NBR L.E.K Shareholder Scorecard: Cashflows and other specifics not markets, move share prices

Friday 14th December 2001

The first 18 months of this century have seen remarkable impacts on shareholder wealth. From the dizzy heights of internet-driven euphoria, to the lows following September 11, share markets have experienced wide fluctuations.

Amid the turbulence, many managers may be tempted to conclude their company's share price has broken ties with business results and is now adrift, to be buffeted by sector or overall market performance.

They might further concede that their share price is out of their control. Perhaps they work in a sector considered "out of favour" with investors. The result can be erosion of management's confidence that hard work and solid performance will be reflected in share price improvement. Motivation may fall and employee turnover may rise.

As tempting as it is to blame poor market share price on a "bad market" or "bad sector," the truth is that companies in bad sectors have generated above-average returns. It seems that the ebbing and flowing market tides do not lift and drop all boats equally. Information gathered by L.E.K. Consulting while developing the New Zealand Shareholder Scorecard suggests long-term company operating cash flows remain the primary driver of share valuations. Consider the following:

Market movements explain around one tenth of individual share movements
Results based on company share and market data and analysis by L.E.K. show that changes in the value of the NZSE explains only 12% of individual share change. The same analysis conducted in the US. and Australia gives a similar result - movements in the S&P 500 Index explain only 17% of share changes, and movements in the All Ordinaries Index explain only 9%. In New Zealand, 88% of a share's movement must be explained by factors unique to the company or its industry sector.
One out of three companies in "bad sectors" still managed to beat the overall market returns
L.E.K. examined 17 different industry sectors as published in the New Zealand Shareholder Scorecard. Specifically, we isolated the seven sectors that under-performed the overall market average. This constitutes a sample of 42 companies that had been traded for three or more years. Then we examined how many of these companies managed to generate three-year average shareholder returns above the market average despite operating in under-performing sectors. We found that slightly over 35% of companies in under-performing sectors still managed to beat average market returns.
A quarter of the companies in "good sectors" generated returns below the market average
Many companies operating in sectors whose average return exceeded the market actually under-performed the market. There are 57 companies in the 10 sectors that outperformed the market average that had been traded for three or more years. Of those 57 companies, 14, or 25%, generated three-year average shareholder returns below this market average.
Performance range within sectors is large
Evidence to support the relatively weak role that industry sectors play in determining individual share returns can be found in the wide range between winners and losers within sectors. The top returning company in a sector generated three-year average annual returns 38% higher than the sector average. The lowest returning company in a sector generated returns 82% lower than the sector average. Listed below are the five companies that generated the best and worst three-year average annual returns in comparison to their sector averages:

Five best performing companies ranked by the absolute percentage-point difference from the three-year sector averages:

HED	Horizon Energy Distribution	38.1%
BCH	Baycorp Holdings	37.9%
INL	Independent Newspapers	27.4%
POT	Port of Tauranga	25.6%
TPW	TrustPower	25.0%

Five worst performing companies ranked by the absolute percentage point difference from the 3-year sector averages:

SFH	Seafresh New Zealand	-81.9%
FOR	Force Corporation	-61.2%
ARB	Arthur Barnett	-60.9%
AQL	Certified Organics	-57.4%
MET	Metlifecare	-56.4%

Tale of Two Sectors

Though examination of average returns can be useful, a review of individual companies within a sector can be more interesting in terms of determining why certain companies manage to over or under-perform their sector.

In New Zealand, the agriculture and fishing sector is one that has consistently outperformed the market. However, not all companies in this sector have enjoyed these positive results. Affco has reduced its value by a rate of around 7% a year over the last five years while Williams & Kettle and Wrightson have performed consistently well. In this sector the main difference between the companies that have outperformed the sector and those that have not has related to the ability of management to successfully execute growth or restructuring strategies.

The intermediaries and durables sector has also regularly outperformed the market. This has mainly been led by the larger shares in the sector such as Fisher & Paykel and PDL Holdings, while smaller companies in this sector have had periods of poor performance.

The smaller shares, such as Scott Technologies, are characterised by a lack of diversification in revenue streams and are therefore exposed to fluctuations in their niche market.

Clearly a share's individual returns are driven by many factors common to an industry sector. However, as the market gyrates and sectors fall in and out of favour, managers may be prone to conclude that the fate of their company's share is largely at the mercy of sector trends.

However, as the foregoing indicates, this is absolutely untrue. Over time, the most important drivers of share price performance are the strategic and operational actions of management. Companies such as Williams & Kettle have been able to create significant value through distinctive strategies, such as smart rationalisation and acquisitions. Affco, however, has had ongoing difficulty in creating value from its core operations. Who knows what the future holds for these companies but the broader point is that management action and not sector returns economics will play the greatest role in their shareholder returns. The lesson for management seems clear. If you operate in a strong sector, take no comfort. If your sector is weak, seek no justification for your low performance. The evidence suggests your fate is more in your hands than you might believe.

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