Why the biggest and best struggle to grow

April 19, 2019

Here is a brief excerpt from a classic article written by Nicholas F. Lawler, Robert S. McNish, and Jean-Hugues J. Monier for the McKinsey Quarterly, published by McKinsey & Company. To read the complete article, check out other resources, learn more about the firm, obtain subscription information, and register to receive email alerts, please click here.

To learn more about the McKinsey Quarterly, please click here.

*     *     *

The largest companies eventually find size itself an impediment to creating new value. They must recognize that not all forms of growth are equal.
The largest, most successful companies would seem to be ideally positioned to create value for their shareholders through growth. After all, they command leading market and channel positions in multiple industries and geographies; they employ deep benches of top management talent utilizing proven management processes; and they often have healthy balance sheets to fund the investments most likely to produce growth.Yet after years of impressive top- and bottom-line growth that propelled them to the top of their markets, these companies eventually find they can no longer sustain their pace. Indeed, over the past 40 years North America’s largest companies—those, say, with more than about $25 billion in market capitalization—have consistently underperformed the S&P 500,1 with only two short-lived exceptions.
Talk to senior executives at these organizations, however, and it is difficult to find many willing to back off from ambitious growth programs that are typically intended to double their company’s share price over three to five years. Yet in all but the rarest of cases such aggressive targets are unreasonable as a way to motivate growth programs that create value for shareholders—and may even be risky, tempting executives to scale back value creating organic growth initiatives that may be small or long-term propositions, sometimes in favor of larger, nearer-term, but less reliable acquisitions.
In our experience, executives would be better off recognizing the limitations of size and revisiting the fundamentals of how growth creates shareholder value. By understanding that not all types of growth are equal when it comes to creating value for shareholders, even the largest companies can avoid bulking up on the business equivalent of empty calories and instead nourish themselves on the types of growth most likely to create shareholder value.

What holds them back?

At even well-run big companies, growth slows or stops—and for complex reasons. Ironically, for some it’s the natural result of past success: their portfolios are weighed down by large, leading businesses that may have once delivered considerable growth, but that have since matured with their industries and now have fewer natural avenues for growth. At others, management talent and processes are more grooved to maintain, not build, businesses; and their equity- and cash-rich balance sheets dampen the impact growth has on shareholder value. For all of them, their most formidable growth challenge may be their sheer size: it takes large increments of value creation to have a meaningful impact on their share price.

The other crucial factor is how management responds when organic growth starts to falter. This is often a function of compensation that ties bonuses to bottom-line growth. In any case, management is often tempted to respond as if the slowing organic growth were merely temporary, rejecting any downward adjustment to near-term bottom-line growth.

That may work in the short run, but as individual businesses strip out controllable costs, they soon begin to cut into the muscle and bone behind whatever value-rich organic growth potential remains—sales and marketing, new product development, new business development, R&D. At one industrial company we are familiar with, management proudly points to each savings initiative that allows them to meet quarterly earnings forecasts.

But the short-term focus on meeting unrealistically high growth expectations can undermine long-term growth. Ultimately, the scramble to meet quarterly numbers will continue to intensify as cost cutting further decelerates organic growth. If the situation gets more desperate, management may turn to acquisitions to keep bottom-line growth going. But acquisitions, on average, create relatively little value compared to the investment required, while adding enormous integration challenges and portfolio complexity into the mix. Struggling under the workload, management can lose focus on operations. In this downward spiral management chases growth in ways that create less and less value—and in the end winds up effectively trading value for growth.

Some companies seem to have recognized the danger in constantly striving to exceed expectations. One company’s recent decision to vest half of its CEO’s stock award for simply meeting (rather than handily beating) the five-year share price appreciation of the S&P 500 may be one such bow to good reason. Ironically, relieving the CEO of the pressure to substantially outperform the market may have given him the freedom he needs to focus on longer-term investments in value-creating organic growth.

Some executives will no doubt find uncomfortable the shift to a perspective that emphasizes the value creation intensity of growth initiatives. Though such a shift would serve shareholders well, it may also lead to lower overall levels of top-line and earnings-per-share growth.

Executive credibility will be on the line in communicating this message to the markets. One executive we’ve worked with, for example, recognized that his company lacked the credibility to quickly lower his overall EPS growth targets in favor of a richer mix of value-creating growth without getting pummeled by the markets. Instead, the company made one more big push on operations, letting only enough of the savings fall to the bottom line to meet the company’s short-term growth projections. The rest of the savings was redirected toward slower, but more value creating, organic growth, with the expectation that once the company had built some credibility in that respect with shareholders, it could more easily make its case to the markets.

* * *

When growing gets tough in the largest companies, tough executives must learn to get growing in value creating ways. Rather than bulk up on the business equivalent of empty calories, they should explore the value creation intensity of different modes of growth to build shareholder value muscle.

*     *     *

Here is a direct link to the complete article.

Nick Lawler and Jean-Hugues Monier are consultants in McKinsey’s New York office. Rob McNish is a principal in the Washington, DC, office.This article was first published in the Winter 2004 issue of McKinsey on Finance.

 

Posted in

Leave a Comment





This site uses Akismet to reduce spam. Learn how your comment data is processed.