CHAPTER 11STRATEGIC RISK MANAGEMENT

Why would risk-averse individuals and entities everexpose themselves intentionally to risk and increase thatexposure over time? One reason is that they believe thatthey can exploit these risks to advantage and generatevalue. How else can you explain why companies embark intoemerging markets that have substantial political andeconomic risk or into technologies where the ground ruleschange on a day-to-day basis? By the same token, the mostsuccessful companies in every sector and in each generation–General Motors in the 1920s, IBM in the 1950s and 1960s,Microsoft and Intel in the1980s and 1990s and Google in thisdecade- share a common characteristic. They achieved theirsuccess not by avoiding risk but by seeking it out. There are some who would attribute the success ofthese companies and others like them to luck, but that canexplain businesses that are one-time wonders – a singlesuccessful product or service. Successful companies are ableto go back to the well again and again, replicating theirsuccess on new products and in new markets. To do so, theymust have a template for dealing with risk that gives theman advantage over the competition. In this chapter, weconsider how best to organize the process of risk taking tomaximize the odds of success. In the process, we will haveto weave through many different functional areas ofbusiness, from corporate strategy to finance to operationsmanagement, that have traditionally not been on talkingterms. Why exploit risk? It is true that risk exposes us to potential lossesbut risk also provides us withopportunities. A simple vision of successful risk taking isthat we should expand our exposure to upside risk whilereducing the potential for downside risk. In this section,,we will first revisit the discussion of the payoff to risk

taking that we initiated in chapter 9 and then look at theevidence on the success of such a strategy. Value and Risk Taking It is simplest to consider the payoff to risk in aconventional discounted cash flow model. The value of a firmis the present value of the expected cash flows, discountedback at a risk-adjusted rate and derives from fourfundamentals – the cash flows from existing investments, thegrowth rate in these cash flows over a high-growth periodaccompanied usually by excess returns on new investments,the length of this high growth period and the cost offunding (capital) both existing and new investments. In thiscontext, the effects of risk taking can manifest in all ofthese variables:- The cash flows from existing investments reflect not onlythe quality of theseinvestments and the efficiency with they are managed, butalso reflect the consequences of past decisions made by thefirm on how much risk to take and in what forms. A firm thatis more focused on which risks it takes, which ones itavoids and which ones it should pass through to itsinvestors may be able to not only determine which of itsexisting investments it should keep but also generate highercash flows from these investments. A risk-averse companythat is excessively cautious when investing will have fewerinvestments and report lower cash flows from thoseinvestments.- The excess returns on new investments and the length ofthe high growth period will be directly affected bydecisions on how much risk to take in new investments andhow well is both risk is assessed and dealt with. Firms thatare superior risk takers will generate greater excessreturns for longer periods on new investments.- The relationship between the cost of capital and risktaking will depend in large part on the types of risks takenby the firm. While increased exposure to market risk willusually translate into higher costs of capital, higher firm-specific risk may have little or no impact on the costs ofcapital, especially for firms with diversified investors.

Being selective about risk exposure can minimize the impacton discount rates. The final and most complete measure of good risktaking is whether the value of a firm increases as aconsequence of its risk taking, which, in turn, will bedetermined by whether the positive effects of the risktaking – higher excess returns over a longer growth period –exceed the negative consequences – more volatile earningsand a potentially higher cost of capital. Figure 11.1captures the effects of risk taking on all of the dimensionsof value.

Figure 11.1: Risk Taking and Value

The other way to consider the payoff to risk taking is to use the real options framework developed in chapter 8. Ifthe essence of good risk taking is that you increase your share of good risk – the upside- while restricting your exposure to bad risk – the downside – it should take on the

characteristics of a call option. Figure 11.2 captures the option component inherent in good risk taking:

Figure 11.2: Risk Taking as a Call Option

In other words, good risks create significant upside andlimited downside. This is the key to why firms seek out riskin the real options framework, whether it is in the context of higher commodity price volatility, if you are an oil or commodity company with undeveloped reserves, or more uncertain markets, if you are a pharmaceutical company considering R&D investments. If we accept this view of risk taking, it will add value to a firm if the price paid to acquire these options is less than the value obtained in return.

