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Lumbering corporate dinosaurs face mass extinction

Andrew McNally explains why so many big companies are doomed to extinction – and John Stepek reveals the four safeguards against corporate scandals.

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Here's how to spot and invest in the survivors...

What do Volkswagen and commodities giant Glencore have in common other than that their shares have both suffered from massive crashes in the last couple of weeks? At first sight, the answer is "not a lot". VW has been hit by scandal, whereas Glencore's woes are down to fears that it has been caught swimming naked, now that the tide is going out on commodity prices. But smart investors should see this as a warning. A new era of ultra-competitiveness is coming and poorly governed or highly indebted companies will be among the first casualties of what will be an extinction-level event for global corporations.

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Right now, life is good for big companies. Profits before interest and tax for the world's largest firms have risen to nearly 10% of global GDP, from 7.6% in 1980, according to a recent McKinsey study. In America, the profit share is at its highest level since 1929. Burgeoning new markets, access to low-cost labour and technology-driven productivity gains have all been powerful tailwinds. But life is about to get a lot tougher. McKinsey thinks the good times can't last by 2025, the profit share will be back to where it was in the 1980s.

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This will be driven by new technology creating more intense competition between businesses and that means lower profits. We've already seen entire industries upturned or rendered extinct. Amazon and similar online platforms have given small firms the same global reach as large ones, while emerging-market companies are coming of age and joining the race for market share. The world, as Thomas Friedman foretold in his Brief History of the Twenty-First Century, is becoming flat.

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It's not all bad news. The profit share might go down, but the absolute level will still go up by 40% to $8.6trn, according to McKinsey. In other words, corporate profits will account for a smaller slice of a much larger pie. But for investors, figuring out which companies are likely to be left standing long enough to enjoy those profits will get a lot harder.

Corporate dinosaurs must evolve or die

Working out what the world will look like even ten years from now is impossible. Apple launched the iPhone just eight years ago, and yet the smartphone revolution it kicked off has already transformed the business world. The convergence of artificial intelligence and robotics today, for example, will render 2025 a radically different place. As the pace of innovation picks up, so will the pressure. That introduces another potentially dangerous incentive to cut corners in all but the most transparent and streamlined companies as the Volkswagen scandal demonstrates.

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You might argue that the future has always been unknowable. But the impact of an increasing pace of change can be seen in the corporate world. Unlike those of human beings, corporations' lifespans have been deteriorating for most of this century. Indeed, corporate lifecycles have been shortening since the limited company was invented. In the 1920s, the average US firm would survive for 67 years, according to Yale professor Richard Foster. Today, the average is just 15 years. One prominent US business school recently predicted that 40% of the current Fortune 500 will be gone within a decade a mass extinction that few are prepared for.

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What is one to do? As Charles Darwin observed of the natural world: "It is not the strongest of the species that survives, nor the most intelligent... It is the one that is most adaptable to change." So it will be with investing. Only by figuring out which firms are most able to adapt and reinvent themselves will investors be able to navigate the next ten years. Discerning a company's resilience its ability to bounce back is no easy ask, but it's essential for navigating the corporate turmoil that lies ahead. Here are four key traits that survivor companies have and more crisis-prone rivals lack.

1. Open to innovation

One of the key challenges that will separate the winners from the losers is the need to innovate to keep up. Those who hope to survive will need to be tolerant of failure and creative dissent from within, and of open collaboration with competitors. It was the lack of these traits that did for erstwhile photography giant Kodak even though it invented the digital camera way back in 1975. The same can be said of Xerox it invented personal computing with the "Alto", but saw Hewlett-Packard, Dell and others seize the opportunity from its grasp.

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This doesn't mean you need to be a Tesla or an Apple, operating at the cutting edge. The more mundane can keep improving too. Frenchman Marcel Bich designed the iconic Cristal ballpoint pen in 1950. His company, Bic, went on to develop an equally distinctive lighter and the first disposable razor. The first two displaced Gillette in America within a few years. The shaver hasn't, but it's done enough damage to generate several hundred million in sales for Bic.

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By the time you have read to the end of this article, another 220,000 Bic products will have been sold around the world, and the new ideas keep on coming the chronology of product development on the company's website concludes with the rightly optimistic words, "To be continued"

Creating a resilient businessthrough the constant innovation of everyday objects isn't new 3M of Scotch tape and Post-it note fame was founded 50 years before Bic, and now has cult status as an innovator. Incentives for employees to develop new ideas and a willingness to allow staff to experiment mean it has a corporate culture few can replicate. Its revenue is $32bn and climbing, and the company's own "New Product Vitality index" tells us all we need to know a third of that revenue is from products launched in the last five years. The management wants that to reach 40%.

2. Trustworthiness

Trust has always been at the leadingedge of economic progress all transactions hinge on trust but now companies need to build strong, trusting relationships with customers, employees and suppliers as never before. Now that the complaints department has moved from the office basement to the web, doing the right thing by all stakeholders has become a necessity, rather than an occasionally irksome luxury. No one understands this more acutely right now than Volkswagen, which in the wake of the emissions rigging scandal now faces as interim chairman Berthold Huber put it "a political and moral catastrophe".

