The Human Capital Telescope: Weak intangibles drive low market values

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IN this two-part article, we pursue the thought that Zimbabwean businesses can push their market values beyond underlying net asset values (NAVs) by building intangibles (non-financial assets) and communicating these to the investment communities. Arguably, the majority of our business leaders in Zimbabwe either have a very strong financial training or bias and as such their professional training was not designed to prepare them to prioritise building intangible firm value.   Report by Brett Chulu

The current Zimbabwean scenario where share prices are trending below underlying NAVs reflects that businesses look beyond financial competencies to impress the investment community. Many of the intangibles desired by investors are architected and built by strategic human resources (HR). Strategic HR competences for Zimbabwean firms are now a must.

 
Sadly, it appears that business leaders in Zimbabwe still believe that current earnings are the most important driver of market capitalisation as partially evidenced by corporate reports that give very brief if not passing narratives on non-financial activities.

 
In developed and emerging markets, current earnings account for a small fraction of a firm’s market capitalisation (share price multiplied by outstanding shares). Baruch Lev, a highly respected professor of finance and accounting at the Stern Business School of the New York University, has shown that S&P 500 firms have for every US$6 of market value only US$1 was being captured in the balance sheet. What this means is that investors in these economies are looking beyond current earnings in ascribing a company’s current financial worth. This reflects that a greater emphasis is being placed on a company’s non-financial drivers.

 
In sharp contrast, a well-known fact is that a number of business leaders and investment analysts in Zimbabwe have been on record decrying that many of the firms listed on the Zimbabwe Stock Exchange (ZSE) have share prices that are significantly below the firms’ underlying NAVs. This anomaly points to two possibilities. First, it could reflect that potential investors in such firms believe the firms’ balance sheet values such as reported earnings cannot be trusted.

 
Second, it may as well be a reflection that investors have extremely low levels of confidence in the firms’ collective capabilities to respond to the current difficult operating environment  characterised by poor liquidity, expensive credit (high interest rates), poor creditworthiness (over-borrowed consumers and organisations) and a tightening legislative environment threatening the going-concern status of businesses, among others.

 
However, a close analysis of individual firms listed on the ZSE shows that the assertion that firms are undervalued on the basis of low market-to-NAV ratios is an over-generalisation. For instance, based on current share prices some firms have a commendable share of intangible value: Colcom has a market-to-NAV ratio of 1,66:1; ZB Financial Holdings has a ratio of 1,52:1; and Lifestyle Holdings (LH), formerly TN Holdings, 2,63:1.

 
Even within broadly similar sectors, some firms have share prices exceeding NAV while others have share prices tailing below NAV. Given that these firms are faced with the same external operating environment, the difference in the market values placed by investors has to do with the firms’ internal environments. Unambiguously, this reflects that some firms in Zimbabwe are better at creating intangibles than their comparators.

 
Low market-to-NAV causes
The key driver of market capitalisation is trust or integrity. Investors deposit or withdraw their trust based on the assessment of four broad organisational dimensions.  First, investors need to place their trust on the quality of reported earnings.

 
Second, investors need to believe in the business strategy crafted by senior executives.

 
Third, they need to trust that the organisation has the necessary competences to drive the business strategy.

 
Fourth, they need to believe beyond the shadow of doubt that the firm has a distinct culture that connects to the expectations of customers.

 
With reference to our current business environment, there is a serious debate around the quality of earnings being reported by businesses. For instance, a number of investors and investment analysts do not believe the earnings reported by our financial institutions are correct due to the perceived deliberate under-provisioning for probable future loan-repayment defaults.
This lack of trust is likely being reflected in a heavy discounting of share values to the extent that shares are dipping below NAV per share. The coded message here is: “We do not trust the reported net asset values.”

 
With such a scenario, the remaining three dimensions of intangibles-creation are automatically discounted. The logic used by the investment community is: “If we can’t trust the integrity of disclosed financial information, why should we trust what you tell us about your strategy, professed competences and culture?’’ Once the integrity of an organisation is put to question, the rest of intangible-creators are soiled.

 
Weak organisational competences are also contributing to low market-to-NAV ratios of some firms. When a near-monopolistic firm fails to steer into profitability, questions on the quality of the organisation’s competences subsist. When investors and investment analysts learn that a firm is using outdated machinery and that a firm’s management blames low production efficiencies on old machinery, the question is: “Why did you fail to replace the antiquated machinery when the economy was in a better shape?’’

 
Surely, the accumulated depreciation figures approaching original cost should have alerted the management on the need to replace machinery. Such reflections of poor leadership justify low market-to-NAV ratios.

 
Poor organisational cultures contribute to low market-to-NAV ratios. If the actions and behaviours of managers and employees consistently disconnect with the expectations of customers, a wise investor knows that the future earnings of such a firm will erode under a more competitive environment.

 
In one retail shop I had a nasty experience: An employee and a supervisor chided me for losing a parcel disc.  In another shop of the same retail chain, a teller told me off when I produced a not-so-high dollar-denominated note towards my purchases. She flatly refused to process my purchases. Put graphically, the teller was saying: “Go away with your money”.
A third time, I had another poor customer service experience with the same retail chain. My conclusion was that the top executives of this retail chain do not have the skills to build a customer-connected employee culture.

 
Involve investors in HR
Cisco, one of US’s top IT brands, sends its top HR executives to interact with investment analysts and top shareholders. Cisco has realised that strategic HR creates intangibles which are captured in its market capitalisation. By allowing its top HR team to explain to the investment community how Cisco is building intangibles such as culture, leadership and talent, investors and top analysts build trust and confidence in Cisco.

 
We strongly believe that firms in Zimbabwe should hold analysts’s briefings in which the firm communicates to the investment community how they are investing in culture, leadership and talent to meet customer expectations.

 
As an illustration, in terms of culture, there are some Zimbabwean firms that are developing outstanding innovation cultures. For instance, LH is currently trading at a market-to-NAV ratio of 2,63:1. Thus, for every US$3,63 of LH’s current market value US$2,63 is not captured in the balance sheet. Arguably, that out-of-balance sheet value represents LH’s growing innovation culture built around innovative business-modelling.

 
If firms in Zimbabwe can deliberately communicate to the investment community how they are building intangibles that connect to customer expectations, leaders and employees, their market-to-NAV ratios will improve.

 

 

  •  Let’s discuss at brettchulu@constultant.com

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