The Fortune 500 is advertised this year as "The Gold Standard of Business Success." The list consists of the top 500 publicly-traded companies by revenue. While revenue is important, it should never be the gauge of success for a business or management team. You would never point to a morbidly obese person as the gold standard of healthy living, but this essentially is what the Fortune 500 does. The most important questions in business are how much value is created for others and how well are resources being used. Making revenue the be-all and end-all promotes bad behavior for CEOs, management teams, and boards. There is a better way.
We tend to glorify the largest companies and their management teams, Fortune magazine calls the companies on the Fortune 500 "winners ." However, their size says nothing about their health. Enron (No. 5 in 2002), WorldCom (No. 25 in 2000), Fannie Mae (No. 25 in 2003), and General Motors (No. 3 in 2007) all reached the top 25 of the Fortune 500 before failing spectacularly.
Management teams inherently have an incentive to grow their company's size, if executives' compensation is highly correlated to the size of the company. This is regardless of whether they are creating value for shareholders or destroying value for shareholders.
The Fortune 500 also encourages empire building: the pursuit of growth to increase an organization's size, power, and influence with no regards to whether it is beneficial for shareholders (the owners of the company). Companies move up the Fortune 500 by growing the business and making acquisitions. You move down the list if your revenue compared to others falls.
When CEOs say things like "Our goal is to be a Fortune 500 company," or "We're not just some cheap Chinese company making a cheap phone, we're going to be a Fortune 500 company," or "Eventually, we're going to be a Fortune 100 company," be aware. Those could be the signs of an empire builder.
Empire builders on the Fortune 500
A great example is provided by Procter & Gamble (NYSE:PG) and General Electric (NYSE:GE) in 2006. At the time these companies were respectively the No. 24 and No. 7 companies on the Fortune 500. Fortune interviewed the companies' CEOs, and the interviewer noted, "the same big idea motivates virtually everything they do-another mantra easy to say but hard to execute: organic growth."
The U.S. economy was growing at about 3% annually at the time. A.G. Lafley, the CEO of Procter & Gamble, had declared a goal of 4%-6% annual organic growth. This just after his company had completed a $57 billion acquisition of Gillette. Jeffrey Immelt, CEO of General Electric, declared a goal of 8% organic growth. So while these men were leading the 24th and seventh-largest companies in the U.S., they aimed to grow those businesses two to three times faster than the U.S. economy.
To give some idea of the absurdity of this, the interviewer noted,
To meet P&G's growth targets, Lafley has to find about $7 billion of new revenue this year, equivalent to a company the size of Barry Diller's IAC/Interactive. At GE, Immelt has to find about $15 billion of new revenue, equal to the size of Nike. And if they succeed, of course, they'll have to turn around and find even more next year.
How did it turn out? Procter & Gamble shareholders would have done just as well putting their money in an index fund, while GE investors would have done far better in an index fund.
The Dearly Departed
The Fortune 500 also offers disincentive for companies to get smaller as they drop down the list. Fortune highlights those that are no longer on the Fortune 500 as the "dearly departed." This comes even as companies that have become smaller and more focused are truly in a better place than when they were overweight with multiple different types of businesses.
A great example is actually Fortune Brands, which is not to be confused with Fortune magazine. Fortune Brands was a diversified holding company that operated businesses focused on home furnishings (Moen faucets, Simonton windows), golf products (Titleist), and liquor (Jim Beam). In 2011, Fortune Brands separated its three businesses into separate companies. Fortune Brands' golf business was bought out, but the remaining two businesses became Beam and Fortune Brands Home & Security (NYSE:FBHS). What was the result?
While the businesses became smaller and no longer were on the Fortune 500, results at both Beam and Fortune Brands Home & Security improved. Beam was acquired in January 2014 by Suntory and Fortune Brands & Home Security continues to do well. Thankfully, some management teams get this. In recent months, Hewlett-Packard, eBay, and Symantec have all announced plans to split up their various businesses to make them stronger.
The gold standard of American business success
Historically, the gold standard was how much gold a dollar could be exchanged for, making gold the benchmark for the value of a dollar. The gold standard of American business success thus implies that these companies are the benchmark for corporate success. However, the benchmark should be outstanding performance rather than size.
The Motley Fool believes the best companies in America are those that best use their resources over time to build sustainable value for all constituents: customers, employees, investors, and the world. While the value to certain stakeholders can be somewhat hard to measure, there are two critical, and clear, yardsticks for the investor:
1. Owner earnings, aka free cash flow
Owner earnings answers the question of "how much value is the business creating for its owners?" That is how much cash flow the business generates for its owners after accounting for all capital expenditures required to maintain its long-term competitive position.
2. Sustained return on invested capital over time
Return on invested capital answers the question of "is the business a steward of the money invested by owners? That is, how much owner capital did it take to earn that cash?" If a business earned $10 million but used $1 billion to earn it, that's not anywhere near as impressive as if a business used only $40 to earn that $10 million. It's also important that returns are sustainable. As business guru Jim Collins said:
In sports, your team has to win championships, or it really can't be called a great team. In business, the measure is financial -- return on invested capital. I think that, to be considered great, a company must have sustained returns on invested capital substantially in excess of other companies in its industry.
Value Investor 500
By taking the top 500 companies in the U.S. by free cash flow, and then ranking them by their five-year average return on invested capital, I came up with a qualitative list of the 500 companies in the U.S., which I call the Value Investor 500.
The Value Investor 500 is certainly far from perfect, but it is far closer to a gold standard of American business success than the Fortune 500. Among the top 25 companies on the Value Investor 500, you'll find some companies you would expect (Apple, Microsoft, MasterCard), as well as some names that might surprise you.
American business success
Warren Buffett could easily be called the gold standard of American business success. Buffett went from humble beginnings to being one of the richest people in the world. His company, Berkshire Hathaway, has been slowly climbing the Fortune 500 for nearly 60 years. Berkshire first made the Fortune 500 in 1956 at No. 431 after the merger of two textile companies, Berkshire Fine Spinning Associates and Hathaway Manufacturing. The companies merged in an effort to survive the declining U.S. textile market in the northeastern U.S..
Buffett bought Berkshire in the 1960s after it hit hard times and fell off the list. Buffett grew the business through investing, and in 1989 the company reemerged on the Fortune 500 at No. 205. Berkshire is No. 4 on the list for 2014.
Why do I bring this up? The old management of Berkshire Hathaway thought the solution to the company's business problems was to merge, grow larger, and gain economies of scale in a declining business. After entering the Fortune 500 at No. 431, Berkshire Hathaway's ranking declined annually for the next three years before the company fell off the list in 1960.
Buffett, on the other hand, built up Berkshire Hathaway by following the same principles of the Value Investing 500. He invested in businesses with long-term competitive advantages that produce sustainable earnings for their owners and allow for high returns on invested capital. If that method is good for one of the best investors in the world, consider it for yourself.
Dan Dzombak can be found on Twitter @DanDzombak, on his Facebook page DanDzombak, or on his blog where he writes about investing, happiness, the secret to success in life, and what is success to you. He has enjoyed reading Fortune and the Fortune 500 since high school, and has no position in any stocks mentioned. The Motley Fool recommends General Motors, Nike, and Procter & Gamble. The Motley Fool owns shares of General Electric Company and Nike. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.