Wealth Creation: A Systems Mindset for Building and Investing in Businesses for the Long Term

Madden combines several concepts like systems theory, lean production, Deming’s Plan-Do-Check-Act learning cycle, key performance variables (metrics) and a valuation model with greater emphasis on the cost of capital (including human capital) into a “competitive life-cycle” view of the firm.

Companies that adopt Madden’s methodology should be better able to overcome Schumpeter’s model of high innovation followed by competitive fade, maturity and eventual failure. Shareowners are more likely able to key in on valuation issues using a longer-term perspective and are likely to be less startled with earnings surprises using Madden’s framework.

Madden argues against “fair value” accounting, arguing that a measure of economic return should express what was received, against what was given up. That can’t be properly measured if the original cost outlays are unavailable but supplementary information on estimated market value would be a plus.

Although he recognizes the need to account for intangibles (especially around human capital), he provides little guidance in this area other than recommending that whatever definitions are utilized should be tagged using XBRL to enable fine-grained analysis. However, one slim volume can’t be faulted for not providing detailed guidance to every step in a recipe.

The book includes a helpful chapter on corporate governance where he calls most management arguments against greater shareowner involvement like their supposed short-termism “a smoke screen because the plain fact is that CEOs want to either hand-pick board members, or at least have veto power over nominees.”

One idea of Madden’s that deserves to catch fire is the “shareholder value review” (SVR), where boards demonstrate in the annual report how they are fulfilling their duty to shareowners to create wealth. Such reviews would include three key elements:

– A description of the valuation model used to connect the firm’s financial performance to its market value, plus a description of how the firm is organized and managed in order to nurture a performance-oriented culture.

– Value-relevant track records that chart the wealth-creation/dissipation performance for each of the firm’s major business units.

– A description of each business unit’s strategy and the related rationale for planned reinvestment or downsizing if the unit has no reasonable plan for well-above-cost-of-capital economic returns.

Again, Madden emphasizes use of XBRL in facilitating the ability of both directors and shareowners to be able to drill down through life-cycle track records to perform customized analysis. Shareowners have recently had some success in filing resolutions requesting that companies include various environmental reports in their annual reports. It would be interesting to see shareowner proposals seeking inclusion of SVRs and their eventual use by funds such as CalPERS in developing their focus lists of underperformers.

Reading, “Wealth Creation” helped to shape my views on what areas I should be focusing my equity research on. The book uses very relevant examples to highlight its points throughout.

The company life cycle analysis is a very good way to visualize where to look for companies when looking to target market and economic cycles.

I would recommend this book for investors who are looking to bring company lifecycle analysis into their own research and analysis, overall a great read

I enjoy reading about systems engineering – I thought this was going to be a little more involved or interesting, but overall, I found it somewhat obvious and more about outside regulatory factors as opposed to building an intelligent system.

This is a great book packed with information for anyone trying to understand stock valuation and more importantly puts the recent credit bubble into perspective (govt’ bailouts vs a truly free market system).

To paraphrase the book, if we look at any investment, the only real way to create and measure wealth is to have a framework that keeps track of long term performance metrics that reward good behavior, punish bad behavior and employ a feedback learning loop so the process continually improves…a life cycle framework. This is the only way a firm’s actions can be tied to changes in stock price and capital can be allocated to the highest returning projects generating more wealth.

There are examples on how corporate managers and investors often focus on short term metrics such as EPS and miss the long term picture to wealth creation. This book provides a mindset and framework for investors to find companies such as Walgreens and IBM that were able to deviate from Wall Streets focus on short term earnings and create real value for it stakeholders.

Also important, and Madden hits on this in the book, is how these same principles apply to gov’t actions that affect the economy. While reading this book, I kept thinking of how the government continually focuses on short term factors such as GDP and monthly PPI. How many of the current decisions by our govt are really centered around a framework discussed in this book that is proven to create value over the long term versus short term actions that help the next report on GDP?

Finally there is a great chapter on how this framework can be employed by boards of directors. At the center is a push to provide BODs a uniform framework to help them measure wealth creation over the long term. In other words, a framework that forces the discussion away from short term earnings to real wealth creation.