Sunday, August 19, 2012

This Strategic Control Map is Nuts!

There are several perspectives we can take on strategy.
One approach is to view our finance group as an independent business, and then deploy strategic tools to understand how to fulfill our mission and vision better (see for example “Rollin' the DICEE -Another Take on the Treasury Vision”). This is a helpful exercise that will lead to improved performance within our organization.
Another option is to take the overall organization’s perspective. This is important if finance is going to be a strategic contributor within the company. The strategic role of finance is becoming more and more important, as evidenced by books (such as “The Strategic Treasurer” and “Finance for Strategic Decision Making”), press articles, financial institution perspectives (“The Strategic Treasurer”), and top-tier finance and strategy firms assessments.
Finance is well-suited to play a strategic role due to the combination of core strengths in understanding value creation and analytics. Today we look at the Strategic Control Map, a tool to assist in strategy assessment and development.

What is the Strategic Control Map?
As discussed in our post on Return on Invested Capital, it is sometimes useful to break down an equation into separate sub-equations in order to understand some of the elemental drivers that produce the final result.
Figure A
The Strategic Control Map is a concept developed by McKinsey in the 90’s, and is essentially a visual representation of this “equation breakdown” process with respect to market capitalization.
Figure A shows the equation for Market Capitalization, which is simply the market value of a company’s equity and debt securities.
Figure B
By adding a numerator and denominator of the same term (meaning you are multiplying the original equation by 1, which does not change the result), we arrive at a breakdown of Market Capitalization into two components: Market to Book ratio, and Book Value. Figure B shows this representation.

Figure C
 The strategic control map can then be plotted with the Market to Book ratio on the y-axis and the book value on the x-axis (Figure C).

Enter Cost of Capital – Stage Right
The market to book ratio represents the market’s valuation of the firm’s investments compared to what those investments actually cost. This leads us to the concept of “excess returns”.
In finance, the phrase “excess returns” is used to describe a situation where the rate of return we earn from an investment is greater than our cost of capital.
Cost of capital represents what an investor needs to earn from an investment that carries a certain amount of risk.  Let’s look at two bonds to understand why.
Short-term US Treasury’s currently yield way less than 1%, due to the fact that they are low risk for two reasons. First, the US is a highly rated entity that has never defaulted on its obligations and has the ability to raise revenue on a large and wealthy economic base. Second, short-term debt is less risky than long-term debt because fewer things can go wrong in the next 6 months than could go wrong in the next 10 years.
On the opposite end, a 10-year Greek Bond has traded as high as 38%, because they are higher risk for reasons we have all heard about for years now. They have a weak economy and are burdening it excessively with funding demands, so there are little means to generate funds to pay off bonds. And there are a lot of things that can go wrong in Greece over 10 years compared to 6 months.
So an investor does not have one single required return. They have many different ones, and they are all related to the risk involved.  
·         Lower risk, lower return. A nice, safe, comfy short-term US Treasury? “I’m happy to make 1% on that”.
·         Higher risk, higher return. A risky 10-year Greek bond? “I need to make 38% to think about taking that one on”

Figure D
 Risk vs. Return is the basis for the cost of capital. Figure D shows this graphically. The more risk (which increases as we move along the x-axis) requires a higher return (which moves along the y-axis). Thus, the required rate of return is going to be an upward sloping line. For a given level of risk, move up the dashed line to find the required rate of return for that risk level, and notice that higher risk things require higher returns, and lower risk items require lower returns.

Enter Firm Investment – Stage Left
A company usually has a choice of several investments that it can make at any given time, sometimes referred to by cool names such as the “potential project portfolio” or “investment pipeline”.
For example, Farmer Joe’s Agricultural Empire might be considering any or all of the following investment possibilities: addition of a combine to accelerate harvesting, purchase of improved seed products, addition of a new grain silo, adding improved dryers to existing grain silos, etc.
Figure E
The investment possibilities will each have a different potential rate of return associated with them. Using the list above, maybe the combine is a 10% project, the seed products are 15%, the new silo is 12.5%, and the improved dryers is 20%.
The result of this fact is that the firm’s investment pipeline can be visualized as a downward sloping line, shown in Figure E, where the y-axis represents the rate of return (i.e. 20%, 15%, etc) and the x-axis is the project (combine, seeds, etc.).

Center Stage
So we have cost of capital entering from stage right, and the firm’s potential project portfolio entering from stage left, with the ultimate result that they meet at center stage.
This meeting is important. The firm’s investors expect a certain return on their investment given the risk level of the business. The firm has choices to make about which projects or investments to go forward with or turn down. The interplay informs the decision making.
Taking our example of Farmer Joe’s Agricultural Empire, if investors in this firm expect to make 10%, then Farmer Joe should undertake all 4 of the potential projects, as they all are expected to make this amount or more.

Figure F
 However, if Farmer Joe’s investors require 15% return based on the risk of the agriculture business, then Farmer Joe’s management should only invest in two projects, the seeds (15% return) and the dryers (20%). The other two projects, at 10% and 12.5%, do not earn enough to meet the investor’s required return.
We can depict this intersection by linking the two graphs we have previously seen together, with cost of capital providing the “connecting glue” between them. This is shown in Figure F.

