How to make sound decisions – Corporate Portfolio

How to make sound decisions in the selection of corporate portfolio: A Manager’s perspective

Managers make portfolio decisions based on a series of logical justifications. The choice to invest, cut back, buy back or exit is ideally guided by the strength of a business’s structural logic; the potential to improve the business or create synergies with other businesses; and the state of the capital markets-whether they are likely to over- or under- value the business relative to the NPV of its future cash flows.

These three logics are essential for making good portfolio decisions. The decision becomes simpler if the three logics all point in the same direction. When they don’t, decision making gets complicated. For example, if a business is likely to sell for more than it’s worth, there is little reason to buy and and good reason to sell- unless the business would perform much better under your ownership or it adds value to another business you own. If a business is structurally less attractive because of being in a low-margin industry and has a significant competitive disadvantage, you are likely to want to sell or close it- as long as the price you can get is more than the value of continuing to own it. But if you improve the competitive position of the business or if it strengthens you capabilities in a related segment, you may choose to retain it.

The trick is to make informed trade-offs among these different reasons for buying and selling businesses. It is important to give weight to all three logics and avoid letting momentum build up around any one so that others have little influence or are completely ignored. Too often we come across executive teams that decide what to buy first and consider how to add value only as a part of integration process- or that commit to hold onto an underperforming business without considering whether it might interest enthusisatic buyers. But here, the focus is more on the cases where these logics suggested different paths and how the managers found a way forward.

You can add value, but the business is structurally less attractive
Most managements try to avoid businesses with low returns, weak positions, and limited growth prospects, especially those in complex industries. But if you are good at adding value tosuch businesses, you should focus on that.
Acquiring businesses in complex, low-margin indutries is not a strategy to recommend lightly. One risk of buying or holding structurally unattractive businesses is that they typically don’t provide a reasonable return on incremental investments. Hence decision makers should consider three logics: How difficult is the industry? Can they add value to compensate for low underlying returns? Can they buy assets at a discount or without paying too large an acquisition?

You can’t add value, but the business is structurally attractive
Every manager likes an attractive business, one with high margins that has a competitive advantage. But if you are not good at adding value to this business, the crack is to learn how to add values, and to do so quickly.
It’s easy to presume that a company will be able to learn to be a good owner, especially when the business is attractive, but developing new skills at the corporate level is not easy. It requires significant changes in the mindset of the people and a willingness to letgo of old habit- failure is common in this.

You can add value to structurally sound business, but it’s overpriced
When you come across an attractive business that you can add value to, you will instinctively hold onto it. But if such a business has the price in the capital markets higher than its NPV, then whether you should refrain from bidding for it or selling it depends on whether you are looking to acquire or whether you already own the business and whether the reason for the overvaluation in the capital markets is likely to be temporary or permanent. One way is to hedge the risk of payment by paying for the acquisition in terms of equity rather than cash, or issue new equity and pay through it. Anothr way is to reduce the risk of overpaying. Even in this, you should still consider it selling under some conditions- if the premium offered by buyer is too big to ignore, or if the cash overcoms a shortage of funding to invest in other parts of your portfolio.

You own a structurally unattractive business and are subtracting value, but buyers are not offering a fair price
Managers with unattractive businesses to which they cannot add value will normally sell. But if you are not getting the right price, many companies will simply keep such a business and wait until they can offload it at a better price. But the tactic to tackle this depends on the reason for low price- be it a lack of buyers, the nature of those buyers, the information they have about the business, or the deal process. Another way to increase the price is to redesign the deal process. What to do depends on the risk of the subtracted value. If no value is added or subtracted, retaining such a business for a while will not reduce its value and so the selling need not rushed into. If the owner is subtracting value, the disposal of such a business is urgent. Getting rid of it, in any way possible, is likely to be the optimum solution.

In all these decision making, financial analysis was an essential aid. But apart from that, these judgements are critical in making good portfolio decisions.

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