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Fast Fact: Great returns aren’t enough

Key insights

It’s not enough to just have great returns – top-line growth is just as critical.

In fact, S&P 500 investors rewarded high-growth companies more than high-ROIC companies over the past decade.

While the distinction was less clear on the JSE, what is clear is that getting a balance of growth and returns is critical.

Strong and consistent ROIC or RONA performers provide investors with a steady flow of discounted cash flows – without growth effectively a fixed-income instrument.

Improvements in ROIC through margin improvements, efficiencies and working-capital optimisation provide point-in-time uplifts to share price.

Top-line growth presents a compounding mechanism – ROIC (and improvements) are compounded each year leading to on-going increases in share price.

However, without acceptable levels of ROIC, the benefits of compounding will be subdued and share price appreciation will be depressed – and when ROIC is below WACC value will be destroyed.

Maintaining high levels of growth is not as sustainable as maintaining high levels of ROIC – while both typically decline as industries mature, growth is usually more affected.

Getting the right balance between ROIC and growth is critical to optimising shareholder value.

Fast Fact: Some of your business segments are destroying value – which?

By Stuart Graham

Key insights

We often see uncertainty in our clients about whether to focus on RONA or growth. While both are obviously important, which will create the greatest value for their companies and shareholders?

We introduced the market-cap curve to help answer this question by plotting the well-known valuation equation for combinations of RONA and growth at a constant valuation.

RONA / growth combinations along the curve preserve the company valuation. Combinations above the curve increase the valuation and combinations below the curve decrease the valuation.

It is easy to see from the graph that companies with high RONA and low growth will benefit more from growth improvements while companies with low RONA and high growth will benefit more from RONA improvements.

The market capitalisation curve provides a useful boundary for capital allocation when business segment performance are plotted against the curve.

ANY performance improvement of ANY business unit raises the aggregate performance and therefore moves the curve outwards – i.e. increases company value.

Fast fact: A quick change in Covid-19 plots shows when countries turn the tide

Fast fact: A quick change in Covid-19 plots shows when countries turn the tide

Aatish Bhatia – in collaboration with Minute Physics – did an amazing job of visualizing the Covid 19 data. His logarithmaic juxtaposition of total versus new cases shows when the virus growth begins to slow.

Logarithmic plotting of new vs total cases shows when infection rates (as measured) slow
When plotted in this way, exponential growth is represented as a straight line that slopes upwards
The x-axis of this graph is not time, but is instead the total number of cases or deaths
Notice that almost all countries follow a very similar path of exponential growth

You can choose the numbers to plot at Covid trends

Fast Fact: Companies should not expect to take price increases without losing volume and potentially risking profitability

Fast Fact: Companies should not expect to take price increases without losing volume and potentially risking profitability

Fast Fact: The rate of technology adoption exploded in the 1990s

Fast Fact: The rate of technology adoption exploded in the 1990s

Staples of bread and meat dominate consumer expenditure on food in South Africa

Staples of bread and meat dominate consumer expenditure on food in South Africa

Expenditure on food, beverage and tobacco accounted for 13,9% of total consumption expenditure in South Africa

There are significant differences between population groups and their expenditure on food as a percent of total expenditure:

Black African households spend 19,9%
Coloured households spend 18,6%
Indian/Asian households spend 7,4%
White households spend 7,2%

Bread, buns and rolls are the primary driver of traffic for food retailers

Although the percentage of total consumption differs amongst population groups and amongst income deciles, the staples in the consumer basket remain consistent

Consumer goods producers might benefit from focusing on staples and providing a range of products that meet the taste and budget for each population and income group

The use of full absorption or average costing in asset-intensive industries with under-utilisation can lead to self-defeating pricing strategies

The use of full absorption or average costing in asset-intensive industries with under-utilisation can lead to self-defeating pricing strategies

The use of full absorption or average costing in asset-intensive industries with under-utilisation can lead to self-defeating pricing strategies

The use of full absorption or average costing in a manufacturing environment with under-utilisation can lead to self-defeating pricing strategies
The increase in price to cover costs results in volume decreases – lowering factory utilisation and increasing unit production costs. This is the start of the utilisation-pricing “death spiral”
Costing according to factory utilisation – partial absorption costing – offers the opportunity to be more strategic about costing and utilisation
“Unabsorbed” costs can be targeted through OEE and volume improvements. At the same time, the “disadvantage” of having a large factory is normalised and pricing can compete with more fully-utilised factories
A recent manufacturing client saw 60% of unit costs arise from factory under-utilisation – sub-optimal OEE levels (non-conformance), low volumes and work-centre bottlenecks contributed to the utilisation gap
These principles can apply to any asset-intensive business – for example banking

Modern portfolio theory (MPT) can be applied to business portfolio decision-making

Modern portfolio theory (MPT) can be applied to business portfolio decision-making

Shareholders seek to maximise company profits while minimising risk
However, lower risk businesses are usually accompanied with lower returns and high risk businesses with higher returns
Comparisons between various risk and return profiles can be measured using the Sharpe ratio – return per unit of risk
Combinations (degree of balance sheet investment) in individual portfolios could realise higher returns per unit of risk than what is achievable in an individual business unit – some combinations are not always obvious
By exiting a higher risk-return portfolio BU J, ABC would be able to increase its return per unit of risk from 4,3 to 4,5
It is often psychologically difficult for businesses to exit high return portfolios
Emotional decision-making can be muted by applying the logic of modern portfolio theory in the board room

White meat consumption has grown with increases in per capita income and growth of the middle class

