World-beating firms can soar if state gets out of the way
THERE is great deal of hand-wringing over braais, shop floors and boardroom tables about South Africa’s competitiveness and its economic future. But there is a South African success story that deserves proper recognition and the right conclusions for economic policy drawn from it.
The success story: South African companies have created tremendous value.
If a company can generate a return on capital that beats the opportunity cost of the capital it employs, it will create shareholder value. The market will reward the successful company with a value that exceeds the cash invested in the company. The inflation-adjusted cash flow return on operating assets (CFROI) for listed South African firms has improved consistently and impressively since the 1990s. Using CFROI, we have been able to demonstrate that political freedom has proved wonderfully fruitful for SA’s businesses and the shareholders they serve.
The economic return on capital has improved spectacularly over time, with today’s median firm reporting a very healthy CFROI of 10%. Until 1994, the average South African company was sporting a CFROI at or below the global average of 6%. South African companies were generally destroying shareholder value before 1994. Since 1994, the median CFROI has sloped upwards and remained well above 6%. The new South Africa has been a value-creating South Africa. At present, 20% of South African firms are generating economic returns on capital of more than 16%, which is world-class profitability.
It is worth noting that if a company generates a 10% real return on capital, it generates enough cash to grow its assets by 10% in real terms. If unleashed from uncertainty and regulation, South African firms can grow at impressive organic rates.
It might come as a surprise to many that South African firms have been generating the highest median economic returns in the world — better than Australia, the UK and US. This is an accomplishment to be proud of and demonstrates that South African companies are well managed and competitive. Reinvestment at this level of economic return would create more value for shareholders, employees, the South African Revenue Service and the country.
Democracy has greatly improved access to global savings and meaningfully reduced the real cost of capital for South African business. In fact, the market-implied cost of capital for South Africa has fallen dramatically and is lower than the eurozone’s in real terms. Improving profitability and a decreasing cost of capital translate into extraordinary expansion of the price over earnings multiples of listed companies, which is what South Africa has experienced.
The cost of capital is ephemeral. Investors don’t like uncertainty. They prefer transparency in government and company policy. If global risk appetite drops, shareholders in all countries suffer. But those with the least uncertainty about corporate governance, government policy, inflation and tax policy will be perceived as safe and suffer less. There are benefits to aligning policy with uncertainty reduction. A lower real cost of capital will increase market values and make marginal investments more attractive. This fuels growth and reinvestment, which create more jobs and tax revenue. Typically, a 1% change in the cost of capital means a 20% change in equity valuation. The reasons for the recent cuts in SA’s credit rating should not be ignored.
These excellent and improved returns on capital have unfortunately been accompanied by significant declines in the number of workers employed by formal businesses. While the return on capital has improved, the production process in South Africa has become more capital and less labour intensive.
Fewer workers have been employed by formal business, to produce significantly larger output of goods and services at improved levels of remuneration. Real compensation per employee in the formal economy has doubled since 1995.
Those able to find and keep jobs in the formal sector have seen their incomes increase dramatically in real terms. Those unable to do so have been left behind in their standard of living, and increasingly depend on welfare grants.
The availability of labour might have worked to counter the forces that have so encouraged business to limit its demand for labour. They have not done so because of the regulation of employment conditions and minimum wages and especially the difficulty in dismissing workers for lack of performance that have made employing workers appear so expensive to potential employers.
It seems impossible to come to anything but this obvious conclusion from the facts of the labour market. The World Economic Forum ranks SA’s labour market regulations at 133 out of 139 countries. It seems clear that the political freedom that brought South Africa’s businesses access to world markets for goods and capital has been accompanied by less expensive capital and more expensive labour. The less expensive capital has been the result of competitive market forces that business has taken advantage of. The artificially expensive labour has been the result of policies that have protected the insiders against competition from the outsiders. Such a bias has to be reversed if the economy is to grow faster and make South Africa less vulnerable to violent protest, disaffection and alienation. Recent developments in the mining sector and the resulting wage increases and higher employment costs will encourage mining companies to employ even fewer workers and employ more capital more productively.
South African companies should continue to focus on generating world-beating returns on capital while the government focuses on minimising uncertainty for them by way of unwelcome interventions with agendas that have little to do with output or employment growth. In particular, the government should remove the constraints on employment growth in South Africa and encourage labour-intensive entrepreneurs to compete with formal business, which is so labour shy. More competitive labour markets might allow smaller businesses, with less easy access to capital markets, to compete more effectively with formal business, if only they were allowed more freedom to do so.
Most important is that South Africa recognises what should be obvious to all but the ideologically blind: that when it comes to delivery — of goods, services, employment opportunities and returns on capital — South African business has proved highly successful and that we should be building on this success. Business-to-business relationships in South Africa work well. By contrast, positive government-to-business relationships have been profoundly compromised, and government delivery of services to the poor — despite an abundance of resources — has been gravely inadequate.
If we can beat the world in managing businesses for return on capital, we can complete the job in building an South Africa in which all prosper. South Africa is its own worst enemy by not according successful business enterprise the respect it deserves from policy makers.
The successes of business can be widely shared beyond shareholders in the form of higher incomes and in revenues for the state that shares, through taxes, so meaningfully in higher incomes. And also, with the right encouragement, this could mean many more employment opportunities.
• Holland is a senior adviser to Credit Suisse. Kantor is chief strategist and economist at Investec Wealth and Investment. The opinions are the authors’ and do not reflect the views of Credit Suisse or Investec.