"Ben—I just want to say one word to you—just one word . . . plastics."

Unfortunately, the career advice offered to Benjamin Braddock in The Graduate wasn't as surefire as it sounded. Even in 1967, when the film came out, the chemical industry was neither as simple nor as lucrative as its cameo role suggested. Today, with more than 7,000 product lines and dozens of geographic markets, the business doesn't seem simple at all. So many strategies—or combinations of strategies—have been developed over the years for so many markets that industry analysts and executives struggle to understand what creates shareholder value.

In an effort to shed light on this question, we launched a study of the global chemical business, with its $1.6 trillion in revenues. Using a database that holds 40 years of financial and stock market data on 130 publicly traded chemical companies in Europe and the United States,¹ we searched for links between strategy and the creation of value.

While previous performance is of course no guarantee of future returns, a careful look at the performance of chemical companies over the past three decades can help them understand their opportunities to create value in the years ahead. Because the industry reached maturity about 20 years ago, the evolution of supply and demand has become, on average, more or less predictable. Unlike pharmaceuticals or telecommunications, the industry isn't likely to be transformed by technologies or regulations in the near future.

The performance of a chemical company correlates strongly only with its portfolio—commodity, specialty, or diversified chemicals

Our research suggests that none of the factors commonly regarded as drivers of value creation in the industry—scale, geography, market position, or focus—makes much difference. The performance of a chemical company correlates strongly only with its product portfolio—commodity, specialty, or diversified chemicals. (Diversified companies sell both commodity and specialty products, with neither accounting for more than 70 percent of total revenues.) Our study shows that diversified companies outperformed specialty companies, which in turn delivered higher total returns to shareholders than commodity companies. Our research also delivered further clear messages about how to create shareholder value.

Listening to the markets

The chemical industry is often regarded as a sluggish, low-growth one—a reputation due partly to its maturity and partly to comparisons between the price of its shares and those of technology companies during the bubble of the late 1990s. But the long-term data show that this reputation is largely unjustified.

To begin with, though the percentage of overall economic activity accounted for by the industry continues to shrink—in the United States, down to less than 2 percent, from 4 percent, over the past 25 years—shareholder returns were on par with those of the broad market indexes in the United States and Europe over the same period. In the United States, for example, both the chemical industry and the broad market expanded by roughly 13 percent a year,² a more robust growth rate than that of other asset-heavy industries, such as airlines, oil and gas, and pulp and paper. This is certainly quite an accomplishment.

Furthermore, the chemical industry stands apart from other commodity industries in that a wide gap separates the top and bottom performers. In June 2002, a month fairly representative of the period we researched, the top quartile of US chemical companies had a market-to-book ratio 3.3 times the bottom quartile's—a far wider spread than that of other asset-heavy industries, such as oil and gas (2.6), automotive (1.9), and pulp and paper (1.8). Companies in those other industries operate in more transparent and global commodity markets with fewer strategic options at the corporate level. By contrast, the far more complex chemical markets are fragmented into thousands of submarkets defined by product, geography, and industry. Although this complexity makes it difficult to identify industry-wide patterns of success, it offers a diverse range of opportunities to exploit niches and create shareholder value.

In addition, there is significant mobility between the upper and lower performance quartiles of the industry—demonstrating its potential for creating (and destroying) value and underscoring the fact that stock markets pay careful attention to the performance of individual companies. Fewer than half of today's top-quartile companies, for example, occupied the top quartile a decade ago. In fact, several of today's top-performing chemical companies—including Ecolab and Valspar—were average or below-average performers until the 1990s (Exhibit 1). And as recently as a decade ago, 22 percent of today's bottom-quartile companies were above-average performers.

This mobility must be understood in the context of the maturity of the chemical industry. No imminent disruptions will transform it as a whole, but myriad changes, such as factor prices and end-user demands, allow companies to redefine their products and services dynamically in specific markets and geographies. Companies in other mature industries, such as pulp and paper or metals and mining, find it much harder to reposition themselves competitively.

What drives performance?

What strategy, if any, correlates with strong performance? Unfortunately, the strategies of chemical companies are hard to classify, for most compete in a range of product and geographic markets requiring a range of approaches: one unit might strive to produce at low cost, another to innovate. Moreover, a degree of subjectivity is involved in the classification of one company as, say, innovative and another as not innovative.

