SG Europe Top 20 Fund Report, SG Asset Management, November 8, 1999

SGAM/Act/Ana/Alfred Park 11/08/99

Confidential

Special Report – SGAM Europe Top 20 SYNOPSIS

In light of strong equity performances across Atlantics over the past 4 weeks, I have briefly revisited

valuation level and market backdrops for the US equities, bellwethers for European equities, by looking

at each sub-component that is supposed to drive values. The result is very alarming, especially when

viewed together with studies of some academicians. This should certainly raise the level of caution for

equities in the US, and to a lesser extent, in Europe.

I have taken a widely accepted theory that the value-driving factors upon which a fair price of an asset

must be based are return on capital, cost of capital, and growth. The wild card that pushed up equity

prices to contradiction of a number of academicians and pundits has been a productivity growth, which

essentially affects the above three variables of value matrix. This report summarises our findings with

respect to the three value drivers, with an extra emphasis placed on productivity growth and its likely

impacts on these value drivers.

CONCLUSIONS

While we are fundamentally bullish for European equities, we have found several things that may be a

little different from otherwise implied by the market:

1. US’ government’s preliminary ruling against Microsoft: This government intervention is a clear

sign of the government not wanting concentration of wealth. I do not think that this is to be

taken lightly because today’s valuation is pricing in a continuing generation of EVA by S&P

companies for more than 30 years, which can only be justified by permission of oligopoly. In

light of this, we should adjust today’s valuation framework by removing a large part or all of

excess residual value contributing to today’s secondary stock price. According to my growth

fade model, a mid-cycle growth in earnings is arrived at 10.2% in base scenario and at 12.3% on

the most optimistic front over the next 10 years. Today’s valuation is discounting an annual

growth of 15-19% over the next 10 years. The US economy is having a banner year in 1999, for

which growth in earnings is expected to peak at only about 15-16%. In addition, the market is

also pre-emptively pricing in dramatic changes in investment/return composition in line with

new business model paradigm. What the market implies, however, is inconsistent with what it

is and unrealistically far from what it can be. Granted M&A effects and sustained productivity

growth, equity valuation still looks very bubbly.

2. Today’s growth mode through M&A has been largely that of globalization, which is heavily

dependent upon cost-cutting. My studies show that corporate buyers may have generally paid

too much for growth, which would likely weigh on return to shareholders in the near-term.

This, when combined with rising interest rates and high equity valuation, will reverse the

market psychology, and thus flow of funds into equities.


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3. Robert Gordon of Northwestern University, one of the leading experts on US growth

performance, has argued that productivity growth has been slower than people think. He

further points out that technology’s contribution to productivity growth has been negligible to

minimal at best. The recent figures on 09/02 showed that productivity growth had slowed and

labor market had been getting increasingly tighter, a combined recipe for inflation pressure.

4. The US private sector is witnessing a double dosage of current account deficit and falling

personal savings, both at unprecedented levels. The US economy is on a thin ice, which can be

easily broken if stepped on too hard. And it is not the Americans, but the foreigners that are

walking on the ice. It is their prerogative.

In the European market, the telecom sector, which is the very important sector I have been most bullish

for, as had been stated on my report on 09/17/99, seems fully valued. At current prices, Telefonica de

Espana, France Telecom, Deutsche Telecom, and British Telecom, all have upsides of less than 10%

(benchmark target price: British Telecom at GBP13) on the most optimistic front unless there are major

upside surprises in the year-end earnings, which I believe, are unlikely. If the telecom sector fizzles, the

whole market would be shaken up because the sector had been responsible for more than 22% (while

accounting for only 12% of economy) of all future growth needed for the market to sustain the current

valuation level.