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Many companies are yet to figure out just how significantly the game has changed when it comes to trust but investors and analysts will start doing that for them. Again, these principles apply to even the simplest of industries. When Domino's Pizza, America's second-largest pizza chain, hit crisis point in 2008, the new management team showed just how vital trust is to business success. The share price was well below its listing price.

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A constant drive to cut costs had driven the quality of the product to an all-time low. To make things worse, a YouTube video of two employees doing unspeakable things with the pizza toppings went viral across the internet. In short, Domino's had lost its customers' trust.

Then, in 2010, the management team did something quite revolutionary it told the brutal truth. "Trying to spin things simply doesn't work any more," announced the new chief executive at the time, Patrick Doyle. So, once it had reinvented its pizzas, it admitted how bad the old ones were. Its own advertisements described them as "cardboard", and customers were allowed to upload their "worst pizza moments" onto the company's website.

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While the marketing pundits were scratching their heads, something strange happened. Customers appreciated the improved pizzas, and they started tosay so publicly. Domino's had won back its customers' trust. For those owning shares since, the returns have been sensational they are up more than 30-fold since then.

3. Strong cores

The ability to innovate, to build trust, to adapt and move on will define the success stories of the future. But that takes a certain strength only a few firms have. To be successful, investors need to look beyond the cash flow statement to understand what makes a firm tick. Firstly, a company needs a strong core a set of values and a sense of purpose with which both staff and customers can identify.

Family-founded firms, such as Bic, often have this in spades, but so do some of history's legendary corporations: Procter & Gamble, Johnson & Johnson, IBM and Apple all have a sense of purpose beyond the cash flow statement. It might be about being the lowest cost provider, offering the best service, being the most creative or the most environmentally friendly but whatever it is, it needs to be clear for all to see.

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Next, a company needs a governance structure that protects this identity and creates value from it over the long run one that supports the company as it adapts to survive again and again. Shareholders' rights need safeguarding but not in the way they are today. Today's obsession with short-term shareholder value misses the point shareholders' best interests are served by protecting the firm's core values and developing its assets so they thrive for as long as possible.

Healthy firms offer incentives that reward managers and staff for developing their assets, not for generating immediate returns or for clever financial engineering. Short-dated share options and bonuses based on short-term profits are all too common in listed companies, and in general, managers are overpaid for what they actually do and achieve.

Even when governance looks good from a technical point of view in terms of board independence, attendance, diversity and so on it still pays to watch behaviour. VW had many of the traits that would indicate health family backing, a strong connection with its community, and a history of survival.

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But this is no simple story. It's not one family with a clear set of values and a shared vision it's two families that have been warring for decades. Establishing what it stands for, and what it values beyond just making cars, will be its first challenge if it is to bounce back. That's not going to be easy, to put it lightly.

4. Sound balance sheets

In more practical, financial terms, the ability to adapt means having breathing space a margin for error when things go wrong. And that means a strong balance sheet. Shareholder capitalism, as it stands, has been especially destructive when it comes to the use of debt. The "efficient" balance sheet restructuring behind the current wave of share buybacks, for example, may look like it's in shareholders' interests. But in time, it will come at great cost. Unlevered balance sheets, on the other hand, might seem "inefficient" to corporate financiers, but they will survive the disruption that all companies will now endure.

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Writing-off legacy assets, scrapping old technologies, working in new ways, and taking time to build trust with customers will all necessitate financial strength that is not normal by today's standards. The age of higher returns on equitythrough excessive leverage is over. Glencore's current woes sufficiently illustrate the dangers of carrying too much debt.

Discerning corporate health resilience isn't easy, but fortunately it persists. Start by finding those who have survived for a long time already they know the tricks. Since its launch in 1911, Nivea has remained one of the most trusted cosmetic brands. Its maker, Hamburg's Beiersdorf, has continuously extended that brand recognition into new areas. Between its main brands, Nivea, La Prairie and Eucerin, the company develops a constant stream of new products from its own research centre, the world's largest. And it has a large family shareholder and cash on the balance sheet.

Similarly, since founding a dressmaker in 1963, Spain's Ortega family has grown Inditex (known to us as Zara) into the world's largest clothing retailer. By reacting to market trends and new fashions more rapidly than anyone else it's claimed it can get a new design into stores within a week, when the industry average is still six months it continues to outsmart its competition. Once again, it is cash rich and family dominated.

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Some of the younger guns get it too. Many have raised eyebrows at Google's $65bn of cash reserves, amassed in just 18 years, but this is the modern innovator in extremis. The company's recent reorganisation is aimed at maintaining this innovative spirit. As founders Larry Page and Sergey Brin say in their introduction to Alphabet, Google's new holding company, "We've long believed that over time companies tend to get comfortable doing the same thing, just making incremental changes. But in the technology industry, where revolutionary ideas drive the next big growth areas, you need to be a bit uncomfortable to stay relevant."

