The firms with the fast returns

There are only 20 sectors in Table 1 since some sectors either did not include a FTSE 100 company or did not have a FTSE 100 company with P2 of over 143.8 per cent (automotive, electronics & engineering are examples). Real estate is also excluded since asset values rather than P2 are the key in this sector; the same applies to housebuilders where land bank assets are a key component of value.

Table 1

Table 1 shows that all but three of the 20 companies increased their VA from 2004 to 2007 and that all the companies maintained P2 at a high level (with only two showing significant reductions). VA is a much better measure of created wealth than sales. Johnson Matthey is a good example. Its sales were £4.8bn as of January 2007, whereas VA was £575m. The reason for the big difference is that the company buys in expensive precious metals that it processes and then sells to customers in processed products such as exhaust catalysts. To understand the meaning of P2, the wealth-creation efficiency, note that a P2 of 100 per cent means that a company only makes just enough VA to cover its employee and depreciation costs – a position that is not sustainable for very long. A P2 of 140 per cent or more is usually needed for comfort.

Price Performance of 2004 VA Portfolio

The share prices of the 20 companies in Table 1 are shown in Table 2 for late January 2004 and late January 2008 (or at takeover for BAA and Hanson). Late January 2008 (24 January) was just after a week of share price losses and the FTSE 100 rose 33 per cent between January 2004 and January 2008. Increases in company share prices should be judged against this 33 per cent rise in the index. Table 2 shows that 14 of the 20 companies had share price rises larger than 33 per cent while just two companies showed a decrease in share price from 2004 to 2008. These two companies were HBOS and BSkyB. HBOS has been marked down in the past few months, along with all the banks, due to concerns over sub-prime losses and the credit crunch which have affected most US and European banks and were not anticipated even as late as January 2007.

In the case of BSkyB, the 2004 VA data suggest that its 2004 valuation was stretched. In VA terms, valuation is assessed using the market cap to VA ratio, which lies in the range four to eight for almost all the companies in Tables 1 & 2 (with average MC/VA varying widely between sectors). BSkyB had a 2004 MC/VA ratio of nearly 19 and might well have been rejected as a portfolio constituent for this high-valuation reason – it would have been replaced by Reed Elsevier, which showed an increase of 26 per cent. The share price performance of the VA portfolio of 20 companies in Table 2 shows an increase in value of over 83 per cent using Reed Elsevier (or 80 per cent with BSkyB) compared with the 33 per cent increase in the FTSE 100 between 2004 and 2008. The portfolio increased by two-and-a-half times as much as the FTSE 100.

Changes in share prices are calculated from January to January since the datafile for the VA Scoreboard is 'frozen' in January. However, it is of interest to calculate how the portfolio did from January 2004 to April (22) 2008. The VA portfolio increased by 91 per cent over this period compared with 35 per cent for the FTSE 100, outperforming the index by more than two-and-a-half times.

Table 2

Price Performance of 2006 and Later Selections

The 2006 VA Scoreboard was published in spring 2006 with data 'frozen' in January 2006. As a second test, it is interesting to see whether companies selected from this Scoreboard also outperformed over the next two years (although two years is rather a short period for such a test). The simple selection criteria were similar to those used for Table 1 (highest P2 FTSE 100 company in top eight of each sector provided it had P2 over 150 per cent and had increased its VA).

The set of 20 companies selected in this way is shown in Table 3 together, with the change in the share price at late January 2008 from that of January 2006 for each company. The FTSE 100 was, in this particular case, almost unchanged over the two-year period, whereas the VA portfolio increased in value by more than 18 per cent. Encouragingly, 15 of the 20 companies showed increased share prices over the period, with HBOS again showing a decrease as expected. It is also noticeable that 15 of the companies in Table 3 are also present in Table 1 even though three of the sectors in Table 1 do not appear in Table 3 in any form; this illustrates the consistent value-added performance shown by many good companies. Again, the value-added portfolio comfortably outperforms the index. If the comparison is made from January 2006 to late April 2008, the VA portfolio increases by 22 per cent compared with a 4 per cent increase for the FTSE 100.

How many of the companies in Table 3 selected from the 2006 VA Scoreboard still have good VA performance in later years? There are two sources of further information: the 2007 VA Scoreboard and the VA data for some companies with research & development (R&D) in the 2007 R&D Scoreboard and whose full-year results were available before end-July 2007, so that the data for them that will appear in the 2008 VA Scoreboard is also that in the 2007 R&D Scoreboard. If we eliminate the two companies from Table 3 that were acquired and HBOS, the remaining 17 companies (except Enterprise Inns) all increased VA over the most recent year for which we have data, except Cadbury Schweppes, where VA was almost unchanged but P2 decreased. We find that both VA and P2 increased for each of the two years after the 2006 Scoreboard data for Johnson Matthey, Scottish & Southern, United Utilities, BG and AstraZeneca, while Vodafone increased both but only for the second year.

Others such as Reckitt Benckiser and Sage increased VA substantially while their high P2 decreased only marginally. For the companies with only one year of extra data, both parameters increased for Diageo, MAN, Legal & General, BSkyB and Antofagasta while Imperial Tobacco showed a small and immaterial decrease in its very high P2 . Overall, the key message is that certain companies are able to both increase their VA and create it with high efficiency (P2) year after year and it is these companies that investors should look at closely. It is still necessary, however, to look at conventional financial measures and, in particular, at valuation measures such as market cap (MC)/VA, price-earnings (PE) ratio and PE/growth (PEG) ratio. Note that MC/VA ratios are listed in the 2007 VA Scoreboard.

Table 3

Conclusions for Investors

These examples demonstrate that a record of consistently good VA data has predictive value in helping to select companies that are likely to perform well in succeeding years. An important point about the portfolios shown in Tables 1, 2 and 3 is that they are well diversified across sectors.

The VA parameters should, in practice, be used in conjunction with other financial information and valuation ratios, but the examples given show just how useful the four basic value-added numbers (VA, P2, change in VA and MC/VA ratio) can be. It is important to focus on those companies that show sustainably good value-added performance and maintain position at the top of their sector (or in first/second place for larger sectors). Investment in areas important to competitiveness is normally needed to maintain a leading position – this may be in R&D, brands, capital expenditure, market development, service, skills or other factors. Investors should also take account of any current special factors affecting specific sectors (eg banks) or companies (eg a recent major acquisition or a new/revitalised competitor). While the examples given above are from the FTSE 100, a similar approach can be used with the FTSEurofirst 100 and 300 or the FTSE 250 (and some 170 FTSE 250 companies are listed in the 2007 VA Scoreboard). Indeed, the 2007 VA Scoreboard not only included 321 listed UK companies, but many unlisted ones together with a further 421 listed continental European companies; each company entry in the Scoreboard gives over 30 items of financial and value-added information freely available for use by investors.