Exchange rate & investment decision. Can you disregard exchange rate?

Do you think your investment decision should always correlate with exchange rate? What kind of analysis or research you do before making an important investment decision? What should be the thesis of your investment philosophy? Are you sure that your investment decision was based on risk adjusted return?

These are the basic questions comes in a mind while considering for an investment decision. Role of exchange rate is very important in investment decision however it depends upon what kind of investment are you committing.

If FII, Private Equity, Sovereign Wealth Fund, Portfolio investors and NRI’s consider an investment decision in emerging market or some other developed alien country then exchange rate plays a very important role to make or break required rate of return (ROI). Short-term investment horizon always requires mitigating risk of exchange rate volatility. Hedging mechanism can be used to reduce exchange rate risk by doing options or future contract.

Long term investment horizon can disregard the importance of exchange rate. If there is huge volatility between exchange rate of investing country and source country then choosing long term investment horizon allows you to neglect the importance of exchange rate volatility as in the long term exchange rate become stable.

Indirect effect of exchange rate should also be considered while making overseas investment decision. For example if destination country’s currency continuously depreciating and your investment exposure were on companies that incur majority of input cost in foreign exchange like importing raw material etc. Oil industry in India is a very good example. Depreciating currency reduces the profitability and ultimately  value of your investment however opposite is also true like if your investment company is export oriented and majority of its input cost were domestically driven then it will be highly profitable with depreciating currency and increases the value of investment like IT industry in India.

NRI’s making investment in their resident country can disregard exchange rate if they opt for long term investment horizon like Fixed Deposit, Mutual Fund, Equity or even Bonds. Long term investment provides them good return as compare to foreign country and simultaneously minimizes exchange risk.

Any Foreign institution or govt. considering an investment by way of FDI in infrastructure projects like rail, road, power, transport etc requires long term investment commitment and can disregard the exchange rate as inflow from these investments will occur after long gestation period however if investments are committed to be made in different tranches then hedging mechanism like forward, future and options can be used to take the advantage of volatility of currency.

Finally, conclusion is that we can disregard exchange rate in certain cases if our investment horizon are long term however in other circumstances it is always advice to consider exchange rate risk while making any investment commitment. If done properly with appropriate hedging mechanism like options, forward, futures or swaps exchange rate volatility or risk can provides additional 100-500 basis points of return above normal ROI.

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Growth and Value Investing

Do you think global macroeconomic environment like exiting of Greece from Euro Zone & slump in US growth or downward pressure of growth in Asian economy should affect your decision as value investor? I believe no.

Value investing and economic growth is not always 100% synonymous. As the name suggest value investing is more about investing on fundamental of business rather than economic condition. Economic growth can improve the prospect of value investing but it is not the core feature of value investing.

No person is better value investor than warren buffet. Warren Buffet philosophy is that an investor should identify investing as life time opportunity and in his whole life he should not invest in more than 10-15 companies.

Yes it’s true that not everyone can become Warren Buffet but an investor can adopt his philosophy of value investing as life opportunity. Now a day’s investors are giving more emphasis on technical analysis to earn short term return that makes the market volatile and even doesn’t show real picture.

Over a period of industry life cycle fundamental value of companies in an industry comes to an average. There may be some companies that give higher return in initial years however there are some which provides low return but over a period of industry life cycle all of them come to an average.

GDP growth rate of an economy should not impact the decision of value investor. All the major value investor like Warrant Buffet, Rakesh Jhunjunwala earn their fortune during the gloom period of economy cycle i.e. somewhat current global economy condition.

Investing is more about understanding the business. If you understand business very well then it doesn’t matter in which industry you play like retail, finance, technology, infrastructure etc. Warrant Buffet never invested in technology sector (except in the recent years when he invested in Microsoft) though we saw boom and bust of technology sector in the last one and half decade. Warren Buffet says “I don’t understand how technology works so I don’t want to invest; I understand how insurance works so I invest in it”.

Value investor should always focus on basic fundamental of business like-

Will the company able to sell its product by beating competitor?

Do they differentiate them with their competitors?

Is the growth sustainable? How they are evolving themselves in changing circumstances?

