Exhibit 11.7 presents a matrix of company growth and value regions to help investors identify the EVA spread/capital formation combinations that lead to wealth creation (or destruction). In the two quadrants with positive capital growth, Quadrants II and III, we see a good company
growth region (Quadrant II) and a bad or overzealous company growth region (Quadrant III). In the two quadrants with negative capital growth, Quadrants IV and I, we see a good company value region where capital contraction creates shareholder value (Quadrant IV) and a bad company value region where underinvestment highlights few opportuni- ties for creating shareholder wealth (Quadrant I).16
From an investment perspective, Quadrants II and IV represent potential buy opportunities while Quadrants III and I represent (short) sell-to-avoid regions, respectively. In practice, we interpret Quadrant I as a region to avoid because it is typically populated by the currently positive EVA spread businesses of mature growth companies—such as food and tobacco companies—that have limited future growth opportu- nities. This underinvestment or poor utilization of capital region is dif- ferent from Quadrant IV where companies are restructuring for positive economic profit change and thereby wealth creation.
In Quadrant II, we see that growth-oriented companies that are expanding their capital base with a positive EVA spread are poised for
16We interpret “growth”—whether good or bad—in terms of companies that are still expanding their capital base, while “value” refers to companies in the EVA sche- matic that are—by default—contracting their capital base.
EXHIBIT 11.7 Company Growth and Value Matrix
continued—albeit substantial--improvement in shareholder value. Invest- ing in positive economic profit and (therefore) positive NPV projects—
both now and in the anticipated future—is the essence of real company growth. On the other hand, Exhibit 11.7 suggests that growth-oriented companies that are moving toward the overzealous company growth quadrant (Quadrant III) are heading in a direction that can lead to sub- stantial compression in stock price and shareholder value.
The movement into the “growth for growth sake” region is most unfortunate for investors in companies with managers who naively believe that revenue and/or asset growth will automatically transfer into economic profit and wealth creation. Worse yet, the movement into Quadrant III is troublesome for investors who are wedded to companies having overzealous growth managers—with inordinate preoccupation with revenue and/or asset growth—that fail to heed the principles of wealth creation. Not surprisingly, growth companies that now face a misguided growth profile are strong sell or shorting candidates.
Revisiting Capital Contraction
As mentioned above, Exhibit 11.7 identifies two regions of capital contrac- tion, Quadrants IV and I. There are several company types that might fall into these regions of the company growth-and-value matrix. For instance, we could be talking about a slow-to-negative growth company in the auto- motive, food, mining, steel, or railroad industries that are viewed as “Old Economy” companies. These companies are different from the high growth companies usually found in technology, health care or consumer segments.
They are also companies that have currently negative economic profit (Quadrant IV companies) or limited EVA growth potential (Quadrant I companies) due to the commodity-oriented nature of their businesses.
Moreover, because these slow growth companies can either restructure for positive change or hardly change at all, we take Quadrants IV and I as regions of good company value and bad company value, respectively. Con- sequently, companies in Quadrant IV are viewed as potential buy opportu- nities (due to the positive restructuring) while the mature-to-stale companies in Quadrant I should be avoided (due to the lack of profitable reinvestment opportunities or poor utilization of capital).
Strictly speaking, Quadrant I is represented by firms that are down- sizing a positive EVA spread business. If this deinvestment activity per- sists, it can only lead to decreases in economic profit and shareholder value. In practice, we interpreted this quadrant as a capital formation region that is reflective of managers that cannot expand their mature businesses without significantly lowering returns on capital. In contrast, Quadrant IV is viewed as a region of constructive deinvestment in the
company growth-and-value matrix. With capital contraction, we see that companies in this region are downsizing or restructuring negative EVA spread businesses—since the expected residual return on capital is less than zero. Based on the financial math of this region, one can say that a negative change in invested capital times a negative EVA spread (business) leads to a positive expected improvement in economic profit and shareholder value. Again, because of efficient restructuring, Quad- rant IV companies represent potential buy opportunities.
On balance, Exhibit 11.7 shows that Quadrants II and IV have the greatest potential for improvement in stock price and shareholder value.
While companies and industries in these regions can be radically differ- ent—we would expect that high barrier-to-entry growth companies would show up in Quadrant II, while forward looking “Old Economy” compa- nies would show up in Quadrant IV—we get to the same economic profit conclusion. That is, companies in Quadrant II are expanding positive EVA spread businesses that stand to create substantial shareholder value. Com- panies in Quadrant IV are efficiently restructuring stale or troubled busi- nesses and should also see noticeable improvement in economic profit and stock price. Consequently, we view these EVA-based regions as the good company growth and good company value regions, respectively. More- over, from the active investors perspective, companies in Quadrants II and IV represent potential buy opportunities while, as we explained before, the bad company growth and bad company value firms in Quadrants III and I represent (short) sell-to-avoid opportunities, respectively.