When stock prices go all wonky, as they have in recent days, it pays to think a little about what really moves asset prices and determines long term business success. For ConvergEx's Nick Colas, the key driver has been – and always will be – return on capital. What investment analysts know as the DuPont model is now 100 years old, but its lessons and applications still drive innovation today. Want to know why Airbnb or Uber are successful?
They leverage existing assets to create higher returns – right out of the DuPont playbook. And consider that time is the scarcest and most valuable asset of all; every successful mobile app or social network tries to give you more choices about how to spend it. Optimizing return on capital – defined as maximizing any scarce resource - is always the compass that points to success.
Via ConvergEx's Nick Colas,
In 1920, General Motors had less than 12% of the U.S. car market; by the 1950s it held more than 50%. During World War II it was a critical part of the “Arsenal of Democracy”, and without it the war would have certainly lasted longer and cost many more lives. Even in the 1990s, when other carmakers struggled – Chrysler almost went bankrupt in 1991 – GM rolled along with an “A” credit rating and a +30% share of the U.S. automobile market. And while we all know the GM of today, it pays to remember that it was once the Apple/Google/Facebook of an earlier era.
That GM’s success lasted as long as it did is more the function of one man and one financial discipline than most people realize today. Alfred Sloan, who ran the company from 1923 to 1956 as Chief Executive Officer and then Chairman of the Board, was the epitome of the 20th century focused and dedicated manager. He centralized administrative functions and left everything else to operating heads. He regularly traveled the country, visiting 5-10 dealers a day to hear their concerns. He never shouted – his nickname was “Silent Sloan” – preferring to lead with quiet consensus building. He was on the wrong side of history as the industry unionized, to be sure, but afterwards he certainly ran a company that delivered a huge slice of the American dream to millions of workers and their families.
The core of the financial system he used to run the company actually came from outside, in the form of a former DuPont executive named Frank (F.) Donaldson Brown. The approach Brown took from his prior employer – and large GM shareholder – was to analyze all the activities of the company along two lines: the assets it took to run the business and the return on those assets in the form of income. We know this approach today, aptly enough, as the DuPont model and every aspiring stock analyst commits it to memory either in the classroom or from their CFA Level One textbook.
While the DuPont model may seem like an archaic approach, soiled in the grease of the manufacturing-oriented 20th century, it is just as relevant in today’s online “Virtual” economy. Consider a few examples:
The hottest venture-backed company at the moment is Uber, the online car service, with a recent $17 billion valuation. Its value proposition to drivers/car owners is an automated and location-optimizing dispatch service that promises more fares than standard human operators can deliver. The driver already has the car – a fixed asset – and Uber offers a better return on that investment than the traditional car service company may be able to provide. For the Uber user, the geolocating feature (in the Uber app) offers potentially shorter wait times and the facility to see how close your ride is to your location. Time is the user’s asset, and less time waiting means more time for everything else. In areas where driver licensing allows it, part time/non professional drivers can more efficiently choose which hours they wish to work, giving them better utilization of their vehicle/fixed asset and their time.
Airbnb, the house/apartment-sharing business, allows a homeowner or renter to use their capital to earn a return above the utility of simply providing shelter. What was once simply a spare bedroom becomes an income-generating property. F. Donaldson Brown and Alfred Sloan would have given that kind of project a big thumbs up at the old General Motors.
Less well known on this side of the Atlantic is the amusingly named BlaBlaCar, a U.K. company that offers ride sharing services. Want to go from London to Edinburgh for the Fringe Festival? Log on and see who is driving the same way on the same day and determine how much of a contribution you’ll need to make to share in expenses. Better asset utilization for the car owner (cheaper trip) and more affordable for the rider than public transport.
The DuPont model isn’t just for new business analysis – it also explains a lot of mergers and acquisitions/new business activity as well. A key here is an often-overlooked part of M&A analysis – how long can the acquirer really keep their business going in the face of new competition or opportunities? Advances in technology create a constant stream of disruptive threats to existing businesses, and sometimes it is better to buy your new competitor than try to fight it out with them. Unless you can develop something on your own… A few examples of popular M&A/business development themes:
Mobile. Consumers generally use smartphone-enabled technology for one simple reason: it is more time efficient than waiting until you are in front of a computer. Businesses like it because they can determine your location – just look on your own smartphone to see how many apps automatically update your location even when you aren’t using them. (Why does the Flashlight app on my iPhone need to know where I am?) In both cases “Time” is the asset in question, and mobile technology leverages that asset in a manner entirely consistent with what the DuPont model instructs: make the most of it. Always.
Money and Payments. Investors always want new and profitable places to invest their financial capital, and peer-to-peer lending is one growth area that addresses this market. These businesses match lenders with borrowers, based on credit scores and other factors, essentially allowing owners of capital to act as a bank and earn the interest on such loans. And bear the risk, of course…
Vendors and merchants would prefer faster payments than the existing banking system affords – assets now are always preferable to assets later – and new payment systems offer the chance to get paid for that skinny latte in seconds rather than days. Alfred Sloan built the General Motors Acceptance Corporation into a lending juggernaut for precisely this reason – getting paid from the dealers immediately, and earning the interest from consumer loans – is a more efficient use of capital. And yes, he would have probably taken bitcoin for car purchases, but only because it is cheaper and faster than GMAC could ever be.
Buying customers and their attention. Some of the more head-scratching tech industry acquisitions of the past year or two (no names here, but you know who we mean) seem to revolve around buying businesses with a customer list and a popular technology. No profits, mind you, and none easily visible in the near future. But lots of users.
I can’t help but think that the acquiring companies feel the heat of “Time as an asset” as they sign on the dotted line for their expensive purchases. It’s not the financial intrinsic value they are buying. Rather, they are buying the time it would take to compete with the business they are purchasing. Time better spent, apparently, doing other things. Especially fighting a competitor who beat them to the punch and bought the same asset.
Taken as a whole, these examples point to two conclusions. First, the nature of capital has changed from the days of Sloan and Brown and the GM of the 1930s-1950s. Valuable assets – time, for example – don’t appear on a balance sheet but that omission is irrelevant to modern business practices. Business owners still have to manage and optimize them just as they did when owning a tool and die machine was the starting point for a new venture. Second, the essential challenge of managing a successful enterprise has not actually changed all that much from when Alfred Sloan used to take his morning walk to work at the GM Building in New York. Manage what it scarce – physical capital, time, talent, opportunity, whatever – and make the most of it.