How they will earn their future cash flow (discounting it with appropriate rate)?

Does the company undervalued?

Growth and value investing are not 100% synchronized. However in gloom and doom economic condition there are more chances to get more value investing opportunities because during the period lot of companies deleverage themselves, invest more on R & D and hold lots of cash to take advantage of low base to future high return.

Current Indian scenario is perfect platform for value investing as equity market is almost bottoming out with below average 12 P/E ratios, hugely depreciated currency, high fiscal & current account deficit and high inflation & interest rate and global uncertainty. These tough conditions put pressure on companies to restructure their business & financial model to leap forward for future growth trajectory. In these conditions there are lots of values investing opportunity an investor just need to indentify it.

How to indentify value investing opportunities:

Look for companies with low P/E and P/BV multiple

Look for companies with Optimal Capital structure

Look for companies with good future free cash flow generation capacity

Look for low EV/EBIT ratio (Enterprise Value ratio considers capital structure of a company. Two companies may have same EV ratio however market capitalization of one company may differs with other due to availability of more or less debt as compare to its peer)

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How NRI will be benefited by Investing in India

India one of the major BRIC member countries is embarking towards high GDP growth rate trajectory by achieving average growth rate of 8% in the last decade or so.

In the last 6 month India’s growth prospect has dampened due to some policy paralysis, high inflation, FII Outflow, high fiscal deficit and depreciating rupee, however this is just a short term gloom but country’s long term prospect is still very robust.

As every evil things bring some good opportunity, same is true here also as short term gloom provides tremendous opportunity for NRI to invest in India as rupee is at all time low, stock market is undervalued and Indian govt. is trying to protect its forex kitty by offering various schemes to NRI to support India’s growth momentum and simultaneously provides handsome return to their foreign citizens.

Where NRI can invest: NRI can invest in –

Bank Fixed Deposit

Equity Market

Real Estate

Bonds

In the last one year Indian rupee has been depreciated around 22% and hovering at 1$ = Rs.55. Depreciated rupee provides an additional yield to NRI investor apart from normal return.

Bank FD: Indian banks are offering 9.5% return on 59 month FD however real return on FD will be quiet high as rupee will appreciate near future. We can understand this with an example-

NRI Investment Amount = $1000

Current Exchange Rate = 1$ = Rs.55

Rupee investment = Rs.55000

Rupee Return (Simple interest) = Rs.26125

Rupee mature Value = 55000+ 26125 = Rs.81125

Scenario 1($ after 59 month): 1 $ = Rs.45

Mature Value = $1803

$ Return = 16% p.a. approx.

Scenario 2($ after 59 month): 1 $ = Rs.50

Mature Value = $1620

$ Return = 12% p.a. approx.

** These calculations are based on simple Interest, if we compounding it monthly/qtrly/yearly then real return will be higher by 0.5-1%.

Equity: Presently equity market is valued at 12.5% to 2013 earning which is undervalued as compare to normal average. This is a double bonanza for NRI investor as current valuation provides…

Good future return + additional 10-12% return with rupee appreciation in future.

Real Estate: Real Estate investment is also a very good opportunity for NRI as current short-term gloom has corrected property valuation and additional 10-12% reduction is available to NRI due to highly depreciated rupee.

Bond: At current monetary cycle interest rate in Indian market is very high but this monetary cycle is going to reverse in the next 3 years or so. It provides an excellent opportunity to NRI investor to…..

Achieve current high interest on bond + future appreciation in bond value due to reduction in interest rate + additional yield through appreciation of rupee in future.

Finally, truth is that the current opportunity is one of the best opportunities for NRI  investor to make investment in India and get benefited of all time low rupee and high interest rate environment.

NRI  investment will also show patriotic feeling towards their country as India needs more forex inflow from their NRI citizen when FII  money has dried up and import bills are towering.

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How to avoid using tax payers’ money and maintain optimum capital structure to maximize shareholders value?

Every organization or banks main aim or motto is to maximize shareholders value. However shareholders were always concern about financial distress situation where they have to dilute their share to pay debt holders or govt. need to step in and use taxpayers’ money to bail out banks/institutions.

