Lean, mean profit machines

As to why productivity is so important, Mr Krugman went on: “A country’s ability to improve its standard of living depends almost entirely on its ability to raise its output per worker.” One might quibble that Mr Krugman’s statement is almost tautological, but in essence it says that rising wealth needs rising productivity since productivity is defined as output per worker, or – slightly more nuanced – output per hour worked.

However, if productivity is so important then it must do more than shed light on a nation’s economic performance. It must also point the spotlight on the performance of companies since almost all those workers are labouring for a corporate entity of some sort, be it in the private or the public sector. Given that, so the logic goes, then the most productive companies must also be the best ones – and investors always have a vested interest in knowing which ones those are.

Better still, if measures of corporate productivity can be related to a quoted company’s share price, then a powerful tool to help with investment decisions may become available. Happily, a company’s share price can be usefully related to its productivity, although it’s not that simple, as we shall see.

First, though, let’s set the scene. It is hardly being too dramatic to say that the crisis in capitalism of modern times owes its origin to the faltering rise in productivity in the developed world since the credit crunch of 2008-09. Yet to be sustained that claim needs a close link between changes in productivity and in real (ie, inflation-adjusted) wages because, so the argument goes, today’s unhappiness of workers in the west has its roots in the stagnation of real pay.

In fact, it is clear that throughout the west – although especially in the US and the UK – growth in real hourly pay has stagnated despite the rise in productivity and this trend was established as far back as the mid 1970s. Josh Bivens and Lawrence Mishel, two economists from The Economic Policy Institute, a US think-tank, showed that in the US from 1973 to 2014 productivity – defined as output per hour worked – rose 72 per cent, but average hourly pay rose only 43 per cent. More telling, median hourly pay – the mid-point between the highest and lowest rates – rose less than 9 per cent. So, strip out the effects of extra pay grabbed by company bosses and by those workers who benefited from the rising premium on transnational skills and you begin to understand that today’s anger among blue-collar workers has been building for a long while.

That said, there is still a clear slump in productivity since the credit crunch and the more recent stagnation of pay might be related to that. Chart 1 illustrates this in respect of the UK. Up until 2008, output per hour worked rose every year bar three in the 37 years from 1971. From 2008, however, hourly output has fallen in four of the eight years to 2015. As a result, the index of hourly output produced by the Office for National Statistics, which was 46 in 1971, should be approaching 120 if it had stayed on the trend of 1971 to 2007, but at 102 in 2015 was still at 2007’s level.

Meanwhile – and perhaps more worrying – the UK’s productivity has started to flag compared with the rest of the developed world (see Chart 2). So much so – and so oddly – that economists label it ‘the productivity puzzle’. Starting from 1991, the UK’s growth in output per hour worked outpaced its rivals partly because it was beginning from a lower level. By 2002, the UK’s productivity was pretty well matching the other six of the G7 group of big, wealthy nations. Near parity continued until 2007 and the start of the financial crisis. Since then, the UK has lost ground and its productivity in 2015 stood at 15 per cent below the rest.

Granted, it’s right to be deeply sceptical about the data, which derive from national statistics via the OECD, a think-tank for wealthy nations. These claim that the only G7 country whose productivity lags the UK’s is Japan despite its capital-rich economy. Simultaneously, the figures tell us that Italy’s workers are 9 per cent more productive than the UK’s.

Accurate or not, data such as these have been sufficient to throw the great and the good of the UK’s business establishment into a panic. The shrill cries of ‘This is a crisis. Something must be done’ mean that the ‘something’ has been to start with a ‘productivity commission’ – actually, a group of business leaders appropriately called the Productivity Leadership Group. This has been followed by chancellor Philip Hammond announcing in his November fiscal statement a £23bn National Productivity Investment Fund, which will channel capital into public sector spending that should best boost productivity. And on the assembly line is the Productivity Council, which will help foster the best practices to realise that aim.

