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Becoming a Value Manager

admin — Sun, 01 Nov 2009 17:27:22 +0000

Becoming a value manager is not a mysterious process that is open to only a few. It does require, however, a different perspective from that taken by many managers. It requires a focus on long-run cash flow returns, not quarter-to-quarter changes in earnings per share. It also requires a willingness to adopt a dispassionate, value-oriented view of corporate activities that recognizes businesses for what they are—investments in new productive capacity that either earn a return above their opportunity cost of capital or do not. The value manager’s perspective is characterized by an ability to take an outsider’s view of the business and by a willingness to act on opportunities to create incremental value. Finally, and most important, it includes the need to develop and institutionalize a managing value philosophy throughout the organization. Focusing on shareholder value is not a one-time task to be done only when outside pressure from shareholders emerges or potential acquirers emerge, but rather an ongoing initiative.
The process of becoming value-oriented has two distinct aspects. The first involves a restructuring that unleashes value trapped within the company. The immediate results from such actions can range from moderate to spectacular; for example, share prices that double or triple in a matter of months. At the same time, the price to be paid for such results can be high. It can involve divestitures and layoffs. Management can avoid the need for cataclysmic change in the future by embracing the second aspect of the managing value process: developing a value-oriented approach to leading and managing their companies after the restructuring. This involves establishing priorities based on value creation; gearing planning, performance measurement, and incentive compensation systems toward shareholder value; and communicating with investors in terms of value creation.
By taking these steps to ensure that managing value becomes a routine part of decision making and operations, management can keep the gap narrow between potential and actual value-creation performance. Consequently, the need for major restructuring that goes with large performance gaps will be less likely to arise. Those who manage value well can guide their companies in a series of smaller steps to the higher levels of performance that even the most comprehensive of restructurings cannot match.
We illustrate the integrated application of value management principles by presenting a case example distilled from the real-world experiences of client executives with whom we have worked. Our purpose is to show the process of transforming a company in terms of value to shareholders and management philosophy.

The EG Business

admin — Wed, 28 Oct 2009 17:28:57 +0000

EG Corporation had sales of just over $3.5 billion in 1998. The company was in three main lines of business— consumer products, food service, and furniture—with its Consumerco, Foodco, and Woodco divisions.
Consumerco manufactured consumer products and sold them through a direct salesforce to grocery and drugstores throughout the United States. It had a dominant market share (more than 40 percent) in the majority of its product lines, all of which had a strong branded consumer franchise.
Woodco was a mid-sized competitor in the highly fragmented furniture business. Woodco had been created through acquisitions and consisted of eight separate smaller companies acquired over 10 years. All served the mid- to lower priced end of the market with complementary product lines. The Woodco companies sold their products under their original brand names. As of early 1999, the companies were still operated as autonomous units, but EG had begun to combine the companies into one unit, consolidating separate administration, sales, and production functions to the extent feasible. EG also planned to establish an umbrella brand to tie together the wide range of Woodco product offerings and establish a base for adding new lines.
Thus far, the Woodco businesses had turned in uneven financial results. Management capability in the eight businesses varied widely. Moreover, Woodco’s business performance was to differing degrees dependent on keeping up with the latest in furniture styling and fashion. Some of the companies were skilled in this area, but the disastrous consequences of missing the trends had been brought home over the years by their uneven performance. Despite this, Woodco’s management was convinced that EG could build a large and successful business. The managers believed consolidation would reduce Woodco’s operating costs significantly and strengthen the company’s management control over the businesses. They thought the new common sales and marketing thrust would lead to increased volumes and higher margins. The Woodco management’s convictions were lent some credence by the existence of several other players in the industry that earned consistently high returns, achieved in part by rationalizing less-efficient companies that they had acquired.
Foodco, EG’s third main division, was in the food service business. Foodco operated a small chain of fast-food restaurants, as well as providing food service under contract to major corporations and other institutions around the country. It had been essentially built up from internal growth plus a few small acquisitions over the last five years. The former CEO had viewed Foodco as a major growth vehicle for EG and had backed aggressive expansion plans and the associated capital spending. As of early 1999, EG’s Foodco unit was earning a profit but was still in the early stages of its development plan. It was a small player in the restaurant business and had only a few institutional food service accounts. In both businesses, it faced formidable competition, but management believed that its operating approach and EG Corporation’s Consumerco name recognition, which was being used as the branding proposition for Foodco, would establish Foodco as a major factor in the industry.
Beyond Consumerco, Foodco, and Woodco, EG Corporation owned a few other smaller businesses: a property development company (Propco), a small consumer finance company (Finco), and several small newspapers (Newsco). No one currently employed by EG could recall why EG had acquired these businesses. They had been added to the portfolio in the 1970s. All were earning a profit, though they were small by comparison with EG’s three main divisions.

