Citigroup Says Bang for Buck Is Key to Everything in Stocks

Updated on
  • Stocks with declining ROIC lagged behind peers in 2012-2015
  • Return on invested capital also targeted by activist investors

Leave it to a bunch of investment bankers to argue that the key to success in the stock market is how fast you restructure.

In a note on the efficacy of return on invested capital, Citigroup Inc.’s financial strategy and solutions group just published a 15-page thesis that posits capital efficiency is what separates winners from losers in equities. If it’s going up, so is your stock, according to their analysis of the MSCI World Index between 2012 and 2015. This benchmark rose 0.1 percent to 1701.00 as of 9:49 a.m. in New York.

Researchers have been falling over themselves for more than a year trying to figure out the best plan of attack for chief executives trying to jumpstart their stocks after global markets ground to a halt in 2015. Beyond buybacks, takeovers and dividends, Citi’s team said selling businesses and maximizing your bang on invested money is the key.

“Asset divestitures and spinoffs have proven to be effective,” they wrote. “Firms engaging in restructuring transactions that improved ROIC experienced a positive equity market response. However, companies have typically waited too long to undertake restructurings.”

If there’s any question how much investors care about corporate profitability in a world starved for growth, take a look at the stock performance of companies based on the measure. Globally, companies whose return on invested capital declined between 2012 and 2015 generated a median shareholder return of minus 0.6 percent, according to Citi. Those for whom it improved saw a median gain of 55.3 percent.

The divergence is bad news in a world overrun with sluggish economies and plunging commodities, where capital efficiency is in what Citigroup characterizes as a “striking decline.” Over the past five years, the median ROIC has fallen to 11.3 percent last year from 14.5 percent in 2011, with decreases spread among 60 percent of the MSCI index’s members, the bank’s data show.

Two things sap ROIC: falling profits and more generous use of cash. According to the Citigroup study, for companies where the return dropped since 2012, almost 73 percent saw operating profit fall and 70.5 percent increased their level of invested capital.

“In today’s environment, bold steps that meaningfully address both the levels and profitability of invested capital are likely warranted for many companies,” they wrote. “Such steps potentially include divestitures or spinoffs of low-ROIC businesses that are not earning a return commensurate with their cost of capital.”

“Equity investors care about the return on invested capital, but also whether that return is in excess of the firm’s cost of capital,” Ajay Khorana, global head of Citigroup’s financial strategy and solutions group, said by phone. “Returns are paramount, but if a company can lower its cost of capital by optimizing its capital structure, it can result in meaningful share price outperformance.”

The bankers cautioned not to rely on ROIC alone, since such a focus may ignore a project’s underlying riskiness.

Targeting companies with anemic ROIC has become a prevalent theme for activist shareholders in recent years, with 29 percent of such campaigns in North America in the past five years involving “demands around operational changes, monetization of assets, or a review of strategic alternatives,” the Citigroup analysts found.

“Based on our analysis of U.S. shareholder campaign activity, we estimate that companies in the bottom quartile of industry-adjusted ROIC face an exposure to activism risk that is
almost three times higher than for companies in the top quartile,” they wrote.

While capital efficiency may be en vogue, stock selection based on normally bullish harbingers like buybacks and activist interest haven’t worked as well, according to Bank of America Corp. strategists. Companies with the most share repurchases tracked by Bank of America fell 2.3 percent in the first half of 2016, compared with a 4.7 percent gain in an equal-weighted version of the S&P 500, while stocks in the index with activist shareholders lost 5.3 percentage points more than the broader market last year.

(Updates with today’s market activity in second paragraph.)
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