Value Investing

Hunting Down The X-Factor In Value Driving

Competitive Advantage Period “CAP” The Neglected Value Driver by Michael Mauboussin

In 1991, a Goldman Sachs limited partner, Barrie Wigmore, released a study that attempted to determine what factors drove the stock market’s above-average returns in the decade of the 1980s. After carefully accounting for earnings growth, interest rate declines, M&A activity and analysts’ “too-rosy” forecasts, it appeared a full 38% of the shareholder value created in the 1980s remained unexplained. Dubbed the “X” factor, this mysterious driver of value left Wigmore and the Wall Street Journal, which published a feature article on the study, at a loss. Given overwhelming evidence of well-functioning capital markets, it appears completely unsatisfactory to attribute such a large component of share price performance to some unidentifiable and seemingly inexplicable force.

Fortunately, we believe there is an answer to this problem. However, to understand the solution there must be a recognition that share prices are not set by capitalizing accounting-based earnings, which are at best flawed and at worst substantially misleading. It appears that this was precisely the paradigm under which both Mr. Wigmore and the Wall Street Journal were operating. The focus must be on the economic drivers of a business, which can be defined as cash flow (cash-in versus cash-out), risk (and appropriate demanded return) and what we have dubbed “competitive advantage period”— CAP— or how long returns above the cost of capital will be earned. CAP is also known as “value growth duration” and “T” in the economic literature. CAP is also similar in concept to “fade rate.”

In this context, we believe Mr. Wigmore’s “X” factor can be explained by the market’s extension of expectations for above-cost-of-capital returns. As Mr. Wigmore’s analysis suggests, the length and relative change of CAP can have a substantial impact on the value of a business and the market overall. For example, the revision in expectations of Corporate America’s ability to generate returns above its cost of capital is a powerful indicator that investors believed that America was more competitive at the end of the 1980s than it was entering the decade. This conclusion was later supported by economic analysis.

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