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Sector or strategy? What drives value?

ANALYSIS: A weak sector or market is no barrier to delivering good returns

Chris Kenny, Bob Neapole and Waris Watanakun

The first two years of this century have been remarkable for the impact on shareholder wealth. From the dizzy heights of Internet-driven euphoria to the lows following Sept 11, global stock markets have seen record variations.

Amid the turbulence, many managers may be tempted to conclude that their company's stock price has broken ties with business results and is now adrift beyond their control, to be buffeted by sector or market performance.

Perhaps they work in a sector currently considered out of favour. The result can be an erosion of management's confidence that hard work and solid performance will be reflected in stock price improvement.

Management matters now more than ever. A reduction in the SET's weighting in the Morgan Stanley Capital Index, unresolved problem loans and a weak banking sector are some of the broad excuses used by managers to justify poor returns.

As tempting as it is to blame a "bad market" or "bad sector", the truth is that many companies in "bad" sectors have generated spectacular returns.

It is important to remember that the market takes a long-term view of performance. Regardless of recent short-term sector or market variations, the ability to generate value-creating and credible strategies that affect long-term operating cashflows remains the paramount driver of stock valuations.

In fact, market movements explain fewer than 20% of individual stock movements. Company stock and market data and analysis by L.E.K. show that changes in the value of movements in the S&P 500 Index explain only 17% of stock changes. The Australian All Ordinaries Index explains only 9% of individual stock price changes.

In Thailand, L.E.K. examined the 30 different industrial sectors as published in the L.E.K. Consulting/Bangkok Post Shareholder Scorecard and isolated the 11 sectors that underperformed the overall three-year market average return of 6.8%.

This left a group of 129 companies that had been traded for three years or more. Then we examined how many of these companies generated three-year average shareholder returns above the market average despite operating in underperforming sectors. We found that 57% or 73 of the 129 companies in underperforming sectors still beat the average market return.

About a quarter of the companies in "good sectors" generated returns below the market average. Conversely, many companies in sectors whose average returns exceeded the market actually underperformed the market.

Among the 186 companies that had been traded for three years or more in the 19 sectors that outperformed the market, 27% or 50 companies, generated three-year average shareholder returns below the market average.

The performance range within sectors is significant. Evidence to support the relatively weak role that the industrial sector plays in determining indi vidual stock returns can be found in the wide range between winners and losers within sectors.

As an example, if we look at the returns within the energy sector we see a broad range. Three companies, Thai Industrial Gases, Banpu Plc and Unique Gas generated three-year annual shareholder returns of 47.7%, 36.8% and 33% respectively.

At the bottom, PTTEP and Egcomp generated three-year annual returns of -6.9% and -8.7% respectively.

Although it could be argued that some fundamental drivers of the energy business are different across fuel and asset types, it is still the investors' expectations of future business outcomes, as reflected in the anticipated impact on operating cashflow, that ultimately drive shareholder returns.

This holds true even for companies competing directly within the same narrow industry sector. For example, in the building and furnishing materials industry, Siam City Cement achieved a three-year return of 76.9%. In contrast, its direct competitor, Siam Cement, generated -33.3% in the same period.

Large differentials such as this between top and bottom performers in the same sector existed even when the same return analysis was taken over a one-year or five-year horizon.

Long-term performers thrive on strategy. Clearly a stock's individual returns are driven by many factors common to a sector. However, as the market gyrates and sectors fall in and out of favour, managers may be prone to conclude that the fate of their company's stock is largely at the mercy of sector trends.

However, as the data suggest, this is untrue. Over time, the most important drivers of stock performance are the strategic and operational actions of management and how those actions affect the volume and timing of cashflows.

Without a doubt external events can alter the value of a particular strategy or affect some sectors more than others. The difference is that companies that consistently create value for shareholders are able to quickly understand the implications of external events on their current strategy and adjust their plans as required to redirect and redeploy resources.

In a declining market, an outperforming manager is someone who is capable of falling less swiftly than his or her peers, thus retaining value and charting a course for future growth.

The lesson for management seems clear. If you operate in a strong sector, take no comfort. If your sector is weak, seek no justification for your low performance. Evidence suggests that your fate is more in your hands than you might believe.

* Chris Kenny is a vice-president with L.E.K.'s Chicago office. Bob Neapole is a director and co-head of L.E.K.'s Bangkok office. Waris Watanakun is a consultant in the Bangkok office. Contact:ckenny@lek.comrneapole@lek.comwwatanakun@lek.com.

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