Situations for outperformance

Many variables, including economic cycles and degrees of market saturation, help a company to enter the top stratum and remain there. What follows is a closer look at four ways companies outperformed the market’s returns to investors. Even the most successful large companies aren’t likely to outperform over time if they don’t find themselves in one of these situations.

Perfecting the business model
Some companies held onto their top positions for at least a decade by continuing to perfect the business model that made them initially successful—and not going beyond it. This group includes a number of high-tech players, as well as retailers and pharmaceutical companies. For most, the core business was still in its high-growth phase thanks to one or more breakthrough products or services. Obviously, management plays a key role in guiding these businesses to innovate and to capture opportunities. But without the undercurrent of real growth in a segment, it becomes very challenging for even a strong management team to deliver outsized performance. Most companies come upon a big idea only once or twice in their entire existence. A global high-tech company, for example, has generated new ideas as its leading breakthrough products slowed down, but the new ones have had a much smaller impact on the overall business. Consequently, the company’s stock performance has lagged behind the market in the past five years. Very few companies have produced a steady stream of new and substantial growth opportunities by aggressively reshaping the business portfolio.

Extending the business model
A second group of companies (for example J&J, P&G), largely in consumer products and pharmaceuticals, outperformed the market by taking advantage of intangible assets such as brands or patents to increase their profit margins and returns on capital. But though owning strong intangible assets was a necessary condition for their performance, it was insufficient on its own. With that as their base, they differentiated themselves from competitors through strategic clarity and consistently strong execution.
As a result, these companies earned high and increasing returns on invested capital. The accumulation of strong brand capital enabled companies in this group to erect effective barriers to price-based competition—barriers that in turn helped them improve their margins constantly. This group of companies also appears to have grown, after adjusting for inflation, at a rate faster than the growth of GDP, probably by taking more market share from competitors.

Rising commodity prices
Many companies owe their sustained outperformance largely to increases in the price of whatever commodities they produce. The price of commodities, such as oil, steel, and commodity chemicals, in turn reflects a number of complex economic, political, and competitive factors beyond the control of most businesses. From the standpoint of fundamental performance, commodity producers do not necessarily stand out: their returns cover their cost of capital but not much more. Their margins remain steady, and their growth is on par with the expansion of real GDP. At the same time, their TRS performance can be volatile as commodity prices swing. The performance of companies in this group of commodity producers may differ widely as a result of the quality of their assets and, to a much lesser extent, of their operating strategies. Over a 40-year period, a majority of commodity players did not outperform the market.

Turning around large underperformers
A small group of companies managed to outperform the market over a decade by dramatically improving their hitherto poor operations. These companies, from diverse industries, regained their vigor after a prolonged period of suboptimal performance and margin erosion. Against the backdrop of low market expectations, their operating margins and returns on capital improved substantially—often under the leadership of new managers—which led to better-than-market returns. For this group, revenue and profit growth tended to be lackluster.

Big round china bubble and more

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"This time is different." How many times have you heard that? As an investor, you should be aware that those are the four most dangerous words.
Walk away and ignore it every time you hear this. This time is never different, at least not in the context of economic and stock market cycles.
Asset bubbles and debt crises are as old as international lending. But I don't think we are going to have to wait too long for the next one.
The bull market of the past few years are driven mainly by excess liquidity. Yes, rich-country interest rates are still stunningly low, even allowing for global disinflation. Craving higher returns, global-portfolio funds are increasingly washing up on the shores of distant emerging markets. With growing world demand once again soaking up emerging-market exports, and with low interest rates making debt finance easy, debtor countries have the best of both worlds. But it is not going to last.
Investors ought to realize that last year's 30-40% average return on emerging-market equities was an aberration. Such explosive returns will not be repeated on a yearly basis. As all prices get higher, squeezing out similar returns will only get exponentially tougher.

Why some companies belong to grade AAA.