Debt crisis in emerging markets just a couple of years ago showed how whimsical markets can be in a

transition to normalization from aberration, of which the latter had been caused by what I would call

‘motivated selling.’ Can this be applied to explain today’s equities in the US and Europe? I think yes. I

argue that the market has been largely driven by ‘motivated buying’ associated with institutional

indexing. For the market to sustain the current valuation, we need absolutely to see an unmistakable

combination of strong dollar, high corporate earnings growth, and continued wealth accumulation in

private sector. Respectively, let us ask ourselves the following questions:

1. Can the US dollar remain strong in spite of record-high current account deficit?

2. Can corporate buying of equities continue with shareholder returns maintained?

3. Can we continue having a magic balance of low unemployment and low inflation?

4. Now that the private savings are record low, are markets free of any possibilities of private

investors being forced into ‘motivated selling’?

5. Will hedge funds stay dormant? If they decide to be active, would they be for or against

equities?

Because I cannot say ‘yes’ to any of the above with strong confidence, we would remain tactically

underinvested in equities. I continue to believe that it is a bit more prudent approach to have stocks at

values that can be rationalized in arithmetic framework as shown below. At the current level of 1,377,

we think that S&P may continue rising on momentum, but likely be capped at 1,450 (5% upside). To the

downside, we would find our first support at 1,250 (-10%) level.


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WHAT THE MARKET IS TELLING NOW?

We start with establishing a valid barometer for cost of capital. I have used a mid-cycle post-tax cost of

capital of 8% (=10%*51%+5.9%*49%) over the next 10 years. This reflects an equity risk premiums of 3-

4%, exactly as the history suggests. Should division of labour and capital, be attained, an equally-

weighted median return on invested capital must oscillate around 8%. As Adam Smith remarked, the

division of labour is limited by the size of the market. But the biggest of all markets is the world. If

people are able to access world markets and know-how, the size of their own economies becomes

irrelevant. This theory by A.S. has not held its own in a full-fledged fashion due to structural problems

in other parts of the world from the U.S, enabling a number of companies in the U.S. to enjoy excess

gains somewhat on the rebound. This is changing, thanks to reshaping of economy in Europe and

Japan.

Second, I have looked at today’s valuation in a Modiglianni/Miller framework. The assumptions are:

organic growth in sales at 6%, representing a sum of real economy growth, inflation and productivity

growth; and annual investment as a percentage of sales at 9% (vs. 10-year average of 7.3%), for which I

have given benefit of the doubt to the companies’ rising confidence in growth opportunities. Based

upon these assumptions, organic growth in capital, thus in earnings, (=(1+sales

gr)*(investment/sales)*capital turnover), which ultimately must converge with sales growth in long term,

is 10.2% over the next 10 years (*Incidentally the consensus 5-year forecast is 7.5% according to Zach’s).

This is quite an impressive number, but is still unrealistically far from the growth level that can explain

today’s valuation. Then how come the large-cap stocks in the US are trading at over 27X free cash flow

though the multiplier suggested by the bond yield is 12.5X?

The answer is 2 folds. First of all, the investors are betting that the large-cap stocks would continue

enjoying excess returns over the cost of capital for very long term, to be exact for 34-35 years.

According to my calculation of top 200 companies in the US, the average return on invested capital

comes out to be about 12% as of 1998. The investors are expecting these excess returns of 4% of

invested capital would remain intact, which subsequently results in re-rating of terminal value by as

1. Pn=SUM{(Di)/(1+R)î}

2. Pn=Bn+SUM{(ROEi-R)*B(i-1))/(1+R)î}

3. B(n+1)=Bn + (1-K(n+1)*E(n+1) = Bn*(1+(1-K(n+1)*ROE(n+1))

4. Pn=Bn*(1+SUM{(ROE-R)/(1+R)Î*(1+(1-K)*ROE^(i-1)}

5. Pn/Bn=K*ROE/R-(1-R)*ROE

6. R=(1-K)*ROE+K*ROE*(Bn/Pn)=(1-K)*ROE+K*(E(n+1)/Pn)

7. R=(1-K)*ROE+(D(n+1)/Pn)

8. E=(1-K)ROE=GRNGDP

9. R=Bn/Pn*(ROE-GRNGDP)+GRNGDP

10. Pn/Bn=(ROE-GRNGDP)/(ROE-GRNGDP-PG)

11. Pn/E(n+1)=1/ROE*((ROE-GRNGDP)/(ROE-GRNGDP-PG))

P=Share Price: D=Dividend: R=Cost of Equity: B=Book Value: ROE=Return on Equity:

E=Earnings: K=Dividend Payout: GRNGDP= Growth in Nominal GDP: PG=Productivity Growth


Confidential

much as additional 50% of invested capital. This essentially raises the required multiple from 12.5X to

25X, which then can be validated by a nominal earning growth of 11% per annum over the 10 years and

prevalence of the same level of confidence for forward excess EVA until 2031 or 2032. Secondly,

investors are expecting a continuing improvement in both productivity and efficiency leading to

unanswered increases in capital turnover while maintaining a currently high ROIC and accelerating the

earning growth over the next 10 years. The dominant factors behind this proposition are further

application of technology in every aspect of every industry and sustaining reduction in costs in light of

the future’s industry profile on the basis of record-breaking M&A transactions.

In short, the scenario implied by the market is a combination of stable increase in real demands of at

least 4% p.a., stable inflation at 1.5% p.a., very low-level of competition in which companies can pass

expense burdens onto consumers by more what inflation indicates as well as maintain a stable

oligopoly pricing, continuing improvement in productivity efficiency by at least 3% p.a. and the same

level of enthusiasm for equities lasting for, at least, the next 20 years.

In many ways, I share with the above propositions. No one can easily undercut the proposition that the

US is close to an acceleration point in the benefits from its technology investments and technology

adoption normally follows an exponentially rising ‘S-curve.’ The market is rightfully discounting this

acceleration point in US productivity as its full benefits have yet to be seen in today’s cash flows. But in

order to justify lofty valuations, I believe there must be concrete answers to the following questions

that are related with rationales behind today’s valuation for equities:

1. Is it fair to assume that excess returns currently enjoyed by large companies would indeed last

for at least 30 years?

2. Would a further consolidation through M&A indeed result in increased shareholder values?

3. Would we indeed see an accelerating pace of productivity growth?

4. Would an inflation-free consumer demand be sustained?

EXCESS RETURNS

As stated earlier, the average return on invested capital of top 200 companies in the US, which I believe

are close surrogates for S&P 500 composites, was about 12% as of 1998. This is, in itself, a misleading

representation in a context of capital market theory because the market-wide return on capital should

equal the market’s cost of capital as investors and corporate finance bankers neutralize each other by

serving the best interests of their own through a well-calculated plans and strategies for optimisation of

excess returns.

The explanation for this discrepancy between return on capital and cost of capital is an increasingly

opportunistic division of capital by quality. Investors appear to be fully convinced that quoted markets

in the US are now comprised of only two animals: global enterprises that continue adding EVA on the

basis of their low cost leadership and sustained productivity growth, and hyper-growth tech enterprises

that would realize supernormal returns on capital.

But at the same time, investors have not fully taken into account competitive profiles in which further

competition in a form of price destruction would be constantly invited and the level of uncertainties,


Confidential

therefore risks, should rise for the incumbent players as some would undoubtedly fail. This essentially

comes down to a question of whether today’s global competition is a ‘zero-sum’ or ‘positive sum.’

While I cannot disagree on the point that technology creates value-added via its low-marginal-cost

intellectual capital, global economy is currently too imbalanced for this effect to go into a virtuous cycle

in a way the market envisions. I simply think that it may be a bit premature to be overly optimistic as to

take excess earnings as ‘given’ in today’s valuation because the two numbers representing return and

risk eventually have to converge. Otherwise, the US (and the world) will be comprised of 150-200

mammoth enterprises with oligopoly pricing and thousands of small enterprises that subsist on

residual demands. This does not exactly fit well with the kind of economic landscape that policymakers

are envisioning, especially in context of division of labour. To policymakers, it is creation of jobs that

serves the most principle purpose in economic welfare. Supportive evidence can be found in the US’

government’s preliminary antitrust ruling against Microsoft on Nov. 5, 1999.

