Managing Director & Partner
This article is the second in the 2016 BCG Value Creators series. In May 2016, we released the 2016 Value Creators rankings, which track the top performers worldwide and in 28 industry sectors on the basis of their total shareholder return (TSR) from 2011 through 2015.
Recent volatility in global equity markets has led to an uptick in bearishness among investors. According to BCG’s eighth annual investor survey, investors are scaling back their expectations for total shareholder return (TSR) and looking for companies that are building value-creating businesses, not just returning cash to shareholders in the form of dividends and stock buybacks.1 Notes: 1 TSR measures the combination of share price gains and dividend yield for a company’s stock over a given period. It is the most comprehensive metric for a company’s performance in shareholder value creation.
The survey—conducted in early 2016 by BCG in partnership with Thomson Reuters, the world’s leading provider of business and financial information—received responses from more than 700 portfolio managers and buy-side and sell-side analysts, representing firms that are collectively responsible for approximately $2.5 trillion in assets under management. BCG has conducted the survey every year since 2009 to understand investors’ views on global capital markets and priorities for shareholder value creation.
Four themes stand out in this year’s findings:
The rise in bearish sentiment is perhaps the most striking finding of this year’s survey. In 2015, 19% of respondents said they were either “bearish” or “extremely bearish” about the market’s prospects; this year, 32% did. This is the highest percentage since 2009, in the midst of the global financial crisis, when 54% of respondents described themselves this way. (See Exhibit 1.)
The 2016 increase is primarily a reaction to the slowdown in China and other emerging markets. As the middle chart in Exhibit 1 illustrates, the percentage of respondents who are bearish or extremely bearish rises to 40% among those who focus on Asia and emerging markets in Africa, the Middle East, and South America. The percentage drops to less than 30% among investors who focus on the US and Europe. When asked to choose the main reasons for their pessimism, 72% of the bears selected the slowdown in China’s economic growth as a key factor.
Despite the relatively high levels of bearishness this year, it’s important to emphasize that the sentiment is strongest for the immediate future. We asked the bearish-bullish question for two periods—2016 and three years out, through 2018. As Exhibit 1 illustrates, the percentage of respondents who are bearish or extremely bearish declines by half for the longer time frame. A slight majority of respondents (51%) said they were “bullish” or “extremely bullish” for the longer term.
Higher levels of bearishness correspond to expectations for lower TSR. Every year, we ask respondents to estimate average annual TSR for the next three years and the underlying rate of earnings growth and dividend and share-repurchase yields. In 2016, the weighted-average estimate of TSR was 5.5%—a full percentage point below the 2014 and 2015 estimates and the lowest in the eight years we have been conducting the survey. (See Exhibit 2.)
Modest expectations for TSR reflect in part similarly modest expectations for earnings growth: 4.1%. Moreover, investors appear to be anticipating a decline in valuation multiples. If one subtracts the estimate for average annual earnings growth, dividends, and share buybacks from the estimate for annual average TSR, the result is an implied decline in valuation multiples equivalent to –3 percentage points of TSR. Put another way, investors seem to be anticipating a decline in valuation multiples that will offset roughly three-quarters of the TSR created by earnings growth, leaving cash returned to investors as the dominant source of TSR. Under this scenario, approximately 80% of TSR over the next three years would come from dividends and buybacks.
Even as the investors we surveyed are expecting the lion’s share of TSR in the next three years to come from cash payouts, they want companies to consider alternative uses for their excess cash. Every year, we ask respondents to indicate their priorities for the use of free cash flow at a financially healthy company. Exhibit 3 compares the 2016 responses with the average for the previous seven years. As the middle two bars in the exhibit show, the percentage of respondents who listed either dividend increases or share buybacks as one of their top two priorities is lower than the average.
Some background helps put this finding into context. In 2015, nonfinancial companies in the S&P 500 returned more than $1 trillion to shareholders—share buybacks made up over 60% of the total, and dividends accounted for the rest. Buybacks have increased more than fourfold since 2009, accounting for roughly 3% of the average 8.5% growth in earnings per share. By contrast, capital expenditure budgets in the S&P 500 have grown only 44% over the same period.
After a period in which companies returned record amounts of cash to shareholders, investors may be looking for companies to use that cash to improve the fundamental value of their businesses. In this regard, it is striking that despite a slight relative decline, investment in organic growth remains a top priority for a majority of investors and is chosen by more respondents than any other area. And the percentage of respondents who see strategic M&A as a priority has grown relative to the average, perhaps reflecting a belief that lower valuations are making deals more attractive.
Another factor at play is the likelihood that the US Federal Reserve will increase interest rates (62% of respondents follow US capital markets). In recent years, many companies have taken advantage of the low interest rate environment to borrow money cheaply and use it to buy back their own stock during a period when stock prices were on the rise. But if interest rates increase even as valuations decline, this may no longer be a viable strategy. Indeed, the fact that an above-average percentage of respondents chose debt retirement as a top priority for the use of excess cash may signal a growing concern among investors that too much leverage will expose companies to liquidity problems in today’s uncertain macroeconomic environment.
Other findings in our survey confirm an increased focus on fundamental value. For example, when asked to identify their most important criteria for deciding to invest in a company, the experience and credibility of the management team and the clarity of its business strategy and vision were among the top choices—32% of respondents chose each of those criteria as one of their top three. (See Exhibit 4.) TSR drivers were also popular: undervaluation was chosen by 32%, three-to-five-year revenue growth was chosen by 29%, and free cash flow yield was chosen by 27%. Less popular criteria, by contrast, were strictly financial metrics such as a company’s free cash flow as a percentage of sales, the level of return on invested capital, and leverage ratios.
When we asked respondents to describe the areas in greatest need of improvement at their portfolio companies, most cited strategic management processes, such as capital allocation, strategy development and planning, investor communications, and risk management. (See Exhibit 5.) Capabilities that are more operational (for example, financial reporting and financial planning) were at the bottom of the list.
The findings from this year’s investor survey should be considered in the context of companies’ ongoing adjustment to a macroeconomic environment that, since the 2008–2009 global financial crisis, has been characterized by relatively low growth. For a time, emerging markets were an exception to this trend, but recent developments in China, Brazil, and other emerging markets suggest that these countries will grow more slowly in the future.
In response, companies have made a variety of moves to deliver value. They have cut costs to improve profitability and free cash flow, taken advantage of low or even negative interest rates to increase leverage, boosted payouts in the form of dividends and share buybacks, and benefited from valuation increases as capital markets have rebounded from their post-financial-crisis lows.
The findings of our survey, however, suggest that investors believe that these strategies are mostly played out. Margins are currently at or near their peak, making additional improvements increasingly difficult. Cash returned to shareholders will continue to constitute a large percentage of TSR, on average, and provide a floor for valuation; but cash payouts alone won’t deliver superior value. Finally, although interest rates have been low, they are likely to increase in the near future. All these factors mean that valuations will be under persistent pressure.
In such an environment, investors want companies to focus on improving their fundamental-value engine: to put in place the managerial vision, organizational capabilities, and capital investments necessary to create a strong foundation for growth in the core business. In a low-growth environment, this is an enormous challenge. But precisely because of this difficulty, delivering value-creating growth will likely be what distinguishes the superior value creators from the rest.
What can companies do to align their value creation strategies with investors’ priorities? We believe four steps will be especially important: