Investors Brace for a Decline in Valuation Multiples

This is the second in a series of articles published in advance of The Boston Consulting Group’s 2014 Value Creators report. In February 2014, we described the strong performance of global equity markets in 2013. In the spring of this year, we will publish a full report that will include detailed rankings of the top performers, both worldwide and in 26 industries, from 2009 to 2014.

After a second year of The Flight to Equities Continues, investors are bracing themselves for a decline, on average, in valuation multiples and for below-average total shareholder return (TSR) in 2014. This new atmosphere of caution is the key finding of BCG’s latest annual investor survey.

In early 2014, BCG invited approximately 1,000 portfolio managers, buy-side analysts, and sell-side analysts to participate in BCG’s annual online investor survey. The survey is the sixth in a series that BCG has conducted since 2009 to understand investors’ views on the global economic environment and on priorities for business value creation. We received 131 responses to our survey this year (a response rate of about 13 percent) from individuals at firms that are collectively responsible for approximately $1 trillion in assets under management and that cover a wide range of industries and locations. Four key themes stand out:

• Growing Concern That Equity Markets May Be Overvalued. After two years of double-digit TSR in global equity markets—approximately 16 percent in 2012 and 26 percent in 2013—the percentage of respondents who believe that valuations have outpaced fundamentals has more than tripled this year compared with last year.
• Decline in Valuation Multiples Likely. Given their estimates for 2014 earnings growth, dividend yield and share repurchases, and average TSR, these investors seem to be assuming a significant decline in average valuation multiples.
• More Focus on the Short Term. This cautious outlook is causing investors to focus more on how companies are going to weather market turbulence in the short term. They want company value-creation strategies to have a dual focus: to defend against valuation-multiple compression in the near term while continuing to pursue value-creating growth opportunities in the long term.
• More Scrutiny on Core Management Processes. Investors are heightening their scrutiny of companies’ core management processes. They are seeking to invest in companies with strong management credibility and solid track records. Key indicators of credibility include the degree to which a company’s business, financial, and investor strategies are aligned with and mutually reinforce one another; strategic capital stewardship; and the strength of a company’s value management and strategic-planning capabilities.

Signs of Overvaluation

A number of indications in this year’s survey signal that investors believe valuations are reaching an upper limit. Every year, we ask our survey respondents their opinions of the current valuation level of whichever equity market they follow most closely. Exhibit 1 shows the responses of participants who are most familiar with the S&P 500 (about three-fourths of our total sample). Although the majority of this group (61 percent) see the market as fairly valued, more than one-third (36 percent) consider it overvalued—the highest percentage since we began our survey in 2009 and more than a threefold increase over the percentage of respondents who chose that option last year. And respondents who consider the market undervalued have almost disappeared, dropping from 23 percent in 2013 to a mere 3 percent in 2014.

Further evidence that investors expect valuation multiples to decline can be found in their estimates of the likely levels of earnings growth, dividend yield and share repurchases, and average TSR in 2014. When asked to estimate the level of TSR this year, the average of their answers was a modest 6.5 percent. An even more meaningful indicator is the trend of the annual TSR estimates, which have declined in nearly every year since 2009. This seems to reinforce the belief that valuations are nearing their peak, especially when one considers that this year’s respondents estimate that earnings will grow by 5 percent in 2014 and that the combination of dividend yield and share repurchases will contribute another 3.4 percentage points of TSR. If these investors estimate a TSR of 6.5 percent and a combined contribution of earnings growth, dividend yield, and share repurchases of 8.4 percent, then, by implication, they are assuming that valuation multiples will decline. (See Exhibit 2.)

A Dual Focus for Value Creation

Investors’ concerns about a near-term decline in valuation multiples have an important impact on their priorities for company capital deployment. In particular, they appear to be developing a dual focus for value creation strategy.

Our annual survey asks respondents to react to a series of statements about the preferences for the strategic agenda of a hypothetical company with “strong free cash flow and a healthy balance sheet.” Over the years, a strong majority of respondents has consistently agreed or strongly agreed with the statement “short term should not dominate.” We have taken this response as a sign that investors want companies to ignore market volatility and Investors Look to the Long Term.

