Originally published in June 2003.

After a two- to three-year dry spell, management teams are starting to see promising opportunities for profitable growth. Yet many executives are reluctant to make the "big bets" necessary to exploit these opportunities.

Their reluctance is understandable. Battle-scarred investors have been hesitant to provide capital after the collapse of the equity markets and the economic slowdown that began in the late 1990s. Likewise, they remain skeptical of management’s earnings forecasts and proposals touting new growth opportunities. Executives, meanwhile, are wary of investing in future-oriented projects for fear that shareholders will not fairly value the expected returns. The result is a vicious cycle, leaving companies without capital and investors without investments.

How can executives make better use of their limited capital and begin to rebuild the confidence of the investment community? In this article, we recommend four steps that, taken together, can help executives capture these opportunities: First, top managers need to seek a more detailed understanding of the "investment and return" profile for each of their businesses. Second, they must increase their investment selectivity, potentially making fewer bets and focusing on those that are big enough to have a significant impact on the company’s intrinsic value. Third, they should address the costs of keeping capital tied up in low-return businesses and free up underperforming capital for reinvestment. Lastly, they must develop economically sound stories for investors that link current investment strategies with long-term value growth.

The Roots of the Problem

It is worth noting some of the reasons behind the current gun-shy attitude of management teams and investors. Generally speaking, there is a changed – and misguided – mindset toward capital. While in the last decade, capital was treated as a cheap and plentiful commodity, today it is seen as very expensive and scarce – and its use is carefully scrutinized. Both views are skewed by the herd mentality that produced them. In reality, capital remains plentiful but expensive. Investors will always fund growth opportunities that they are confident will deliver attractive returns.

Furthermore, whereas investors in the 1990s often took management’s growth forecasts at face value, today there exists a high degree of doubt that ambitious growth plans will ever pay off. Consider, for example, the experience of the U.S. bank industry. Between 1995 and 2001, many of the largest American banks aggressively pursued mergers and acquisitions to grow earnings and assets. While these deals were accretive to earnings, they have yet to benefit shareholders. The reported ROEs for these companies averaged 18%, but when returns are adjusted to include goodwill, the ROE falls to about 9% – less than many banks’ cost of capital.

Having gotten their fingers burned in the go-go Nineties, many executives are hesitant to exploit the real profitable growth opportunities that exist today. Capital-starved companies are selling businesses at reduced prices to generate cash. Acquisition premiums and the underlying value of target companies have fallen low enough to make the economics of M&A attractive. This is especially true in the U.S. financial services sector, as market-to-book values for transactions have steadily declined since the late 1990s (see Figure 1). This is leaving many good potential acquirers and their shareholders on the sidelines.

The situation was summarized well by the CEO of a global financial services client: "We see more opportunities now than we have the capital to pursue. Raising capital is possible, but it’s not overly practical. Our investors, feeling the pain of the last few years, aren’t yet on board with the opportunities, nor have they factored in the consequences of not pursuing these opportunities."

Breaking Out of the Cycle
How can executives and investors break out of this vicious cycle? Are we really stuck in an environment where business leaders, the companies they run and shareholders are forced into temporary holding patterns? Our work with a number of leading companies that have achieved profitable growth suggests that this need not be the case. These companies have developed a disciplined plan of attack that both identifies opportunities to raise capital and builds investors’ confidence that their capital will be put to good use. Below, we explain four steps that companies in this situation can take to accomplish similar success. The ideas, while certainly not new, are too infrequently part of the management mindset. When used together consistently, they can create a multiplier effect that allows management to rebuild its bridge with the investor community and fund opportunities that are in the best interest of shareholders.

  1. Create a granular understanding of the investment and return profiles within each business. Managers tend to overlook the extent to which capital that has already been invested can be put to better use. By developing an "investment and return profile" for each business in their portfolio, they can better see where capital is lying fallow and where it is producing generous returns. Investment and return profiles provide a detailed view of capital efficiency by showing the amount of capital invested in each business – and often products and customers within that business – as well as the returns on each of these investments. Chief executives can leverage this information to determine which businesses (and importantly, which strategic options in those businesses) can make good use of capital and which can afford to release capital.