So we chose to examine the performance of chemical companies in relation to some easily measurable dimensions of their corporate activity—such as scale, geography, market position, and product focus. By classifying companies in this way, we could test a number of hypotheses about what drives the creation of value, defined as total returns to shareholders (TRS), market-to-book valuations, and returns on invested capital (ROIC). Data from the last full commodity cycle (1992 to 2000) generated surprising insights.

• Scale: In the chemical industry, bigger is thought to be better. But given the highly fragmented nature of its various markets, size isn't the sole influence on total returns to shareholders for the industry at large. Economies of scale do, however, provide some benefits in the commodity and diversified segments.
• Geography: Although North American chemical companies are widely thought to have higher market-to-book valuations and better total returns to shareholders than their European competitors, our research showed that the gap has narrowed so much over the past decade that it is no longer meaningful.

• Market position: Most industry analysts believe that companies with a market-leading position—those that derive more than 50 percent of their revenues from businesses ranking first or second in global or regional sales—should have better total returns to shareholders than second-tier players. Yet one of our more surprising findings was that companies with market-leading positions had no significant performance advantage.

• Focused versus unfocused companies: Conventional wisdom also holds that tightly focused companies—those deriving more than 80 percent of their revenues from only two kinds of businesses—tend to have higher total returns to shareholders. In reality, the larger diversified companies performed strongly over the past decade.

Surprisingly, companies that had market-leading positions didn't have a big performance advantage

In fact, our analysis showed that the only statistically significant characteristic that correlated with the fundamental measures of performance—total returns to shareholders, market-to-book valuations, and returns on invested capital—was a company's product portfolio: commodity, specialty, or diversified chemicals (Exhibit 2). In the period we studied (1992 to 2000), diversified companies generated higher total returns to shareholders (11.3 percent) than did specialty companies (8.6 percent), which in turn outperformed commodity companies (2.7 percent).³ As measured by returns on invested capital and market-to-book ratios, specialty companies performed best. The diversified companies' higher TRS over this period can be explained by the expectations of shareholders, who thought, in an extrapolation of past performance, that specialty companies but not diversified ones would perform well financially. When diversified companies did better than expected, their shares rose considerably; meanwhile, the specialty companies had to perform well merely to keep their total returns to shareholders stagnant.⁴

Although the performance of companies in the chemical industry correlates well with their product segments, they shouldn't rush to modify their portfolios, for some specialty companies perform much worse than some commodity players (Exhibit 3). Besides, the wide range of performance within each segment proves that portfolio choices alone don't guarantee success. But a diverse set of opportunities, some relatively overlooked, seems to be available for creating value in market niches.

A closer look

The data sent some clear messages about how commodity and specialty companies can improve their performance. For diversified companies, the results were more ambiguous.

Commodity companies

Although commodity companies performed less well than their specialty and diversified counterparts from 1992 to 2000, plenty of evidence suggests that they can find the right strategy to create shareholder value—or at least to avoid destroying it. Many of our findings confirm accepted beliefs about what makes commodity companies successful, but few companies seem to heed them.

The first finding for the commodity segment is that size does matter. Larger companies had less cyclical (though not higher) returns on invested capital, and the less cyclical returns were correlated, albeit mildly, with higher total returns to shareholders. These companies not only could cut their production costs but also had sufficiently diversified offerings—and therefore sufficiently stable cash flows—to weather cycles for individual products.

We also found that commodity players can't outgrow their problems, since real growth doesn't exist. The modest amount of nominal growth we found was heavily masked by the industry's largely self-imposed cycles, not by broader macroeconomic trends. As a result, investors haven't rewarded companies that tried to grow, either organically or through acquisitions, at below-average profitability. In our sample, such companies had a paltry median market-to-book ratio of 0.5. At the end of December 2002, for example, the shares of Terra Industries were trading at roughly $2 each—less than 50 percent of the book value of its assets.

Our clearest finding reinforces this basic point: a chemical company’s returns on invested capital matter much more than revenue growth

The problem is that too many companies have sought to achieve scale without paying enough attention to the returns on their invested capital. The clearest finding of our research reinforces this basic point: returns on invested capital matter far more than revenue growth. Companies with above-average returns on invested capital had the same market-to-book ratios whether they were growing quickly or slowly. In fact, only returns on invested capital drive market-to-book valuations, because there were no significant valuation differences as a result of revenue growth among companies.

Our research also confirmed the idea that the timing of capital investments, rather than fluctuations in demand or changing economic conditions, must be blamed for the industry's volatile cycles. An industry-wide herding instinct for capital-investment decisions has created large supply-and-demand swings.⁵ Since companies make most of their capital investments during the cycle's upswings, prices fall quickly as new supplies flood the market.

