Perspectives Managing Through the Lean Years
Managing Through the Lean Years Remember the Pharaoh who dreamed about seven fat cows and seven lean cows? Joseph interpreted the dream to mean that Egypt would experience seven years of plenty followed by seven years of famine. The solution: put aside grain during the fat years to meet the needs of the people during the lean years. If only it were so simple today. For nearly 20 years, unprecedented profitability, declining risk, and a host of new growth opportunities have led to ever expanding equity values. Today that expansion has come to an end. Investors allowed simple extrapolation of those strong trends to be factored into share prices, creating an expectations bubble that companies had no hope of fulfilling. More than $10 trillion of market value has already disappeared since early 2000, turning investor psychology and momentum strongly negative. Corporate earnings are under pressure; many companies are now deeply in debt; the economy s growth has fallen off substantially. As if all that weren t bad enough, management credibility has suffered as more and more investors have come to the conclusion that too many executives became rich during the fat
years from performance that was mediocre, unsustainable, or outright fraudulent. Senior executives don t have seven years to prepare for these changes. They must cope with them now. To do so, they need to challenge some managerial assumptions that became ingrained during the fat years and that continue to guide behavior and expectations even though they have become dangerously dysfunctional. Executives must also rethink their entire corporate-development agenda to make sure it focuses on how to create value in a much tougher business environment. Dysfunctional Norms To appreciate just how difficult the current moment is for many senior executives, think back to some of the factors that contributed to the unprecedented period of growth that began in the early 1980s: The cost of capital fell, driven down by more efficient and more liquid capital markets. A decade ago, most companies assumed a market risk premium of about 6 percent. Today the norm is closer to 3 percent. Profitability increased. Before 1985, the aggregate level of profitability (measured by cash flow return on investment, or CFROI) for the largest U.S. companies had been stable at around 7 per-
cent. For the past five years, however, it has plateaued at more than 11 percent almost twice the corresponding cost of capital. Although CFROI has decreased somewhat in the current downturn, it is not yet clear how low it will go or how permanent the change will be. Average growth rates for big corporations were higher than the historic norms, reflecting the impact of globalization, the merger wave, technological advances, and stronger underlying growth in GDP for many economies. Together, these forces helped deliver an unprecedented 15 percent annual total shareholder return (TSR) over 20 years a level unmatched at any time in history. Much of what happened during the fat years established a set of powerful norms for investors and companies alike norms that persist despite the radically changed economic environment of today. For example, CEOs still commonly aim for double-digit growth in earnings per share (EPS). Some have even publicly committed to targets as high as 15 percent. And yet, as a glance at history clearly shows, 7 to 8 percent is the longterm norm. Views on incentive compensation have also become outmoded. In particular, the reliance on sizable stock options to align and motivate the senior management team seems increas-
ingly counterproductive. In a world where share prices will be hard to move upward and dividends are increasingly attractive, companies that rely on options as a primary compensation tool are going to find themselves unable to retain top talent. Today such beliefs could amount to a recipe for disaster. Of course, it s impossible to know for sure how the markets will behave over the next decade. But the following scenario seems plausible: The high CFROIs enjoyed by U.S. companies today will come under pressure, removing existing price umbrellas. If CFROIs revert to normal historical levels, the result will be an enormous drag on share markets and less cash to reinvest for growth. Equity values will not only deflate to intrinsic values but also overshoot (as has happened repeatedly in history). We could face an extended period when companies trade at a discount to intrinsic value a trend exacerbated by baby boomers taking money out of savings to fund consumption in retirement. In an effort to deliver against unrealistic EPS expectations and keep the share price moving, companies will progressively harvest the future in order to boost short-term performance. Put simply, they will milk their businesses thus undermining the foundations of future growth.
Management for the Lean Years What must companies do today to avoid this vicious circle? Here are six suggestions for managing through the lean years: Revisit the logic of your portfolio. Now, more than ever, is the time to make sure that the portfolio comprises only fundamentally healthy businesses. In the 1990s, a company could achieve reasonable growth in share price if its performance put it in the top twothirds of companies; today it will require being in the top third or better. A company cannot achieve this goal when it has the albatross of low-cfroi businesses hanging around its neck. Executives will need to be hard-nosed about such businesses: they will have to turn them around or get them out of the portfolio fast. And those businesses that remain will need to be managed for long-term strength, in a manner that protects and builds competitive advantage. Eliminate internal barriers to growth. In the long term, growth is by far the main contributor to TSR more than improvements in margins or asset productivity. And yet, over time, every company develops internal barriers to growth that hinder its ability to build new businesses. Typical examples include overly democratic capital allocation, toofrequent rotation of line managers, and shortterm incentives that encourage managers to
milk their businesses. During periods of relatively easy growth, companies tend to ignore such practices. In lean years, no company can afford to overlook them. Look beyond earnings per share. Although growth is critical, managers need to give up their exclusive focus on EPS growth especially when that growth comes at the cost of lower return on investment and poorerquality earnings. It is equally important to focus on improving the relative valuation multiple, which is a function not only of growth prospects but also of balance-sheet risk, operational risk, and management credibility. Unlike the absolute multiple, which is a function of macroeconomic and industry trends, the relative multiple can be managed: new techniques are letting companies analyze the drivers of their multiple and anticipate how specific strategic moves will affect it. 1 Exploit value-driven mergers. During lean years, mergers and acquisitions go out of fashion. Potential buyers are preoccupied with the declining value of their own stock as an acquisition currency. And yet, the evidence suggests that active acquirers in downturns have higher TSR over the long term than companies that acquire during a boom. As market 1. For a more detailed discussion, see New Directions in Value Management, BCG Perspectives, November 2002.
values deflate, there are many excellent buying opportunities for those management teams that really understand what drives value in their businesses. What s more, they can use the cover of the downturn to strip away nonperforming assets and restructure their company and their industry. But to succeed at mergers and acquisitions in the current environment, executives must view them as an integral part of a coherent corporate strategy not just as a quick way to boost earnings. Engage in a direct dialogue with investors. In an era of diminished investor confidence, companies will have to increase disclosure about special-purpose entities, consolidations, and industry-specific accounting practices. But that s only the start. They must also engage in a direct dialogue with their longterm shareholders. Indeed, they should start applying to these investors some of the same strategic disciplines that companies typically apply to their most important customers. 2 Redesign executive compensation. Despite all the controversy about whether or not to expense stock options, the fact is that options are a lousy way to motivate managers to create shareholder value. They reward executives in boom times for improvements that often 2. For a more detailed discussion, see Treating Investors Like Customers, BCG Perspectives, June 2002.
have little to do with their contributions to the business (and, conversely, penalize them in downturns no matter how successfully they perform). Now is the time to compensate senior executives in terms of relative, not absolute, TSR and to link compensation to sustained long-term performance. A company s relative performance compared with a carefully selected peer group better reflects what management actually contributes. And in a share market that is likely to go nowhere for some time, denominating incentive rewards in cash or restricted stock options will probably be a more effective way to attract and retain talented people. Together, these moves add up to an aggressive corporate-development agenda. This agenda is the modern-day equivalent of the grain stored in ancient Egypt. It is what companies need to see them through the lean years. Mark Joiner Mark Joiner is a senior vice president and director in the New York office of The Boston Consulting Group and leader of the firm s global Corporate Development practice. You may contact the author by e-mail at: joiner.mark@bcg.com The Boston Consulting Group, Inc. 2003. All rights reserved.
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