Risk

Portfolio Management’s Time Has Come

Which businesses to capitalize, which to wind down, which to scrap or sell off immediately: CFOs have to start guiding their companies toward hard ...
Vincent RyanMarch 8, 2013

Actively managing a collection of business units with the aim of allocating capital where it will earn the best return for a given amount of risk  portfolio management is perhaps the toughest job CFOs have. I was reminded of that listening to Eduardo Cordeiro, CFO of Cabot Corp., at the CFO Rising East conference in Orlando this week. Cordeiro told the story of how he shook up things at the $3 billion in revenue chemicals and performance-materials maker by reevalutating a portfolio that had been stagnant for about eight years. The result, after five years of work: historic increases in earnings and return on invested capital.

Internal corporate politics, pet projects of executive management, and a misguided sense of equality (“every business unit should have the same opportunity to thrive”) all interfere with a rational, numbers-driven approach to resource and capital allocation. And a clear, hard, objective look at the performance of businesses  the first step in portfolio management  is not easy to accomplish. But, particularly now, it’s essential.

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A McKinsey study called “How to put your money where your strategy is” found that companies that more frequently allocate capital generate higher returns than their peers. The study found “a major disconnect between the aspirations of many corporate strategists to boldly jettison unattractive businesses or double-down on exciting new opportunities, and the reality of how they invest capital, talent, and other scarce resources.”

Indeed, CFOs like Cordeiro who plan and implement a portfolio-management approach are rare. The financial crisis caused companies to close down and divest money-losing businesses, but that was a fight for survival and a desperate attempt to save cash, not a well-contemplated, strategy-driven exercise.

In a slow-growing economy, but one in which capital is so abundant and cheap (for most multiline businesses), CFOs may be satisfied with a less-than-optimal portfolio. A mature business limping along and earning low-single-digit returns can easily justify funding year after year. And, truth be told, CFOS are still wary about moving that low-yielding capital into innovative, higher-risk projects that could boost earnings and sales growth long term.

But portfolio management’s time has come, whether CFOs embrace it or not. Here’s why:

1) It’s a time of disruption. There are severe disruptions occurring inside U.S. industries (computing, banking, and retailing, to name three) that demand constant reevaluation of a company’s investment priorities. (If the management of Dell had analyzed returns on its PC business earlier, perhaps it would have thought to jettison it, and its shares wouldn’t have lost one-third of their value last year.) As a Fast Company column says, a company can either cause disruption or fall victim to it. Portfolio management can help companies “strike the right balance of long-term, higher-risk efforts versus less-adventurous projects with a higher probability of a near-term payoff,” CFO editor Kate O’Sullivan wrote in 2009.

2) Activist investors are attacking. CFOs can preempt activist investors by having a smart, detailed analysis of where the company is investing and with what return expectations. Increasingly aggressive shareholders are digging into company financials and questioning that capital allocation in detail. They’re not only demanding companies buy back more shares or issue one-time dividends, but, as in the case of International Game Technology,  they’re questioning the criteria CFOs use to determine when to buy back shares and proscribing what kind of instruments (preferred stock) companies should issue. With that level of scrutiny, companies need detailed forecasts and performance goals for every business. “It gives [a company] a great opportunity to build confidence and credibility with the board, investors, and other stakeholders,” said Cordeiro of portfolio management.

3) Unrestrained cost-cutting is over. Most CFOs have cut all they can out of overhead, boosting margins and profits but leaving little fat on business operations. The game now, assuming the economy sputters along, is capital efficiency ­across businesses and product lines. It’s not enough for a business to no longer lose money; it has to, on a risk-adjusted basis, out-return other investments. Pouring cash going into share buybacks and dividends has driven the Dow Jones Industrial Average and the S&P 500 to near-record highs. But a higher share price implies even greater expectations for future earnings. Assuming an economic boom is not around the corner, companies are going to have to be super-efficient with capital to deliver the yields implied in robust share prices.

4) Portfolio management is easier. That’s probably an overstatement, given the discipline, persistence, and patience it requires. But from the perspective of the availability of data and sophistication of analytical tools, portfolio management is within the grasp of more companies. The car-sharing service Zipcar generates tons of information on customer rental habits, fleet utilization, business seasonality, and business-line costs. At the CFO Rising East conference, Ed Goldfinger, the company’s finance chief, said he has more than 12 years of such data to drive behavior around cost allocation, pricing, fleet capacity, and  product strategies. It’s not just the amount of data that matters, though, it’s the visualization of it. “You [also] need interesting ways to capture and see the data,” he stressed.

Some of this requires a certain type of CFO.

In January, McKinsey consultants Ankur Agrawal and John Goldie described what they saw as the four types of CFOs. One kind is “growth champions,” a growing group that now accounts for 25% of new CFO hires. “They are most common in industries with frequent disruptions that require dramatic changes in resource allocation  and in companies that plan to grow considerably or reshape their portfolio of businesses through aggressive M&A or divestiture programs,” Agrawal and Goldie said.

I’m willing to bet money that in the coming years more CFOs will fit into or adapt to this mold. It’s really the next level up from being a CFO focused on operational improvements. Portfolio management requires high-level thinking and knowledge of the entire spectrum of a company’s businesses. And it has to be done with merciless objectivity.

Companies that avoid holding a mirror up to their organization to figure out what to fund, what to jettison, and what to let run on its own steam may eventually find stakeholders and shareholders making the choices for them. Investors and bankers, by selecting what areas they will take a stake in or lend against, will be perfectly happy to jump into the vacuum and make the tough portfolio-management choices CFOs don’t.