If we only relate supernormal growth for 10 years with no EVA after the 10th year without reflecting

additional 400bp in terminal value, the implied nominal growth rate in earnings is 19% p.a. More

loosely, if we assume supernormal growth over the next 10 years and attribute 40% of today’s stock

price to terminal value in today’s valuation framework, for which, we do not care about validity or

justification, an annual growth rate to justify the current valuation is arrived at 14.5%. With organic

economy growth rate at 6%, this however can only come from combination of cost saving enough to

produce additional 4% growth annually in earning and mid-cycle capital turnover at 25% higher than the

current mid-cycle level that I had calculated to be about 1.19. This proposition is, needless to say,

inconsistent with what we have seen. Consider the following reality checks:

1. Since 1991, an US company’s operating margin has improved at an annual coefficient of only

1.28 in spite of much publicized efficiency improvement, implying an additional contribution to

earning growth by mere 30-40bp.

2. As for capital turnover, it has fallen for 4 consecutive years since 1994 and is now at 1.29.

Today’s equity valuation would have made sense if the market-wide capital turnover were 3.7

instead of 1.29.

3. According to my screening of 8,876 companies in the US, only 630 of them had a capital

turnover of 3.7 or higher in FY98. All, but only 34, were small-cap companies with

capitalization of less than USD3bn. that do not count in the index .

4. Out of 34 S&P 500 member companies, only 15 fulfilled the criteria with respect to ROIC (for 3

years) and capital turnover (in 1998) that deserve the rating that the market is currently

implying for the whole economy.

In any cases, whether today’s valuation assumes supernormal growth is to be realized for 10 years or

longer, a hurdle rate we need to witness is 14.5% while a current ROIC of 12% is maintained, below

which, today’s valuation would prove to be faulted.

EFFECTS OF M&A

My initial objection in this context is that the investors may have failed to interpret the effect of M&A in

a fair manner. A record number of M&A deals have bid up prices of quoted shares in the market, which


Confidential

were then justified by the premise of cost saving effects and growth factors. Investors often

overestimate the effect of M&A in a highly emotional and theoretical mindset. The starting point for a

rational analysis must be the fact that mergers and acquisitions have historically proven a success ratio

of only 46% though it had risen a bit higher in the recent years.

There are five types of growth direction, namely market penetration, vertical integration, horizontal

integration, diversification, and globalisation. These modes all have their own merits. Fir instance, a

type of growth that can truly multiply the synergy if successful is that of horizontal integration. An

illustrative example is Disney. As a result of its pursuit of horizontal integration strategy for years,

Disney was able to multiply its bottomline revenue base in a truly “blockbuster” way. The company, for

example, grossed over USD2bn. from the movie “Lion King” for which the budget was only USD50mn. by

leveraging synergies between the movie, video, theme parks and merchandise sales. This type of

“blockbuster” result is not a main objective of other types of growth. The mode of growth through M&A

that we are witnessing today is largely that of globalisation, which bases its merits on economies of

scale and transparency in pricing. This is consistent with both the larger changes in the world economy

and with the current emphasis on focused companies. For this type of growth, the key word is cost

saving.

Cost saving as a result of M&A is usually related with marketing expenses, intangible amortization,

advertising expenses, product promotion expenses, research and development expenses. The above

items together account for about 10% of sales. Suppose 30% of these costs were spared, operating

margin would rise by 3% (*In actuality, subsequent restructuring costs partly offset this increment). The

impact on shareholders is a consequential increment in returns on capital by 2.6-2.9% (=increase in

operating margin*(1-tax rate)*capital turnover) on a post-tax basis depending on a degree of variance of

effective tax rate. However this assumption has not taken into account increases in invested capital for

financing the transactions. In order for a shareholder to gain any benefit, magnitude of increase in

capital has to be less than 24% based on a current capital structure of corporate America. Therefore I

would look at a likelihood of cost cutting of this magnitude and the magnitude of capital addition in

digesting the deals in 1999.

Total M&A transaction volumes in the US are

on pace to amount to USD 1 595bn. in 1999.