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Healthcare, robotics, drones; all are in their sights. Many would baulk at the price of America's second-most valuable corporation. Yet with DNA like that, I wouldn't bet against it becoming a great survivor.

In short, as corporate evolution runs at breakneck speed, traditional investment research long-range forecasts, discounted cash flow models will prove impotent. When companies themselves can't see their predators coming, complex financial models definitely won't. Investors need to understand the traits that create resilience above all.

The most vunerable sector

Perhaps the sector most at risk rightnow is banking. Regulators are puttinga brave face on it but the reality isthat nearly all banks remain woefullyoverleveraged, have failed to regainthe trust of customers, have incentivestructures still way out of line withtheir long-term interests, and nowface an existential challenge from new firms deploying new technology.

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Theinvestor who finds the bank, or modernequivalent, developing the most trustwith customers today, has probablyfound the bank that will be thrivingten years from now. The 'challenger' banks and peer-to-peer lenders areworth keeping a close eye on.

Andrew McNally is CEO of Equitile. He has 25 years experience in equity asset management, brokerage and investment banking.

Four safeguards against corporate scandals

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In an ideal world, scandals like VW wouldn't happen at all, writes John Stepek. In most cases, it boils down to skewed incentives. Overpaid management teams work in collusion with apathetic institutional shareholders, both of whom are more interested in the short-term movements of the share price and its influence on their own pay packets, rather than the long-term health of the business.

That aids and abets an ethos of corner-cutting and in the end it's the customers and smaller, long-term shareholders who pay the price. It was the same story with the banks everyone in narrow pursuit of their own bonuses with no care for the damage their actions were storing up for the future.Of course, no system can prevent every corporate scandal, but here are four factors that we believe, if addressed, would make a big difference.

1. Clarify ownership rights and responsibilities

As economist John Kay notes, ownership implies many things, including control over an entity and the "obligation to refrain from harmful use". Companies are said to be owned by their shareholders. But in reality, if you look at who exerts the sort of control that we associate with "ownership", it's the managers. They're supposed to work on the behalf of the shareholders, of course. But as Bank of England chief economist Andy Haldane points out, that runs into a "co-ordination problem" how do you get all the shareholders to agree on a course of action?

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On top of that, most shareholders don't have much at stake in any individual company. So it makes more sense for those who are unhappy to sell out than to force change. Another factor is that in any case most people own their shares through an intermediary a fund manager or a passive tracker so they have little understanding of the companies they "own". When firms have unusual, elaborate shareholding structures (like VW), it only makes things worse. But the fundamental problem is this lack of engagement by shareholders.

2. End the pay insanity

One solution to the ownership problem mentioned above is to align management's interests with those of shareholders. As Haldane notes, this is why average US chief executive compensation went from being a third in stock and stock options in 1994, to more than 50% by 2006. But this doesn't work. If you reward managers for driving the share price higher, then that's what they'll focus on and that encourages short-term financial engineering and corner-cutting, not long-term cultivation of a strong business. Beyond that, says Antony Hilton in the Evening Standard, "most executive pay packages are so complicated that no one on the outside can understand" them.

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Yet data show that "executives consistently collect around 70% of their maximum theoretical bonus whatever happens", suggesting that the whole exercise is designed by highly paid remuneration committees to act as "a fig leaf" to conceal what the company really wants to pay the boss. The fund management industry is waking up to this and wants to make compensation more transparent. The trouble, as Hilton points out, is that fund managers are equally reluctant to make details of their own pay packages more easily comprehensible, because then clients might start to insist that they get fixed salaries "like everybody else outside the financial services industry".

3. Reward long-term shareholders with bigger dividends

One way to address both the lack of engagement and theshort-termism issue is to reward long-term investors overshort-term traders. As Merryn has pointed out on her blog, if managers were given an incentive to think long term instead of focusing on the next blip in the share price, "they might invest properly, productivity would rise" and our economies would grow.

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There are various ways to do this and it's important not to introduce new complexities or loopholes in doing so. But one option that might well work, says Merryn, is "stepped dividends" you don't get paid dividends until you've held for a certain amount of time (say, two years) and the longer you hold, the more you get. Not only does that encourage a longer-term mentality, it also shifts the focus to dividend payouts, one of the few company health metrics even a clever accountant can't distort for too long.

4. End the favouring of debt over equity

The fact that our taxation system favours debt (because you can claim tax relief on interest payments) over equity creates a whole load of distortions across the financial system. As Andrew McNally has pointed out in his book Debtonator, financing a company via debt rather than equity contributes to a more volatile business cycle it's the most indebted companies that go bust in a downturn as banks pull in their horns. "Equity can last forever; debt only until it matures."

The favouring of debt also encourages the financial engineering of share buybacks whereby management teams can boost "earnings per share" figures by switching equity for debt financing. That helps them to hit their bonus targets, without actually doing anything to improve the underlying business in fact, it makes the company's capital structure more risky. The European Commission is consulting on putting together a draft law "to stop tax regimes that favour raising corporate debt over equity", reports Reuters, and plans to report on the topic in 2016. But there's nothing to stop the UK from making a move on this before then.

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