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


First Capital, Then Strategy

Alternatively, the short-term payback can be generated finan­cially — by increasing the dividend or initiating a stock buyback. In 2006, media giant Time Warner fended off a boardroom coup by financier Carl Icahn by acceding to his request for an accelerated stock buyback program. Icahn ultimately went away, taking his larger threats with him.

Whatever executives do to generate short-term returns, they will gain traction to the extent that they are doing what the hedge funds, sovereign funds, and private equity firms would have them do anyway. There is no shame in such a stra­t­egy; it’s part of surviving.

As executives’ priorities shift this way, they are left with the question of what constitutes a sufficient level of short-term payback — and how they can ensure it. Two steps are required to figure this out.

The first is pinpointing the half-life of investor demand for a given industry — how many years, on average, shareholders tend to stick around. Investor fashions change, so this number is not fixed. Still, there is often a positive correlation between investor tenure and the predictability of an industry’s profits. Industries that produce more predictable profits can, in general, be more open about taking on additional risk.

The second step involved in figuring out how much overt risk to take on is understanding the discount rate investors use to evaluate the payoffs from long-term projects. Lower rates, of course, imply more-certain cash flows. If you were Nokia at the beginning of the cell-phone boom in 1998, with your business taking off in every corner of the globe, you could be pretty sure that most of your investment in new mobile devices and in R&D would increase your profit. That’s a long-term undertaking with a low discount rate. Conversely, if you are a biotech company in 2008 working only on a cure for pancreatic cancer, you have no idea whether your compound will work or get government approval. It’s a Hail Mary: high discount rate.

Though the calculations aren’t simple, these parameters allow for at least some comparisons between industries. For instance, you would expect media companies, which rise and fall based on individual “hit” products (a movie sequel here, a prime-time television show there), to look for ventures that produce more stable short-term returns. And you would expect beverage companies, most of which generate plenty of cash, to have the license to do more things that represent overtly long-term payoffs. Thus, an in­creased dividend would probably go farther to mollify investors at Walt Disney Company than it would at Pepsico Inc. Similarly, an e-commerce company that ends a costly promotional initiative — and increases its near-term profit margin — would gain more with investors than a household products com­pany that did the same.

Other factors also enter the equation. One is the size of the long-term investment. For instance, although a regional electric utility company such as Duke Energy (based in Charlotte, N.C.) could theoretically take advantage of its predictable returns to build a new nuclear plant, its investors might not support Duke if it decided to build five plants — an undertaking that would require a capital outlay equal to the company’s entire market value.

Thus, to their industry-related calculation, or what might be called the “fickle capital” quotient, executives must add factors specific to their company. This requires, to begin with, unflinching answers to the questions we posed earlier: How much capital can the company attract, at what cost, and how much patience can be expected of stockholders and bondholders? That’s the fact-finding part of the mission. The trick lies in deliberately allocating the capital between a mix of short- and long-term projects. If you have to sell one of the “cash cows” in your domestic portfolio at a pre-peak price to fund a 10-year foray into China, then that’s what you do. In other words, if you can’t trust investors, with their increasingly impatient mind-set, to allocate the capital you need for long-term investment, you’re going to have to raise the money yourself and move it around.

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