What are value patterns, and what do they indicate?

This is a way of describing a company’s starting position — its investment thesis. Value patterns reflect a company’s business model economics (gross margins, R&D intensity, capital intensity), growth exposure, investor expectations and riskiness. Within a given industry like retail, for example, investors tend to think about the trends and challenges all retailers are facing. But individual companies within a sector can have very different profiles — or value patterns — depending on their individual context.

For instance, retailers include early-stage, high-growth, competitively-advantaged formats that just need some time to expand their footprint (like Ulta Salon, the popular chain of beauty shops); and at the other extreme, over-capitalized, disadvantaged, late-in-lifecycle companies (like Sears) that are dealing more with contraction and restructuring priorities. These retailers face very different risks and opportunities from a stakeholder standpoint and as a result, the prescriptions for corporate priorities and the tradeoffs are very different. Calibrating a particular company’s value pattern adds richness and, to some degree, prescription as to what kinds of moves are likely to make a company more vital — versus moves that are ill-advised.

You have identified several types of value patterns. Please describe them.

The value patterns work started out from working on corporate strategy issues across industries and seeing repeating patterns and dynamics. Over the last few years we have been deepening our ability to characterize value patterns quantitatively, with a statistical clustering technique. The clustering has been pressure-tested with feedback from professional investors, input from clients and empirical evidence on the success and failure of different companies. The goal was to try to reconcile the intuitive clusters that different investor types specialize in with a quantitative clustering of public companies.

85 per cent of companies in the Healthy High Growth pattern are no longer in that group five years later.

In the end, we identified 10 distinct value patterns. They have names like Healthy High Growth — companies such as Tesla or Netflix that have very favourable business economics and high and sustained revenue growth rates expected in the future. These companies may be forecasted to double their revenue quite profitably two or three times in the next five to 10 years, and as a result, they have very high investor expectations and valuations.

However, that particular starting position has some specific pitfalls and risks: They are in a great position competitively, but because expectations are so high, there is a real possibility that these companies will encounter a hiccup along the way. We’ve found that about 85 per cent of companies in the Healthy High Growth pattern are no longer in that group five years later, because that kind of mega-growth doesn’t last forever. A successful outcome for this value pattern is not to grow at high rates forever; instead, success means fading down in an orderly way over time, rather than hitting a wall.

Another starting position is the High Value Brands pattern. These companies are mature and differentiated, with high gross margins, some capital intensity (but not too much), modest technology intensity (low R&D) and low overall risk. They’re viewed as Steady Eddys by investors; there’s not a lot of uncertainty around their competitive position. When you look at these companies — like 3M or PepsiCo — they often have high market share in healthy, stable segments, high return on capital, and they generate good cash flow.

There is a very different set of investment-thesis issues for these companies. For one thing, they are much more likely to still be in the category five years later: about 75 per cent stay in the High Value Brand pattern. However, when these companies change value patterns, they often change in a downwards direction, because it’s hard to return to Healthy High Growth from High Value Brand.

High Value Brands tend to be companies that are leaders in their core business, but sometimes the broader category in which they lead commoditizes. So, for example, several newspaper companies were High Value Brand businesses 10 to 20 years ago, but many of them have since down-clustered to lower-value patterns over time. Right now, the retail sector is going through a similar kind of sector pressure, with many of the legacy High Value Brands feeling a lot of pressure and some down-clustering. In a down-clustering, a company moves from a higher value pattern to a lower one, reflecting meaningful degradation in its key indicators: margins, growth exposure, return on capital, balance sheet quality, valuation and risk profile.

Tell us about the deep value pattern.

These companies have a much more commoditized business profile. They’re not in financial distress; they have a decent balance sheet. But they show a low return on capital, low gross margins, often zero-to-negative revenue growth rates and very low investor expectations with low valuations. They often trade at a market value less than their total asset replacement cost — $0.20 on the dollar, $0.40 on the dollar, that kind of thing.

You might look at these companies and say, gee, they don’t look as good as the Healthy High Growth or the High Value Brand companies. That may be true, but Deep Value companies are just as likely to create shareholder value, because investor expectations are low to begin with. From an investor’s standpoint, they’re not actually a worse group, they’re just different. Companies that do well from a Deep Value starting position often face real pressure to transform, and thus take strong actions — like restructuring, existing legacy positions, changing leadership or getting taken over. These sorts of big moves can create a lot of value from a low-expectations starting position.

