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 / Summer 2008 / Issue 51(originally published by Booz & Company)


First Capital, Then Strategy

Along with the removal of international barriers, this herd mentality explains why market bubbles are happening more frequently, are of greater intensity, and are bursting (when they inevitably do burst) more dramatically. The dot-com implosion at the beginning of this decade shouldn’t have been a surprise — that’s what happens when investors stop thinking critically and clamber into the latest hot stock group or asset class, pushing it to levels that defy reason. A similar implosion is taking place now, of course, with subprime mortgages. Next up could be the bursting of a bubble in commercial real estate, which has doubled in price in the last seven years. Or maybe the bubble will be in commodities, if justifiable bullishness, brought about by emerging-country demand for raw materials, attracts copycat speculators. No one knows for certain where the bubbles will form or when they will burst. We only know that, with the herd mentality currently in place, more speculative bubbles are coming.

For executives trying to figure out how they’re going to kick off their company’s five-year strategy session, the changed investor environment poses a dilemma. On the one hand, long-term investments cannot be abandoned. Many companies tried such a strategy during the 1980s and ’90s, focusing only on short-term returns, and in most cases those companies have been acquired. In a global market where customers can quickly discard old brands for new ones, innovation and investment in new technology may be more important than ever. And those who live by expediency die by expediency.

On the other hand, few shareholders are going to hitch their fortunes to a management team that says, “Look, we’ve got a five-year journey ahead of us; stay with us.” That appeal might have resonated in an earlier era, but it doesn’t work with the hedge funds, private equity funds, and sovereign funds that increasingly constitute a company’s most vocal shareholders. Whatever else those shareholders may be, they are not a CEO’s friends. Their willingness to fund a company’s capital agenda cannot be assumed. It must be stress-tested.

The Fickle Capital Quotient
Increasingly, an effective capital-procurement strategy — whether based on debt, equity, or a com­bination of the two — will require the same kind of market segmentation of the capital base that many companies already conduct for their customer base. The questions that executives must answer include: Who is providing our capital and over what duration? Under what terms and conditions are they providing this funding? What are they expecting in return for their investment? And what actions will they take if we don’t meet their expectations?

As part of the same analysis, executives should ask themselves some broader what-if questions that could also affect their access to capital. What if interest rates spike? What if the short-term debt markets choke us off? What if our sector falls from favor? What if an influential shareholder group such as CalPERS suddenly rejects us for its own reasons, such as perceiving us as not being green enough?

Executives whose companies have been the target of activist shareholders have already gone through this self-assessment process; they’ve had to. But getting a read on capital sources should be a priority for every executive today, whether a hedge fund is knocking at the door or not.

In many cases, the only way to appease one’s capital base and maintain access to capital is to generate short-term returns in a way that reinforces long-term prospects. This can be done operationally, by picking projects whose near-term success is virtually certain — for instance, outsourcing a function to generate immediate savings or revenue instead of undertaking the long-term investment that would be required to build the capability internally. An example of a real-world missed opportunity: In 2007, Yahoo was reported to be considering a partnership with Google to boost its search results. Had Yahoo consummated such a partnership, it would have been assured of higher near-term revenue and profit — a circumstance that might have helped the company avoid Microsoft’s unwanted 2008 acquisition bid.

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