Bad bosses = bad economy?

Thursday 1st November 2001

Rod Oram reckons bad management is a major contributor to our below-average economic performance. Roger Kerr begs to differ.

Rod Oram - Contributing editor

Latest figures from ANZ Investment Bank show the top 40 listed New Zealand companies destroyed $1.1 billion of economic value last year. That's a lot of destruction. Yet according to the ANZ, it gets worse. The bank employs a useful tool for measuring company performance: economic value added (EVA). If a company generates profits in excess of its cost of capital, it creates EVA. If it doesn't, it destroys EVA. A study of 600 private and public companies beyond the top 40 revealed about $3.3 billion of negative EVA.

In my story on bad management in April's Unlimited ("Good ideas, bad company"), I argued that numbers like these, and other reports from the OECD and the World Economic Forum, suggest bad company performance and management are major contributors to New Zealand's poor economic performance.

Rubbish, says the Business Roundtable. Management has created considerable shareholder value, says executive director Roger Kerr, drawing on a Roundtable study by Bryce Wilkinson of Capital Economics (read his paper at unlimited.co.nz/investor).

Wilkinson's paper is worth reading for its detached view of the world. One of Wilkinson's mistakes is to take a version of EVA called market value added (MVA) as his measure of corporate success. MVA is the value the stock market places on a company, minus the cost of company assets. And indeed, New Zealand companies have generated positive MVA, or shareholder value.

But MVA is a flawed measure. First, MVA is an expression of the market's hopes for any future EVA a company can create. Problem is, this hope is only that, a hope - the company may not deliver. Second, the valuation is imperfect because it is affected by external factors, such as the overall market. A rising market lifts or punishes all shares without regard to individual EVA. MVA barely measures unique company performance, as Wilkinson admits.

Wilkinson's argument gets even more curious when he turns to EVA. He says EVA for all companies in an economy will average at zero over time. Where a company is making positive EVA, competitors and new businesses will be encouraged to enter and thus drive down EVA. Conversely, market forces such as takeovers will sort out companies generating negative EVA. For example, roughly the same number of New Zealand companies generate positive EVA as those that generate negative. But he ignores the net effect of negative EVA, which means that New Zealand ends up on the side of value destruction.

Wilkinson's theory has no real-world application. Across the globe, outstanding companies in highly competitive industries continue to create positive EVA thanks to their management's astute strategy, innovation, creativity and intellectual property - the very type of company we aspire to create. Similarly, some markets are better than others at forcing negative EVA companies to shape up. They are characterised by change agents such as active institutional shareholders, robust brokers' analysis and pay-for-performance remuneration of executives. Those hardly describe New Zealand, so it comes as no surprise that corporate New Zealand is a destroyer of economic value. It is this dynamic that I have identified as one cause of New Zealand's poor economic performance.

If Unlimited was alone in this analysis, it would be either heroic or wrong. It is neither. "Management is critically important to business performance, and indirectly the performance of the economy. New Zealand has many excellent managers, but I do not believe it is endowed with its fair quotient," says David Teece, a New Zealander with the Institute for Management Innovation and Organisation at University of California, Berkeley.

Harvard economist Michael Porter weighs in, too. "I've got to acknowledge the extraordinary changes in corporate New Zealand in the 1990s, but it's time for the next step … it's time to transform company strategies," he told the "Catching the knowledge wave" conference.

"Why is so much of corporate New Zealand foreign owned?" asks Kerry McDonald, executive director of Comalco New Zealand. "Fundamentally, it's not because of a shortage of capital. It's because New Zealand management is not as well equipped as managers in multinationals with the management infrastructure that really makes a difference to performance."

As a result, multinationals can generate greater value from our assets than can our owners and managers - so they can justify paying a higher price for the companies. Witness, for example, Shell Oil's purchase of Fletcher Energy.

McDonald is a rarity in New Zealand. A distinguished economist, he also cuts the mustard in the corporate sector. In August he gave a seminar at New Zealand Institute of Economic Research entitled "The critical lack of capability in New Zealand organisations". He argued that the private and public sectors lacked a "capable culture" of performance and improvement. The evidence? New Zealand's "abysmal economic performance" since the 1950s; erosion of value in the private sector shown by EVA data; generally weak private sector leadership on the critical issues of organisations, systems and processes (with some notable exceptions); an opportunistic, deal-making culture; a shortage of good consultants and advisers; and a particularly big exposure to these factors by small and medium-sized enterprises.

Is New Zealand management at least partly to blame for its poor economic overall performance? Yes.

Roger Kerr - Business Roundtable executive director

It's simply erroneous to claim bad management is the principle cause for countries' economic performance. The facts are clear: what matters most is the economic framework, largely a function of government economic policy.

I'm not disputing that a handful of New Zealand firms have destroyed shareholder value in recent years - so too have BHP, Pacific Dunlop, HIH, OneTel and others in Australia, and the dotcom companies in the United States. If Nokia hit the wall in Finland, the annual change in aggregate shareholder value in that country might well turn negative. There are a few other relevant factors, such things as weak international forestry markets and high oil prices. There will always be bad business and investment decisions because business is risky and people in business are not omniscient.

