McKinsey & Co., arguably the world's most prestigious management consulting firm, just published a book, Value: The Four Cornerstones of Corporate Finance (Wiley, 2011), for non-financial executives on how they can create shareholder value. In a Dec. 2 interview, the book's lead author, Tim Koller, shared his thoughts on how his book might also help investors profit.

Koller, who runs McKinsey's Corporate Performance Center out of its New York office, told me that Value is designed to help executives -- but it could be a useful guide for investors as well. The key is that if investors can get early indications about positive changes in a company's approach to creating value, they can profit from the heads-up.

To understand that approach, it's worth pointing out that the signals will come from the way executives address two questions:
  • Should I try to accelerate my company's growth or boost its profitability?
  • Should I trade off short-term profits for longer-term performance?
Growth vs. Profitability

Koller's research suggests that companies often make a choice between faster growth without regard to profitability -- which he measures as Return on Invested Capital (which is profit divided by investments like property, plant, equipment and working capital) -- or maintaining high ROIC, while accepting slower growth.

He argues that while different kinds of investors have different trading horizons and strategies, executives should focus on satisfying the subset of investors who want to buy and hold companies that produce superior long-term value. Koller believes that such intrinsic-value investors place capital in those companies that come closest to achieving the ultimate goal of high ROIC and rapid revenue growth.

He contrasts that group with investors who bet on whether a company is going to meet its quarterly earnings targets. Their actions will move stock prices in the short-term, but the resultant gains or losses tend to evaporate over time.

To serve the needs of intrinsic-value investors means making the right trade-offs between growth and profitability, which depend heavily on a company's historical choices. If a company competes in a rapidly growing industry with low ROIC, it faces the risk that the industry's growth will slow down. This will force the company to decide whether it should acquire other competitors to reduce excess industry capacity, or to seek out a buyer for itself.

Alternatively, if a company is in a profitable, but slow-growth industry, there's always the chance that competitors will gain entry by offering lower prices. That could undermine the profitability of the industry and threaten the company's long-term value. Such a company's response could be to enter other industry sub-sectors that offer higher ROIC and growth.

That pursuit of high growth is important: Koller's research suggests that for the same level of earnings growth, companies with high revenue growth have higher price/earnings ratios than slower-growing companies. At the same time, he argued, it's important for companies to grow their profits, because when earnings growth falls faster than revenue growth, companies suffer a bigger drop in their stock prices.

In general. Koller has observed that for companies with high returns, it's difficult to keep growing earnings faster than revenues, and executives that aim for that often end up cutting costs that are "robbing from the future," such as product development or marketing expenditures. Of course, some cost cutting measures can enhance productivity, but those eventually run out. In Koller's experience, very few companies can improve their margins consistently for more than about seven years.

So while reviving earnings growth is important, executives should only invest in new business areas if they have, or can obtain, the capabilities needed to take market share. How companies might specifically find growth opportunities that offer high profit and growth potential in areas where they can compete effectively was a question for which Koller did not offer a ready reply.

Short-Term vs. Long-Term Performance

Not surprisingly, McKinsey & Co. favors trading off the short-term for the long-term. Specifically, if a company is worried that it won't meet its quarterly earnings targets, McKinsey counsels it to cut non-value-added costs if it can. While Koller didn't mention what those might be, I would imagine they would be the types of expenditures that don't help the company to attract and retain its customers.

On the other hand, Koller counsels against companies using short-term earnings pressures as a reason to cut product development or marketing costs. While he didn't cite specific evidence to support this, Koller argued that cutting such costs would lead to lower revenue growth in the longer-term which would damage the company's intrinsic value.

My concern with this advice is that much of the money invested in product development and marketing never pays off. For example, big pharmaceuticals companies spend billions of dollars annually on research that does not result in products that they can sell. This has led some pharmaceuticals to buy biotechnology companies as a way to outsource their research to firms whose R&D is further along in important product categories. Given that, perhaps those acquirers might be better off cutting way back on their research budgets, and using the money for acquisitions.

Implications for Investors

The key for intrinsic-value investors -- those who buy and hold -- is to get wind of changes in a company's strategy that they believe will boost growth and profitability relative to its competitors over a three- to five-year period. This is important, because Koller argues that about 80% of the differences in P/Es within an industry are due to how a company performs compared to its competitors.

One way to find such opportunities is to analyze companies' public statements about their growth opportunities and their track records. Investors should put capital into companies that make very specific statements about how an acquisition, for example, will help to boost revenues, cut costs, make distribution or manufacturing more efficient, or provide other specific benefits leading to sustainable higher growth and profitability.

While Koller did not provide an example of this, one came to mind after our interview. As I described in my book, Capital Rising, co-authored with Srini Rangan, investor Wilbur Ross multiplied a large bet by 14 by gambling on just such growth and profit boosting developments. In 2002, he saw the combination of a pending 30% spike in U.S. government tariffs for imported steel and big demand growth from China as great reasons to acquire bankrupt LTV for $325 million. He sold it two years later for $4.5 billion.

Obviously, we can't all buy whole companies, but the trick for intrinsic investors is to do what Ross did: Get ahead of the pack in finding such opportunities in publicly traded stocks.

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December 09 2010 at 8:23 AM Report abuse rate up rate down Reply
crimson00king

Americans we must agree on 1 thing the rich do not need any more tax breaks. They have not created jobs in fact they have helped send jobs out of the country. It is shameful what the GOP and a few Demcrats are doing useing what i would call as extortion to get tax breaks for the rich. The time is now to e-mail or call your senators congressmen and the White House and TELL THEM NO MORE TAX BREAKS FOR THE RICH

December 05 2010 at 10:42 PM Report abuse rate up rate down Reply
bfpowersjr

I can't argue with the article, but, I believe that the founders and executives of a very large number of companies have been too interested in creating share holder value for THEMSELVES (e.g., with stock options") rather than creating value for the average investor (not to even begin to mention dispersing dividends.) For example, I could name some technology companies that I believe my criticism applies to, but, I won't.

December 05 2010 at 3:07 PM Report abuse rate up rate down Reply