Thinking in investment cases

Directing and controlling a company includes above all setting and attaining its objectives, i.e. aspirations and goals, and aligning or at least balancing the interests of the many stakeholders. Addressing ‘governance arbitrage’ here promotes the philosophy of understanding businesses as investment cases, which makes corporate governance more measurable:

Thinking in investment cases adds time value of money and fungibility as evaluation criteria.[1] Being a good entrepreneur requires to be a good investor and vice versa. Investment cases should have a defined start and end – which is neither likely to be a fiscal year nor necessarily the start of a new CEO. This is no contradiction to long-term value creation with a next generation view or to a successful perpetuation of a company, as thinking in investment cases also represents a rolling model of a company’s development stages.[2] The length of each phase can be influenced by value expectations and investment horizons of shareholders, by the time required to execute a plan and its major initiatives, by a business cycle, or even the time to build a new business, but three to seven years seems to represent a common understanding.[3] Although Warren Buffet (referenced by Barton (2011)) “has quipped that his ideal holding period is ‘forever’”, fundamentally there is no imperishability in the business world, in particular not for products, for technologies as a differentiators and for business models. Naturally, in particular a majority shareholder takes the freedom to define his holding period alongside with satisfaction with returns, i.e. including for example legacy aspects. However, the key principle applies: “There are two ways to go: significant ongoing return of cash to shareholders or an attractive exit” (Viguerie et al. (2007)).

 

As well, when looking at a portfolio within a conglomerate of businesses or even more when looking at a project portfolio[4], a consequent thinking in investment cases is precondition to allocate financial and human resources between alternatives – strategy means choice (beyond of any anchoring bias). McKinsey research on 1,500-plus US companies has shown that during a 20-year period “the most aggressive reallocators – companies that shifted more than 56% of their capital across business units over that period – delivered 30% higher returns to shareholders” (Barton & Wiseman (2015)). In case of doubt when creating the required portfolio transparency, the due diligence of business units has to consider the sum-of-the parts while allocating shared assets according to the major user principle and applying transfer prices where needed in order to reflect interlinkages.[5] Taking then the overall portfolio perspective should complete but not blur the picture.

 

The related, specifying question is about the necessary elements to describe an investment case. First, an investment case should follow a compelling and consistent, long-term equity story, which reflects the strategic dimension of the business.[6] The case should systematically include the value creation drivers and potential, a portfolio of initiatives (plans and conditions for successful execution) and implementation horizons (short-, mid- and long-range focus). It needs to follow the principles of reward/risk profile and asset liquidity (‘exit’ opportunity).[7] To use an analogy from the EPC (engineering, procurement, construction) business, the resulting ‘value contracting’, i.e. committing to deliver the promise, combines ‘value engineering’ and ‘performance contracting’. Second, entry/exit timing of an investment (over the economic cycle) is of paramount importance, or even a core driver where investment opportunities are arising from discontinuities, like rapid organic expansion, M&A opportunities, disruptive technologies or succession planning (Baestlein (2014)). In particular in M&A, valuations based on multiples of money (MoMs) are exposed to economic cycles, are susceptible to fluctuations and perceptions regarding trends, and are sensitive to ‘peer group’ positioning and flavours of the capital markets.[8] Investors are looking for change correlated with the period in which it is to be made happen, i.e. “the life of the investment” (Gadiesh & MacArthur (2008)).[9] Being able to spot the change potential of a company and/or an industry before the price reflects it, i.e. recognizing the potential of a ‘superior’ investment case is one of the key strategic and entrepreneurial skills that justify ownership (cf. Porter (2008), Baestlein (2014)). ‘Buy low, sell high’ remains a winning formula.

 

With this in mind a key driver for any investment case is innovation as a combination of intellectual property, innovation pipeline and proven innovation power, i.e. the track record of inventing and making inventions work.[10] The innovation potential of a company, related to products and services, processes (quality / speed / cost improvements) as well as to the business model (e.g. access to markets), could be measured as margin increase and/or growth. It comes alongside with an organization’s potential for change. “Successful companies strike a balance between aspiring on attractiveness and anchoring on familiarity” (Kant et al. (2015)). Thus, ideally they leverage assets and capabilities to innovate in adjacent markets (cf. Kant et al. (2015)). The more facing globalization and digitization, innovating at scale gains importance.[11] Assuming a fair entry value, be it as virtual or real acquisition price, (i) the untapped market potential, depending on the size of the market and the speed of its saturation, and (ii) the innovation potential are typically the basis of the investment idea. The more a company is unable to meet its three- to five-year growth objectives, the more urgent the demand to explore innovation becomes (cf. Kant et al. (2015)).[12] Vice versa Goedhart et al. (2016) recommend for high-growth companies, “thinking about what the industry and company might look like as the company evolves from its current high-growth, uncertain condition to a sustainable, moderate-growth state in the future”.