Thinking in the UK – and the response – has been strongly influenced by a substantial report from the OECD in late 2015, The Future of Productivity. The essence of this report was that a “global diffusion machine” had broken down. By “diffusion”, the OECD meant the pace at which efficiency-enhancing innovations spread through the global economy from the best companies, to the average ones and then to the laggards. Whereas once diffusion had been a fairly smooth process, in the years leading up to the financial crisis – and for reasons that remain obscure – it began to fail and, with it, the growth in productivity.

As to possible explanations, there is the secular slowdown theory. This is a sort of grand super-cycle hypothesis associated with a US economist, Robert Gordon, who popularised it in his 2016 book, The Rise and Fall of American Growth. Professor Gordon suggests that productivity is failing because growth is becoming more difficult in the absence of any truly major innovations to stimulate it. Meanwhile, the growth that resulted from what he labels “the three great industrial revolutions” – coal and steam, followed by electricity and the internal combustion engine and then computers and the internet – have all but run their course.

Yet Professor Gordon’s pessimism is balanced by a more optimistic scenario linked to two other US academics, Erik Brynjolfsson and Andrew McAfee in their 2011 book, Race against the Machine. They suggest that better computing power will promote innovation, and therefore raise productivity, basically because so many aspects of fostering business – monitoring results, sharing ideas, replicating innovations – will speed up.

What matters more than conjectural explanations of the past is the OECD’s notion that there are now three types of company in terms of productivity. First are the so-called ‘global frontier’ companies. Almost by definition, these are the most successful not just because their productivity is the highest but because it has continued to grow smoothly since the financial crisis. Second are the national leaders, the companies of the second rank which – in theory anyway – pick up on the productivity advances made by the global leaders. Third are the companies that the OECD labels the “laggards” – the companies that, apparently, used to raise their efficiency when improvements filtered down to them via the national leaders. However, now that the productivity-diffusion machine is broken, these companies languish.

True, this scenario may be as much theoretical as real. As the OECD acknowledges, “research on the global frontier is scarce”. Even so, the OECD also says it has identified the 100 most globally-productive companies in each broad industry category and found that, compared with average companies, they are larger, more profitable, more likely to be awarded patents and are younger; although – perhaps ominously – the average age of the global leaders has been rising since 2001.

What applies globally may apply across the UK, too. At least, in a paper produced in December, the chief economist at the Bank of England, Andrew Haldane, drew on returns from the 30,000 companies on the database of the Office for National Statistics to show striking differences in productivity between the very best and the also-rans. Mr Haldane showed that for most UK companies productivity – measured as gross value added per employee – had flatlined since 2002. However, for the top 1 per cent of companies productivity had marched upwards by, on average, about 6 per cent a year.

In addition, there were, he said, big differences between the productivity of all companies within regions and between the productivity of companies within broad industry categories.

However, this raises the important matter of the nature of company productivity and its relation to profits. At its simplest, productivity is only a ratio of a measure of output per unit of input (see the box, Productivity – a primer). Across a whole country it is generally measured as gross domestic product per worker, or per hour worked. For companies, the roughly-equivalent measure that is readily available is gross profits per employee (preferably per full-time equivalent). From that, it follows that the most productive companies will be those that can make their money while employing comparatively few workers. Simultaneously, companies in labour-intensive industries will look to be unproductive.

But such a judgement would be wide of the mark. To see the fallacy clearly, consider that among companies in the FTSE 350 index, the sector with the highest profit per employee is property companies. For example, the UK’s biggest property company by stock market value, Land Securities (LAND), is among the most productive, generating £901,000 of gross profit per employee in 2016. The second biggest – British Land (BLND) – produced £978,000. Yet the chief reason these two are so productive is that they have so few employees – 626 for Land Securities at the end of 2016 and 589 for British Land.