This amount roughly represents 20% of the

aggregate invested capital of S&P 500

companies. A further improvement in working

capital management is very much limited after

rigorous measures taken about inventory

control and the companies’ rising willingness

to lower receivable turnover in the face of

fierce competition. Therefore we could assume

for the last year’s increases in capital to be

about 23-26% (~20% + 6% of organic growth - decrease in working capital), which incidentally matches

with the magic number mentioned in the preceding paragraph. This shows that the business

development managers in the US are not stupid at all, but will the cost saving be on track exactly as

they plan for?


Confidential

Because of high exposure to costs that are subject to be reduced, banking and pharmaceutical sectors

are two of the sectors for which the saving effect is greatest. I have taken two actual sample cases to

see the effect of cost cutting.

Bank One has been on M&A binge over the past several years. In March 1995, it successfully acquired

First Coppell Bank, which was very well received by the market and awarded with rapidly rising stock

price on the premise of cost cutting. This acquisition was actually a decisive factor to put a brake on a

2 year-long downgrading of the company’s stock price. The ensuing results have proved to be quite

disappointing as can be seen in the below table.

In the pharmaceutical sector, the most highlighted marriage over the last 5 years was probably that

between Glaxo and Wellcome, creating Glaxo Wellcome in May 1995. This deal was also highly

applauded for positive outlooks then and, more importantly, is today considered one of success stories

in M&A arena. It is equally difficult to conclusively trace the effect of cost cutting during 95-98.

Statically in 1995, operating margin did improve by 1.4% on a pre-tax basis (thus less post-tax), but the

company’s invested capital also increased by over 68%, resulting in a deterioration of 5% in return on

invested capital. Bottom-line earning measure, ROE, did and does continue to render a wrong picture of

the company’s profit generation capacity. Although the company’s shareholder value seemed to

recuperate in 1996, it was attributed to one-off decrease in capital base due to asset sales, for which

merger is only partially responsible. The evidence of falter is clearly shown by successively decreasing

ROIC in 1997 and 1998. After 4 years of what people dub as a “perfect marriage”, the company’s

operating margin and per-head efficiency are down and cash profit returns continue to deteriorate

following the merger.

In conclusion, execution of cost cutting seldom takes place as planned out on the drawing board prior

to the merger. The plan by the business development managers to raise a pre-tax operating margin by

3% to offset the impact on return on invested capital due to a 20%+ increase in invested capital, as

implied by the market valuation, is a truly ambitious one, which leaves a very little room for mistake.

PRODUCTIVITY GROWTH

What is driving the economy’s performance? There are two schools of thoughts today. The first is that

the economy’s result is largely the result of good luck. Plunging import and energy prices due to the

economic problems overseas should explain the booming economy. This school of thought would have

it that the good times will appear substantially less good a year from now.


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The other school of thought has it that the economy has undergone a structural formation. An

apparent acceleration in the pace of technological change and ongoing globalisation of the economy

have raised the economy’s underlying productivity growth and heightened competitive pressures so

that the economy can grow more quickly at lower unemployment with subsequently lower inflation. The

economy’s current performance, according to their view, will thus be long lasting.

Robert Gordon of Northwestern University, one of the leading experts on US growth performance, has

analysed the impact of productivity growth. According to Gordon, growth in output per head since the

last quarter of 1995 has recovered more than two-thirds of the productivity growth slowdown

registered between 1950-1972 and 1972-1995. Thus between the last quarter if 1995 and the first

quarter of 1999, non-farm output per hour rose at an annual rate of 2.2%, which is not far below 2.6% of

the period between 1950 and 1972, and far above the 1.1% of the period between 1972 and 1995.

However, Gordon also argues that all of

this productivity rebound can be explained

by thre factors: improved measurement of

inflation; the response of productivity to

the exceptionally rapid output growth over

the last few years; and the explosion of

output and productivity in the production

of computers. More specifically, of the 1

percentage point improvement in

productivity growth in non-farm private

business since 1995 compared to the

period of 1972-1995, Gordon concludes

that 0.3% are explained by the recent

cyclical acceleration and 0.4% by the

improvement in measurement of inflation.

This leaves a structural improvement in

productivity growth of only 0.3% a year, all of which can be explained by productivity improvement in

the manufacture of computers alone.