 

The price of a company, the so-called enterprise value (EV) and finally the value of its underlying equity (EqV) is measured by valuation MoMs and IRRs. Value-based management, or here interpreted more active ownership oriented as equity governance, is about maximizing the equity, which is by definition a scarce and limited resource, invested in operational, human and financial assets. Maximizing the EqV by increasing the EV is the task of the management with the board of directors as a nota bene advisory and supervisory authority. Its success should be measured periodically by the increase of EV and EqV, and for an investor by the IRR of his equity investment. Responsible investing, and therefore governing equity, should pursue a long-term value creation.

 

Frankfurt, 7 December 2016

 

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[1] Thinking in business cases with a fair market value as starting point and an implied ‘exit scenario’ is the logical way to calculate a forward-looking internal rate of return (IRR) (Baestlein (2014)).
[2] “The investor of today does not profit from yesterday’s growth.” (Warren Buffet)
[3] Barton (2011) stresses that value expectations embedded in share prices typically relate by far more than 50% to activities and cash flows expected more than three years out. For the leveraged buy-outs (LBOs) of PE funds, where the investment period is limited time wise by the articles of association, in most base case scenarios the underlying practical, actionable time frame for getting to full potential – when considering performance improvement as the dominating lever for value creation – is three to five years (Gadiesh & MacArthur (2008), cf. Baestlein (2014)). Porter (2008) sees for most industries a three-to-five-year horizon as period for a full business cycle. And McKinsey research suggests, “the time required to invest in and build a profitable new business … [as] at least five to seven years”, which Barton (2011) considers as a rough definition of ‘long term’.
[4] A detailed description of portfolio management provides, e.g. Henderson et al. (1994, based on the model developed by the Boston Consulting Group in the early 1970’s, known as the ‘BCG Matrix’).
[5] One consequence of thinking in investment cases – except for volatile, high-velocity industries – is to consider tailoring the time- and resource-intensive strategic planning cycles to the needs of each business unit and to the success in executing the plan and its major initiatives rather than undergoing a full exercise in any given year (Dye & Sibony (2007)).
[6] “Storytelling is the ultimate example of creative judgment” (Twohill (2015)).
[7] Illiquidity demands a premium, i.e. management can balance short-termism but not endlessly, like a promise, which is nothing worth if not kept at one foreseeable point in time. The typical exit alternatives are a trade sale (to a strategic investor), an institutional buy-out (to a financial investor), and an initial public offering (IPO) or in a broader sense the recapitalization of a company.
[8] Multiples refer to comparable companies. “To apply multiples properly … [Koller et al. (2010) proposes] four best practices:
  1. Choose comparables with similar prospects for ROIC and growth.
  2. Use multiples based on forward-looking estimates.
  3. Use enterprise-value multiples based on EBITA to mitigate problems with capital structure and one-time gains and losses.
  4. Adjust the enterprise-value multiple for nonoperating items, such as excess cash, operating leases, employee stock options, and pension expenses (the same items for which we adjusted ROCI and free cash flow).”
[9] ‘Business as usual’, too often sold as continuity, is the greatest enemy of change and gaining from discontinuities – which typically offer the biggest upsides.
[10] Thus ‘innovation’ is in mathematical terms placed outside the brackets of the subsequently ‘market-to-equity’ algorithm.
[11] de Jong et al. (2015) surveyed the “essentials of innovation” and categorized them as strategic and creative (aspire, choose, discover, evolve) and executional and organizational (accelerate, scale, extend, mobilize): (1) Aspire innovation as important for the organization, e.g. based on a far-reaching vision, (2) choose, ideally out of a ‘seeded’ portfolio of ideas, (3) discover, e.g. market insights and a technical solution, and translate it into a winning value proposition, (4) evolve a defensible business model with scalable profit sources, (5) accelerate compared to competition in developing and launching innovations, (6) scale with the right magnitude and reach, (7) extend by developing the ecosystem and capitalizing on the external network, and (8) mobilize by embedding into the organization’s culture and rewarding.
[12] Christensen (2016) distinguishes between efficiency innovations (with surest returns), ‘sustaining’ or incremental innovations (to keep the market running, but per definition without creating growth) and disruptive innovations (with the highest upside, where simpler and cheaper products oust more complex and expensive ones) (cf. Christensen (1997).