How to dodge a downturn


By Dr Adrian Saville, Chief Strategist, Citadel

In times of weak economic growth, companies need to be that much smarter to survive and thrive. To understand what is needed to navigate and negotiate changing times and tough conditions, we studied the behaviour and performance of more than 1,200 South African-listed companies over a period of 15 years. Through this in-depth work, we identified two primary business attributes that actively help to recession-proof a business.

Research has shown that the greatest influencing factor on company valuations is company earnings. As Buffett put it, in the short run, markets are voting machines, cast about by changing sentiment; and in the long run they are weighing machines, with the weight or intrinsic value of businesses as a function of their ability to generate and sustain cash-based earnings. And if earnings matter to the worth of businesses, there is a rich body of evidence to show that the single biggest determinant of aggregate companies’ earnings performance is economic growth.

If valuations are based on the ability of companies to generate, sustain and grow earnings, then factors such as dominance in a market, pricing power, brand strength, economies of scope, scale and so on all matter in terms of a firms’ ability to perform. But the single greatest explainer of earnings growth for business as an aggregate is economic growth.

This holds true across geographies, through industries and across time periods. It is only the degree of the relationship that differs, but there is always a positive correlation between macro-economic factors and company earnings. Nowhere is this rule broken in a study of companies that represent 98% of world market capitalisation in 25 countries over 15 years. In some countries, such as the small, open economy of Singapore, 90% of the change in earnings can be explained by economic growth. Whereas in other economies, such as those of India and Italy, the influence of the economy on earnings tends to be more modest, with economic impact on company earnings measuring as low as 50% explanatory power. In South Africa, 70% of the change in earnings growth is derived from economic growth.

The same is true of the relationship between earnings growth and company valuations. The relationship may vary from country to country, but in the fullness of time, the single biggest explainer of intrinsic value is earnings – and more specifically cash earnings. Globally, 80% of company valuations is explained by earnings growth. In South Africa, it is as high as 90%, in Germany it is 80% and in Canada it is 75%.

South Africa is undeniably in the economic doldrums, with economic growth of 0.5% recorded in 2016, perhaps 1.5% to 2% in 2017 and possibly a bit better than 2% in 2018. And in such tough times, the evidence suggests that the average South African company is in an earnings recession. Through our work on business performance, we have established that when South Africa’s economic growth rate is 0%, the average company earnings falls 5% in real terms, equivalent to a hefty 12% fall in nominal earnings in the 2016 landscape.

It is, of course, mathematically impossible for every company to be the exception. But there are companies which have been able to escape the force of economic gravity – a time when customers, suppliers, competitors, all other market players are equally subjected to a poor economic environment. Those businesses which can reach escape velocity are not immune to economic gravity, but they are able to sustain growth and performance through economic cycles.

Rita McGrath of Columbia University published a study in Harvard Business Review (2012) which shows that of nearly 5,000 companies, each with a market value in excess of $1 billion, just ten firms achieved uninterrupted real earnings growth ahead of world economic growth over ten years. Of great interest is the nature of the firms which make up this exclusive set of ten – they include search firm, Yahoo (Japan); Spanish construction operation, ACS; Chinese brewer Tsingtao; and Atmos Energy, a US-based alternative energy business. It would be hard to find a more eclectic set of companies if one tried.

Against this backdrop, and given McGrath’s remarkable result, we extended her research to look at South African companies over seven different ten-year rolling periods to assess the application of her findings to South African businesses. Whilst McGrath stopped surveying companies below a $1bn valuation, we included companies with a market value as low as R50m, the smallest JSE company that had sufficient data for us to study.

Notably, our findings reinforce those of McGrath: of the more than 1,200 firms we surveyed, just two generated real earnings growth every year without interruption that is also ahead of South Africa’s economic growth over the full 15 years of the study – Clientele Life and EOH. A few others saw uninterrupted year-on-year real earnings growth over 14 years down to 12 years, including the likes of construction firm WBHO, Mr Price, Famous Brands, Bidvest, Aspen, Investec, Truworths and Distell.

From research into this universe of McGrath’s 5,000 companies and our 1,200 companies, we have identified two attributes which contribute to the long-term success of a company across geography, industry and time, namely agility and absorption.

  1. Agility references a company’s speed and nimbleness as well as the ability to choose speed. To be more explicit, agility comes in three flavours:
  • Operational agility which features efficiency;
  • Portfolio agility which reflects the ability of businesses and industries to adapt and change over time in response to a changing environment; and
  • Strategic agility which reflects the ability of a business to move ahead of the competition.
  1. Absorption means the ability of a company to roll with the punches, although it is more nuanced than that. Absorption also references the ability of a company to throw punches, when necessary. This comes in many flavours, including:
  • Latent slack – how swiftly a company can grasp opportunities;
  • Intangible assets, such as the value of brands;
  • A strong balance sheet with modest debt levels and high cash balances that give optionality;
  • A diversified (and strong) cash flow;
  • Loyal customers; and
  • Constant innovation, represented by many small bets and informed by clients’ wants and needs.

Only a handful of South African companies have displayed these attributes on an enduring basis and it is immediately obvious that they are the unusual suspects. Outside of this list, there are very few companies that have achieved uninterrupted earnings growth over multiple 10-year periods.

Looking at the collective survey of over 6,000 companies in total, the shares that will perform over the next 10 to 15 years will be “ripped” in the two attributes of agility and absorption.

But leaders aiming to endear themselves to shareholders should note that these characteristics are not given. They must be consciously, and constantly developed and nurtured.