Tuesday, April 18, 2006

Wal-Mart: Consistently Superior Success or Failure ?

As I read yesterday's comment on my Wal-Mart post, it occurred to me to revisit my thoughts of last fall concerning the company.

When I read the two posts together, they portray me as perhaps a bit schizophrenic in my assessment of the company's fortunes. Back in September, I classified Wal-Mart as an aging and no-longer consistently superior performing retail giant which will probably not regain its luster. I noted that it has not been in my equity portfolio selections for many years. Yesterday, I referred to it as having usually outperformed the S&P during the last 25 years.

Some clarification is in order.

My proprietary research unearthed performance benchmarks which, when applied to large-cap companies, increased the probabilities that a given firm could outperform the S&P's total return consistently over a period of multiple years. The benchmarks differ for low-growth and high-growth firms. However, firms that would adhere to their respective operating benchmarks would have statistically significant increases in the likelihood that investors would reward such performance with consistently superior total returns, in the form of stock price increases.

When these insights are applied to the selection of equity portfolios, some adjustments must be made. A CEO may, or may not, adhere to my benchmarks, and still enjoy some periods of superior total returns. Further, whether or not the firm meets my investment criteria, it may still do better than the S&P over various periods.

However, as an investor, I need to use better quality criteria for portfolio construction than I would advise a CEO to use for actually running his company. This is because the CEO has some control, or at least influence, over his firm's operating characteristics and performance. Thus, the level of certainty of achieving the recommended operating benchmarks is probably higher for the CEO than for me as an investor. I don't have any control over the assets I own, whereas the CEO has control, via business strategies and resource allocation.

So a company, such as Wal-Mart, may, ex post, have outperformed the S&P for some years, yet still not, ex ante, have displayed investment quality performances that would have merited its inclusion in my equity portfolios.

Thus, as a business strategist and observer, I observe that Wal-Mart has created shareholder value at a superior rate, relative to the S&P, for most of the past 25 years. As a disciplined equity investor, however, I observe that the company's evolving performance characterisitics over the same time period did not warrant risking investment in the firm, relative to other opportunities in the S&P500, in order to construct portfolios which had significant likelihoods of consistently outperforming the same index.

I still doubt that Wal-Mart's new thrust to move upmarket with its retail brand will succeed. By "succeed," I mean consistently create superior total returns for shareholders over the next 5-10 years. The company may eventually move its brand franchise up the "wheel of retailing," but I believe the time and cost will not, in the end, have been warranted, relative to other strategic opportunities available to the firm. I wrote of these in my earlier piece.

This is not to say that I think it cannot occasionally realize better total returns than the S&P in the next few years. However, my guess is that its fundamental performance will continue to keep it out of my equity portfolios. Its current strategy is, in my opinion, unlikely to provide the performance consistencies which I have found to be the hallmarks of desirable investment opportunities among large-cap companies in the S&P500.

This is one of the conundrums of using the same shareholder return performance measure from inside a company, as opposed to an investor's perspective. The CEO may achieve above-average, though statistically unlikely, total return performances for a while, thus rewarding shareholders. But the chances of that occurring consistently may be so low as to make owning those shares too risky, from a disciplined investment process perspective. The CEO will have succeeded, and done well for some shareholders at certain times. But that does not mean, ex ante, it was an attractive stock to own.

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