One of the most challenging task a top executive of a business faces is to maintain & grow portfolio of business that provides maximum returns to an organization.
In today’s environment companies that actively mange their portfolio of business are finding that the traditional method of balancing portfolio like invest free cash flows in more attractive businesses, preferably with synergies to existing ones, and look to build a strong position—often creates little value. Given the breadth and pace of today’s global markets, companies must constantly compete for acquisitions across the world and pay a hefty premium for highly attractive businesses. Often, merely reinvesting free cash flows makes little difference to the portfolio’s value.
In order to take decision beyond the conventional model of portfolio management, today’s business mangers take ad-hoc decisions and act more on gut feeling rather than on actual data. Portfolio strategy, at its core, is about being or becoming the natural owner of businesses and balancing investment opportunities against the supply of capital, given the predicted returns of current and potential investments.
What’s natural owner of business & how to become the natural owner of your business?
Companies can be natural owner of business in several ways depending on how they add value to a business-
Operational synergies, for instance, may let them use the same technology, produce in the same plants, or distribute to the same channels where business systems overlap. In specific situations, such as emerging markets, natural ownership can include superior access to capital and talent—one of the reasons emerging markets still have conglomerates with a broader business mix than in more developed markets.
A company that isn’t the natural owner of a certain type of business can decide to become one by building a large enough position and striving for distinctive performance in key areas. When many universal banks acquired investment banks in the 1990s, they worked to become natural owners in a very attractive business segment. Many failed, but some of the most successful global banks built their position in this way.
Corporate skills also can be a source of natural ownership. The skills of any company are the product of its culture and history. Certain oil companies know how to foster operational excellence in refining; these companies have repeatedly created significant value by acquiring refining assets from other oil companies and improving their performance.
Measuring natural ownership isn’t straightforward but does provide an important point of comparison among portfolio options.
The best test for natural ownership is whether a different owner would ascribe a higher value to a business. Measuring this point is difficult and subjective, but business managers can do so for an existing business by valuing their plans assuming realistic performance levels and then comparing this value with the price the business would command if it were sold, using either private equity-style valuation models or recent M&A multiples. For M&A opportunities, managers can compare the price they could rationally offer with the likely bids of others—keeping in mind that other offers aren’t always rational.
Portfolio Balancing Opportunity with Capital
Even if a company is the most natural owner of all its businesses, merely investing free cash flows in the most attractive ones may not be the best approach for generating maximum returns. Companies must consider that almost all businesses can be bought or sold and that capital can be raised or returned to shareholders. Therefore, managers must constantly examine a company’s entire portfolio of businesses and opportunities as if they were planning to reinvest all its capital.
The notion of capital balance starts with the mix of investments in new and existing businesses—the mix that creates the most value. More often than not, the amount of capital a company has for investment doesn’t equal the amount of capital required by all of its opportunities. Companies with more investment opportunities than capital, such as a fast-growing technology company with interesting intellectual property, tend to look for more capital. These companies will be more aggressive on divestments, impose higher hurdle rates on investments, and ponder raising more capital through additional debt or equity issues. Companies with more capital than investment opportunities, such as a successful company in a mature market, tend to accept lower returns from new opportunities, are more reluctant to divest, and look for ways to return cash to shareholders via buybacks and dividends.
Calculating capital balance requires a clear understanding of the current portfolio, investment and divestment opportunities, and available capital and financing.
In analyzing the capital balance, business managers should distinguish among three types of capital decisions:
Capital deployed in existing businesses
Almost all businesses require a certain rate of reinvestment—for example, to develop new products or keep production facilities up to date. While the current rate of reinvestment may create the most value for a mature business, a higher rate may be necessary to gain market share or expand into new markets.
Capital deployed in larger investment opportunities
Big opportunities include completely new investments, such as an acquisition or a market entry, and dramatic shifts in current businesses. An example of a dramatic shift could be a decision to transform a company from a technology provider into a service provider that owns and operates its technology.
Capital gained by exiting existing businesses
Exiting some businesses, such as those that have scarce assets—say, mobile-phone businesses in markets with a limited number of licenses—often brings a company a premium above the current value. In other businesses, an exit won’t necessarily generate a price that reflects the business’s true economic stand-alone value; in many transactions potential buyers discount the price they’re willing to pay by assuming a worst-case economic scenario. Certain businesses are too interlinked with other operations or the corporate identity for divestment to be practical. Some involve government or other stakeholders that put a sale beyond a company’s control.
In all situations business managers who understand the elements of capital balance can make better-informed decisions. These managers have to arrive at a number of judgments on the relative merits of investments and divestments, such as trade-offs between strategic fit and short-term value creation and whether to modify hurdle rates.