Shareholder-Oriented Economies Perform Better

admin — Thu, 15 Oct 2009 17:26:06 +0000

We doubt that the strong economic performance of the United States since the mid-1980s would have taken place without the discipline of shareholder capitalism and an increasingly sharp eye by many participants in its economy on creating shareholder value.
The U.S. corporate focus on shareholder value tends to limit investment in outdated strategies—even encourage divestment—well before any competing governance model would. Schumpeter’s ”creative destruction” is fostered by a bottom-line focus. Moreover, it is hard to claim (as many have at times, albeit often managers of poorly performing companies) that the capital markets are shortsighted compared with other corporate governors—the high number and value of technology and internet companies going public in recent years attests to this. Foolish maybe, but shortsighted? Certainly not.
But what about actual economic performance? Economists widely agree that the dominant measure of an economy’s success is GDP per capita. The United States—the world’s most capitalist, shareholder friendly economy—has a lead of more than 20 percent over other major countries. Up to 1975 other countries were catching up, but this convergence has since stopped. If anything, the lead of the United States has been widening. From 1994 to 1997, the McKinsey Global Institute carried out a series of research projects to analyze the differences in GDP per capita between the United States and other countries. The research, which focused on the United States, Germany, and Japan, attributed the U.S. advantage to much higher factor productivity, especially capital productivity. How can the United States be outperforming other countries with a savings rate that is often deplored as wholly inadequate? The answer is what happens to those savings. In the United States they are invested in more productive (i.e., economically profitable or value creating) projects than in either Germany or Japan. Financial returns in the corporate sector in the United States between 1974 and 1993 were dramatically higher than in Germany or Japan.
This is not to say that the shareholder value system is always perceived as fair. Job losses from restructuring disrupt lives. At the same time, one can argue that an economy’s ability to create jobs, or its lack thereof, is the better measure of fairness. On that score, the track record of the United States compared with the other countries speaks for itself. Two centuries ago, Adam Smith postulated that the most productive and innovative companies would create the highest returns to shareholders and attract better workers, who would be more productive and increase returns further—a virtuous cycle. On the other hand, companies that destroy value would create a vicious cycle and eventually wither away. In today’s terms, we believe that a company that focuses on building shareholder value is served well by being a good corporate citizen. Why? Simply because such a company will create more value for its shareholders. Consider the employee stakeholders. A company that tries to fatten its profits by providing a shabby work environment, underpaying employees, and skimping on benefits will have trouble attracting and retaining high quality employees. With today’s increased labor mobility and more educated workforce, this kind of a company will be less profitable. While it may feel good to treat people well, it’s also good business.
The empirical record also strongly supports the conclusion that shareholder wealth creation does not come at the expense of other stakeholders. We analyzed the relationship among labor productivity, increases in shareholder wealth, and employment growth across a range of industries in the United States, Japan, and Germany. Our conclusions are that companies with higher labor productivity are more likely to create more value than those with lower productivity, and that these gains do not come at the expense of employees in general. Companies that are able to create more value also create more jobs.