We have faced these kind of similar situation during 2008 financial crisis where billion of $ i.e. tax payers money were used to bail out several banks. How to undo this kind of financial distress situation & avoid using tax payers’ money? One answer to this question is adding contingent capital (coco bonds) in capital structure.

What is contingent capital? Contingent capital is a debt that converts automatically to equity after some triggering event like decline in the market value of equity or capital below threshold limit. Contingent capital is likely to play a very important role in new BASEL III agreement. As per estimate banks need to issue $ 1 trillion of contingent capital to replace existing security that no longer qualified as regulatory capital.

However generally contingent capital (coco bonds) are tied with certain regulatory ratio like capital ratio (core Tier 1 capital), once the banks breaches the ratio then the debt automatically gets converted into equity to avoid financial distress situation. However problem with this concept is that it is regulatory based not market based and it transfers wealth from shareholders to bondholders and kills the main motto maximizing shareholders value (Creating value for shareholders means creating value for all the stakeholders) as conversion takes place at predefined price or at current market rate.

Capital ratios are calculated on quarterly basis and doesn’t provide true market impact of current situation & can’t handle market manipulation properly.

 Mean & Median (Core Tier-1 Ratio in 2008) of 50 major banks (%) 

	March 31	June 30	Sept. 30	Dec. 31
Mean	8.07	8.14	8.16	9.12
Median	7.88	7.92	7.89	9.14

By comparing September 30 ratio with March 31 and June 30 ratio we can hardly make out occurrence of any financial distress situation but market reality was totally different as we saw during the crisis.

COCO bond seems ideal instrument to maximize shareholders value however they are not. In February 2011 Credit Suisse issued a coco bond that gets converted into equity whenever bank’s core tier 1 capital falls below 7%. However regulator can also force conversion if it sees that credit Suisse will need public fund to avoid insolvency. The conversion price was fixed at minimum of $ 20. As per these characteristics this bond seems risky.

First, trigger is based on capital ratio which is an accounting number therefore will be different from the market based measure of financial leverage, especially during financial crisis. Hence, there is no way to predict stock price at the time of conversion.

Second, if the stock price at the time of conversion is less than $ 20 then bondholders will incur significant loss.

Third, the possibility that regulators can force conversion before the trigger is reached creates an additional risk which is difficult to price. Though the bond was successful among retail investor but its base was very limited due to its riskiness.

Better contingent capital should be linked to current market situation and triggers are based on current stock price / market value of asset.

Generally market based trigger are criticized as they create instability. Bondholders has incentive to short sell shares to trigger conversion and at the same time fear of huge dilution makes shareholders sell their share and create death-spiral for a company.

What’s the challenge?

Main challenge in issuing these kinds of debt instrument is that instruments should carry minimum risk so that it can be catered to mass risk-averse investors and simultaneously protecting the motto of maximizing shareholders value. In normal convertible bonds wealth gets transferred from equity holders to debt holders. Shareholders don’t prefer these instruments in company’s capital structure.

What will be the ideal instrument that avoid share dilution, protect the money of contingent bondholders and handle market manipulation or panic perfectly?

CALL OPTION MARKET TRIGGER CONVERTIBLE (COMTC) BOND can be ideal contingent bond that can be issued above 20-30 basis point of risk-free bond and caters to mass risk-averse investors who know they will be paid at the time of financial distress situation.

How does COMTC works?  

COMTC bonds target to risk-averse investors and provides return above normal risk free bond. This instrument carry forced right to get paid at the time of financial distress situation. It carries a conversion trigger point which is less than then current market price. However in order to avoid market manipulation & panic shareholders got pre-emptive rights to buy-back shares from bondholders so that they can avoid any conversion that results from market manipulation or panic. At the same time in order to avoid huge dilution shareholders got the right to issue share (right issue) at the same conversion price and pay back the bondholders and maintain proper capital structure.  As bondholders will be paid back they have no incentive to hedge their investment by shorting the stock when the leverage ratio approaches the trigger point.

Why conversion trigger price is lower to current market price?

