The Fringe Benefits of Failure and the Importance of Imagination

JK Rowling's Commencement Address to the Harvard graduates of 2008.
I was skeptical at first but she really impressed me and her speech is actually so much more profound than it seems at first sight. I have a new found respect for this woman and the way she lived her life and I think there are really some valuable lessons to take from this speech. Below my favorite parts:

"So why do I talk about the benefits of failure? Simply because failure meant a stripping away of the inessential. I stopped pretending to myself that I was anything other than what I was, and began to direct all my energy into finishing the only work that mattered to me. Had I really succeeded at anything else, I might never have found the determination to succeed in the one arena I believed I truly belonged. I was set free, because my greatest fear had been realised, and I was still alive, and I still had a daughter whom I adored, and I had an old typewriter and a big idea. And so rock bottom became the solid foundation on which I rebuilt my life."

"So given a Time Turner, I would tell my 21-year-old self that personal happiness lies in knowing that life is not a check-list of acquisition or achievement. Your qualifications, your CV, are not your life, though you will meet many people of my age and older who confuse the two. Life is difficult, and complicated, and beyond anyone’s total control, and the humility to know that will enable you to survive its vicissitudes."

"Choosing to live in narrow spaces leads to a form of mental agoraphobia, and that brings its own terrors. I think the wilfully unimaginative see more monsters. They are often more afraid."

"What we achieve inwardly will change outer reality. " - Plutarch
"As is a tale, so is life: not how long it is, but how good it is, is what matters." - Seneca

If you want to see the full speech, it is here:
http://harvardmagazine.com/commencement/the-fringe-benefits-failure-the-importance-imagination

You know you're Romanian when....

You know those Facebook groups "You know you're this or you've done that when..." - well there is one for Romania as well! Here are, in my opinion, the "best of"s of that group (the wordings belong to the author, Adrian Popescu):

You know you're Romanian when...

...Everything you eat is savored in garlic and onions.
...You are standing next to the two largest suitcases at the airport.
...You talk for an hour at the front door when leaving someone's house.
...You can fit 10 people into a Dacia.
...Your mom tells you you're too skinny even though your 30 pounds overweight.
...Your dad ever butchered a pig or lamb. [or a chicken for that matter]
...Your mom ever chased you with a rolling pin or a broom telling you to stop so that she could hit you. [I couldnt say that's true for me but it's a funny one!]
...You don't use measuring cups when cooking.
...If you don't live at home, when your parents call, they ask if you've eaten, even if it's midnight.
...Your parents don't realize phone connections to foreign countries have improved in the last two decades, and still scream at the top of their lungs when making foreign calls.
...Your parents brew their own wine and ţuică
...You say "La Mulţi Ani" for every holiday.

Timing investments

I was just reading this article about timing strategic moves and i think this is the key question on every CEO's lips nowadays. As the stock markets start to recover and investors slowly regain confidence, many companies predict a growth in earnings for the following year and start venturing into long term planning and strategic investments again. These strategic investments might be big investment projects or acquisitions of rivals or of complementary businesses. Indeed, there is a lot of value in M&A deals at the moment, as companies that have overcome the financial crisis and have a stable cash position can look into acquiring businesses at a discount of over 30% compared to 2007. Similarly, according to McKinsey Quarterly, some investment projects might be considerably cheaper now than they were before, although I am not sure we can say this is the case for most industries (I am inclined to believe it is more an effect in a specific sector/company than a generalized trend). In any case, investing now is a good move to secure a better competitive position, as it can give the company a headstart compared to its rivals that are cutting growth plans and focusing on the short term. Innovation will be key to get out of the slump, and developing new R&D projects is costly and time consuming - therefore there is a clear benefit for the companies that invest now and will be able to ripe the benefits of innovation much earlier than their rivals. However, we are talking about sizable investments which, if undertaken, can expose the company to a significant risk and maybe even weaken it completely. Therefore timing of these moves becomes key: executives should wait long enough to have some visibility on where the market is going, but not too long, because otherwise they will lose the inherent value in buying these projects now. If they wait too long, everybody will see the interest of these deals and will be willing to invest, the prices will go up and thus will eat up the perceived value. So how can one determine the right timing for these investments?

McKinsey Quarterly proposes scenario analysis, which, I believe can indeed be a good tool. In their case, a certain strategy was clearly superior to the others in all scenarios considered (i.e. invest now rather than wait, because the benefits of waiting are too low compared to the possible losses in the value of the projects). However, what happens if there is no such clear cut strategy emerging? Scenario analysis can give us an idea of where the value of the investment evolves depending on the direction of all the uncertain variables, but it is not always a decisional tool, as it does not offer a combined value for that opportunity on which to decide. It's not like the NPV, where you can clearly state that investing in this project is worth that much, and if it's bigger than this number, we should always go for it. With scenario analysis, you know that if scenario X happens, then your project is worth this much... in order to get a global value of the investment you need to assign probabilities to each scenario which, in my opinion, is impossible to do in the current economic context where any attempt at previsions is mere guess.

