Wealth Creation Fallacies

Which would you rather own, stock A, with a 10-year annualized total return of 10.6%, or stock B, with total return over the same period of 2.8%? The answer seems obvious although not according to Chief Executive Magazine. You see, the magazine's third annual Wealth Creation rankings are out, and number three on the list of wealth creators is stock B, otherwise known as Federated Investors (NYSE:FII); while stock A, J.M. Smucker (NYSE:SJM), is not on this year's list.

When a company is able to deliver positive total returns in nine out of 11 years, averaging double-digit annual gains, I'm sold - and this points out an enormous flaw in Chief Executive Magazine's methods.

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Analyzing Wealth Creation Components
The magazine bases its rankings on four components:

• Enterprise Value / Invested Capital
• Economic Margin (average of last three years)
• Economic Margin Growth
• Management Quality

A company's ranking is based on the four components above weighted to produce an overall score. The company with the highest result is the best wealth creator and receives a score of 100. The worst creator of wealth gets a score of one. Companies with a higher score get a higher ranking, and vice versa. The article discussing the rankings shows us that the top 50 wealth creators outperformed the bottom 50 between January, 2007 and June, 2010. While I don't have a problem with any of the criteria, the period for any comparison should be at least five years (if not 10), and only companies with CEOs who were in place for the entire period should qualify. Three years is just too short a period to value wealth creation, if it's even possible at all.

Creators and Destroyers
The magazine identifies T. Rowe Price (NYSE:TROW), Colgate-Palmolive (NYSE:CL) and DeVry (NYSE:DV) as three examples of wealth creators, and U.S. Steel (NYSE:X), Nabors Industries (NYSE:NBR) and Dean Foods (NYSE:DF) as examples of wealth destroyers, and its likes or dislikes about each of them. If you actually read each of the paragraphs accompanying the rankings, you'll see that it is subjective analysis. For example, T. Rowe Price is "... on the investor's side", although not for the reason you'd think. Rather than highlighting something useful such as, "T. Rowe Price offers the lowest MERs in the industry," it informs us that the company provides educational games at EpcotCenter in Disney World. That's great, but if you're truly on the side of investors, you charge them less to buy your funds. As for wealth destruction, Dean Foods is at the top of that list.

The magazine sights the company's lack of diversification beyond milk as its downfall. While it's true that milk prices haven't exactly lit the world on fire, it still continues to generate lots of free cash flow, putting some of this money to work buying top-selling brands like Silk and Horizon Organic. To judge it fairly, you need to look at the company when milk prices are both high and low. Personally, this analysis comes across as shortsighted, amplifying the reasons why Dean is a great value play at this time.

The Bottom Line
In the end, the only thing that matters when discussing wealth creation is shareholder returns. Do you really think Berkshire-Hathaway investors fret about performance in the short-term? Think 10 or 20 years out, not one or three. You're more likely to produce winning returns. (If your portfolio has been knocked out, we'll show you how to come back fighting. Check out Bouncing Back From A Portfolio Hit.)

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