The industry has been lagging behind the market for the past five years. Our research shows that the most basic ROIC performance and income growth are the most favored indicators for investors.
By the end of 2019, with an investment of $100 in 2001, the rate of return of the global chemical industry will be $550, about $200 higher than the market. But the company has been underperforming in the past five years, despite a brief rebound in 2017. To help chemical suppliers regain their attractiveness in global capital markets, we conducted extensive new research to determine what investors really value. Our research results show that CEOs should pay attention to ROIC and growth, which is taught by corporate financing theory. Our research confirms the basic principles of value creation.
In this article, we explain what distinguishes winners from losers in the chemical industry and what rewards the best in performance. In addition, we described in detail how the management team should respond to this year’s challenges (including covid-19 and oil market disruption) to maximize its company’s capital market performance.
Look back at the golden age
From 2000 to 2019, the performance of the chemical industry is about 3 percentage points higher than that of the whole capital market every year. There are three reasons for this success. First, the demand for chemicals in emerging markets (especially in China) has increased significantly, which creates favorable conditions for established international enterprises and local enterprises trying to expand their scale. The second is the significant improvement of ROIC of specialty chemical suppliers from 2000 to 2011, which is due to their rigorous work in functional excellence and the measures to maintain and strengthen their position in the value chain. Finally, from 2009 to 2014, the emergence of low-cost and unconventional raw materials, especially shale gas in the United States, helped to significantly increase profit margins.
Over the same period, as measured by the multiple of enterprise value and earnings before interest, tax, depreciation and amortisation (EV / EBITDA), the valuation of the industry grew faster than the overall market valuation. The gap narrowed from about 10% at the beginning of the millennium to near parity at the end of 2019. Despite these positive long-term trends, the industry’s momentum in the capital markets has weakened: from 2015 to 2019, the industry’s performance lagged by 2.5 percentage points per year.
Which aspects of the performance of chemical suppliers are most rewarded by the capital market?
To understand this reversal of fate, we analyze the drivers of value creation to determine what investors want most. Our study used a statistical method to analyze the financial data of about 450 chemical companies worldwide over the past 20 years (see sidebar “our methods”).
Corporate finance theory predicts that higher ROIC and faster growth will drive higher total shareholder return (TRS). The chemical industry is no exception. What may surprise many observers is that these factors do not show any significance. After considering the differences between ROIC and growth, we find that many factors that are generally considered important to investors, such as the particularity and commodity characteristics of the company and the geographical area of activity, have no significant impact on shareholder value. Therefore, leaders in the chemical industry should focus on how these factors drive ROIC and growth, rather than targeting them.
As most observers of the industry know, the rising trend of ROIC contributed to the strong performance of capital markets at the beginning of this century. Our ROIC and TRS multiple regression models show that in the period of our study, companies with a percentage point advantage in ROIC and companies with similar performance in all other aspects have the same advantage in TRS.
As long as the difference persists, the impact will compound every year: a company whose ROIC performance is one percentage point higher than that of another company will have one percentage point higher TRS performance than that of another company. Although the difference seems insignificant, the mathematical calculation of compound interest means that the first company will return nearly 20% more in 10 years (compared with companies with annual returns of 7% and 6%). The same model shows that the TRS of chemical companies with one percentage point higher growth rate is about 0.2% higher than that of another company. Similarly, companies with higher growth rate will expand the difference of TRS performance every year.