Finding the way forward when growth stalls

MANY management teams these days find themselves in intense debates over a pressing question. There is a lot of cash on the company's balance sheet right now. Should we buy back some of our shares or should we invest in growth?

Share buybacks have an obvious appeal and an obvious limitation. They give a quick shot in the arm to earnings per share and (usually) the stock price. They pacify activist investors clamouring for the company to return cash to shareholders.

But while buybacks may be viewed as a sign of a company's confidence in its future, they are pure financial engineering. They do nothing to stimulate growth. This failure to invest is bad news, both for individual companies and the economy. Investments in innovation are a key source of growth in jobs and GDP. A business that can't grow will eventually shrink or die, destroying jobs and value.

Investing in growth is like playing a competitive sport. If it is not done often enough, skills atrophy and muscles deteriorate.

GROWING THROUGH M&A

One category of growth investment - mergers and acquisitions (M&A) - illustrates the importance of keeping in shape. Many observers believe that M&A, on the whole, destroys value. Of course, some deals do. But M&A creates value, because it can lead to greater efficiency.

When we studied the total shareholder return of more than 1,600 companies from the year 2000 through 2010, we found that companies engaging in M&A outperformed inactive companies by a substantial margin.

The more transactions a company did, and the greater the cumulative value of those deals, the higher the total shareholder return (TSR), defined as stock price changes assuming reinvestment of cash dividends.

The top performers were companies that averaged at least one deal every year, with the cumulative deals accounting for 75 per cent or more of their market capitalisation. These growth-minded acquirers turned in nearly double the TSR of companies on the sidelines. Those companies making acquisitions that add a large amount of their market capitalisation did the best. In general, the more a company's market cap comes from its acquisition, the better its performance is likely to be.

Large-scale and frequent acquirers - we call these companies "mountain climbers" - outperform companies that occasionally engage in M&A or sit on the sidelines. As a group, mountain climbers achieved an average annual TSR of 9.5 per cent.

Share buybacks are no substitute for growth investments. In the first year, buybacks do have a minor effect on TSR, though they are far less important than, say, a change in a company's price-to-earnings ratio. Over five to 10 years, the effects of buybacks on TSR virtually disappear. What really matters in the long haul is improvement in operating profit, and that requires growth.

How can companies rebuild their growth muscles? Certainly there's no shortage of burgeoning opportunities for innovation and investment.

Bain estimates that a billion new consumers will join the global middle class over the next several years, adding some US$10 trillion to the world GDP. The primary goods sector - food, water and energy - is likely to add another US$3 trillion. Then, there is infrastructure, health care and new technologies.

IDENTIFYING OBSTACLES

To get there, however, companies will have to re-examine two factors that are holding them back: their hurdle rates for new investments and their attitude towards risk.

Right now, the typical company probably assumes it has to earn at least 12 per cent on a new investment - 8 per cent for its cost of capital and a 4 per cent risk premium.

Does this make sense in an era when money is so cheap?

The cost of future capital is likely to be considerably lower than in the past. A proportionate risk premium would be only a couple of percentage points. A company's job isn't to avoid risk entirely; that would mean closing shop. Rather, the task is to reduce risk to manageable levels.

The best companies do that by building up their capabilities. They search hard for merger or acquisition candidates that will add to their operating profit and fuel balanced growth. They pursue nearly as many "scope" deals as "scale" deals, moving into adjacent markets as well as expanding their share of existing markets. They create a model for M&A that they can reuse.

What they find, unsurprisingly, is that there are plenty of good investments to be pursued, and that the risk decreases over time.

Remarkably, 24 per cent of these companies have sustained at least 5.5 per cent annual growth in revenue and earnings over 10 years while earning their cost of capital, compared with only 11 per cent of companies in general. The moral of the story for leadership teams isn't to focus exclusively on M&As; most successful companies pursue a balance of organic and inorganic growth investments.

But growth doesn't just happen. Companies have to pursue it by investing in it, and those that do so will get better and better at it over time. That creates a more positive outlook for everybody - executives, employees, and shareholders alike.