in science and math education and progressive tax policy to spur innovation and entrepreneurship are absolutely vital. The template for success is here. All we need to do now is execute.
NB: Check out my earlier post on optimal cash balances. I profiled Apple in my discussion back in March 2007.