What companies need is a tool that allows them to integrate uncertainty, avoid making previsions and still help them decide whether to invest or not, and, most importantly, when is the right time to invest. For corporate internal projects, this is exactly what the Real Options method does. Based on the financial options pricing framework, namely binomial pricing , the Real Options approach considers that management has the option (the right, but not the obligation) to purchase a certain investment project by investing the required amount. This model allows companies to express the full range of the uncertainty in a binomial present value tree, avoiding the need to make predictions and commit to numbers which are impossible to get right. Real Options valuation considers that the project is actually an American call option, and so using financial options pricing allows management to identify the best timing for its exercise (i.e for making the investment). It also discounts into one single number all the possible values of the project, be they negative or positive NPVs, thus taking things one step further than scenario analysis, because it becomes a decision tool. The decision criterion is: if adjusted NPV with RO value > 0 we should invest in the project. Thus, this framework is a bit more standardized and rigorous than scenario analysis for timing investment projects and their phases. However, I have been thinking if this could also be applied to value companies for M&A?... I am not sure yet..i'm afraid I will leave this open for discussion for now.

Funny Dilbert

A different view on strategy

For those who know me for a longer time, you know that I have always been interested in business strategy and management, and that I wasn't much of a finance person. In fact I didn't like finance at all. But an interesting turn of events made me pursue a master's in corporate finance and I am surprised to see, that at the end of this year, my perception has changed dramatically. I now realize I had been looking at the wrong kind of finance - or rather looking at it in the wrong way. Now it's become my favorite subject and I understand, after putting myself in investors' shoes for the whole of last year, that any strategy that doesn't take into account finance is shallow and empty like an old coffer: you expect to find treasure but instead there's nothing but dust.

I could start by giving all these arguments related to investor's motives for starting or financing a business, such as gaining a return higher than they would by putting their money into safe instruments like bonds or bank accounts...and how a company's strategy should be steered to achieve this goal and provide to investors (shareholders) the minimum rate of return that they expect. But there's nothing new here - we all understand this more or less intuitively. What I did not understand that well until this year is just how much corporate finance is a decision tool in setting and steering a company's strategy.

Although that might sound weird at first, by thinking that a company's strategy is in fact represented by its collection of investment projects it all starts to make more sense. Indeed, to see what a company's strategy is, look at its budget. Their investment decisions and the projects they pursue uncover the true direction in which they are heading. Of course, I am not trying to wipe out the entire strategic process - there is unquantifiable value added in setting the long term direction of the company, anticipating future trends in the industry and devising tactics for a better competitive positioning. But when it comes down to one step further towards the implementation of this long term vision, financial decision making is key. If strategy is a collection of investment projects, then project portfolio management and investment decisions are strategy's true drivers, so project valuation and considerations about profitability of investments are key tools used to set the strategy. A great vision about the future but with the bad investment decisions will definitely lead to catastrophic results.

In this context, an interesting question is the issue of cross-subsidizing, especially when we think about product portfolio management. Quite often, a company finds itself in the situation of evaluating a project which is of strategic importance but has a negative NPV so it is not profitable on its own (ex. keeping operations running in a certain country to maintain a position and avoid competitors taking over that market segment completely). Should the company pursue this project? If they believe that the loss they would make by not keeping these operations open is higher than what they lose by committing themselves to this project, then they probably should - based on the fact that the loss of this project will be subsidized by the earnings of another project. But what happens when there are more projects like this to consider? How many and up to what amounts should the company subsidize, to avoid eating down the profits from the other higher value added projects? This is an interesting question to look at in the context of strategy setting. (the Real Options method helps ease the decision making in this context but I will probably talk about that in more detail in a following post). So are mergers and acquisitions - essential growth possibilities for some companies, but which can lead to failure of the entire group if not performed correctly. And here the financial considerations are again extremely important, as there is a tendency to overpay the target thus eating out most or all possible synergies.

These are just a few examples and a few ideas that came to my mind now, but this master's degree has been full of such examples that drew my attention. It truly opened my eyes and gave me a new perspective. I think Porter is good. Porter is great! But if Porter is not backed by numbers, it is worthless, it cannot add value. And unfortunately as I look at the strategy consulting industry I see a lot of times (maybe more so in boutique companies?) that the recommendations are based on pure qualitative analysis, experience of the industry and market studies, but not enough on finance. What will the future look like? I'm curious to find out!

