Have you invested in a ‘Level 10’ stock?

 

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If you are a long-term investor, your objective for investing is bound to be two pronged. You expect short-term (dividends) as well as long-term returns from the stock. To fulfill the latter objective i.e. capital appreciation, the company needs to focus on building shareholder value. However, in pursuit of short-term gains and stock price appreciation, a company may sacrifice long-term value creation. In order to avoid such companies, you need to look for a ‘Level 10’ company. So, what is a Level 10 company? And, how can companies strive to become one? Let us help you investigate.

 

So, what is a ‘Level 10′ company?

According to Alfred Rappaport, a Level 10 company could be seen as a company that follows 10 simple practices that enable it to create continued growth and shareholder value for its investors. Such a  company delivers superior long-term returns to its investors by growing its share price faster than the competitor’s share price, thus, exceeding the market’s expectations.

Is your company focusing on shareholder value?

So, is your company a Level 10 company? Are its strategies focused on achieving short-term gains or long-term shareholder value creation? As a long-term investor, you would obviously prefer the latter. How do you gauge whether your company is on the track to creating shareholder value? Let’s discuss some practices currently followed in organizations, and figure out what does or does not lead to fulfilling the long-term investor’s objective:

1. Is the company playing The Earnings-Management Game?

Companies play the earnings-management game when they accelerate revenues to the current period and defer expenses to future periods. This entails a decrease in the company’s spending on long-term value-creating activities including R&D, advertising, maintenance and hiring, or even a delay in new projects, in order to meet the desired earnings benchmark for the current period.

Thus, a company that is actively investing in value-creating activities and opportunities, is focusing on shareholder value and will stand to benefit in the long-term.

2. Is its strategy maximizing expected future value?

It is important to decipher whether the strategic decisions taken by the management are aimed at maximizing the expected value of the business. Even though they may come at the expense of lowering near-term earnings, the impact of such decisions should essentially be measured against incremental cash flows generated in the future.

3. Acquisitions as a means to create value

Value creation in a business occurs as a result of efficiency in day-to-day operations of the business, as well as, through strategic acquisitions.

In case of acquisitions, a mere rise in post-deal EPS is no good indicator. Acquisitions will lead to value creation only when the present value of incremental future cash-flows (after providing for the risk that synergies may not materialize), exceeds the acquisition premium paid.

Also, if it is financially feasible and the management perceives the synergies arising out of the acquisition to exceed the acquisition premium, they will usually try and pay for the deal in cash so that their existing shareholders do not have to give up on any post-merger gains because of any dilution in stake. On the other hand, if the premiums exceed the synergies, it is more than likely that the acquirer will offer stock in order to hedge its bet.

4. Is it carrying assets that maximize value?

A company that focuses its spends on high value-adding activities, while outsourcing the low value-adding ones, creates shareholder value. High value-adding activities are activities that help the company gain a comparative advantage over its peers, such that buyers are willing to pay a premium for its stock.

Popular examples of this practice being successfully implemented are:
•    Hindustan Unilever Limited: outsources manpower-intensive manufacturing and sourcing, while focusing on value-enhancing marketing, sales & distribution and brand-building.
•    Bharti Airtel: has outsourced its towers to Bharti Infratel and Indus, equipment to Nokia Siemens and billing and IT to IBM, while retaining ownership of spectrum and marketing of telecom plans with the company.

5. How is the company using its excess cash?

It makes good business sense for a company falling short of viable value-adding opportunities, within the business and beyond, to return the excess cash it generates in the course of its operations, to its shareholders. The shareholders can invest it elsewhere to get better returns. At the same time, this will ensure that the management does not get into overpriced acquisitions. Such return is usually in the form of dividends or share buybacks.

However, share buybacks undertaken with an objective to boost EPS, fail to add any shareholder value.

How is the company rewarding its employees?

6. Senior executives: history has enough proof that standard stock options haven’t really delivered the desired result, as most executives cash out early on any increase in share price and also shift focus to near-term performance and price increase to make immediate gains on exit. In such a case, a company that focuses on value creation could use restricted or discounted indexed option plans that rewards the holder when the company’s share outperforms the peer index, hence delaying exit. Alternatively, the company could also lower the exercise price or extend the vesting period for existing options.

7. Operating-unit executives: Does the company have any metric in place to determine whether the operating cash flows generated by a unit exceed the investment required by it? If yes, is the company rewarding its operating unit level executives, accordingly?

8. Middle management & Front-line employees: Have any key indicators and value-drivers been linked to performance and reward measures? Time to market for new product launches, employee turnover and customer retention rate are examples of such value-drivers.

9. Is there a sense of ownership in the management?

To create a sense of ownership in the firm’s management, the company could mandate a minimum stake in the firm as a function of the base salary. However, the value creation oriented company also needs to create a balance between requiring executives to have a continuing stake in the firm on one hand, and restricting their liquidity and diversification on the other.

10. Does the company provide value-relevant information?

A company with better disclosures providing value-relevant information lessens investor uncertainty, thus, reducing the cost of capital for the firm, and improving the share price in the long-term.

So, if you find a company that fulfills all these ten criteria, you can rest assured that it is a Level 10 company, focussed on shareholder value creation, hence, the perfect bet for a long-term investor’s portfolio. However, a company striving to achieve the same, or qualifying on at least 7-8 of these parameters, could also serve your purpose. At the same time, long-term investors should remain wary of companies that have a short-term performance and price focus.

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