Compare those numbers with UK companies that made similar levels of profit in 2016. Spirax-Sarco (SPX) – the sort of specialist engineer that epitomises the need to innovate to thrive in a global market place and, therefore, should be very productive – made the same gross profit as Land Securities (£564m) yet needed 5,300 employees to do it. Or take Playtech (PTEC), which writes online gambling software and therefore should rely on a comparatively small number of highly qualified staff, making it very productive – it needed 5,000 employees to make £606m of gross profit.

The fact is that property companies are the archetypal two-men-and-a-dog operation because few employees are needed to manage a property portfolio, especially as the maintenance and the development (if there is any) will be done by outsourced labour. That may make them ostensibly productive, but it does not necessarily make them wonderful companies. Chiefly, it makes them capital intensive rather than labour intensive.

From this, three key points about the productivity of companies follow:

■ First, there is no absolute measure of company productivity. Productivity is a ratio and, like any ratio, it only makes sense in comparative terms. It is not possible to say that profits per employee of £500,000 is good while £300,000 or less is bad any more than it’s possible to say that a PE ratio of 10 is better than a multiple of 15.

■ Second, productivity begins to make sense when the comparison is between companies in the same or similar industries. Thus, as we saw, comparing property companies with engineers is meaningless, but comparing engineers with each other can be worthwhile.

■ Third, productivity is more useful when assessing the performance of companies over time and it is most useful when simply assessing a single company over some years. All else being equal, when a company shows rising profits per employee that must be good. The trouble is that only rarely is all else equal. Let’s discuss.

As good a place as any to start is with the OECD’s contention that there are global leaders, national champions and also-rans. That view is echoed on a UK level by the Confederation of British Industry which produced a report in March, Unlocking Regional Growth, which was about “understanding the drivers of productivity across the UK’s regions and nations”.

From the perspective of investors, the major shortcoming of both reports is that, all the while they discuss wonderful companies and those in their tail wind, neither actually names a single company. Yet we want to know which ones are the conquerors and which the conquered. So we started from the opposite perspective. We selected a variety of companies that look as if they should be global leaders, national champions and followers. Then we checked: (a) how their productivity has changed over the years, (b) what they have done to foster productivity growth, and (c) what effect, if any, this has had on their share price performance.

Table 1 deals with this for 16 companies. We are most interested in comparing the compound growth rates in the table, which are for changes in productivity (as measured by gross profits per employee), changes in so-called ‘growth spend per employee’ (explained in the next paragraph) and in each company’s share price.

Table 1: Global leaders and followers – maybe

Ideally, there should be a link – or even a virtuous circle – between these three features. Rising productivity should help boost a company’s share price and, in turn, productivity should be helped by the pace at which the company raises its capital spending, its outlays on research and development and its investment in intangible assets (these three are captured in ‘growth spend per employee’).

For some companies, the link looks quite strong. Take the world’s most valuable company (by market value of its equity), Apple (US:AAPL). With gross profits per employee of over £560,000 in 2015-16 spread across its 116,000 workforce, few companies can match Apple’s productivity. Fewer still can beat the pace at which its productivity has risen – 11 per cent a year compound in the 20 years to September 2016. Even more remarkable is how productivity has risen with so few blips. That said, there are signs that its productivity has peaked. The figure for profits per employee was about £770,000 in 2011-12 and it has dropped in three out of four years since then.

It’s impossible to say how much Apple’s growth spend per employee drove rising productivity or whether it was largely a function of the company’s marvellous profitability, which enabled it to splash the cash. But clearly no other company in the table comes close to matching its spend that could make employees more productive. So the possible link between rising productivity and Apple’s soaring share price almost looks persuasive. Meanwhile, because a company’s share price will depend on so much more than rising profits per employee, it’s not surprising that share price growth has far outstripped productivity improvements – by approaching 28 per cent a year compared with 11 per cent.