Evidence on Risk Taking and Value It is easy to find anecdotal evidence that risk takingpays off for some individuals and organizations. Microsofttook a risk in designing an operating system for a thennascent product – the personal computer- but it paid off bymaking the company one of the most valuable businesses inthe world. Google also took a risk when it deviated fromindustry practice and charged advertisers based on those whoactually visited their sites (rather than on total traffic),

but it resulted in financial success. The problem withanecdotal evidence is that it can be easily debunked aseither luck – Microsoft and Google happened to be at theright place at the right time - or by providing counterexamples of companies that took risks that did not pay off –IBM did take a risk in entering the personal computerbusiness in the 1980s and had little to show for this interms of profitability and value. The more persuasive evidence for risk takinggenerating rewards comes from looking at the broader crosssection of all investors and firms and the payoff to risktaking and that evidence is more nuanced. On the one hand,there is clear evidence that risk taking collectively haslead to higher returns for both investors and firms. Forinstance, investors in the United States who chose to investtheir savings in equities in the twentieth century generatedreturns that were significantly higher than those generatedby investors who remained invested in safer investments suchas government and corporate bonds. Companies in sectorscategorized as high risk, with risk defined either in marketterms or in accounting terms, have, on average, generatedhigher returns for investorsthan lower risk companies. There is persuasive evidence thatfirms in sectors with more volatile earnings or stock priceshave historically earned higher returns than firms in sectors with staid earnings and stable stock prices. Within sectors, there is some evidence albeit mixed, that risk taking generates higher returns for firms. A study of the 50largest U.S. oil companies between 1981 and 2002, for instance, finds that firms that take more risk when it comesto exploration and development earn higher returns than firms that take less. On the other hand, there is also evidence that risk taking can sometimes hurtcompanies and that some risk taking, at least on average,seems foolhardy. In a widely quoted study in managementjournals, a study by Bowman uncovered a negativerelationship between risk and return in most sectors, asurprise given the conventional wisdom that higher risk and

higher returns go hand-in-hand, at least in the aggregate.This phenomenon, risk taking with more adverse returns, hassince been titled the “Bowman paradox” and has beensubjected to a series of tests. In follow up studies, Bowmanargued that a firm’s risk attitudes may influence risktaking and that more troubled firms often take greater andless justifiable risks. A later study broke down firms intothose that earn below and above target level returns(defined as the industryaverage return on equity) and noteda discrepancy in the risk/return trade off. Firms thatearned below the target level became risk seekers and therelationship between risk and return was negative, whereasreturns and risk were positive correlated for firms earningsabove target level returns. In conclusion, then, there is a positive payoff to risktaking but not if it is reckless. Firms that are selectiveabout the risks they take can exploit those risks toadvantage, but firms that take risks without sufficientlypreparing for their consequences can be hurt badly. Thischapter is designed to lay the foundations for sensible riskassessment, where firms can pick and choose from acrossmultiple risks those risks that they stand the best chanceof exploiting for value creation. How do you exploit risk? In the process of doing business, it is inevitable that you will be faced withunexpected and often unpleasant surprises that threaten toundercut and even destroy your business. That is the essenceof risk and how you respond to it will determine whether yousurvive and succeed. In this section, we consider five waysin which you may be make use of risk to gain an advantageover your competitors. The first is access to better andmore timely information about events as they occur and theirconsequences, allowing you to tailor a superior response tothe situation. The second is the speed with which yourespond to the changed circumstances in terms of modifyinghow and where you do business; by acting faster than yourcompetitors, you may be able to turn a threat into an

opportunity. The third advantage derives from your pastexperience with similar crises in the past and yourknowledge of how the market was affected by those crises,enabling you to respond better than other firms in thebusiness. The fourth derives from having resources –financial and personnel – that allow you to ride out therough periods that follow a crisis better than the rest ofthe sector. The final factor is financial and operatingflexibility; being able to change your technological base,operations or financial structure in response to a changedenvironment can provide a firm with a significant advantagein an uncertain environment. The key with all of theseadvantages is that you emerge from the crises stronger, froma competitive position, than you were prior to the crisis. The Information Advantage During the Second World War, cryptographers employed bythe allied army were able to break the code used by theGerman and Japanese armies to communicate with each other.The resulting information played a crucial rule in thedefeat of German forces in Europe and the recapture of thePacific by the U.S. Navy. While running a business may nothave consequences of the same magnitude, access to goodinformation is just as critical for businesses in theaftermath of crises. In June 2006, for instance, themilitary seized power in Thailand in a largely bloodlesscoup while the prime minister of the country was on a tripto the United States. If you were a firm with significantinvestments in Thailand, your response would have beenlargely dependent upon what you believed the consequences ofthe coup to be. The problem, in crises like these, is thatgood intelligence becomes difficult to obtain, but havingreliable information can provide an invaluable edge incrafting the right response. How can firms that operate in risky businesses orrisky areas of the world lay the groundwork for gettingsuperior information? First, they have to invest ininformation networks – human intelligence as the CIA or KGBwould have called it in the cold war era – and vet andnurture the agents in the network well ahead of crises. Lest