Conversion price of COMTC bond should be less than the trigger price. Suppose the market price of $ 10 share will come down to $ 5 during financial distress situation. In this case conversion price of the bond should be fixed at below trigger price say $ 1. We can understand this with an example.

Example:      Senior Debt    –     $ 1000

Equity Capital –   $ 10*7 = $ 70 (7 share with face value of $ 10)

COMTC          –        $ 30

Scenario 1    (Financial Distress Situation) = Market Price $ 5

Conversion Price = $ 5 (Conversion price = Market Price)

New diluted Share price = (6*5+7*5)/13 or (30+35)/13 or 65/13 = $ 5 per share

(Assume that repayment will be made after conversion)

Total Value of Assets = 1000+65 = $ 1065

Shareholders will exercise his option of right issue & pay back bondholder at its par value till the time value of assets is $ 1065. If value goes below $ 1065 shareholders will not exercise his call option and all the value above $ 1000 will be shared between bondholders & shareholders at the time financial distress or bankruptcy.

Scenario 2    (Financial Distress Situation) = Market Price $ 5

Conversion Price = $ 1

New diluted Share price = (7*5+30*1)/ (7+30) or (35+30)/37 or 65/37 = $ 1.76 per share (Assume that repayment will be made after conversion)

Total Value of Assets = 1000+65 = $ 1065

Shareholders will exercise his option of right issue & pay back bondholder till the time value of assets is $ 1037 or market value of share is $1. If the market value goes below $1 or total assets value becomes less than 1037 shareholders will not exercise his call option and all the value above $ 1000 will be shared between bondholders & shareholders.

Thus with $ 1 conversion price, bondholders become shareholder when value falls below $ 1037. With $ 5 conversion they become shareholders when value falls below $ 1065. Lower conversion price clearly reduces riskiness of convertible debt which lowers financial distress and makes the security more marketable among fixed income investor.

How COMTC bonds are different from COCO bonds?

COMTC BONDS	COCO BONDS
COMTC bonds are market triggered bonds that provides true financial leverage	Normally COCO bonds are regulatory triggered bond i.e. capital ratio. Such mechanism are accounting measure and  doesn’t work when company’s capital structure deteriorate rapidly
Regulators can’t intervene as it is totally market based	Regulators are aware that capital ratios are stale, they may be tempted to intervene and pull the trigger themselves and this regulatory risk may difficult to asses, even for major credit rating agency.
COMTC bonds are risk-averse bond, it can easily marketable & cater to mass market.	COCO bonds are difficult to market as investors know that capital ratio doesn’t provide true picture so in order to mitigate risk they demand higher spread however issuer thinks firms financial distress risk is lower and reluctant to pay higher risk premium.

Conclusion

COMTC bonds are risk-averse bond that can be targeted to mass market as it provides assurance that bondholders will be paid at the time of financial distress. These are market related bonds triggered at certain market price or market value of assets. It considers current financial leverage and provides absence of regulatory intervention. All the normal bonds carry tax deductible interest rate and in order to make COMTC bonds attractive it should also be tax deductible. These bonds can be issued by any institutions apart from bank to prevent financial distress situation and maintain optimal capital structure.

COMTC bonds are superior to COCO bonds and one of the best debt instruments to be part of organizations/banks capital structure.

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Shareholders Value Creation

How to create value for your organization? Why TSR (Total Shareholders Return) is the best metric for value creation? Why is it difficult to create sustainable value? How to build sustainable value creation strategy? Why CSR & brand value change not consider as a part of TSR? Why multiple compressions are so difficult to beat? Why investors & analyst discounts valuation multiple? How to transit majority investors without eroding TSR? How to create value in low growth economy? How to play your strategy with sustainable TSR matrix as per investors eye? Why investors communication is so important for value creation? Which strategy you should use for value creation? How to use value creation scenarios? Why cash strategy is so important in low growth economy?

If all these questions bother you before developing your company’s corporate strategy/value creation strategy then you must see New Year’s complimentary presentation

Shareholders Value Creation – “A handy e-book on how to create sustainable shareholders value”

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Granular Business Portfolio Matrix

GE developed 9-box matrix strategy to manage portfolio of business when business grows to more than 150 business units.