White meat consumption has grown with increases in per capita income and growth of the middle class

South Africa has experienced rapid growth of middle-to-upper-class citizens fuelled by the parallel increase in disposable income of this socio-economic group
The GDP per capita of South Africa has grown by 54% in real terms from R45 580 in 1981 to R70 184 in 2013
As the poor emerge from poverty and the emerging middle class consumers are able to afford more protein in their diets, chicken, being the most affordable and versatile, has emerged as the meat of choice for this burgeoning population group
The result has been growth in white meat per capita consumption ahead of red meat coupled with added benefits of being easy to produce and with less cultural constraints than pork
White meat consumption per capita has grown by 223% from 11,93 kg/capita in 1981 to 38,5 kg/capita in 2014
Consumption of white meat has also been fuelled by the growth of QSRs like KFC and to an extent, people trading down for a cheaper source of protein
Red meat, being more expensive, is growing at a slower pace
Pork and sheep meat i.e. Lamb (the most expensive of all red meat) and mutton consumption have remained fairly flat while beef consumption has grown since 2001

Going niche is not always a viable strategy for South African manufacturers

Going niche is not always a viable strategy for South African manufacturers

Niche food markets are relatively small in South Africa when craft beer, pure-ground coffee, Fairtrade coffee and organic foods are used as proxies.
According to Global Advisors analysis, niche products account for between 0,38% and 19,60% of total market volumes and have a potential consumer size of just over 900 000 adults if Gauteng, Kwazulu-Natal and the Western Cape are targeted.
Companies within the niche market space must therefore carefully consider the size of their particular niche market, in terms of the potential volumes that they should produce, the number of potential consumers, in terms of the targeted LSM group, and where these consumers are located.
For companies already producing mass market products, niche products might require a different business model and could become a distraction to their core product offerings.
The size of these niche sectors are expected to increase in South Africa in the near future due to the rise of the middle-class.

There is a positive relationship between long production run sizes and OEE

Evidence suggests that longer run sizes lead to increased overall equipment effectiveness (OEE).
OEE is a measure of how effectively manufacturing equipment is utilised and is defined as a product of machine availability, machine performance and product quality.
Increasing run sizes improves availability as a result of less change over time, and performance as a result of less operator inefficiency.
North America facilities that previously ran at world-class OEE rates, have experienced lower OEE rates due to a move towards reduced lot sizes and shifting large volume production overseas¹.
- Shorter run sizes resulted in increased changeover frequency which led to increased planned downtime and reduced asset utilization.
- As a result OEE rates dropped from 85% to as low as 50%¹.

Trends show a decline in traditional pay TV offerings as consumers seek more convenient options

South African retailers have maintained flat margins on lamb and seen declining margins on beef

Beef producers’ share of retail prices has increased from 43% to 45% from 2000 to 2013 while lamb producers’ share has decreased from 55% to 53%
Lamb prices have escalated above other meat prices as producers have passed on supplier increases
- Retailers have been unwilling to cushion these increases
Retailers have cushioned an increase in beef producer prices and taken smaller margins
- Retail prices of beef have risen at a slower rate than producer prices
Beef consumption is growing with the rise of the middle class while lamb consumption is declining
Demand for beef is higher than lamb due to affordability
- Retailers are willing to take less margin on beef in order to maintain foot traffic through their stores

While African insurance premiums have been growing they have not kept up with GDP growth

The African insurance industry is predominantly group life insurance business, and due to limited spending power there has been much slower uptake of individual insurance policies.
Poverty has been reduced somewhat in Africa but this is primarily in the lowest income bracket of the middle class who are prone to falling back into poverty.
Furthermore, policyholders are typically unaware or sceptical of the benefits of owning insurance products, they are difficult to reach and often do not earn regular incomes.1
Microinsurance products are growing more quickly – this presents an opportunity for targetting lower income groups.

3,6% of South African retirement funds make up 80% of total value

The South African retirement industry is highly concentrated with 80% of the total fund value being held by less than 4% of registered retirement funds.

Of these approximately 3000 are active, most of which are small – 70% of funds have assets of less than R6m.

Membership in the system is voluntary, with only around half of formally-employed workers participating, and balances are low, partly because few members preserve their funds for retirement.

There has been a substantial move to umbrella funds due to the focus on retirement fund costs and the audit requirements of underwritten funds.

Underwritten funds used to be exempt from submitting audited returns to the Pension Funds Registrar, as they were effectively registered by the insurance division of the FSB.

This exemption has now been revoked and so underwritten funds are also required to submit audited results which incurs significant compliance costs.

Mining’s contribution to South Africa’s GDP has declined while financial services has increased its dominance

Mining is the only sector to have experienced an overall decline in contribution to South Africa’s GDP since 1993 with a negative CAGR of -1,3%.
The decrease in mining’s contribution to GDP has been a result of an increase in secondary and tertiary industries as well as a continuing decline in gold – and recently platinum – production over the years.
Mining companies have faced a myriad of obstacles including inadequate transport and logistics, electricity rationing warring unions and increasing labour costs – labour costs per kilogram of gold have more than quadrupled in the last decade.2
Going forward, government efforts in developing the downstream or beneficiated minerals industry could increase mining’s indirect and thus overall contribution to GDP.
Financial services however has grown from 17% of 1993 GDP to 24% of 2012 GDP and has outstripped growth of every sector bar communication.

Africa’s “middle class” has kept pace with India’s

West African countries are leading the growth in African food consumption

Comparing Africa’s regional FDI inflows and economic growth rates

Returns for South African packaging companies have been more volatile than their international counterparts

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