Interesting for investors is the apparent relationship between productivity and the share price. This is shown in the right-hand column of Table 1 – the ‘share price driver’ – and in Chart 3, which shows the data for Apple as a scattergram. ‘Share price driver’ is shorthand for the extent to which there is a pattern between value-added per employee and the share price. In formal statistical terms, it is the ‘R squared’, which measures the fit between – in this case – productivity and the share price. The lower the average distance between each data point in the chart and the trend line, the higher the R squared. In the case of Apple’s chart, the stats say that 87 per cent of changes in the share price are driven by changes in productivity.

Don’t take that figure literally. It means there is a particularly close fit between the data and that may make its signals stronger. So the chart indicates that the data points above the trend line occurred when Apple’s share price was ahead of the game; when they were below the line, the shares were cheap. Thus it may be a concern that the highest data point also occurred for the latest year-end when Apple’s share price was $113 even though productivity had fallen 15 per cent in the year. Maybe more worrying still, Apple’s share price has not stopped there. Recently it topped $140, implying either that the shares were really expensive or that other factors were driving the price.

We can work through Table 1 making similar observations. It is noticeable that, among the great and the good of global leaders, the R squared is fairly high, implying a steady connection between productivity and share prices. The link is weakest – but still significant – where productivity has actually fallen over the 20-year period, as with Nestlé (SWX:NESN), or where the share price is lower than 20 years ago, as with GlaxoSmithKline (GSK).

Interestingly – although not necessarily significant – the share price driver is much lower for those companies styled ‘national champions’ or ‘others’. We might expect that in respect of foods processor Associated British Foods (ABF) and WD40 (US:WDFC), where productivity is actually lower than in the mid 1990s; or at pubs operator Marston's (MARS), where the share price is lower. But the outcome is surprising for household goods supplier McBride (MCB) or defence contractor BAE Systems (BA.), where growth in both productivity and the share price has been in the same direction, albeit at a slow pace.

It is also possible to make selective comparisons between companies. In the table, the standout match-ups are between the global leaders in fast-moving consumer goods – Unilever (ULVR), Procter & Gamble (US:PG.) and Nestlé – and McBride, which is an own-label supplier. It is intriguing that Unilever and Nestlé both generated almost equal gross profit per employee in 2016. It is not so much that Unilever did a lot of catching up to get there; rather, Nestlé’s productivity faltered from its peak in the mid 2000s. Indeed, it faltered so much it is possible that the drop was due to a change in Nestlé’s operations more than a decline in efficiency. That would be consistent with the way that these consumer goods global champions churn companies in and out of their stable of subsidiaries.

At least it is comforting that the data for McBride compared with the global leaders are consistent with its status as a follower. Its productivity is half the level of Unilever and Procter and its growth spend is a fraction of theirs. Small wonder, it’s tempting to conclude, that its share price performance has been so comparatively dull.

Then there is the comparison between the aero and defence companies, Boeing (US:BA.), BAE Systems and Cobham (COB), each one of which fits fairly neatly into a status slot (see Table 1). That BAE, a much smaller company than Boeing, should lead the US company on value-added per employee may say more about the specialist nature of BAE’s defence business than Boeing’s lack of productivity. Meanwhile, Boeing’s ‘spending to grow’ looks high. That might augur well for the future except that the figure has hovered around 2016’s level for some years. And BAE’s growth spending figure looks low except that, according to the database we use, BAE does not split out its research and development spending in its accounts. At least Boeing and Cobham produce scattergram charts that show a useful link between productivity growth and share price movements and that is reflected in the high values for R squared, the ‘share price driver’.

And that may be the chief judgement on Table 1. It seems to confirm the third of our three key points on assessing productivity – that gauging productivity is most useful when assessing single companies over time.

Even so, there are still conclusions to be drawn from aggregating data. First, though, let’s understand that assessing companies’ productivity comes with a built-in difficulty because productivity is a measure that can only be calculated once a year. So by the time enough data have been collected to make a useful judgement – 20 years, or as near as possible, for the companies in Table 1 – the nature of the observed companies may have changed so much as to make assessments suspect. After all, 20 years ago GlaxoSmithKline was Glaxo Wellcome and its merger with SmithKline Beecham was still almost four years away.

