How Many Companies Actually Create Value?

At Morningstar, we're big fans of companies that generate economic profits, but we're skeptical that many firms can do so for very long. After all, success attracts competition as surely as night follows day, which is why barely 10% of our 1,400-plus stock coverage universe earns a wide economic moat designation.

But how many companies actually have managed to create economic value over the past few years? Which sectors have created wealth and which ones have destroyed it? We recently pulled data from about 1,100 of our in-depth discounted cash-flow models to get some answers. Some of the results simply confirmed what you would intuitively expect (tech and telecom stocks destroyed a ton of value in the recent past), but some results were surprising. For example, who would have thought that plain-Jane consumer-goods companies recently generated just as much economic value as their more-exciting counterparts in the health-care sector?*

Economic Profit
First, some brief background for those of you not familiar with the concept of economic profits. An economic profit differs from an accounting profit in that it adjusts for the amount of capital used to generate profits, in addition to the cost of the capital employed. For example, two firms that each generate $100 million in accounting profits may look equally profitable from one standpoint, but if firm A used $80 million in capital, and firm B used $95 million in capital, firm A has a higher "return on invested capital" or ROIC. Essentially, Firm A is a more efficient user of capital.

In addition to the quantity of capital used to generate profits, however, we also need to account for the cost of that capital. Without getting too complicated, think of "cost of capital" as an expected return--you'd expect a higher investment return from a tech company than a utility to compensate for the higher risk that the tech company might turn out to be a stinker. So, the tech company's cost of capital will be higher than the utility's cost of capital. Generally speaking, debt is a cheaper source of capital than equity, because interest payments are tax-deductible and debt payments take priority over payouts to equity holders. When you put debt and equity together, you get a company's "weighted average cost of capital," which goes by the unfortunate acronym WACC. This is basically the overall cost of capital for a firm.

When a company's ROIC is greater than its WACC, it's generating an economic profit, or "excess return." In other words, it's making money after adjusting for the amount and cost of its capital base.

The Real Money-Makers
Generating excess returns is harder than you might think. Over the past five years, the average excess return of our non-financial coverage universe was just 1.1%. Fully 43% of the companies failed to generate excess returns, on average, over this time. Granted, the past five years were relatively tough economic times, but I was also generous in calculating the results--I tossed out companies with ROICs below negative 100% (there were several), and counted a company as having generated an excess return if it came within 2% of its WACC. (A company's exact cost of capital is pretty debatable.) Even so, more than four out of 10 companies didn't make enough money to cover the cost of their capital base.

So who was making money and who's been destroying value? The table below shows how each sector fared in this regard over the last five years, and also compares the excess returns of no-moat, narrow-moat, and wide-moat stocks.

Economic Profits by Sector and Moat
	Historical ROIC ( % )	Cost of Capital ( % )	Excess Return ( % )
Business Services	17.4	9.6	7.8
Consumer Goods	14.8	9.4	5.4
Consumer Services	10.2	9.7	0.5
Energy	8.5	9.6	-1.1
Hardware	4.5	10.8	-6.3
Health Care	13.6	10.0	3.6
Industrial Materials	7.8	9.7	-1.9
Media	14.1	9.5	4.6
Software	24.5	11.0	13.5
Telecom	7.1	10.7	-3.6
Utilities	4.7	7.8	-3.1
No Moat	4.2	10.1	-5.9
Narrow Moat	12.7	9.6	3.1
Wide Moat	27.6	9.2	18.4

As you might guess, those wonderfully profitable wide-moat firms were largely responsible for squeaking out the 1.1% average excess return. Wide-moat companies generated returns of about 18% above their cost of capital, narrow-moat firms averaged excess returns of 3%, and no-moat firms returned an average of 6% less than their cost of capital. In other words, the average no-moat firm that we cover returned $0.94 on every dollar of its invested capital, after adjusting for the cost of capital.

On average, telecom, energy, industrial, and technology-hardware companies all destroyed value over the past five years--hardware firms did so with abandon, returning 6% annually below their cost of capital. You can chalk this up to low energy prices (until recently), an industrial recession, and the bursting of the tech and telecom bubbles, but that's only part of the story. Each of these industries is capital-intensive and fiercely competitive, after all, and only a very few firms can consistently generate economic profits in such an ugly environment. Most fail to do so, and their shareholders suffer the consequences.

On the other end of the spectrum, software companies led the pack, generating more than 13% above their cost of capital, while media, health-care, and consumer-goods firms all clocked in at around 4%-5% excess returns. It might seem surprising a sector full of companies such as  Hershey (HSY) and  Gillette  could hold its own against one with patent-protected behemoths such as  Pfizer (PFE) and  Merck (MRK), but it makes sense when you think about it--there's massive survivorship bias in the consumer-goods sector. In other words, if a firm couldn't make a go at selling chocolate or razors, that company is long gone, whereas there are still thousands of small upstarts trying to discover a drug that will make them the next  Amgen (AMGN) or  Genentech . (Wide-moat and narrow-moat firms in health care and consumer goods have generated very similar excess returns, but the ROICs for the no-moat health-care firms we cover have been much lower than the ROICs for no-moat consumer-goods firms.)

What to Make of the Numbers
You can argue reasonably that these gloomy numbers aren't indicative of what the next few years will bring--unless we run into another recession, of course, but that's a debate for another day. You can't, however, ignore two things that these data make painfully clear.

One, some industries are structurally more attractive than others from the perspective of a long-term investor. Sure, you might find that one chip firm that turns into the next  Intel (INTC) or an energy company on the verge of a big strike, but you'll be hurting if you guess wrong because it's so tough to create a lasting business advantage in an industry as competitive as semiconductors or as commodified as energy. On the other hand, firms with patents, strong brands, or barriers to entry are more likely to bounce back from whatever troubles befall them.

Second, across a large enough group of companies--like the entire economy--excess returns are a zero-sum game. What one smart capitalist makes, another will work like the dickens to take away. It's no coincidence that our 1,100-company, non-financial sample universe generated average excess returns of just 1.1%. If we included all the firms that have closed their doors over the past several years, it would likely be closer to zero. (This is that same survivorship-bias issue again.)

That's it for the historical data. Next column, I'll look at what kinds of excess returns and earnings growth we're forecasting in the future--the expectations that underpin our fair value estimates.

* Ground rules and caveats: The data above do not include financial-services companies. We value these types of firms in a slightly different way than "regular" companies, and so the figures for economic profits aren't exactly comparable. I'll include financial firms in future studies. Also, the data are straight averages--not adjusted for company size or market capitalization--and include five years of historical data.