Total Shareholder Return or TSR appears to be your key gauge of value creation. Please explain why.

To clarify, what we look for is sustained TSR over long holding periods, usually measured relative to a peer group. So, if you said, I’m in the top third of my industry peer group over five to 10 years, I would assert that that is consistent with strong performance for a broad set of stakeholders including customers and employees, and that it’s a holistic measure of performance because it includes all the economic forces at play in your sector. It’s a relative measure, and it minimizes the distorting effect of beginning and ending valuations, because it’s a long-term measure.

When you look at the companies that have outperformed their peers over sustained periods from a shareholder value standpoint, they are consistently succeeding in the marketplace: They’re winning competitively; earning more share of wallet with more customers; and doing this in a way that each dollar they reinvest in the company compounds in value over time. It’s very hard — nearly impossible — to cost-cut your way to 10-year industry-leading performance.

What is your take on Michael Porter’s theory about creating shared value—creating value for both shareholders and for society via your business model?

I think it’s unambiguously correct. One of the great misunderstandings, from my standpoint, is the idea that shareholder value as a phrase has come to be code for a focus on near-term financial results. When I use this phrase, to me, it means thinking like a founder about competitive vitality and the creating of fundamental value for the world over time.

BCG released a report recently about what we call Total Societal Impact (TSI), looking at a series of companies and industries and tracking TSR and TSI — the broader, nonfinancial performance (this report is available online). In looking for well-run (and therefore lower risk) companies, one of our hypotheses was that non-financial indicators such as ESG measures (environmental, social, governance) are a value-added additional piece of information above and beyond traditional financial performance indicators.

It’s very difficult to manage a large enterprise in a complex world if you embrace financial reductionism, or at the other extreme, if you have only qualitative strategic motivations. You need to balance both shape and numbers, pursuing purpose and adding value in the core business, and to do so in a sustainably value-creating way. The goal for every company should be to find double word scores — things that make you strategically stronger while also creating tangible net value for society.

The double-edged objective function of great company and great stock is a nice tension to put into a management process.

One shorthand I use for this is that in thinking about corporate strategy and portfolio priorities, you have to worry both about building a stronger company to leave to the next generation, and being a great stock along the way. Which means creating attractive value for owners during the holding period.

If you take either one of these goals alone, it won't work very well. If you say, I want to be a great company, but I don’t care about shareholder value — you are essentially saying you want to build a really nice house but you don’t care what it costs. You don’t even care if that house is worth more in the end than what you spent to build it. Alternatively, if you are unbalanced in the other direction and say, I don’t care about leaving behind a great company, I just want to maximize immediate shareholder value, that is not a route to success either. It leads to corporate dismemberment (auctioning the pieces) and encourages irresponsible risk taking. The double-edged objective function of great company and great stock is a very nice tension to put into a management process.

What are some of the common mistakes you see investors making with their portfolios?

One thing I see is mistaking an attractive stand-alone business for one that I can add value to if I buy it. For example, in commodity chemicals, for many years, everybody wanted to trade up to specialities, and a lot of the track record of those companies was we’ll pay a really high valuation for something that is higher margin and higher value added. But, just because you bought it and it’s a speciality, it doesn’t mean that what you do with it makes the company more valuable over time.

It’s essentially the problem of acting as if you’re in a different value pattern than you are. If you’re a Deep Value company, you shouldn’t try to buy a High Value Brand company and merge with it; you should try to take your Deep Value starting position and fix it, creating fundamental value by matching your actions to the realities of your starting position. Another error is sticking with the status quo — the idea that what we’ve owned for a long time and gotten comfortable with is who we are. And along with that, assuming that the world we see today can be smoothly extrapolated into the future. It can be very difficult for management teams to have an objective perspective on the rate of change and to recognize when a different portfolio becomes necessary.

You have said that the term maximizing shareholder value drives you nuts. Please explain.

That phrase carries so much baggage. It’s all about people trying to maximize their equity compensation linkages to get themselves rich on the back of whatever it takes, and I find that to be a really nasty and dispiriting aspect of shareholder capitalism. If someone says, I want to profit-maximize in the current period versus I want to have more risk-adjusted area under the curve over time, in my view, the latter perspective is far more mature. My colleagues and I think more about generational leadership and competitive vitality as being very good objective functions. The goal should be to leave behind a more valuable company — one that is able to solve difficult problems in the world, in a manner that is hard to imitate.

---

This article originally appeared in the Spring 2018 issue of Rotman Management magazine.