Stop Focusing on

GROWTH STRATEGY

Profitability and Go for

Growth
by Michael Mankins
May 01, 2017
The global financial crisis prompted many companies to
pull in their horns, hoard cash, trim costs, and take a wary
view of large investments. Yet the same crisis ushered in a
new age of capital superabundance. Bain & Company’s
Macro Trends Group carefully analyzed the global balance
sheet and found that the world is awash in money. Global
capital balances more than doubled between 1990 and
2010 — from $220 trillion (about 6.5 times global GDP) to
more than $600 trillion (9.5 times global GDP). And capital
continues to expand. Our models suggest that by 2025
global financial capital could easily surpass a quadrillion
dollars, more than 10 times global GDP.

Capital superabundance, combined with tepid economic

growth, has produced historically low capital costs for most
large companies. For much of the 1980s and 1990s, for
instance, the average cost of equity capital for large U.S.
corporations hovered between 10% and 15%. Today, the
average cost of equity capital sits at close to half that: just
8% for the roughly 1600 companies comprising the Value
Line Index. And the after-tax cost of debt for many large
companies is close to the rate of inflation. So, in real terms,
debt financing is essentially free.
The ready access to low-cost capital should change the way
business leaders think about strategy, and in particular the
relative value of improving profit margins versus
accelerating growth. When capital costs are high, strategies
that expand margins are almost always better than
strategies that accelerate growth. When money is
expensive, a dollar today is worth a lot more than a dollar
tomorrow — or even the promise of many dollars
tomorrow. But when capital costs are low, the time value of
money is low. So the promise of more dollars tomorrow
(through growth) exceeds the value of a few extra dollars
next quarter. In these circumstances, strategies that
generate faster growth create more value for most
companies than those that improve profit margins.

To elaborate, a company’s
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If a company’s long-term
ROE is anticipated to be 400 basis points (bps) or more
above its cost of equity capital, then the value created by
accelerating growth will exceed the value created by
improving pre-tax margins
If a company’s long-term ROE is anticipated to be
between 300 and 400 bps above its cost of equity capital,
then the value created by accelerating growth will be
roughly the same as the value created by improving pre-
tax margins
If a company’s long-term ROE is anticipated to be less
than 300 bps above its cost of equity capital, then the
value created by improving pre-tax margins will exceed
the value created by accelerating growth. In fact, in cases
where a company’s long-term ROE is anticipated to be
below its cost of equity capital, accelerating growth will
destroy value
Historically, when debt and equity costs were high, for most
companies the trade-off between profitability and growth
favored profitability. Accordingly, business leaders sought
to improve efficiency by employing Six Sigma, process
reengineering, spans and layers, and other tools.

But the scales have now tipped in favor of accelerating

growth. For the average company, defined as the equity-
weighted average of the roughly 1600 companies
comprising the Value Line Index, the cost of equity capital is
just 8%. And the average long-term ROE is more than 25%,
reflecting improved efficiency combined with greater
reliance on financial leverage at most companies. On
average, then, the value created by accelerating growth by
1% far exceeds the value created by increasing pre-tax
margins by 1% on a sustained basis. In fact, the multiple of
value created by growth versus margins is more than four
to one.

But a lot can get lost in the averages. Every company faces a
different trade-off between growth and profitability. For
example, in some industries — say, construction — long-
term ROEs are very close to the cost of equity capital. For
these companies, taking steps to improve margins will
generate higher returns for investors than those designed to
boost growth. But in most other sectors, ROEs are much
greater than the cost of equity capital. In these settings,
investors should value strategies that accelerate growth
over those that improve margins (see the chart below).

So if

companies should value growth more than margins these

days, why don’t they? In our experience, companies still
focus more on cutting costs than on developing and
executing new growth strategies. Reuters found that total
new capital expenditures and spending on R&D was less
than the amount many companies devoted to share
repurchases last year. Finally, in earnings call after earnings
call, we hear CEOs describing one or two bets — at most —
on growth, and devoting most of the time to showcasing the
results of restructuring, offshoring and other cost-focused
initiatives.

Why is growth shortchanged at so many companies?

In our work with clients, we see three common reasons

why companies continue to pursue margins over growth
— but we also see how smart companies avoid those traps:

A dearth of good ideas. Creativity and ingenuity have

always been precious. A single great idea can put a company
on top. Think the iPhone at Apple, horizontal drilling at
Continental Resources, or the reinvention of home goods at
Ikea. And having a number of small good ideas can keep a
company ahead of its rivals for years.

But many companies struggle to come up with enough

promising growth options. Some focus their best people on
finding ways to squeeze out more profitability from existing
operations, rather than creating new businesses. Others
reward easy-to-measure improvements in existing
processes over less-easily-quantified innovations. And then
there’s culture: Many organizations implicitly or explicitly
discourage risk taking, limiting their employees’ desire to
put new growth ideas on the table. Others fail to build in
time for experimentation or penalize unsuccessful
experiments — even though few breakthroughs spring forth
without some initial failure. The result: a shortage of good
growth ideas.

