Be wary of firms pursuing 'engineered growth'

Within the corporate world, the innovation dynamic, or Schumpeter’s ‘creative destruction’ is nothing new. In order to maintain long-term success, businesses will continue to strategically invest and adapt to a rapidly evolving world.

While some companies will stimulate organic growth through new products, services and pricing models, not all companies seek to drive organic innovation. Analysing 2018 corporate activity, we have observed a trend towards engineering growth – either at the top or the bottom of the income statement.

While engineered growth has its merits in generating shareholder returns, investors must evaluate whether excessive short-termism can lead to long-term value destruction. Below, I look at three ways companies are looking to juice returns and what the implications are for long-term investors. 

Massaging the books 

Activist investors and management teams are seeing slower sales growth and glancing down to the bottom line, wondering how to massage profit numbers higher. The latest craze to sweep the global consumer goods sector is ‘zero-based budgeting’, where each year all expenditures are set to zero and any increase from there must be justified by the budget owner.

We are all for efficiency where it makes no impact on or improves the long-term potential of the firm but are cautious about how far this trend should be taken. For example, marketing spend must be made, otherwise brands will ultimately fade into the background, to be superseded in the public consciousness by the aforementioned young upstarts.

Be a debt vigilante

Leverage is another method of engineering shareholder returns which is being deployed across industries. Debt applied to the balance sheet might juice up profit growth to the shareholder, but increasing financial risk makes the firm more susceptible to unexpected events in the longer run. 

We are not against leverage per se, but in our view it should be used appropriately and sparingly. We are vigilant to this trend through our own risk management processes, limiting the position sizes in the fund for those businesses that choose to take on more debt.

Time will judge M&A success 

Merger and acquisition activity has the potential to enhance both revenues and profits through cross selling goods and services, creating better routes to market, and through cost-stripping ‘synergies’. In early 2018, we have already seen the impact of a proposed takeover of Dr Pepper Snapple, a purveyor of soft drinks, by Keurig Green Mountain, a seller of coffee. 

The rationale for combining these hot and cold beverages is that Dr Pepper knows how to get store coverage, and Keurig knows how to sell to people on line. By teaming up, they are confident they will be able to quench consumers’ thirst wherever they are, with whatever they fancy, and however they want to purchase. This is another form of innovating via the corporate structure, and time will tell if this is fruitful for Dr Pepper and others that are engaging in similar activity (Thomson Reuters and UBM in the Evenlode Global Income portfolio for example). 

The French put it well – the more things change, the more they stay the same.  Some will merge and some won’t keep up; we’ll look out for the adapters and be wary of the laggards who fail to invest in themselves.  Currently corporations across many industries are welcoming some brighter trading with the US, Asia and even more recently Europe are experiencing something of an economic upturn. Those that have invested well in their products and services will be able to make hay while and where the sun shines.  

Ben Peters is co-portfolio manager at Evenlode Global Income Fund.

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