Firms Should Long for Long-Term Growth

Many managers have spent their time in this nascent will-it-won’t-it recovery wondering what to do with their company’s cash: spend it, pay down debt, keep it in case things get worse, or return it to investors. The trend across the past 20 years has seen a marked drop in capital expenditure (capex) in favor of rewarding investors, especially through share buybacks. R&D expenditure — the other big way that firms can spend their cash — has stayed steadier than capex but has still declined (see chart 1).Chart 1: Comparison of S&P 500 Uses of Cash, 1990-2009

None of this is good for the long term. Yes, investors as the ultimate owners of the firm should be rewarded for investing funds in a successful enterprise. However real success — i.e., sustainable long-term growth — will only come from growth investments (any CEB advisor you meet will gladly argue that long-term growth is the most important business imperative). The problem is that growth investments take longer to deliver visible returns, and so managers must find the knack of not only making the right investments but ensuring employees and investors understand the value of these decisions and support them across time.

Good Things Come to Those Who Wait — Your Growth Investments Will Pay Off

It is understandable that managers don’t want to commit resources to projects when there is no guarantee of a payoff, especially in this uncertain start to the decade. However our data support the fact that organic growth investments produce the best returns. We carried out a regression analysis on the performance of 179 S&P 500 firms between 1990 and 2009, highlighting the relationships between R&D spend and sales, and capex and sales. The findings showed that R&D spend and capex drive total shareholder return more effectively than the alternatives (see chart 2).

Chart 2: Maximum Impact of Different Drivers on Total Shareholder Return

The analysis also showed that it takes, on average, three to four years for the impact of R&D spend and capex to be recognized in enterprise value and shareholder returns. This lag in shareholder valuation is eminently understandable. First, shareholders don’t recognize the effect of R&D spend or capex immediately; and second, the firm’s managers have an incentive to keep quiet about new investments for fear that competitors may copy them.

Making Growth Investments Work at Your Firm

Long-term growth investment is undoubtedly a good thing but that doesn’t mean it’s easy. There are four steps that executives should take to make good long-term investment decisions and keep employees and shareholders aligned behind the vision that drove those decisions.

1. Segment Your Portfolio into Low-and High-Value Investments: To assert that simply spending more on organic growth yields lasting competitive advantage would be a gross simplification. Executives are advised to distinguish between different types of R&D and capex as they invest for growth. A higher proportion of breakthrough R&D in the portfolio, or higher levels of reinvestment as measured by capex to depreciation, generate faster margin and sales growth relative to peers.

2. Design Investment Screening Criteria That Do Not Bias Decisions Against Longer-Term Growth Investments: An overreliance on financial projections to make the business case for growth investments, perversely, often increases executive risk aversion. Instead, firms should emphasize project performance success measures that focus business managers on credible nonfinancial indicators of success.

3. Force Constructive Engagement Around Organic Growth Investments: To identify the most promising growth bets, companies must use expertise from across the enterprise. Design interactions and build incentives for business leaders to jointly explore breakthrough opportunities.

4. Educate Investors on How to Value Growth Investments: Few companies explicitly differentiate themselves through key investor messages despite the fact that portfolio managers view competitive differentiation as a key factor in bear markets. We see leading investor relations departments take advantage of their unique visibility into the competitive landscape to differentiate their firms from peers’ investment decisions.

If you get these four steps right you could go a long way to helping your firm outperform competitors by a wide margin, and not just at the next annual results party but for the next decade. Please leave comments below or contact me if you have a question.


To hear Randeep talk about this research, listen to his recent podcast.