Today, we’re going to talk about something that is particularly important to investors: corporate value creation. Ultimately, the true hit investments are companies that create very significant value over and above what was put in by investors.
Now, there’s a problem here because often people get very excited about a technology and they think that the companies that are in that space are therefore going to create a lot of value. That may not be the case; in fact, quite frequently, it is not the case. Let’s take the example of automobiles. Automobiles have been a uniquely desirable investment. Americans have bought automobiles by the millions and millions, enjoyed them, and made them a deep part of their culture. That has created a lot of value, but the value flowed to the consumers of the automobiles, not to the companies producing them. In fact, there have been over 4,000 producers of automobiles in the United States since the introduction of the Model T, and virtually every one is bankrupt, some twice.
Airlines, quite frankly, are a similar story. Air travel has been an incredible value-creating boom for consumers, but it hasn’t been so good for airlines. In fact, Warren Buffett quipped that had he been at Kitty Hawk, he could have done investors a favor by shooting down Orville. Virtually no airline companies created much value. Well, why? What’s going on here?
I think if we go to the computer, we can gain some insight as to what the problem is. So here on the computer, you can see that there are so-called excess earnings. Excess earnings are fundamentally related to value creation. Excess earnings are earnings minus the book value, which is the amount of dollars that investors put into a business, times the cost of equity. If you just earn the cost of equity, then you are not going to create value. If the earnings only equal the book value times the cost of equity, this second term is going to be zero. There are going to be no excess earnings. It doesn’t mean the company isn’t earning money; it’s just earning a normal profit. It’s not creating value.
There’s an interesting way to write an equation that gives the fundamental value of a company, and that is shown below. The fundamental share value equals the book value, which is the amount of money that investors have put into the company, plus the present value of all future excess earnings. That present value is the amount of value created by the company.
Now, you might ask, well, how many companies create value? Don’t most of them do that? In fact, most do not. Henrich Bessenbinder, who’s a professor at Arizona State University, has examined this very carefully. He actually uses an easier hurdle for creating value. He says that a company creates value if its earnings exceed the book value times the treasury bill rate, not the company’s cost of equity. But even using that lower hurdle, here’s what Professor Bessenbinder finds. He looked at all 28,141 firms on the Center for Research in Securities Prices (CRSP) database from 1926 to 2022. These are all firms that were on that database any time during that period. He examined their lifetime value creation from when they first went public to when they either were no longer public—perhaps they were bought out, perhaps they merged, perhaps they failed—or until the end of the database if they were still around.
Of the 28,141 firms, 14,481 destroyed value, even with his softer criterion. Well over half were value destroyers. Of the 11,633 firms that did create some shareholder value during their life, the top 50—just 50 out of 28,141—accounted for 43.1%. This is something that could be a real concern for investors.
If you were to go in and buy 10 random stocks, the chance would be that six of them would destroy value, and you might not get one of the top 50 at all. The others would be mediocre value creators. If you don’t own one of the 50 that are big value creators, your performance relative to the market is going to be poor.
So, at Cornell Capital, we think very deeply both about how you might identify firms that are going to be value creators, and we’re going to talk about that in a subsequent Reflections on Investing. But we humbly refer to it as a reason for diversifying. If you buy a very well-diversified index, you’re going to have a lot of losers, you’re going to have a lot of mediocre firms, but you’re probably also going to get most of the top 50. The reason the S&P 500 has done so well over this century is it’s always had enough big winners to pull the average up to a return on the order of 10%.
At the close, let me just give you a list of some of the Bessenbinder big winners. These are all from his top 20. No surprise here: Apple, Microsoft, Exxon—oil companies get a bad rap, but Exxon’s been a huge wealth creator for investors—Walmart, Buffett’s Berkshire Hathaway, Chevron (another oil company), Coca-Cola, Home Depot, and Altria, which owns cigarette companies. So, it’s quite a diverse group. If you were to purchase stocks and not have any of these, your chance for beating the market is limited. Understanding wealth creation is a core skill for wise investing.
This has been Reflections on Investing with the Cornell Capital Group.