Directors & Boards Second quarter 2016 (p17)
Many firms are experiencing a difficult 2016, withcontinued weak earnings and stock prices. Especially concerning is sluggish revenue growth at many businesses.Explanations for these results include a lowgrowth economy and political uncertainty, both of which are likely to continue. Some analysts are even pushing for high-risk transformationalchange to restart growth. Consequently, managers are under increased ]\pressure, real or imagined, to grow either organically or through acquisitions. Uncritically succumbing to the pressure togrow, however, can destroyshareholder value.Firms need to first evaluatethe financial viability of theirgrowth strategy to ensurethey are not overpaying forgrowth. Growth is not free; itrequires capital, which carriesa cost. The evaluationinvolves comparing the costsof the required capital investmentswith their expectedreturns under multiple scenarios. This is the samecapital budgeting process used to evaluate projectslike plant expansion; this time applied at thecorporate level. Next, the credibility of projectionsmust be assessed.Many companies have failed to earn theircost of equity since the Great Recession. Theirpersistent low return on equity (ROE) reflectsaging business models and unattractive industrydynamics. Growing under these conditionsis unlikely to fix the return problem underlyingdepressed stock prices. Moreover, it violates thefirst law of hole digging — stop when you arein one. Understandably, the market response tomost growth strategies, particularlyacquisitions, is lukewarmat best.Firms should only growif there is a reasonable likelihoodof ROE exceedingtheir cost of equity basedon believable projectionspreferably supported by historicalevidence. Such evidencereflects a sustainablecompetitive advantage ormoat. Growth without a moatis likely to be fleeting oncecompetitors respond. Manyfirms will be hard pressed tosatisfy this test, and shouldnot grow. Instead managersshould reallocate capitalto shareholders throughincreased dividends.Understandably, mostmanagement teams prefer torun larger growing firms forboth prestige and compensation reasons. Othersbelieve higher dividends signal lower expectedearnings growth and tired management. The evidence,however, shows a positive relationshipbetween the dividend payout ratio and futureearnings growth — possibly because dividendsreduce the risk of value-destroying investmentsin low-return growth initiatives. Additionally, theysignal a shareholder friendly management teampracticing sound capital allocation. Making thisalternative more acceptable to managementmeans changing current growth-orientatedincentive compensation plans.Boards must critically examine optimisticaggressive growth initiatives championed byambitious executives, consultants and analysts.As Warren Buffett notes, when a managementwith a reputation for brilliance tackles abusiness with bad economics the reputation ofthe business wins. The twin anchors of industrylife cycle and market growth are difficult toovercome. Second acts like Steve Jobs hadat Apple are difficult to achieve; usually theefforts are based on an unrealistic assessmentof one’s potential.All growth is not the same. Growth is notalways the best way to create value. Frequently,the problem is not growth but return. Thus, a betteralternative may be increasing ROE throughenhanced capital efficiency. Managers shouldavoid putting shareholder value at risk withquestionable growth initiatives. Growth withouta commitment to careful capital managementevidenced by sound dividend policy and anacceptable ROE is a recipe for investor disappointmentand shareholder activism.
Joe Rizzi is a partner at Macro Strategies LLC,an advisor on strategy, capital and risk management( Hehas over 25 years of banking experience. He isalso an instructor at Chicago-area universities,including Loyola and DePaul. He blogs on M&Atopics at “MergerProf” ( can be contacted at .