Sustainability
of Excess Returns
In
the discussion of sector returns, we examined
some of the reasons why a firm may generate
high returns, relative to the sector, in the
first place. These reasons - luck, skilled
management and competitive advantages such
as brand name - also explain why firms generate
excess returns. In fact, almost all discussions
of competitive strategy can be considered
to be assessments of the magnitude and sustainability
of excess returns. Competitive advantages
that are strong and sustainable generate larger
excess returns for longer periods than more
fleeting or weaker competitive advantages.
While
the connection of excess returns to competitive
advantages is both intuitive and logical,
there are two empirical questions that we
need to answer to be able to put this it into
practice.
The
first question has been examined by both academics
and practitioners, though much of the work
that is useful for valuation has come from
the latter. Holt Associates, the proponents
of CFROI, described in the first part of this
paper, have done extended work on what they
title "fade factors", measuring how quickly
excess returns decline in different sectors
and across the entire market. Though much
of what they have done remains behind proprietary
barriers, Madden (1998) summarizes some of
the findings in his book on the topic:
1.
The real cash flow return on capital across
all US firms has averaged about 6% over the
last few decades.
2.
There are companies that generate higher and
lower returns than this average at any point
in time, but these returns move towards the
average, albeit at varying rates. The differences
in fade factors across firms can be attributed
to both management quality, sector specific
characteristics and luck.
3.
Excess returns at small firms fade much more
quickly towards the average, and with higher
volatility, than excess returns at large firms.
4.
Excess returns also tend to fade faster at
firms that reinvest more (higher reinvestment
rates) than at firms that reinvest less. Very
few companies are able to maintain high excess
returns while reinvesting large amounts.
5.
Mirroring our findings at the sector level,
companies that have stronger competitive advantages
and longer product cycles tend to report more
stable returns. Highly volatile companies
with short product lives, facing constant
innovation, have both more unstable returns
and returns fade much faster towards the average.
In
a more recent study, McKinsey provides backing
for the notion that excess returns are far
more sustainable that growth rates. In other
words, firms that have high excess returns
and high growth rates will see their growth
rates decrease quickly but excess returns
remain high. Figure 9 summarizes the McKinsey
results on excess returns across all firms.
The
McKinsey study suggests that while revenue
growth tends to revert quickly to average
levels, returns on invested capital can remain
high for extended periods. While the sustainability
of excess returns should provide some solace
to investors, there is little work that has
been done on whether different competitive
advantages generate different periods of excess
returns. The Holt findings on differences
in fade factors across sectors can be viewed
as indirect evidence that these differences
do exist.
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