Companies that encourage innovation take steps to

overcome these organizational obstacles. They create flux
time for employees to devote to new projects. (3M, for
example, has long allowed engineers to devote 15% of their
time to skunkworks projects, without supervisor approval.)
They reward risk taking, by encouraging executives to
capture learnings from efforts that come up short and then
build these lessons into the next round of experiments. And
nearly all of them provide their employees with autonomy
and authority to bring new ideas to life. It’s hard to
create an organization capable of generating a pipeline of
good growth ideas, but it is imperative in today’s world of
superabundant capital.

Practices (and beliefs) that foreclose too many growth

options. Sadly, some companies do start with a healthy
pipeline of promising growth ideas, but then screen out too
many of them by employing outmoded approaches to
strategic investment planning. A flood of great ideas goes
into the top of the funnel, but only a trickle emerges from
the bottom.

A central premise of traditional strategic investment (e.g.,

Pareto analysis) is to limit the field of potential options,
focusing the company’s precious capital on a few “sure
bets.” In an era of low-cost capital, these traditional
practices end up closing too many doors. More worrisome,
these screens encourage executives to stick for too long
with the few investments that do make it through, rather
than cashing out and starting over. Finally, the continuous
winnowing of growth options based on investment
attractiveness (and other tests) can lead organizations to
adopt a “growth is risky” mindset that bleeds into other
aspects of the business, discouraging subordinates from
developing and considering new growth options.

Companies that are successful in fueling growth lower

hurdle rates and relax other constraints that reflect a
bygone era of scarce capital. Like Alphabet, Google’s parent,
they invest in a number of experiments — say, Google Fiber
or autonomous vehicles. They are quick to spot the losers
and shut them down, and double down on the experiments
that show promise. These companies don’t seek to screen
out ideas at the start, but instead look to open as many
doors as possible before deciding which ones to walk
through.

A lack of talent and capabilities to translate promising

growth options into profitable new business. The assets
that are truly scarce at most companies are the skills and
capabilities required to turn great growth ideas into
successful new products, services, and businesses. Even
when an organization has a robust pipeline of growth ideas
and manages to keep many of them alive, it may lack the
human capital needed to accelerate growth.

Bain recently completed research on workforce

productivity. This research highlights that companies that
treat the time, talent, and energy of their workforce with
the same discipline as they do financial capital perform far
better than the rest. The most productive companies have
the talent they need to generate good growth options. And
they put these “difference makers” in roles where they can
make the biggest difference in the company’s profitability
and growth. Workers at these companies have the time they
need to devote to creative work, free from excessive process
and bureaucracy. And, perhaps most important, employees
at these organizations are engaged and inspired by their
work, bringing far more discretionary energy to their jobs
every day.

The best companies in our research are 40% more

productive than the rest. These companies get as much
done by 10:30 AM on Thursday morning as their rivals do
all week. And they keep working, serving customers,
innovating, and generating many more new ideas. Not
surprisingly, the best generate profit margins 30%–50%
higher than industry peers and grow faster.

Today’s era of superabundant capital rewards faster growth.

To thrive in this new world, leaders must overcome the
obstacles to growth in their organizations. They must
reward the creativity and ingenuity required to devise new
growth options. They must avoid screening out too many
growth ideas, and opt instead to invest in a portfolio of
growth experiments (or options). And, finally, they must
build the skills and capabilities required to capitalize on
their most promising experiments. This requires treating
the time, talent, and energy of a company’s workforce as
the truly scarce resources that they are and managing them
with the same care and rigor that has been brought to
financial capital in years past.

Michael Mankins is a partner in Bain &

Company’s San Francisco office and a leader in the
firm’s Organization practice. He is a coauthor of Time,
Talent, Energy: Overcome Organizational Drag and
Unleash Your Team’s Productive Power (Harvard
Business Review Press, 2017).

This article is about GROWTH STRATEGY

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Comments
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12 COMMENTS

Chandra Pandey 3 years ago

Very useful insight of financial perspective as a function of economic
opportunity/factor in calibrating the business strategy. Although cost of
risk lowers in such approach, it is also a reflection of overall economic
environment where growth is not obvious or benign & more futuristic
reflecting longer gestation periods in ROE. Finally how well the financial
ratios of business is positioned in these economic cycles to leverage
growth is key decider. Although it may apply better in certain businesses
where the operating cycle time from assembly line/software to market is
low, may not be of much benefit where operating cycle time is high as in
Logistics/Industrial goods/manufacturing.
Disclaimer: The views and opinions expressed are personal in nature and
do not reflect the official policy or position of any organization.
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