Modern market theory states clearly that no one can do much better than the average market performance for very long because universal information availability and transparency — the notion that everyone can see what the winners are doing and copy it — will force a rapid regression to the market’s mean performance level.
It’s also conventional wisdom that, because there are really many uncorrelated “markets” for different classes of investable assets, you should spread your investments across the different areas where markets are made. This lets you balance risk — you might lose everything if a single market crashes — with reward – you might get rich if you somehow bet exactly right. That is the basis of most “asset allocation” strategies.
According to efficient markets theory, rather than try to pick winners, your portfolio should be as much like the market (and everyone else’s) as possible. In the financial world this often means following an index (or a collection of indices) that mirror the structure of the market. Only if you can bet big (very big) and thus move the market in a particular asset class should you try to do better than the average.
If you want to beat the market theorists, you only have three tools: concentration, turnover and leverage. In investment terms this means: (a) fewer but larger bets; (b) short time horizons for the bets to pay off; and (c) using borrowed capital to make the (bigger) bets with. The theory behind the strategy is that you can find enough opportunities that the overall market has so far missed (and hence undervalues the assets), cash in quickly before the market catches on (as theory says it must) and then move on to the next “hidden” opportunity.
Notice that this is a very different approach from the asset allocation models that urge diversification across uncorrelated asset classes, low turnover (to reduce trading fees) and a periodic rebalancing of the portfolio as different asset classes go through cycles of performance.
What’s all this got to do with corporate investments in new products and services and how does it impact the CFO? Think of the average organization as a kind of specialized investor employing an asset allocation strategy. Using other peoples’ money (business unit capital), the CFO orchestrates a portfolio of investments in asset classes (technology, facilities, people, products and services, marketing campaigns and so on) that will generate returns for the business.
Each of these asset classes has a required investment cycle (build or buy; deploy; support and enhance; retire) and an expected “yield profile” that provides the basis for a return on the investment. Doing only safe and obvious things is unlikely to get you what you want, so some risks are necessary, but risky investments should have a higher yield.
The challenge for the CFO — just as it is for the manager of purely financial assets — is in maintaining a balance among the asset types, most of which have very different yield profiles and associated risks. Spend too much on core operational improvement efforts and you won’t be competitive in rapidly emerging market areas. Ignore “infrastructure” and your operational costs will increase as changes in technology drive new cost-effectiveness opportunities you can’t take advantage of. Ignore the basics to do only innovation-driven projects and core operational capabilities can suffer. Getting the balance right isn’t easy or obvious, but it is critically important.
Most of the CFOs I know have opted for a corporate version of “efficient market theory” in part because they have limited discretionary investment capital these days. As a result, most corporate portfolios look pretty much the same, making truly differentiated business capabilities are quite rare. Add in the fact that most portfolios also have low “turnover” — new investments tend to be added to older ideas rather than replace them — and the corporate portfolio takes on a “mature” look. In financial investment terms the portfolio looks like a risk-averse, infrequently balanced 401k.
It doesn’t have to be like this — and some CFOs have recognized that a different approach is possible, although, as with successful financial investment, it takes hard work and can be risky. Let’s look at how our three “beat the market” tools might apply to managing a portfolio of corporate programs and projects.
We start with concentration. In most businesses there is still more diversity of facilities, processes and technology than there needs to be. Simplification, standardization and consolidation can have had a big impact on returns — and not just from economies of scale. Labor and management flexibility are also enhanced. And when something needs to change, it’s going to be easier and less risky if it’s already standardized into common practices.
CFOs often tell me they don’t like to be too dependent on a single supplier (they fear “lock-in” and a lack of pricing leverage) while bemoaning the cost of integration and support across multiple products and platforms. A more concentrated strategy does have risks, supplier viability amongst them, but a simpler, more standardized approach also lets us use our second tool — portfolio turnover — more effectively.
Turnover affects the organization in two ways. Firstly, shorter lifecycle stages (and the projects that we do to implement these stages) gets us to the available benefits of new investments sooner and allows us to change course (if and when we need to) more frequently. Frequent small course adjustments are much better from an investment optimization point of view than large, infrequent course changes, although they require much more sophisticated measurement and decision-support systems.
Secondly, shorter overall life-cycles require us to shift from an ROI model based on cost to one based on returns. In essence, we can choose between increasing our ROI by decreasing the cost for a given level of return or by increasing the return for a given level of cost. This might seem a minor distinction, but in practice very different investment strategies (and mind sets) are required to make the different approaches work.
Our final tool is leverage: using “borrowed” capital to make the investments so that our bets can get bigger. We’ve already noted that CFOs already use their business unit “customers’” capital for their investments, even though this is often hidden in the ROI model (they don’t factor costs of capital into the model). We can go beyond this, however. With the right level of concentration and turnover in place, capital from one set of investments can create capabilities that benefit other sets of users. Customer relationship management, product lifecycle management and common infrastructure investments are good examples. We need to find a way to ensure that the initial investor doesn’t carry all the cost (or risk) when the benefit accrues to others, but there are several ways to do that.
There are a couple of final twists to worry about. Just as all investments don’t have the same unit price or potential yield, not all corporate projects have the same absolute cost or level of return. It’s tough to know whether to spend $20 million on one large project, $2 million on 10 small projects or something in between. This is another aspect of balancing the portfolio: in most organizations you want a mix of moderate but certain yields and high but less certain yields. Not all the projects bearing higher risks will come out right, but the mix, if managed right, will give you the aggregate yield you need. And you don’t want anything that has a low and certain yield — unless you have no choice. Most of all you don’t want guaranteed losers — and it amazes me how many portfolios actually contain a few.
Accept the mixed portfolio notion and you’re also going to have to periodically dump investments that don’t meet your yield criteria and replace them with investments that do. That means killing projects or platforms that don’t work out, and that’s always hard to do in the real world. Get it all right (or mostly right — no one gets it all right), and you’ll be in as good a shape as possible.
You can read part two of this column here.
John Parkinson is an affiliate partner at Waterstone Management Group in Chicago. He has been a global business and technology executive and a strategist for more than 35 years.