W hen it comes to shareholder value creation, many corporate executives and board members view activist investors as little more than balance sheet hecklers with bulky presentations.
Then again, executives who think of activists as just another set of unruly participants in the public markets fail to face a strikingly simple truth: Few companies have a meaningful analytical process for managing their investment choices and the link between those choices and their impact on the company’s shareholder value creation over time. Negative returns on invested capital are surprisingly common and difficult to ignore. According to BCG, more than one-third of the $8 trillion of invested capital in the S&P 1500 does not earn the cost of capital. Moreover, over a five-year period, half the companies experience a significant write-off, divest a major business, or see a decline of 50 percent or more in company value.
The lesson of experience is that relying solely on tools such as discounted cash flow and earnings per share (EPS) will fail to protect against investment failure. A better approach is to effectively assess the tradeoffs among competing investment choices by grounding the company’s investment thesis and analysis in the realities of the company’s competitive situation, opportunities, and risks.
A functional investment thesis tends to focus on three to five crucial measures that are essential to attain attractive returns on invested capital over a three to five year time horizon. The reason for this is that a company’s levers for shareholder value creation at any point in time are likely limited to just a few key value drivers.
The key is to weigh opportunities and risks and adopt a contrarian perspective. Without a clear understanding and reason of why the short seller’s thesis is incorrect and the general market view driving a company’s present valuation is too conservative, there ought to be little reason to invest in a company.
To understand the difference an effective and focused investment thesis can make, consider BCG’s account of two CEOs of a large, highly diversified consumer-products company.
To realize successful and sustainable shareholder value creation, the management team had to focus not only on revenue growth and expanding margins but also on the implementation of a disciplined capital structure. Managing the delicate balance between reinvested cash to drive profitable growth and distributed cash (including dividends, share buybacks, and debt pay downs) to increase cash flow yield efficiently is paramount if sustainable shareholder value creation is a priority.
The revised investment thesis pushed the management team to concentrate on three important levers for shareholder value creation. Business unit heads no longer perceived capital as free and growth as the only way to drive corporate initiatives. Instead, cash flow was allocated to drive positive returns, causing an affirmative shift in investor sentiment by focusing on strategic, high-return acquisitions and enhancing margins through disciplined innovation. The increase in valuation multiple helped rank the company’s three- and five-year shareholder value creation track record best-in-class among its peer group.
While enhancing profitability and shareholder value in due course is a commendable objective for any public business enterprise, the course chosen will be fundamentally distinct more often than not. Industry dynamics, competitive forces, and corporate priorities will need to be evaluated and integrated. At times, the most opportune course of action will require short-term pain, including eliminating a distressed business or risk from the balance sheet, for the sake of sustainable long-term gain and greater liquidity. Other times, shifts in consumer behavior may cause the long-term viability of an entire business model to be called into question.
But before anything else, the first challenge management needs to tackle is to formulate a functional investment thesis by identifying the appropriate shareholder value levers that are tailored to the company’s competitive situation, opportunities, and risks.
Originally published on Carried Interest (October 30, 2014).