  2. Don’t "share the pain" when rationing capital. The business doctrine often adopted when times are tough is one of shared pain – each manager has to give a little, proportionately no more or no less than any other manager. While this seems fair and politically expedient, rarely do the businesses within a company have the same investment and return profile. While pro rata capital rationalization may seem fair, underinvesting in the best growth opportunities and overinvesting in moribund segments can sacrifice substantial value creation or, worse yet, destroy value for shareholders. Bottom line: Executives should funnel capital disproportionately to those businesses with the best investment and return profiles.

    3. An example of the right mindset can be seen in the recent action of a leading UK financial services company with extensive international operations. The multi-business firm had developed excellent investment and return profiles for its business units and had tracked how well capital was working in each area. When the opportunity arose to make a retail bank acquisition in Spain that was projected to have excellent returns, the parent company redirected funding away from its corporate banking business, which had a weak and deteriorating competitive position. The objective was not to "rob Peter to pay Paul," but to reallocate capital so as to maximize the value of the entire company.

  3. Consider the return on alternative uses of capital when reviewing divestiture candidates. While deal pricing may not be optimal for selling businesses in the current environment, there are other factors to consider before dismissing the idea entirely. Assume, for example, that management has an opportunity to invest $1.0 billion in a core business that it estimates will earn a rate of return greater than 12%. Should it divest a non-core business for $1.0 billion that it values as a going concern at $1.2 billion? Often a management team in this situation would say no, because the disposal value is below the value of the business as a going concern. But because new investment is expected to have a higher return and strengthen a core business, it would more than compensate for the "loss" from disposal (see Figure 2). Such cases are frequent: Low-return businesses with weak competitive positions tie up capital that could be reinvested to strengthen businesses that are competitively advantaged and offer material growth opportunities.

  4. Create an investment story that shows the link between business strategy and long-term value growth. In the current environment, investors prefer the certainty of cash today to the promise of cash tomorrow. This "show-me-the-money" attitude in regards to earnings growth has taken its toll. The onus for changing the investor mindset lies squarely on the shoulders of executive leadership. In order to move investors back to a more forward-looking attitude, CEOs and CFOs need to provide credible, transparent information on the underlying economics of the opportunities they face. By delineating the choices and trade-offs, and by making clear the linkage between their strategy and short-, medium- and long-term growth and value, management will have the best shot at overcoming cautious investor sentiment. The risk of ignoring this approach is that executives will let investor expectations shape their strategy instead of letting their strategy shape investor expectations.

One way to do this is to change the traditional way financial forecasts are made to the investment community. Instead of presenting EBITDA, earnings and cash flow at a consolidated level, management should be more transparent about the strategies it proposes for each of its business units and what the consequences are for capital, income and growth. This makes it clear to investors how the company will deliver long-term value growth. It can also have a positive impact on valuation.

For example, at one client company, the leadership was being pressured to move toward a more income-maximizing strategy (near-term dividends). Management responded by defining the strategy choices and consequences for income, capital and value implied by an income-oriented strategy versus alternatives that were more growth-oriented (see Figure 3). The exercise made clear for management the risks and associated costs of catering to near-term analyst criticisms. It also provided ammunition for building investor confidence in management’s chosen strategy, which would better balance income and growth in the near term and accelerate growth in the future.

In summary, the vicious cycle of whether to invest in profitable growth opportunities despite tight capital and investor skepticism is in large part what CEOs and their teams choose to make of it. Heeding analyst and investor sentiment risks sacrificing the company’s longer-term prospects to meet near-term and potentially ill-conceived goals. On the other hand, making reasonable bets using existing resources can turn a vicious cycle into a virtuous one. Such bets can restore investor confidence and generate the income and capital needed to fuel long-term value growth.

Marakon Associates advises some of the world’s best-known companies on the issues that most drive their performance and long-term value. The firm’s focus on value creation enables it to bring an original, independent view and unique expertise to the critical challenges business leaders face. Marakon has offices in New York, London, Singapore, Chicago and San Francisco.