The Popularization of Equity

admin — Thu, 01 Oct 2009 17:21:11 +0000

The remarkable performance of U.S. and European equity markets since the early 1980s not only contributed to the popularization of stock options in executive pay packages, but also to the increase in stock ownership by households in many countries. This is not to say that many U.S. and non-U.S. households have become active investors in individual equities. What has happened is that growing segments of the population are becoming shareholders through mutual funds and retirement programs. Among the most vocal proponents of shareholder value are the managers of major retirement systems, such as the California Public Employees Retirement System, which has $130 billion in assets under management, a large part of which is in equities.
Equities are by far the largest asset class in which pension funds are invested in the United States and the United Kingdom, with 58 percent and 76 percent, respectively, in 1996. The difference compared to countries like Germany, with 8 percent, and Italy, with 3 percent, is quite striking. But the situation in these countries is changing rapidly, with an increasing proportion of pension assets moving into equities. A shareholder culture seems to be developing in many European countries. This has been prompted partly by privatization of large government monopolies in areas such as telecommunications, where governments became active marketers of the shares of these companies. Noteworthy was the German ”Deutschland Aktienland” (Germany: Country of shares) campaign in support of the privatization of Deutsche Telekom. The subsequent strong performance of the shares of the privatized companies gave a boost to the popularity of stock investment in these countries.
While in 1975, 25 million people, representing 12 percent of the population, owned equity shares, by 1995 this number had surged to 69 million and 26 percent, respectively. Under these circumstances, the old notions of labor versus capital are losing currency. No longer is the shareholder someone else: The shareholder is us. As a consequence, the ideological tension that fired the debate on shareholders versus stakeholders is diminishing. With more and more people as shareholders, the support for shareholder value as the objective function for a corporation is gaining momentum.

EG’s Financial Performance

admin — Wed, 30 Sep 2009 17:30:11 +0000

Overall, EG Corporation’s financial performance had been mediocre for the last five years. Earnings growth had not kept pace with inflation, and return on equity had been hovering around 10 percent. Part of the problem was that EG had been hit with unfavorable ”extraordinary items” that had depressed bottom line results. Beyond this, though, the company had failed to deliver on overall commitments for growth and operating earnings in its businesses for the last few years. From an investor’s standpoint, the company’s stock price had lagged the market for the last several years. Analysts bemoaned the company’s lackluster performance, especially in view of its strong brand position in Consumerco. They were disenchanted with the slow progress in building profits in other parts of the company. Some security analysts had gone so far as to speculate that EG would make a good breakup play. EG Corporation’s board and senior management were frustrated by their inability to convince the market that EG should be more highly valued.

The Increased Role of Stock Options

admin — Wed, 23 Sep 2009 17:21:02 +0000

In the mid-1970s in the United States, there was growing concern about the perceived divergence between managers’ and shareholders’ interest. In part, this feeling reflected anxiousness over 10 years of falling corporate profitability and stagnant share prices. The concern was also fueled by the increasing attention paid to stakeholder model arguments, which, in the eyes of shareholder value proponents, had become an excuse for inadequate performance. Meanwhile, a number of academics became interested in management’s motivation in decisions relating to the allocation of resources, a branch of research known as agency theory. In 1976, Jensen and Meckling published a paper, ”Theory of the Firm: Managerial Behavior, Agency Costs, and Ownership Structure.” They laid out how over the previous decades corporate management had pursued strategies and projects that were not likely to optimize resources from a shareholder’s perspective and called for redesigning management’s incentives to be more closely aligned with the interests of the shareholders. Stock options had been a component of the pay packages of most senior executives in the United States, but the size of option grants coupled with the anemic performance of the stock market as a result of high inflation, effectively made them weak motivators of managerial behavior.
The situation changed in the early 1980s. The emergence of the LBO, and especially the management buyout, created instances where both the performance of the company in shareholder value terms and the pay packages accruing to executives as a result of their equity holdings became very large and noted by the public. At about the same time, in 1982, the U.S. Federal Reserve Board embarked on a program that drastically reduced inflation, which in turn prompted a sustained rise in equity values. As a result of this confluence of factors, the role of stock options in executive pay soared.
Over the same period, boards of directors had come under increased criticism for perceived negligence in representing shareholder interests (which, at least under the legal requirements in the United States, they were supposed to do). A movement developed to require that nonexecutive board members have an equity stake in the companies they represented so that they would be more inclined to pay attention to shareholder returns, if only for self- interest. By the late 1990s, 48 percent of medium and large companies had a stock grant or option package for board members, in contrast to virtually none in 1983.
The widening use of stock options has greatly increased the importance of shareholder returns in the measurement of managerial performance. Such developments are not limited to the United States. Stock options and share grants have become important elements of executive pay in England and France. As the competition for executive talent becomes global, it seems likely that the use of stock options will become more and more popular in most open economies.