The Market to Book Ratio Link
Now that we understand that a company makes decisions on various projects and opportunities that need to take into consideration the cost of capital, we can explore how this might work in the marketplace.
Case A: If we are a firm investing in 1 project that costs ²100 (for new readers, the symbol ² represents Treasury Café Monetary Units, or TCMU’s, freely exchangeable with any currency of your choice at any exchange rate you desire) and will return 20% forever after with no growth, then each year the firm will make ²20 in cash on this investment.
If the cost of capital for our firm is 10%, then using the simplified Dividend Discount Model (see “Apple’s Dividend – Good Financial Strategy?”) the market will value this investment at ²200 (20/10%). Our Market to Book ratio is therefore 2.
Case B: If we are a firm investing in 1 project that costs ²100 that will return 5% forever after with no growth, then this will generate cash each year of ²5.
If the cost of capital for our firm is 10%, then using the simplified Dividend Discount Model the market will value this at ²50 (5/10%), and our market to book ratio will therefore be 0.5 (50/100).  
Case C: If we are a firm investing in 1 project that costs ²100 that will return 10% forever after with no growth, then this will generate cash each year of ²10.
If the cost of capital for our firm is 10%, then using the simplified Dividend Discount Model the market will value this at ²100 (10/10%), and our market to book ratio will therefore be 1 (100/100).  
What we learn from these three cases is that if we earn our cost of capital then our Market to Book ratio will be 1, if we earn more than our cost of capital it will be greater than 1, and if we earn less than our cost of capital it will be less than 1.

Back to Strategic Control
Figure G
McKinsey breaks down the Strategic Control Map into 4 quadrants, as shown in Figure G. Companies in the upper left are in control, earning high returns on a large amount of investments. Companies in the bottom right are vulnerable, earning low returns on few investments. Companies in the upper right are considered vulnerable to takeover, given their smaller size but attractive returns. Companies in the bottom left need to focus on cost consolidation, as their large investment base needs to earn higher returns.
Figure H
In Figure H, we combine this quadrant view with our Project Portfolio line (shown in blue). This shows how difficult it is for a firm to be in strategic control, because there is a tension between earning high returns and making lots of investments.
From our example earlier, if Farmer Joe undertakes just its best investment, it will earn 20% and have a market to book ratio of 2. Few investments, high market to book ratio. This would place them in the upper left quadrant.
If they undertake all 4 projects (and if we assume equal value for each), they will average about 14% return, and their market to book will be about 1.4. Many investments, lower market to book ratio. This places them in the lower right quadrant.
To be in control a firm needs to find many, many high returning investments. Not so easy to do!

Using the Strategic Control Map
Figure I
For our Return on Invested Capital discussion, we used a local Chicago firm called John B. SanFilippo and Sons as our example. They are a producer of snacks such as peanuts, pecans, cashews, etc. sold under various brand names (hence this post’s title).
I looked up in Google Finance and Yahoo Finance their competitors, and created a strategic control map for this set of companies (using graphics in R). This is shown in Figure I.
Viewing this map, we can see several things.
·         First, there is one “big dog” and a bunch of “smaller dogs”.
·         Some firm’s are not earning their cost of capital (market to book below 1)
·         Evidence of the tension brought about by the Project Portfolio line is evident (higher returning firms are smaller in size)
·         Our friends at SanFilippo (JBSS in the graph) have some work to do
This last bullet I mention because if we overlay the Project Portfolio line into the graph, then the optimized tradeoffs should be on the line, so the line becomes the “most efficient frontier”.
Figure J
 We cannot be “upper and to the right” of the line because higher returning investments are not there.
Figure J shows the situation if we are “lower and to the left” of the line. In this case we are sub-optimal, we should either be earning higher returns on the investments we have made (the “earn more” direction) or be undertaking more investments at that particular rate of return (the “make more” direction).
Figure K
Figure K shows the Strategic Control Graph with the addition of what it looked like two years prior. The lines connect each firm’s current vs. previous position, indicating their progression over the past two years.
Several things stand out on this graph:
·         Our friends at SanFilippo have remained relatively constant, there is little movement within the two years
·         Both Lance (LNCE) and Diamond Nuts (DMND) exhibit movement consistent with the slope projected by the Project Portfolio line
·         Golden Enterprises (GLDC) and American Lorain (ALN) has seen their value reduced and have not grown
·         Inventure Foods (SNAK) has done something to dramatically increase the returns on its existing portfolio
From JBSS’s perspective, they need to either move to the right along the map or move upward. Given the distance traveling left to right between them and Diamond or Ralston (RAH), they would need to invest a lot of money in order to achieve this. It seems like it would be more likely that they be able to find a way to improve returns on their existing portfolio.
Alternatively, a merger with SNAK should move them up and to the right, which is the direction that you want to head on a Strategic Control Map.
From an industry perspective, it is possible that a merger between Lance and Diamond would move them to the right on the map. If they could combine this with improving returns on their product lines (either through synergies from the merger or better investment possibilities), they would be in a position to challenge Ralston for control within the industry.

Key Takeaways
The Strategic Control Map is one tool that can be used in a strategy setting to generate insights into industry performance and direction. Its usefulness is enhanced when we employ finance concepts into the analysis.
·         What does the Strategic Control Map suggest to you in the way of JBSS’s actions?
·         What insights for the industry do you notice from the Strategic Control Map?

Add to the discussion with your thoughts, comments, questions and feedback! Please share Treasury Café with others. Thank you!

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