Executives with the courage to defy conventional wisdom and withstand pressure from their boards, investors, and bankers by investing in new capacity countercyclically (or at least independently of cycles) could generate substantial returns. Indeed, a related McKinsey study estimates that companies might double their returns on new capital investments by pursuing an independent approach.⁶ One might speculate that privately held commodity companies, which are free to buck pressure for conformity, might stand a better chance of breaking out of the industry's self-destructive investment cycles.

Specialty companies

In the 1990s, there were two distinct periods for specialty companies: 1990 to 1997 was a time of robust returns; after 1997, valuations fell sharply. Despite continuing evidence of an industry slump, however, specialty companies have ample opportunities to create value in the thousands of product and geographic markets in which they compete.

During the boom years of the early to mid-1990s, specialty companies enjoyed real and sustained sales growth, higher returns on invested capital, and greater total returns to shareholders. Yet they didn't deliver these strong results through higher margins—a somewhat counterintuitive finding, since specialties are thought to have higher average margins than commodities. In fact, notwithstanding higher prices and lower depreciation rates than commodity companies can boast, specialty companies turn out to have a higher cost base in R&D, marketing, technical support, and the like. Over full commodity cycles, their margins are thus comparable to those of commodity companies.⁷

Specialty companies earned their higher returns through their higher capital productivity—a result of smaller plants for smaller batches

Specialty companies have achieved higher returns than commodity companies through higher levels of capital productivity—the result of the smaller facilities needed to produce smaller quantities of chemicals that command higher prices. The specialty segment's higher levels of capital productivity have generated higher returns on invested capital, which (coupled with revenue growth) have created shareholder value. Since high capital productivity drives shareholder value in this segment, specialty players must preserve it.

Thus the massive decline in the specialty segment's capital productivity during the mid-1990s came as a surprise. The decline is due in part to rising levels of invested capital, most notably from a string of acquisitions laden with goodwill, such as Clariant's purchase of BTP and Imperial Chemical Industries' acquisition of Unilever's specialty chemical businesses. Moreover, as specialty products have come to face increased competition and commoditization from low-cost producers in China and India, prices have fallen, and the resulting decline in revenues hasn't helped. The fate of vitamin C is a good example: from 1990 to 2000 the global market share of Chinese producers rose from zero to 10 percent; meanwhile, prices per kilo dropped by 69 percent, to $5, from $16.

In the late 1990s, when investors noticed the combination of declining growth and declining capital productivity, many lost faith in the segment. As companies seek to regain the investment community's confidence, they should bear in mind the need to increase capital productivity. Some highly successful companies, such as Ecolab, have focused on organic growth through new business models and the extension of capital-light service lines, such as cleaning services for the food industry. Companies that avoid high goodwill costs from acquisitions will have an advantage in maintaining their capital productivity rates and positioning themselves for stronger performance.

Diversified companies

The performance of diversified companies during the last cycle presents a much more puzzling picture. Their high total returns to shareholders were driven, as we have seen, by their unexpectedly strong financial performance. But not all of them performed well. From 1992 to 2000, the large ones (defined as those in the top quintile of sales) actually had higher returns than both commodity and specialty companies (Exhibit 4). The smaller diversified companies, by contrast, haven't recovered from the combined effects of an industry downturn and the 1997 Asian economic crisis, and our research didn't identify clear performance drivers for this segment.

Nonetheless, we believe that large diversified companies have thrived as a result of disciplined attempts to concentrate their business portfolios only on segments in which they can be major players. Although market position wasn't a value driver for the industry in general, within the diversified segment it correlated moderately with higher returns. Such discipline might have helped transform these companies' fundamental financial performance over the past decade: DuPont, for example, increased its pretax returns on invested capital from 9 percent in 1992 to 15 percent in 2000, driving up its capital market valuation by upward of 50 percent over the same period.

Having outperformed specialty players in median returns on invested capital, the large diversified companies now need to seek new ways to create value. The challenge continues to be managing both a low-cost commodity business and a high-value-added specialty business within the same organization. It will be interesting to see how the large diversified companies live up to the expectations underlying their higher valuations. Our research did not, however, indicate what steps smaller diversified companies should take to improve their fortunes.

The highly fragmented and complex chemical industry is more dynamic than many people think. A careful look at the way the pieces of the industry puzzle came together over the past 25 years has created a much clearer view of how commodity and specialty companies can create shareholder value in the years ahead.