One niche services company had calculated its current capital balance realized that it could create further value in its core business but would be better off diversifying into adjacent businesses with a superior long-term outlook and uncorrelated risks.
Assessing Future Investment Returns
To allocate capital among various opportunities, management has to understand the future economic returns that potential investments will generate, but assessing future returns is a very challenging task. Many management teams still focus on accounting returns, such as profits on book capital, ignoring the fact that the market value of an existing business is higher than the book value if its returns are above the cost of capital (and lower if its returns are below the cost of capital). Likewise, the value of new businesses must account for any goodwill paid to acquire them. Management often compare the book returns of existing businesses with the net value creation from new ones; the result is an unfortunate bias toward keeping lackluster businesses and shying away from new opportunities that require the payment of goodwill or entry costs.
For Example any new deal’s value creation depends on the potential synergies (cost, capital, revenue, and growth) it produces and the extent to which the premium paid cancels out those gains. Synergies, of course, must be rigorously quantified. The likelihood of actually realizing forecast synergies also needs to be assessed, along with such offsetting factors as lost revenue. The projected value created must then be weighed against any premium paid over the target’s intrinsic value rather than against the current share price, which often reflects takeover speculation.
Calculating the net returns of a portfolio of investments can be complex, as actual returns may differ markedly from accounting ones. The most accurate approach is to decompose net returns into the underlying future returns of the business, minus entry costs and plus synergies gain. Management can estimate this value by using simple proxies; for example, they can usually derive a good estimate of future returns from long-term returns on invested capital, which are surprisingly stable in many industries. Note that long-term growth heavily influences future returns; at typical levels of profitability, growth at twice the rate of GDP generates returns that are two to three times higher than growth at GDP.
The main reason many companies fail to create value when they change their corporate portfolios is that managers have misjudged the exit or entry costs, such as acquisition goodwill or start-up losses. Again, managers should consider external proxies. In the case of acquisitions, executives know the premiums paid for past transactions, and premiums for new businesses can be justified by synergies even if they are assessed only approximately. In the case of a divestment, a substantial loss of value can result from the loss of synergies, and while few companies bother to quantify the synergies among existing businesses, that oversight can lead to unpleasant surprises at the moment of a divestment. When a large financial institution tried to divest its asset-management business, it found that more than a third of its value depended on captive business, which buyers would exclude from a stand-alone valuation. As a consequence, the company had to grant extensive guarantees in order to sell.
One proxy for future returns that is often used—but should not be—is short-term growth in earnings per share. This approach does not adequately account for the amount of capital needed to acquire or maintain an investment, so it tends to favor acquisitions even if they will destroy value.
A practical approach should be to calculate the net return, typically over the next five to ten years, from all portfolio moves under consideration: keeping a business, investing in step changes or new businesses, or selling businesses. Managers should always calculate returns relative to the current value of a business, existing or new. Coincidentally, this metric resembles the approach taken by private-equity firms. It lets managers easily link the results of portfolio strategy to a business’s medium-term targets for growth and returns. In that sense, only investments that give a company some form of advantage sufficient to pay back the costs of entry and exit are likely to generate sufficient returns on capital. Here, the connection to natural ownership becomes clear: the ideal investment is one where natural ownership leads to superior net returns. The ideal portfolio is one with enough such investments to deploy all the available capital at rates clearly above the cost of capital.
Given the complexity of portfolio decisions, how should managers go about defining a portfolio strategy? Here are four useful hints-
Understand the context and objectives
Approaches to portfolio strategy can vary considerably, depending on the context. One company may want to determine which businesses it can divest with minimal loss of value and strategic coherence. Another might want to assess the range of investment options for cash flows generated by its current, maturing businesses.
Manage Decision Issues
Operational managers do not have the best position for making portfolio decisions: they are often inclined to favor the businesses they are currently responsible for, so they are reluctant to recommend reallocating capital to new opportunities. To overcome such decision issues, a company should charge people who are independent of the operating businesses—typically, the board, advised by the CEO and the CFO— with the responsibility for making all final portfolio decisions.
Do Rigorous Analysis
Any rational portfolio decision depends on a true understanding of a business’s performance and upside. Management often claims they have all the data, although those data are purely internally focused. To analyze a portfolio, a functional team, led by the CFO, should rigorously and quantitatively benchmark the returns and growth of individual businesses as compared with those of their peers. The team also needs to challenge internal plans by comparing them with the historical performance of the business or that of peers.
Maintain Capital Discipline
Even the best portfolio strategy cannot adequately account for all future developments. Investors do not expect a company to predict the future, but they do expect it to show discipline once projected returns do not materialize.
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