INSIDE OUT: Rentokil's share price and fair value moved up in seamless progression - until it acquired its rival BET, an inferior business. You are what you eat ..

INSIDE OUT: Rentokil's share price and fair value moved up in seamless progression - until it acquired its rival BET, an inferior business. You are what you eat .. - What is the price of trust? Horrible question, isn't it? In the best of all market econom

by ROBERT PESTON, City editor of the Sunday Telegraph; e-mail:peston@peston.com
Last Updated: 31 Aug 2010

What is the price of trust? Horrible question, isn't it? In the best of all market economies, we would not have to ask it. Everyone's word would be their bond. So there would be no question of Carlton and Granada trying to lop pounds 130 million off what they promised to pay ailing football clubs for the rights to screen lower-division football matches.

Meanwhile, Enron would have ensured that its accounts were utterly transparent.

And it would not have crossed the mind of any Andersen partner to shred a document.

Moving from EC1 to SW1, Gordon Brown would not have to agonise about how to raise personal taxes without breaching a manifesto promise to maintain the basic and top rates of tax.

Anyway, I am not going to embark on some sophisticated game theory modelling to show that it is rational for companies and entrepreneurs to behave in a trustworthy way. As a close observer of the heroes and villains of the great capitalist epic over the past two decades, I have seen the scum rise to the top far too often to have any confidence that the meek will inherit the squillions.

But in a way, the saints and sinners are the least interesting cases.

The more important question is what kind of sanction applies to a company (or individual) that lets down its investors or staff as a result of the most human of failings: promising too much.

The pressures on CEOs to hype the prospects of their businesses are immense.

But it also turns out that the market has an Old Testament approach to punishment. It can be pretty wrathful.

I saw this almost every day in my role as editorial director of Quest, the online corporate analysis service. At the heart of Quest is an assessment of what companies are worth based on their long-term cashflows.

On the basis of discounting these cashflows, the shares of many of these companies trade at a premium to their intrinsic value, while others trade well below their so-called fair value. Much of the difference between these groups can be explained by whether shareholders trust management.

An interesting case is Rentokil. For something like 17 years until the late 1990s, its earnings per share never failed to rise by less than 20%.

And its share price and fair value both moved higher in an impressive, seamless progression.

I should point out that I regard earnings growth as a slightly spurious measure - even though it is loved by the City - since it tells you nothing about the more vital measure for investors of the return being generated on capital employed. It is possible for earnings to grow very rapidly but returns to fall simultaneously, simply by expanding the capital base at a fair lick (through acquisitions, for example). However, Rentokil was a pretty good business on more sensible yardsticks as well.

Unfortunately it transformed itself with the acquisition of its rival BET, a vastly inferior business. In the ensuing years Rentokil became more like BET, rather than the other way round, which was what shareholders had expected.

Its returns were dragged down by the BET businesses, proving that you are what you eat, as my former colleague Terry Smith (chief executive of Collins Stewart) puts it. And when shareholders realised they had been let down, Rentokil's share price plunged.

By 2000, it had moved from a substantial premium to Quest's assessment of fair value to a discount of 50%. The cost of losing trust was probably about pounds 2 billion, since that was the size of the gap that gradually opened between its market value and its fair value.

Anyway, it is not just individual companies that suffer when they lose the trust of shareholders. Whole sectors are also afflicted. The housebuilding sector, for example, has produced spectacularly good returns for the best part of a decade. But shares in 16 UK housebuilders trade at 60% below their intrinsic value.

The reason is that painful memories linger of the boom-and-bust inflationary cycle of the late 1980s and early 1990s, in which so many builders got into trouble. And what is particularly galling for those companies is that responsibility for the boom-bust cycle lay with government. So they can say, with some justification, that it just ain't fair that the market does not trust them.

But what do you do when you lose the trust of a vital constituency? Well, if you're lucky enough to keep your job, you put your head down, tighten your belt, put on the hairshirt and devote yourself to grinding out the profit.

That is what Sir Clive Thompson, chief executive of Rentokil, did after his company's fall from grace. He has sold businesses accounting for a third of its turnover and overhauled management processes. The share price is on the rise again and there is a sign that the company is gradually winning back its following.

But whether it will ever again rejoin the pantheon of corporate heroes is moot. When the deity of the market feels spurned, it does not forgive quickly or easily.

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