How to maintain maximum return on Portfolio of Business?

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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ROIC, Growth, & Total Return to Shareholders (TRS) are always aligned

Yes, this happens to organizations which are in a category of Superior Performance.

Not every organization comes under this category. And no one can even sustain it for a very large period of time that’s why we see some executives even with low returns promote growth instead of ROIC. Large company in particular finds it difficult to grow without giving up some of their existing returns. When an industry reaches maturity and consolidates, companies may find it impossible to avoid slow growth and, at the same time, compressed margins. And when a company cannot find growth opportunities or improve its returns on investment, executives might better serve shareholders by selling the company to owners who can drive higher growth or returning capital to shareholders through stock buybacks.

What are the characteristics of Superior Performance Company?

1. Superior and sustainable return on investment (ROI)

2. Growth while maintaining superior return on investment, and

3. Superior total shareholder returns.

A company has to pass the following stringent test in order to be called as Superior Performance Company.

• Cash flow returns, comparable to a very diligently computed return on invested capital (ROIC), had to exceed twice the cost of capital consistently for more than 10 years straight.

• Growth rates in invested capital, the principal of the business, much like a savings account, had to exceed local gross domestic product (GDP) growth rates and industry averages in rates or totals over the same period.

• Total shareholder returns (TSR)–a combination of the share price gains adjusted for any stock splits plus dividends–had to exceed market performance over the time period consistent with high cash flow return and growth levels.

What kind of strategy these kinds of companies adopt to achieve superior performance?

Commitment to Return on Invested Capital and High Integrity

High-performance companies show a strong commitment to and discipline for creating shareholder value by focusing on return on capital. They have goals, performance measures (such as return on invested capital or ROIC), and incentives that are firmly aligned with sustainable ROI. They also find ways to grow their business in a disciplined manner so as not to sacrifice returns. These companies achieve superior returns and growth while adhering to the ethical parameters of their constituents and communities.

Companies like Johnson & Johnson have achieved superior ROI, grown their business, and shown an adherence to ethical standards. J&J is famous for its Credo, which is a foundation for ethical business conduct at the company and focuses on shareholder value through a philosophy of “capital-efficient profitable growth.”

Focus on Unmet Customer Needs in Growing Market Segments

High-performance companies have a hyper vigilant focus on customer need that’s much deeper than and different from other companies’ focus. To avoid commoditization, they concentrate on fulfilling otherwise unmet customer needs. They have the processes, capabilities, customer information, and customer intelligence to better identify and target customer needs. These companies also target the right customer groups with the intent and ability to dominate.

Innovate Offerings to Better Fulfill Customer Needs

High-performance companies constantly reexamine their products and services (their offerings), modifying existing ones and developing new ones that will better fulfill customers’ unmet needs. These kinds of companies always come out with new product/ offering which distinguish them from their competitor.

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How Chinese CEOs do business?

The outlook and career experiences of the CEOs who head many of today’s rapidly growing and increasingly confident Chinese companies are markedly different from those of Western executives. Understanding these differences can help to explain behavior that otherwise might seem curious to the executives of many multinationals—and could also suggest competitive opportunities.

Nowhere is the contrast with Western corporate leaders starker than it is for the chief executives of state-owned Chinese enterprises. Most of these CEOs have spent their careers shuffling between the private and public sectors. A capable leader might start out as a senior provincial-level executive in a state-owned enterprise, then hold a provincial-level Communist Party post, follow it up with a stint as the CEO of the state-owned enterprise, and move back to the party infrastructure to serve as the mayor of a major city or as a provincial governor. A final career step might be attaining a senior position in the central government or the party—for instance, a seat on the State Council or the Politburo.

Because the career of a typical CEO of a state-owned enterprise usually straddles the corporate and political spheres, these chief executives pay careful attention to politics—in particular, to developments in the Communist Party. In fact, it’s not unusual for such CEOs to link the timing of long-term strategic decisions to plans outlined in the annual National People’s Congress (China’s legislature) or to other significant political events, such as trips to China by foreign leaders or the creation of new government agencies. What’s more, the symbiotic relationship between the enterprise and the state makes such CEOs sympathetic to corporate social and economic goals beyond maximizing shareholder value.

China Mobile’s rural-expansion strategy shows how one major state-owned enterprise has grown while supporting national-development goals. Since 2004, the company has extended mobile service to millions of people in the vast countryside to support the government’s rural-infrastructure program, which includes initiatives linking rural areas through a mobile-telecommunications network. Government objectives such as maintaining social stability by keeping China’s huge workforce employed and by redressing economic and social inequities are partly responsible for the importance that many CEOs of state-owned companies attach to top-line revenues. In fact, we find that chief executives in both the public and the private sector talk more about revenue growth, market leadership, and competitive advantage than about shorter-term financial objectives, such as higher earnings. The emphasis on driving top-line growth to keep factories humming and employees on payrolls often means that Chinese companies are generalists playing in several different business areas and markets.

Foreign players therefore have an opportunity to carve out niches in rapidly growing but underserved segments. Some pharma multinationals, for example, avoid head-on competition with Chinese companies in large product categories, such as antibiotics, which today accounts for as much as 30 percent of the total pharma market but is declining in importance. These multinationals are instead targeting smaller, faster-growing therapeutic areas—for instance, oncology and hypertension.

Perhaps not surprisingly in a rapidly expanding market, Chinese CEOs rely less on rigorous analysis, market research, or a detailed understanding of customer preferences than their counterparts in developed markets do. Instead, many of them make decisions instinctively, feel comfortable with rapid and flexible responses to new industry trends and shifts, and have a keen interest in holding down costs in order to boost competitiveness and to keep companies growing.

These tendencies also create opportunities for multinationals. The dealer strategies of Chinese automakers, for example, emphasize low-cost facilities in favorable locations that pull in customers. Few of these companies have focused on providing a high-quality showroom experience. GM, by contrast, applies to each of its dealerships strict customer service standards—all the way down to details such as how many seconds should elapse before a dealer greets a customer who enters a showroom and how many times a telephone should ring before a dealer answers it.

To be sure, such strategies aren’t a silver bullet for multinationals: local pharma companies continue to hold a 70 percent market share in China, and GM is locked in tough competition with other foreign carmakers and with Chinese ones as well. But unless multinationals use such approaches, success will be even more elusive. A better understanding of Chinese companies and of the executives who lead them is an important starting point when multinationals decide how to compete.

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