Fact: Only 9 out of 1,077 (less than 1%) large global companies outperformed their competitors on both revenue growth and profitability over a decade, a McKinsey study finds—confirming that such strong performance is rare.

Characteristics that made the 9 companies outperform:

First, the top nine performers strongly preferred organic growth: they made few acquisitions and divestitures when compared with other companies in their industries. Further, none of the deals these companies made were transformational; that is, no divestiture or acquisition had a value exceeding 30 percent of their market capitalization in the year before the deal.

Second, it was found that all nine companies had higher market-to-book ratios than their competitors did. (The M/B ratio is a measure of corporate performance that compares a company’s market cap with its book value.) In fact, these top performers logged M/B ratios more than two times higher than those of poor and average performers, as well as 25 percent or more higher than those of companies that excelled at either revenue growth or profitability, but not both. These findings indicate that the nine companies rely on intangible assets more than the rest do. Their ability to generate value from knowledge-intensive intangibles (such as copyrights, trade secrets, or strong brands) represents a good starting point for further exploration of their superior performance.

Companies to avoid

People spend a lot of time discussing what companies to buy. But in the spirit of not losing money, it's equally worthwhile to understand the types of businesses that we investors should steer clear. At this moment, there are 5 main categories:

1. Businesses that rely on some fad or sexy growth stories and no cashflow.
Sometimes, share price of a company goes up because the management is touting a new technology or painting a rosy picture over their business prospects. Investors take in the stories and chase up the prices. In all cases, it will be wise for investors to dig for more information before commiting their money. Looking at the cashflow the company can generate is one of the trick. Personally, i will avoid if the company cannot have positive cashflow regardless how glowing the prospects are. These are growth stories without any substance. Also, after promising so much, if the financial results do not improve sufficiently, the share price will be dealt a crippling blow.

2. Businesses dependent on research
It's quite reasonable to believe that research can be a competitive advantage for certain companies. Nevertheless, there is an obvious downside to research. Often, innovative companies are required to do research simply to maintain their competitive position. And if the research dries up, the company suffers.
For instance, consider the plight of Creative. Early on, Creative has had impressive periods of earnings growth because of new breakthrough products and promising future developments. But since the bursting of the internet bubble, it has been on a downward spiral. The company has seen Mp3 player market share eroding in its ever present fight against Apple and earnings have suffered. Creative still produces fine products but the race to keep pace is costing shareholders money.
This is in stark contrast to a company like Diary Farm, which could develop nothing for a decade and still have a healthy business. While I don't think this is sufficient reason to sell off all your tech or biotech stocks, you can understand why certain legendary investors avoid such investments.

3. Debt-burdened companies
In general, one should avoid companies with a lot of debt. This makes sense. During the best of times, large amounts of debt mean that cash that could be put toward growing the business or rewarding shareholders is instead servicing the debt. In a crisis, debt greatly limits a company's options and can sometimes lead to bankruptcy.
A more subtle point is that great businesses throw off piles of cash. Great businesses generally don't need to use huge amounts of debt leverage to achieve an acceptable return for shareholders. So, if a company needs debt to achieve reasonable returns, it's less likely to be a great business.

4. Companies with questionable management
Management has incredible power as they often hold more than 50% of the stakes. If executives want to enrich themselves at the expense of shareholders, either directly or by misrepresenting the company's prospects, individual shareholders have almost no hope of stopping them. One should avoid companies where there's even a hint that management lacks integrity. Some clues to look for here include excessively optimistic press releases, overly generous compensation or options grants, and frequently blaming external circumstances for operational shortcomings.

5. Companies that require continued capital investment
Over the long term, shareholders make spectacular returns by buying businesses that are able to achieve extraordinary returns on capital. This leads to excess capital that the company can use to repurchase shares, pay a dividend to shareholders, or reinvest in further growth. Companies that constantly need to make additional capital investment to keep the business going are the antithesis of this ideal and the main beneficiaries will not be the shareholders.