This year, 70 percent of respondents again either agreed or strongly agreed with this statement—a substantial decline from the 80 percent who did so in 2013. This result may suggest a growing caution among investors about any value creation strategy that does not also have a plan for dealing with the likely drop they see coming in average valuation multiples.

A further clue comes from respondents’ preferences for how companies use their excess cash. Organic investment was a high priority, the first or second choice of 68 percent of respondents, up from 59 percent last year and slightly above the average since the first survey, in 2009. The choice to increase dividends came in second, selected by 45 percent of respondents—10 percentage points higher than the average of those who chose this answer in previous years. (See Exhibit 3.) We take these results to be an indication that investors want companies to pursue a dual strategy. They want companies to increase dividends, both as a guaranteed return in an environment where yield is scarce and as a signal of management’s confidence in its long-term agenda. At the same time, they want companies to invest in value-creating growth opportunities in order to deliver the fundamental value over the long term that will justify the expectations currently embedded in those companies’ stock prices.

Investors’ shifting attitudes about M&A reinforce this dual focus. Strategic M&A was the third-highest priority for uses of free cash flow, selected as a first or second choice by 41 percent of respondents. Although this percentage equals the average of all six surveys, it is 11 percentage points higher than last year’s result. This heightened interest in M&A is confirmed by answers to another set of questions about whether companies should focus more aggressively on M&A and divestitures. Exhibit 4 shows the responses to these questions from surveys in 2012, 2013, and 2014. For the first time, a clear majority of respondents (61 percent) either agrees or strongly agrees that companies should be more aggressive about M&A.

At first glance, it may seem curious that investors are becoming more interested in M&A while also assuming lower TSR and a decline in average valuation multiples. But as Exhibit 4 shows, an even higher percentage of respondents (80 percent) believes that companies should also be more aggressive about divestitures. These two responses taken together suggest that investors want companies to aggressively manage and reshape their business portfolios, when appropriate, in order to improve their growth and margin trajectories and deliver stronger and more sustainable TSR—in other words, to beat the average through more effective management.

The Management Challenge

Pursuing a dual value-creation strategy that carefully balances the short term with the long term will be challenging for many companies, especially in an environment where the top investment criterion for respondents was the management team’s track record and credibility.

One indicator of management’s credibility is how well it has aligned its business, financial, and investor strategies. A full 60 percent of this year’s respondents said that the companies they follow or invest in are only partly aligned or even poorly aligned. Another indicator of credibility is the professionalism of a company’s management processes associated with value creation. Nearly half of the respondents (45 percent) said that there are either significant or very significant opportunities for improvement in value management (including metrics, target setting, budgeting, resource allocation, and incentives) at their portfolio companies, while 43 percent said the same for strategic planning.

We believe that four steps are especially important in determining companies’ value-creation strategies in today’s investment environment:

• Define a long-term growth strategy. Because delivering profitable growth has become more difficult, companies must work harder to identify the most promising growth opportunities and successfully implement growth strategies. In addition to pinpointing the most likely sources of organic and acquisitive growth, an effective long-term growth strategy will require many companies to substantially retool their business portfolios and develop strong execution skills.
• Understand what drives differences in the valuation multiple. To combat multiple compression, a company needs to understand what has driven differences in valuation multiples in its peer group. In our experience, roughly 80 percent of the factors that drive differences in valuation multiples among similar companies can be identified and managed.
• Develop a disciplined approach to cash payout. A company’s dividend and share buyback policies are too important to be mere afterthoughts. A dividend policy, in particular, can help stabilize and put a floor under a company’s valuation multiple in an environment where there is likely to be downward pressure on multiples. Investors are looking to invest in companies that are careful and strategic stewards of their capital.
• Upgrade core management processes. Companies also need to do more to improve the alignment among their business, financial, and investor strategies. To support this, they should revisit core management processes such as target setting, budgeting, planning, resource allocation, risk management, and incentives to ensure that they reflect the company’s value-creation agenda.

Download a copy of the complete findings of the BCG 2014 Investor Survey.