Nor would any reasonable person dispute that the overall quality of New Zealand business management could be improved. Companies get what they pay for in the international market for managers. We struggle to pay international rates.

What is in dispute is whether the concentrated losses of shareholder value reflect the performance of the corporate sector as a whole, and whether they represent "a very serious drag on the New Zealand economy".

On the first issue, Oram misinterprets both EVA and MVA statistics. He seems to argue that a negative EVA is evidence in itself of a poor management team. The relevant indicator of management performance is the trend change in EVA, not the figure for a particular year. Moreover, the existence of some firms with negative EVAs, while competing firms have positive EVAs, is evidence of competition. Economic theory indicates that in competitive markets firms on average will achieve normal profits over time 1 they will just cover their cost of capital. EVA (and MVA) should average out at zero. The fact that only half the top 40 New Zealand companies achieve positive EVA is only to be expected. In an article 'NZ Companies are World Class' in the Business Herald (June 16, 2001), Jim Eagles reported that "By way of comparison, in the most recent Stern Stewart figures 53% of Australian companies, 28% of British companies and 55% of Canadian companies also recorded a negative EVA. Perhaps most telling of all, of 1000 American companies studied by Stern Stewart, 494 were unable to create positive EVA in 2000."

Every self-respecting company aspires to steal a march on its competitors by raising its game. But if every firm raises its game, none steals that march.

The article then criticises Bryce Wilkinson's use of forward-looking MVA statistics which indicate that the top 40 companies have cumulatively added value. First, Oram asserts that EVA provides the best measure of company performance. This defies the common sense of those 'ma and pa' investors who focus on share price performance and dividend yields. Moreover, the entire theory in finance of portfolio selection is based around the risk and return attributes of a company's share price, not EVA.

Second, he criticises MVA because share prices are affected by factors outside management's control. But net operating profit, the starting point for measuring EVA, is also affected by factors outside management's control, such as spikes in oil or electricity prices or recession in key markets. Moreover, EVA ignores entirely the implications for future profits of a management team's current strategy. It is bizarre to prefer a myopic measure because the future is uncertain.

Oram's third reason for favouring EVA relates to intangible assets. His argument is simply wrong. The price of a company's shares includes the value of its intangible assets, just as EVA includes the tangible earnings from intangible assets. Furthermore, both statistics are derived from a common measure of contributed capital. This measure in principle includes capital spending on intangible assets. Any errors in measuring contributed capital should affect EVA and MVA alike.

In short, none of Oram's reasons for ignoring MVA stack up. Both measures have merit.

What about his argument that that the overall losses in shareholder value by a few major corporates are "a very serious drag on the New Zealand economy"? Several points can be made here. First, losses due to competitive processes are inevitable and essential to the achievement of prosperity. Second, a significant proportion of the losses results from higher world fuel prices (affecting Air New Zealand) and cyclical factors in the forestry and building sectors. Third, gains and losses are expected across a risky (global) portfolio. Prudent investors will not incur 'massive' wealth losses when some of their shares lose value - their total wealth may not even drop. Fourth, losses often result from the transfer of wealth rather than its destruction. (The electricity firms that incurred large losses from failing to hedge electricity wholesale prices illustrate this point. Their loss was their customers' gain.) Fifth, losses incurred by foreign shareholders are not a drag on New Zealanders' incomes 1 indeed they might represent a transfer of wealth in favour of New Zealanders.

What is left of the claim about a "serious drag" on the New Zealand economy? Essentially nothing. Suppose (invidiously) that a quarter of the $1 billion loss incurred by the three 'offending' top 40 companies was due to value-destroying bad management. Suppose further that foreign ownership in the same firms averaged around 40%. Such a loss would then reduce national disposable income by around 0.2% - a tiny amount. The idea that a lapse in management performance accounts for New Zealand's mediocre economic record in the last few years, following a period of strong economic growth and good sharemarket returns, is patently absurd.

Bryce Wilkinson concluded his article by noting that since around 1993, government policy drift and more recent policy reversals have pushed New Zealand towards a path of lower economic growth rather than towards a vigorous, dynamic outward-looking future. Given the mobility of capital, businesses and management and other skills that we observe today, what matters overwhelmingly for a country's prosperity is its general economic framework.

In an essay on the reasons why some countries enjoy better economic performance than others, the late Mancur Olson, one of the world's leading economic theorists, observes that "Those countries with the best policies and institutions achieve most of their potential, while other countries achieve only a tiny fraction of their potential income". Olson goes on to say that "the large differences in per capita income across countries cannot be explained by differences in access to the world's stock of productive knowledge or to its capital markets, by differences in the ratio of population to land or natural resources, or by differences in the quality of marketable human capital or personal culture … The only remaining plausible explanation is that the great differences in the wealth of nations are mainly due to differences in the quality of their institutions and economic policies."

Oram's article reveals both a woeful understanding of basic financial economics. As a consequence, like the guns of Singapore, his criticisms are pointed in the wrong direction.

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