In today’s global environment where world is flat, global economy, workforce & businesses are integrated, boundaries are narrowed traditional 9-box matrix is not very useful for managing portfolio of business. It requires more granular approach towards business portfolio.

This presentation is an advanced version of “traditional matrix (9-box) business portfolio strategy”.

Manage business portfolio in new multi-power economy with (2-way 9-box) matrix strategy

Organization Vision & Corporate Strategy

Every organization has a vision & in order to achieve that vision organization develops corporate strategy.

How to develop an optimal corporate strategy that carries both Blue Ocean & Red Ocean products?

Organization Vision & Corporate Strategy

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Strategy Control Map (Market Capitalization Dynamics)

Strategic Control Map (Matrix) is based on market capitalization dynamics to help companies identify their biggest opportunities and threats and boost their odds of hunting for acquisition targets rather than being hunted themselves.

Please follow the below mentioned link to see 1 slide presentation on my slideshare account.

Strategy Control Map Matrix

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Optimal Finance Strategy for Shareholders Value Creation (SVC-3)

Financial Strategy- utilization of capital, sources of funds & distribution to shareholders have significant impact on value creation.

Does your organization use optimal Financial Strategy for value creation? Normally organization gives more emphasis on operational strategy to improve operational efficiencies and altogether ignore systematic approach towards Financial Strategy. In order to fulfill shareholders expectation & value creation organization needs to properly align Operational & Financial Strategy.

In order to develop optimal Financial Strategy organization needs to develop Financial Strategy framework for sources & uses of fund.

There are 3 steps that need to be followed to develop optimal Financial Strategy-

• Establish an appropriate Capital Structure
• Understand whether the organization is undervalued or overvalued in the market
• Develop a Financial Strateg

Establish an Appropriate Capital Structure

Capital structure is often viewed as a minefield of finance theory. Because of this, many executives default to the status quo that, given changing circumstances over time, rarely results in full value creation. An important key to solving the capital structure puzzle is remembering that equity funds (even for private companies) are not free – in fact, they are very expensive. While there is not a contractual obligation to pay shareholders in the same manner as there is for debt holders, there is a very real opportunity cost inherent in equity funds. The cost of equity is high because shareholders bear the systematic risks of being in a particular industry and will suffer the most in a bankruptcy. In comparison, debt financing is less costly because, being subject to contractual obligations – paying interest and repaying principal – debt holders exchange more certainty for a lower expected yield. Additionally, debt is in a preferred position in a bankruptcy and is tax deductible, further reducing its cost to the company. While this favors using leverage, doing so increases financial risk, the cost of debt, and the cost of equity. How do these and other factors interact to determine an appropriate capital structure for a company?

One of the organizations suffering from excess cash availability & undervaluation by market uses the following strategy to develop appropriate capital structure–

Downside cash flow scenario modeling - A capital structure is derived from a set of downside cash flow scenario forecasts. This yields a capital structure that can withstand the shocks of the downside scenarios.

Peer group analyses - Peers’ current capital structures and trends are analyzed for insights into operating characteristics that might indicate the ability to support more or less debt.

Bond rating analysis – The debt capacity within given debt ratings is assessed.

Establishing base case and downside scenario cash flows changes the exercise from a theoretical discussion to an intuitive one because it permits the inclusion of risks, management preferences, and cash flows into the decision.

To understand the magnitude and volatility of cash available for debt service, the first step is to build a base case cash flow forecast for the next three to five years. Collaborating with management, a number of key risks were identified and quantified to develop a series of downside cash flow scenarios. In each scenario, decisions were made about the level of capital investment that would be made and whether the dividend should be changed in order to work from a realistic set of forecasts.

With the downside cash flow scenarios quantified, the next steps were to:

• Identify repayment terms for debt that were realistic in a downside scenario.
• Value the potential for making acquisitions and keeping some “dry powder.”
• Discuss with management the safety margin that would appropriately balance shareholder value with the risks in the business.
• Calculate the amount of debt that met the cash flow constraints and made full utilization of the interest tax shield.

