In Berkshire Hathaway annual report (1985), Warren Buffett wrote the following:

When a management with reputation for brilliance tackles a business with reputation for poor fundamental economics, it is the reputation of the business that stays intact. [1]

My wife and I recently spent some time in Egypt. For a few days we sailed up the Nile from Luxor to Aswan on a cruise ship that counted nearly 70 crew members serving the total of five guests. The manager of the vessel was Mr. Khaled, an impeccably polite and always well dressed man in his 40s who, in spite of running a nearly empty ship managed to keep the crew’s morale high and ran the ship’s operations admirably well. Unfortunately, even if Mr. Khaled were the world’s best cruise ship manager, this particular situation was a good illustration of what Warren Buffet was talking about in his 1985 annual report. McKinsey & Co. stumbled on the same principle in analyzing a large sample of American corporations. McKinsey looked at the performance of about 100 of the largest US corporations in 17 different sectors of the U.S. economy over two business cycles, from 1984 to 1993 and from 1994 to 2003. The study [2] sought to answer the question: “How does a large company achieve and maintain strong growth?” The authors intended to understand which factors made some corporations more successful than others in terms of revenue growth and total returns to shareholders (TRS).

They expected that answers would emerge from individual firms’ performance in strategy, marketing, operations and organization. What they discovered instead was startlingly different. From among 102 corporations studied over the 1994-2003 cycle, they identified 32 “growth giants” – firms whose revenue growth outpaced the GDP and whose stock outperformed the S&P 500. Among these growth giants, 90% were concentrated in only four sectors of the economy: financial services, health care, high tech, and retailing.

Those four sectors happened to have enjoyed favorable market trends during the business cycle: financial services benefited from deregulation, increased borrowing and an increasing public participation in equity markets; health care expenditure grew with the nation’s aging population and through innovation; the high-tech industry also enjoyed a massive wave of innovation in the 1990s; retailing grew through growing consumer affluence and format innovation by firms like Wal-Mart, Target, Lowe’s and Home Depot. While the overall economy grew at a rate of 5% from 1994 to 2003, financial services grew by 7%. High-tech also grew 7% overall with services in high-tech industry growing even faster at 9%. Health care expenditures grew at 7%, but most of the growth in health care sector was concentrated in pharmaceuticals, which expanded by 12.5%! In retailing which grew slower than the GDP at 4.5%, growth giants expanded much faster.[3]

McKinsey’s analysts wrote that, “What’s striking for a large growth-minded corporation is just how crucial it is to have this kind of favorable wind at their backs when they try to achieve strong growth.” (McKinsey took pains to avoid using the word “trend” in their articles. In some writeups they used the term “currents,” but ultimately what they were talking about were trends) Indeed, favorable market developments gave rise to trends that were the key driver of value creation for 90% of the most successful corporations. By contrast, “when large companies face slow-growing markets,” wrote the report’s authors, “opportunities to change the growth trajectory are limited.”

It follows that, far from being a figment in the imagination of the unlearned, market trends could well be the single most important element to consider in generating and sustaining investment returns over time. This indeed is a highly thought-provoking phenomenon.

Alex Krainer is an author and hedge fund manager based in Monaco. Recently he has published the book “Mastering Uncertainty in Commodities Trading“.

Notes:

[1] Berkshire Hathaway Annual Report, 1985, p. 9.

[2] Smit,, S., et al. The do-or-die struggle for growth. McKinsey Quarterly, August 2005.

[3] Only one of the 102 corporations – perhaps the exception to prove the rule – built a big new business without the backdrop of a strong trend of growth in the market: Wal-Mart managed to grow rapidly in the slow growing market for perishable groceries through leveraging of its brand, supply-chain muscle and format innovation.