Pension Insolvency

admin — Sat, 15 Aug 2009 17:22:16 +0000

The fourth contributing factor for the increasing importance of shareholder value is the time bomb ticking away under the public pension systems of most developed countries. In these countries, mandatory public pensions represent the largest part of the income of retirees, with Germany and Sweden leading with respectively 95 percent and 91 percent of retiree income derived from public pensions. Most of these public plans are set up as pay-as- you-go systems where contributions by workers today are used to pay the retirement of current retirees. This system worked fine as long as there were relatively few retirees in relation to contributing workers. This is changing.
In 1990, for example, there were almost two workers in Germany to support one retiree. By 2035, this number will drop to one retiree per worker. As a consequence, the average contribution rate for a German worker to the mandatory public pension system will rise to 34.1 percent of gross wages in 2035 if no actions are taken, compared with 19.7 percent in 1996. This is the stuff of which revolutions are made.
Although avoiding a pension crisis is possible, there are no easy fixes. Most analysts agree that these countries have no choice but to move to some form of funded pension system, where at least a part of the premiums that workers pay are actually set aside for their retirement. The challenge is how to make it through the transition from pure pay-as-you-go to partially or wholly funded. While there are several variations of funded pensions systems, they all lead to the same conclusion—there is no solution unless the savings in the funded part of the system generate attractive returns.
With this in mind, one solution would be to increase premiums by a sufficient amount to build a surplus that can be reinvested, with the combination of premiums and investment returns covering the future shortfall. Here is a simplified example of how this might work in Germany. If the additional premiums were invested in German government bonds, which historically have yielded real returns of about 4 percent, the necessary incremental premium would amount to 3,103 marks, a 13 percent reduction in disposable income. If, on the other hand, these savings were invested in Germany’s private sector, where real long-term returns between 1974 and 1993 have averaged 7.4 percent, these premiums would drop to 2,068 marks. If the German private sector were as successful as its U.S. equivalent, which generated real long-term returns in the same period of 9.1 percent, the annual premiums would drop to 1,706 marks, a reduction in disposable income of just 7 percent.
Thus, in combination with measures such as gradually increasing the retirement age, the burden can be reduced to a level where political consensus becomes feasible, if the investment funds generate good returns. Defusing the pension fund bomb dictates that the private sector be held to a standard where generating high returns on invested capital and creating opportunities to invest additional capital at high returns is of paramount importance. It is not coincidental that California’s public employee retirement fund is one of the most vocal advocates of creating shareholder value in the United States, and has made it clear that it expects shareholder value to be a priority in other markets.
If the funded plans are to work and intergenerational competition is to be avoided—whether in Germany or other developed nations—then there must be steady pressure on companies to generate shareholder value.

Currency Overlay

admin — Sun, 05 Jul 2009 15:37:38 +0000

Again, it is probable that most currency overlay managers might not appreciate being labelled as speculators. Here however, the definition we have used in this blog for currency speculation appears to work well. After all, the very job of a currency overlay manager is to differentiate currency risk from underlying asset risk within the overall risk profile. Active currency overlay requires that currency risk be managed separately and independently from the underlying. Therefore de facto, it falls within our definition of currency speculation. This does not mean that a currency overlay manager is of necessity anything like a prop dealer or a hedge fund. The job of a currency overlay manager may be either to ensure the total return of the portfolio by reducing risk as much as possible, or alternatively it may be to add alpha.
Either way, currency overlay managers use currency hedging benchmarks. They can manage the currency risk passively by maintaining the currency risk according to the benchmark. Alternatively, they can manage the currency risk actively by trading around the currency benchmark to add to the total return of the portfolio. The former are clearly not currency speculators in that they are hedging currency risk related to an underlying asset and moreover they are doing so passively. They are not “taking a view”. The latter group, who trade actively around the currency benchmark, are indeed currency speculators in that they are taking positions not specifically related to the underlying asset.
Corporate Treasurers and currency overlay managers may think their world is as far away as one can get from those of the prop dealer or hedge funds, but there are times when the distinction between the two sides becomes decidedly less clear than many might like to think. In turn, this should mean one takes a more balanced and measured view of the very topic of currency speculation.

