Peter Lynch, once of history’s greatest investors, famously coined the word diworsification several decades ago. Diworsification is, in simple terms, diversification gone wrong.
In many cases, companies that look to expand too fast, or expand outside their area of competence end up diworseifying rather than diversifying.
And it is easy to spot a company that’s gone down this route.
Take Tesco for example. Over the past decade, the company has neglected its business here in the UK while trying to expand overseas.
Many of these overseas ventures have failed, and the core business has deteriorated. HSBC has made the same mistake, and it’s easy to spot the deteriorating performance of these companies by using one key metric.
Return on capital
Return on capital employed is a key metric used to measure business performance. ROCE shows how well a company is using both its equity and debt to generate a return. It other words, the metric shows how much profit the company is generating for every £1 invested in the business.
Investors tend to favour companies with stable and rising ROCE numbers as this shows that the business is using economies of scale to become steadily more productive. A falling ROCE implies that the enterprise is becoming inefficient, and returns are deteriorating.
Numbers reveal all
Tesco’s ROCE has been steadily declining over the past decade. Under the stewardship of Sir Terry Leahy, Tesco continually reported an annual ROCE of around 19%.
However, during the past five years ROCE has dropped steadily to 13%, then to 11% before coming to rest at 7.6%.
Like Tesco, HSBC’s returns have suffered due to the bank’s size. Rising legal costs and regulatory issues have also weighed on returns, despite drastic cost cutting measures.
Indeed, HSBC has closed 77 businesses and slashed 50,000 jobs over the past few years, shaving around $5bn from the bank’s cost base.
Nevertheless, over the same period the bank’s cost income ratio — a closely watched measure of efficiency — has remained stubbornly high at around 60%. HSBC’s full-year 2014 cost income ratio was 67.3%.
HSBC’s return on equity — a key measure of bank profitability and a similar metric to ROCE — has fallen steadily, from around 10% to 7% over the past five years.
Moreover, HSBC’s management has now given up on the bank’s target of generating an ROE of 12% to 15%. The target has been lowered to “more than 10 percent”.
The Motley Fool has recommended shares in HSBC Holdings and owns shares in Tesco.