Besides, there are not that many companies around for which there are 20 years’ worth of consistent data. Where there are – such as for Apple or for West Midlands engineer Castings (CGS) – then the resultant charts look helpful. Reduce the period under review and more companies offer up useful data. Tables 2, 3 and 4 do this for the components of the FTSE 100 index with data from 2004 – conveniently before the financial crisis – to 2016. The aim is to find which are the most productive – and least productive – companies among the 100. Given what we have already discussed, defining ‘most productive’ brings its own challenge; and what we know about the natural variation in profit per employee from sector to sector means that simply ranking by that figure would be useless.

Tentatively, we suggest that the best – or least worst – way to rank company productivity is by using the percentage change in gross profit per employee from a start date (2004 wherever possible) to an end date (2016). That side steps the difficulties caused by starting with volatile data and using average growth rates, be they mean or arithmetic. The percentage-change figure is then tempered by using the standard deviation of yearly percentage changes: the lower the deviation, the steadier – and, implicitly, the more reliable – the growth in productivity.

Table 2 shows the best 20; Table 3 shows the bottom 20 and on the web site there is a table showing comprehensive data for all components of the FTSE 100. Table 4 aggregates data for all 91 Footsie companies for which there is satisfactory data then adds some telling statistics for UK inflation and changes in private-sector wages over the relevant period. What shouts loudest is the difference in share price performance between the most productive 20 and the least productive. In the 12 years 2004 to 2016, the best 20 saw an average rise of 264 per cent in the price of their shares, exactly twice the rise of the bottom 20. To that extent, the message coming across is ‘productivity counts’.

Table 2: Footsie’s most productive

Table 3: ...and least productive

Table 4: Footsie productivity versus inflation & wages

However, it is also noticeable that the standard deviation of changes in productivity – as usual, measured by gross profits per employee – was much higher for the leaders than the laggards. That implies their improvements in productivity were arriving in a haphazard way; yet, apparently, investors were willing to put up with this. It is also important to point out that using an arbitrary start date (2004) affected the outcome. Several of the leaders – InterContinental Hotels (IHG), GKN (GKN) and United Utilities (UU.) – would not be there if the start date was, say, 2005 or 2006.

What chiefly speaks out about the least productive companies is ‘crisis’ – the crises that hammered profits in banking and retailing. When profound change undermines the profitability of companies, it is well-nigh impossible for them to maintain profits per employee. So it is no coincidence that three supermarkets operators and two clearing banks are among the bottom 20.

That said, some companies that are perceived as very successful also feature – insurer Admiral (ADM), pharma group Shire (SHP) and Associated British Foods, in particular. Their apparent lack of productivity may be a sign of success – new employees have been piled on faster than profits. Alternatively, their bosses may have been busy acquiring different sorts of businesses, possibly the wrong sort.

Questions such as that can only be addressed in detail. And, in a way, that’s the chief point of this article. Sure, it is useful to read the messages coming from Tables 2 and 3 that, on average, companies’ share prices are rewarded when productivity improves and they suffer when it falters. It’s also interesting to see that even an average FTSE 100 company has raised its productivity by more than twice the rate of inflation and almost three times workers’ average pay in the 12 years 2004-16 (see Table 4). That strikes a chord with the US research mentioned earlier – that employees’ pay was stagnating despite rising productivity rather because of falling efficiency.

However, for investors, studying productivity is most useful when it is done one company at a time – or maybe in a very selective comparison – with data stretching back a good few years. It also works best for companies whose activities remain stable even if the business environment in which they operate doesn’t. And, without a good database to help, even finding the necessary figures may be daunting.

To that extent, Paul Krugman is probably right – “productivity isn’t everything”. But in the long run it’s a mighty useful way to gauge a company’s performance.