UK: EDITORIAL - NO FUNKING THE EQUITY HURDLE. - Investors in equities expect their holdings to provide significantly higher returns than other less risky forms of investment, such as bonds.

Last Updated: 31 Aug 2010

Investors in equities expect their holdings to provide significantly higher returns than other less risky forms of investment, such as bonds.

Companies have been achieving the required returns over the past few years, partly as a consequence of growth in the economy, and partly, in many cases, by adopting cost-cutting measures of unprecedented severity throughout their operations. Now, as David Smith points out in The Equity Squeeze (p36), the pressure to satisfy the expectations of equity investors is on. With the economic cycle likely to turn in the next 18 months, and the scope for further cost-cutting reduced by all that has been done in the past, managers are struggling to see how these demands can be met.

Their long-standing prop and support in this endeavour appears to have disappeared: no longer can inflation be relied upon to drive through the price increases needed to keep profits - and hence shareholder returns - buoyed up. Nor will inflation disguise the real rates of return being achieved.

There is little comfort here for those who believe themselves less affected than their rivals because they have no requirement to attract external capital. Their competitors will be striving to achieve high levels of return; if they succeed, not only will capital be drawn towards them but they will also generate more capital internally. Those who prefer to sit on the sidelines will find themselves limited in their ability to invest, either in equipment or technology - or in people.

Some managements have responded to the demands of shareholders for high returns by reducing the equity capital in their businesses by way of share buy-backs or special dividends. Another reflex is to replace equity with debt. A highly geared business needs a lower return on overall capital employed in order to satisfy equity investors than one which is carrying no debt. But this is to ignore the fundamental problem: the cost of capital implied by current share prices cannot be met by marginal improvement in ongoing business practice.

This was the problem for which business process re-engineering was perceived as the solution. Sadly, for too many enterprises this turned into a pretext for savage and unthinking cost-cutting. The result for many has been that longer term problems have intensified. The real solution can be found in the reason why investors expect to receive their higher returns: risk. It is the job of business leaders to take calculated risks, using all their accumulated knowledge and judgment. There is nothing new in all this. The hallmark of most successful companies has been an understanding of the importance of innovation - and, in recent times, of employee involvement.

Both depend on business leaders who have the ability to assess risks and the willingness to take them, whether they affect products or markets or people. Such attitudes are now compulsory for business growth, even for corporate survival.

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