Corporate Treasurers

admin — Fri, 03 Jul 2009 15:37:06 +0000

I realize fully the reaction that may be caused by labelling some corporate Treasurers as speculators, but frankly that is what some of them are according to my de?finition of currency speculation. This is in no way whatsoever a criticism. It is however a reflection of the realization that while most corporate Treasuries see their main goal as management and reduction of risk, a (not small) minority see the Treasury as a profit centre in addition to the underlying business. These deliberately take asset and currency market positions for the specific purpose of adding to the company’s bottom line. There is no definitive answer as to whether this is “right” or “wrong” in very simplistic terms. It goes without saying that one had better know what one is doing if conducting such speculative activity. While adding to the company’s bottom line is clearly a good thing — both for the company and for the Treasurer —financial markets charge a risk premium for P&L or balance sheet volatility. This should be a consideration when deciding whether or not to allow active speculative activity within the Treasury, using that balance sheet.
The other and decidedly more frequent kind of speculation that corporate Treasurers go in for is in not hedging out currency risk. We looked at this in earlier posts in substantially more detail and it is certainly not for here to go through that again. However, within the overall topic of this blog, it is important to reiterate and make clear the point that not hedging currency speculation equates to taking a currency view, and that in turn equates to currency speculation. Granted, it is a stretch to ?t this type of currency “speculation” within the narrow definition chosen for this blog. There is after all an underlying asset. That said, not hedgingmeans leaving that underlying asset exposed to financial market volatility. Such a decision would seem to be speculative under most broad definitions of speculation. This is in no way to suggest corporate treasuries should hedge currency risk each and every time they have an underlying exposure. The aim here is not to counter one extreme with another. Rather, it is to seek to challenge an idea, an ideology almost.
The idea and the ideology is that currency hedging represents a cost, while losses due to not hedging are simply the result of unpredictable market volatility. To me, the latter represents an abandoning, a shirking of responsibility. It is part and parcel of the job of a Treasurer or finance director to predict their business needs. Should it not be also to predict the context within which those business needs exist, the context being of course the global financial markets that specifically affect the risk profile of their business? A corporate Treasurer may say that they have to explain the cost of a currency hedge to the company’s board, particularly if it had a notable impact on the company’s figures. They should equally have to explain when they do not hedge, and subsequently the company’s unhedged currency exposure leads to extraordinary losses and balance sheet pain. It is sloppy thinking to just leave it to the market to blame. If markets were completely unpredictable, strategists or analysts would not exist. Granted, some are better than others, but the very existence of the profession suggests that at least some are getting it right part of the time. That in turn suggests that a corporate Treasurer or finance director, who is far more senior in both experience and rank to a bank’s strategist, should be at least as well informed as the latter. Companies exist within the market context their businesses operate in. The two cannot be separated. Some need to do a better job of understanding that context.