Gordon’s conclusion is that underlying productivity growth may be a little better than in the past two

decades after the first oil shock but this performance remains far from that of the pre-1973 golden era

and the technical progress in the production of computers has not really spilled over to the other 99%

of the economy. Based on these facts, I am subsequently more convinced of the first school of thought

while the optimists have failed to rationally quantify exactly how and why this ‘productivity thing’ has

meant so much for equities thought it is not really a new thing.

Perhaps the most prudent presumption should be to acknowledge both sides of schools of thoughts.

However as there must be an answer or logical explanation to everything, I am leaning more towards

the assumption that the economy’s current rate of growth (and more markedly, equities’ rate of return)

is not sustainable.

Productivity growth in the second quarter was just 0.6% on a seasonally adjusted annualized basis. This

is the slowest growth since the second quarter of the last year. The downward revision was the result of


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downward revisions to output and upward revisions in hours of all persons. This slowdown was not

unexpected. At this late stage in the business cycle, the exceptional productivity gains of the recent

past were not expected to be maintained. Furthermore, strong business investment growth over the

past three years, which was the primary influence behind the improved productivity growth, slowed in

the first quarter. Productivity growth is expected to slow over the next several quarters though the 3Q

figure to be released on 11/12 may come out a bit high on the rebound.

What is more problematic about the latest

revisions was the increase in unit labor costs. Unit

labor costs, which are the amount of money

employers pay in wages and benefits for each item

produced, was revised upward to 4.5% on a

seasonally adjusted annualized basis. This is the

largest increase in unit labor costs since the first

quarter of 1994. Wage pressures are unlikely to

stabilize in the near term as jobless claims remain

near a record-low level (picture).

The increase in labor costs and decline in

productivity is largely due to acutely tight labor

markets. With markets so tight, expanding firms

are increasingly forced to hire less-qualified

individuals. As such, firms are facing training

costs and paying higher wages to less qualified

workers. This results in increased costs and lower

productivity.

While one or two quarters do not make a trend, should labor compensation continue to rise at such a

rapid pace, and if lower productivity growth is sustained, it will eventually give rise to growing

inflationary pressures. On net, the latest report raises concerns that inflation pressures are mounting.

Business can delay the time at which they will have to either raise prices or experience falling profits by

eking out productivity growth that is already reaching its upper bounds by almost any standard. The

jobless rate will have soon fallen below 4% (refer to the above chart) and labour costs will be

accelerating. Moreover, profits are at best growing only marginally, far from a level that can otherwise

explain today’s valuation.

THE HIDDEN TRAP: CURRENT ACCOUNT DEFICIT

An increasingly popular scenario of sustained growth upon which the stock markets has strongly rallied

from the end of Oct. into the beginning of Nov., actually poses a great threat because a large part of

the growth had been financed by external monies, which no one has really argued against. Since stocks

are highly vulnerable in an environment characterized by weak (relatively) profitability, rising interest

rates, and record-breaking valuations, even a little crack in a stock market could be enough to reverse


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the market liquidity, which in a severe case can even push what should be an already slowing economy

into an outright recession.

A critical assessment hinges on whether growing foreign indebtedness, which is now equivalent to 20%

of gross domestic product, is used to increase the level of US productive investment or to boost

immediate consumption. There is no available analysis that shows clearly whether investment or

consumption is stimulated by such forces. However, although it does not provide an arithmetic

explanation because of different base (consumer spending is about 5 times gross investment), the

above table shows that current account deficit and consumer spending have moved hand in hand

during 1990s. Growth in private investments has been more sporadic and seems to be slowing since

1997. Therefore I do not think that it is out of line to assume that 80% of current account deficit has

gone into boosting immediate consumption.

Along with sharp pick-up in consumer credit and consumer spending in the 3rd quarter on YoY basis,

household savings as a percentage of disposable incomes dropped to 1.6% in Sep. for only the second

time since 1970. The only other time this number had been seen was in April of 1997, several months

before the equity market crash.

SG Europe Top 20 Fund Report, SG Asset Management, November 8, 1999

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Transcript of SG Europe Top 20 Fund Report, SG Asset Management, November 8, 1999