Market for innovation

I stumbled upon a very interesting concept today while researching something at work: www.fluidinnovation.com. I think this is an amazing idea: it is in reality the equivalent of a market for innovation, as any company that created any kind of improvement, innovation, process etc that is protected by a patent can sell it to other interested parties through this intermediary. It probably exists for a long time, and I am sure this is not the only company of its type, but I must admit I have never wondered how companies go about selling licenses of their patents and capture the associated profits. Seeing this it all dawned on me. Indeed, it is pretty straightforward for example for a software development company to produce and sell licenses for its software, because this is their core competency and their business model relies on marketing these licenses. Thus is makes sense to keep this process in house.

However, when a company like Boeing develops a new method for valuing investment projects using Real Options, it cannot really go about trying to market this innovation and sell it to other companies that might be interested. Why not? Because it is not their business. Their business is to make and sell airplanes, not investment decision software, and they would have no interest to allocate internal resources to diversify in that area. As a result, they would own a sleeping patent, one which could generate revenues but does not because a sustained, coordinated internal effort to market it would not make much economic sense given the company's business model.

Also, another benefit I see for this initiative is that it helps innovation to develop even more. New knowledge builds on the existing stock of knowledge, and a market for innovation only allows to broadcast the new discoveries to a wider public and especially to the interested parties. This should facilitate related innovations in these companies and create a synergy effect.

Shareholder value

Today’s ‘Strategy and Financial Policy’ class raised an interesting point regarding strategy and shareholder value creation. Over the 2000-2005 period while the world economy grew at about 3%, shareholders had set unrealistically high targets of, on average, 6% revenues growth and 12% earnings growth for their companies. Empirically, a study conducted by Bain & Co looking at 1,854 companies over the last 10 years finds that only 240 of them (13%!) actually managed to earn their cost of capital. Does this mean that the shareholders were over-demanding, or simply that the companies were bad?...

To answer this question, I would analyze the reasons that make us believe that shareholders might be asking too much of these companies. This issue is especially important nowadays, in a period of crisis, where shareholder demands put more pressure on companies to seek short-term, external growth through M&A rather than sustainable organic growth. At first glance, what strikes me is that shareholders set a target of 12% increase in earnings whereas they only demand a 6% increase in sales. This would mean that about half of the growth in profits should come from cost reductions and improved efficiency! This is obviously not sustainable over the longer term, especially if we look at the fact that the 6% growth target for sales is very ambitious as well (double that of the market).

However, this is not the main problem. The biggest question here is whether the shareholders are entitled to ask for a 12% return given the riskiness of the company’s activity or they are just setting an unrealistically high target. As we know, shareholders have the right to ask for the CAPM rate of return, which is basically the risk-free rate + the market risk premium adjusted for the riskiness of the company. Now, when we calculate the risk premium we basically look at the average return on the S&P over a very long period of time (ex 1926-2006) but in this way we dilute the impact of economic shocks, such as periods of crisis… whereas now we are precisely in such a period. Thus it becomes questionable whether the risk premium we should use during crisis should be the same, because when all markets collapse, demand falls and uncertainty rises we cannot expect the companies to earn the same returns as they did two or three years ago. If indeed the shareholders set their expectations according to the CAPM rate of return, then these might indeed be unrealistic and become a too high target for the company in the current conditions. It is very likely that this is what was also happening in the 2000/2001 crisis… and this is perhaps why many companies did not manage to meet their targets and earn the required return on equity capital after servicing their debt. This is in fact saying that the companies are not bad, but that, indeed, shareholders probably asked for a too high rate of return. How the shareholders should react is by adjusting their demands to more reasonable levels: seeing that only 13% of the companies were able to earn their cost of capital should send a clear signal to investors that they should lower their targets. All companies cannot be bad performers, and it is more likely that shareholder expectations lag behind new market developments.
I would say this situation is reinforced by the company’s managers as well. Even though it’s the shareholders, through their power to change the CEO, that decide on the revenue and earnings targets that the company should achieve, managers have an incentive to show a growth in earnings and profits as well. This is mainly because analysts and investors tend to look less at the company’s performance in that year in isolation or as compared to the competitors, than they do as a comparison to the previous years’ performance. Thus managers have a pressure to provide every year higher earnings (or at the very least, show no losses), be it through M&A or simply through questionable accounting practices such as earnings management.

However, what should be the appropriate return for the risk incurred in this case by the shareholders, and how the market risk premium should be assessed during a crisis period, remains an open question…