In my previous article I talked about the concept of adding value. And will now discuss two different ways of creating value—from operations and from financial engineering. Let’s start with a look at telecom stocks. Six-seven years before, these were doing better than Internet stocks. Then came the big meltdown and investors lost more money in telecom companies than in Internet stocks. Since then, telecom companies have rebuilt themselves and debt-equity ratios have begun to improve, cash flows have been strong and the sector is again getting revalued by investors.
Then take steel. For years a moribund sector, with companies languishing. Till a Lakshmi Mittal came along and made so much money here that he briefly became the world’s third richest man. And take commodity companies worldwide. The smart ones expand when the chips are down and the sector is going through a rough patch. That’s when valuations are down, investor expectations are low, cash flows are poor and acquisition of assets is cheap. That’s why the market gives a premium to larger and/or more diversified companies that have the cash flows even during bad times. Take a look also at private equity companies worldwide. They make money, but not out of running companies. They do so out of savvy financial engineering.
The point is that most companies focus on running their businesses or operations. So, the natural tendency is to think of growth, or value creation, through the organic route. However, organic expansions, which can take several years to complete, cannot be responsive to swiftly changing markets. With markets becoming more fickle and India becoming more open to fast changing global developments, the conditions on whose basis a project was originally conceived may have changed dramatically by the time the project comes onstream. But you cannot simply junk a project midstream because markets have changed. You have already invested expensive capital, which cannot sit around in unproductive investments.
The point is, at different points in time, even within a sector, different value creation strategies work better. Organic growth may be better in certain industries and at certain times. At other times, financial engineering-based value creation may be more relevant. By not having the skills to create value through both forms, depending on the need, organisations may be hobbling themselves. Every organisation needs to focus on all means of value creation. Skills in financial engineering can be as, and often more, important as organisational capability in running operations.
Organisations with a good mix of both capabilities will do better in the long run. But it is equally important to have the ability of determining which strategy is more suitable at a given point in time. For example, if we consider private equity as a proxy for financial value creation, it has been going through a great run for the past few years, delivering annual returns in excess of 20-30% globally. But the cycle may now be coming to an end and may take many years to return. Having said that, if we consider the public market as a proxy for operations-driven value creation, then even over longer periods, private equity has generally delivered superior returns.
• Organic expansions need time and can’t respond to fast changes in markets
• Financial engineering offers a useful alternate tool to add value
Does this mean every organisation should have its own in-house private equity prof- essionals to balance its operations focus? Clearly, the answer is no. Most firms have a clear business focus and need to stick to it. However, the finance departments in most firms do need to be trained better and be more alive to the possibilities of value creation through financial engineering. Within their sector, given their deep knowledge of the business, they should be the ones best able to create financial value.
In turn, senior managements and CEOs need to be more responsive to such concepts. Organisations should chart their strategies to ensure a balance of both forms of value creation. With timing and market conditions determining the actual growth strategy. Firms which learn to balance both forms of value creation will, ultimately, be the ones who succeed. For that, they have to be nimble and responsive, with the ability to manage and, often, reconcile both types of activities, which require very different skills and expertise.
Source: The Financial Express