Understand whether the organization is undervalued or overvalued in the market

By comparing investors’ expectations of performance of a company’s value drivers – sales growth, operating profit margins, cash tax rate, incremental fixed and working capital investment to management’s expectations, it is possible to pinpoint the areas where they differ and investigate how they can be addressed, what are investors expectation. Once differences in investors & management’s expectation identified then the next step is to bridge the valuation gap.

Taking the same example, The organization suffering from undervaluation & excess cash availability observes that there are no major investment opportunity available and company is under levered and can generate debt at choice in future, if required urgently, investors expects that the company should return excess cash to investors.

In order to find out how much money company should return to investors & by which means money should be returned e.g. Nominal Dividend, Special Dividend, Share repurchase etc. organization need to develop Financial Strategy Framework.

Develop Financial Strategy

Scenario developed from capital structure serves as a basis for quantifying the amount of excess cash expected to generate from the business.

Definition of Excess Cash

Net Income

+ Depreciation & Amortization

+ Difference between Book Tax and Cash Tax

– Incremental Working Capital

– Capital Expenditures

– Acquisitions

– Dividends

+ Proceeds from Exercise of Options

= Excess Cash

In the normal circumstances organization return excess cash by paying debt however in the above mentioned example organization is already under levered so excess cash need to be return to shareholders and share repurchase option ideally suited due to following-

• Creates value for remaining share holders as the stock is undervalued.
• Signals to the market that the stock is undervalued, helping to raise the stock price closer to management’s valuation.
• Returns cash to the shareholders who want to sell their stock, thereby not imposing a possible taxable event on those who do not want one, as would be the case with a dividend.
• Provides flexibility to distribute cash as fits the company’s circumstances.
• Can return larger amounts of cash to shareholders than an increase in regular dividends.

Management and Investors consideration along with market condition should be considered before finalizing amount of repurchase.

 Conclusion

Boards of Directors and management that are sharply focused on maximizing the value of the firm will recognize the importance of reviewing and adjusting their financial strategy just as rigorously and frequently as their operating strategy. The latter supports the former, but many companies stop after having addressed only their operating strategies, leaving on the table the opportunity to create even more value.

Communicating both internally within the company and externally to investors can help refine a financial strategy and possibly avoid costly missteps. Creating a common framework within Board could discuss financial strategy in a holistic manner proved to be constructive and avoided endless debates. While financial strategy is just part of a broad arsenal of tools available to enhance shareholder value, it is an important one because it provides a number of levers that can be fine tuned on a regular basis. Its effectiveness relies on management teams and Boards willingness to evaluate and adjust those levers as frequently as they do those of their operating strategies.

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Shareholders Value Creation through Strategic Market Positioning (SVC-2)

What is market share? Does market share mean share of product, share of category, share of channel, share of customer, share of region or share of something else? How does your company define market share? Companies that cannot answer this very important question cannot effectively engage in Strategic Market Positioning (SMP) and in the long term, will find it difficult to invest successfully for growth.

What is Strategic Market Positioning (SMP)? For a business or product line that competes in only one strategic segment, SMP is simply the market share of the business in its strategic market segment. For a company competing in multiple strategic segments, its overall SMP is the average of its SMPs in each strategic segment, weighted by the business’s sales or investment in each strategic segment.

Achieving effective SMP involves analyzing an industry to determine strategic market segments and then making investments in those segments that will lead to increased returns.

Does SMP = Market Segmentation? Normally market positioning is considered as market segmentation. This is totally a marketing technique that involves breaking down market into smaller segments in order to better understand consumer behavior & identify opportunities to increase overall market share.

However on the other hand SMP is different because it creates shareholders return. It brings together the disciplines of strategy and finance to help shape a company’s approach to value creation. Organizations that fail to differentiate between market segmentation and Strategic Market Position may be at risk because the definition of market share often does not correlate with company profitability, returns and strategic potential.

Do you think larger market share provides superior return? As per research by one of the top consulting, larger market share even provides low return in comparison to companies having smaller market share with Strategic Market Positioning. There are several reasons supporting to this finding. The smaller, more profitable company may avoid going head-to-head with larger, more powerful competitors. It may deploy its investments into segments where (among other things) the dominant players simply do not compete. In essence, it positions itself in its industry strategically and allocates more assets in fewer, carefully selected ways. As a result, it has a much higher market share in its chosen segments.