“Hedge” Funds

admin — Wed, 01 Jul 2009 15:36:19 +0000

The very term may for some conjure up the devil incarnate. There is little question that the image of the hedge fund has changed over time. Before we get onto that image, let us first deal with what they do. The first thing to say is that there are hundreds, if not thousands, of different types of hedge fund. The term “hedge fund” is in fact an extremely vague one, encompassing the activity of a very wide variety of funds that trade in currency and asset markets. Certain specific hedge funds may seem particularly synonymous with the term, but while their funds are some of the largest they are in fact the tip of the proverbial iceberg in terms of reflecting this section of the financial community.
For a start, most of them unlike their name do not hedge. Indeed, their aim is to take asset market or currency views, to increase risk albeit selectively rather than to hedge risk. Rather than tie up balance sheet capital through spot positions, they frequently use derivatives to express a view, using leverage. The amount of leverage that hedge funds are allowed to use has decreased significantly since the failure of LTCM in 1998. Hedge funds are still active participants in the currency markets, though their involvement has in fact diminished substantially for a number of reasons. Firstly, the LTCM failure caused the counterparties of hedge funds — the banks they dealt with — to take a broadly more conservative approach with regard to credit and leverage given to the hedge funds. This in turn reduced the ability of hedge funds to take on the large, leveraged positions they had in the past. Secondly, the global equity rally (i.e. bubble) in 1999–2000 represented a competitive threat to this sector of the financial community. Hedge funds achieve popularity with investors precisely because of their outperformance to “the market”, that is to the traditional equity and fixed income markets. Thus, when equity markets were exploding higher in 1999, it became extremely dif?cult for some to achieve that outperformance, particularly when this took place at a time of deterioration in the relationship between hedge funds and the rest of the financial markets in the wake of LTCM. Thirdly, the larger a fund becomes the more unwieldy it can become in terms of its market positioning. Benchmarks have to be outperformed and that can be achieved only with size when traditional markets are performing well. Yet, to do that may lead to market disruption, both on the way in and on the way out, reducing the attractiveness of taking the original position. In the end many hedge funds became trend followers in 1999, buying the NASDAQ and running with the crowd, more with the aim of defending returns than generating greater returns. Currency speculation is generally less attractive during times when traditional asset markets are trending so clearly, given that a fundamental part of currency speculation is tofind economic imbalances — positive or negative — that the markets are not pricing in and trade on those in the expectation that the markets will eventually realize such imbalances and trade their way. Several hedge funds reduced their currency speculating operations in 1999. This decision may have been somewhat premature. The bursting of the equity bubble in 2000 has brought hedge funds the opportunity to add value once more, including doing so by means of currency speculation. Indeed, it would not have been difficult to beat the NASDAQ’s return in 2000 and the first half of 2001! Equally, while there may have been a reassessment of hedge funds in the US, both from within and without, the hedge fund community has blossomed and flourished in Europe subsequently, particularly in several countries in continental Europe. The umbrella term of “hedge funds”, even those that focus on the same asset or currency or have the same trading style, can reflect a variety of different types of organization. Recently, a number of total return or leveraged funds have been created. These may have not have a strict mutual fund structure, which helps at least to give some definition to the traditional hedgefunds one thinks of, but they do have a very similar trading approach. In addition, banks can have internal hedge funds for specific client products. In sum, there are a very large number of hedge funds that “speculate” in a large number of assets and currencies. The performance of speculative currency funds is measured by a number of organizations, including the MAR (Manager Accounts Report) Trading Adviser data (available at: www.marhedge.com), Parker Global (www.parkerglobal.com) and the Ferrell FX Manager Universe. The irony with regards to their critics is that most base their trades either on inconsistencies in market pricing, which can instantly be arbitraged, or on sound macroeconomic principles. This latter group, known as the “macro” hedge funds, make up by far the largest group of funds that are publicly known. They are speculating according to fundamental principles. Thus, one could argue they are not speculating at all.
While many may seek to make a clear distinction between speculative and non-speculative activity, any such line of distinction is frequently uncomfortably blurred. At its most basic level, there is the idea that corporations take currency positions purely for transactional or hedging purposes, while hedge funds or prop dealers take currency positions for directional gain, with no underlying asset. The idea that there is such a clear distinction between the two sides is a fiction. Over the last decade, several major corporations have experienced painful losses and some have even collapsed as a result of taking on financial market positions that subsequently went sour. In this regard, problems tend to start when financial speculation overtakes the underlying business in importance.
Whatever the case, there are therefore other currency market participants we need to examine, which can at times be considered as currency speculators. Though many would no doubt bristle at the term, that is what they are if the individual transaction they are conducting has no related, underlying asset.