How to create Value through Strategic Market Positioning (SMP)

Following 3 approaches should be followed to create value through SMP-

Be Creative & think Broad: To maximize the chances of identifying successful strategies, think beyond the current business offerings. Apply the Blue Ocean Strategy principle “Reconstruct Market Boundaries” & “Reaching Beyond Existing Demand”. Evaluate other businesses that share the same customers or leverage the same technologies. Consider services as well as product offerings. Identify the range of organic or acquisition initiatives that could be used to pursue potential growth strategies.

Conduct SMP Test: Identify the growth strategies that have the greatest potential to increase the company’s weighted average relative market share, as measured across all strategic segments impacted by the strategy. This will identify strategies that have the potential to improve the company’s overall position on the most important drivers of profitability. Conduct SMP test quantitatively to specific initiatives to see whether market share, appropriately defined, increases or decreases.

Conduct Value Creation Test: “Strategic value” is defined as the net present value of cash flows from higher revenues, lower costs and lower capital requirements that will accrue from the growth opportunity and the existing business being run together versus separately.

We will see an example of Southwest Airline & America West Airline to know how SMP creates higher value.

Southwest Airline & America West Airline started in roughly the same position, but ended in very different places. Both formed as low-cost, low-fare regional carriers, both airlines grew their operations and profits on roughly parallel tracks through the early 1990s.

America West followed a traditional hub-and-spoke design for its flights and became well known for its expansionist strategy. Southwest, on the other hand, grew at a slower pace, taking the time to build up strong positions in specific markets before penetrating additional markets. Southwest’s emerging strategy was creative in that it focused on short haul, high frequency flights in city pairs where the airline could secure a strong market share position, often flying to a secondary, lower-cost airport. In addition, its costs were controlled as a result of the corporate decision to use (and therefore maintain) only one type of aircraft: the Boeing 737.

By contrast, America West’s expansionist strategy called for international routes, which in turn called for a heterogeneous and expensive-to maintain fleet. America West did not base its strategy on the core tenet of SMP: build the type of market share that maximizes high-impact growth and leverages economies to the greatest extent possible.

  Summarize two Airlines positions & Strategies

Summary Stats ( 1990)	South West	American West
Revenue	$1186 M	$ 1315 M
Number of Aircraft	106	104
Types of Aircraft	1	4
Flight Design	Point-to-Point Short Haul	Hub & Spoke

Figure 1: Compares the two airlines in terms of traditional market share and Strategic Market Position to reveal the true impact of their different strategies

 Source: Bloomberg 

Although America West and Southwest had similar US total market shares in 1990, this measure obscures their relative competitive strengths.

In the airline business, pricing power and operating costs are driven more by share of flights between states or, more precisely, by share of flights between specific city pairs. Travelers prefer to fly an airline that has several daily flights between two points because it gives them more flexibility in the event of a missed or delayed flight. This is better for airlines because they are likely to have larger scale and more efficient operations at each end.

Southwest Airlines recognized this as a critical factor and was careful to enter a new market only when it felt it could achieve substantial strategic share in that market. By contrast, America West assumed that, by entering larger and increasingly international markets, it was strengthening its overall position in the airline market. In fact, it was neglecting its core franchise and spending limited resources to enter new market segments where it had little to offer against strong competitors.

Figure: 2 illustrates the value creation outcome of these two Airlines while adopting different strategies

As America West’s emergence from Chapter 11 in 1994, its stock has declined at a CAGR of -4.9 percent, while Southwest’s stock has grown at a CAGR of 9.9 percent.

Conclusion

Strategic Market Positioning (SMP) is a proven and highly effective tool for creating value. It is founded on the assumption that not all growth is good – in fact, that some growth actually destroys value. SMP helps companies identify the difference and respond accordingly. By being creative and thinking broad to maximize the chances of identifying successful strategies, and by conducting the SMP and value-creation tests, an organization’s leadership can gain valuable insight into organic growth ,acquisitions and other growth investments and be better able to formulate strategies that have the potential to improve the company’s overall performance.

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