this be seen as an endorsement of corporate skullduggery,businesses can use their own employees and the entities thatthey deal with – suppliers, creditors and joint venturepartners – as sources of information. Second, thereliability of the intelligence network has to be testedwell before the crisis hits with the intent of removing theweak links and augmenting its strengths. Third, the networkhas to be protected from the prying eyes of competitors whomay be tempted to raid it rather than design their own. Astudy of Southern California Edison’s experiences indesigning an information system to meet power interruptionscaused by natural disasters, equipment breakdowns andaccidents made theee general recommendations on systemdesign:(a) Have a pre-set crisis team and predetermined action planready to go before the crisis hits. This will allow information to get to the right decision makers, whenthe crisis occurs.(b) Evaluate how much and what types of information you willneed for decisionmaking in a crisis, and investing in thehardware and software to ensure that this information isdelivered in a timely fashion.(c) Develop early warning information systems that willtrigger alerts and presetresponses. As companies invest billions in information technology(IT), one of the questions that should be addressed is howthis investment will help in developing an information edgeduring crises. After all, the key objective of goodinformation technology is not that every employee has anupdated computer with the latest operating system on it butthat information flows quickly and without distortionthrough the organization in all directions – from topmanagement to those in the field, from those working in thetrenches (and thus in the middle of the crisis) to those atthe top and within personnel at each level. Porter andMillar integrate information technology into the standardstrategic forces framework and argue that investments ininformation technology can enhance strategic advantages. In

figure 11.3, we modify their framework to consider theinteraction with risk:

Figure 11.3: Information Technology and Strategic Risks

As information becomes both more plentiful andeasier to access, the challenge that managers often face isnot that they do not have enough information but that thereis too much and that it is often contradictory and chaotic.A study by the Economist Intelligence Unit in 2005 confirmedthis view, noting that while information is everywhere, itis often disorganized and difficult to act on, with 55% ofthe 120 managers that they surveyed agreeing thatinformation as provided currently is not adequatelyprioritized. The key to using information to advantage, whenconfronted with risk, is that there be a screening mechanismthat not only separates reliable from unreliable informationbut also provides decision makers with the tools to makesense of the information.

As a final point, it is worth emphasizing that havingbetter information is one part of successfully exploitingrisk but it is not a sufficient or even necessary pre-condition. A study of intelligence in military operationsfound that while good intelligence is a factor in success,it is only one factor, and there are cases where armies havefailed despite having superior information and succeedednotwithstanding poor information. The Speed Advantage When case studies are written of effective responses tocrises, whether they are political or economic, theygenerally highlight the speed of response. One reasonJohnson and Johnson was able to minimize the damage ensuingfrom the Tylenol poisoning scare in the mid 1980s was thatit removed bottles of the pills immediately from storeshelves and responded with a massive public relations blitz,warning consumers about the dangers, while reassuring themthat it had matters under control. In contrast, the FederalEmergency Management Administration (FEMA) was lambasted forthe slowness with which it responded to the breaching oflevies in New Orleans in 2005, in the aftermath of HurricaneKatrina. J&J’s actions did not just reduce the costs fromthe tampering incidentbut the goodwill and credibility gained by their responsemight have actually made the incident a net benefit for themin the long term.8 In essence, the company turned intopractice the adage that every threat is also an opportunity. So, what determines the speed of the response? Onefactor is the quality of the information that you receiveabout the nature of the threat and its consequences – theinformation advantage that we noted in the last section isoften a key part of reacting quickly. The second factor isrecognizing both the potential short term and long-termconsequences of the threat. All too often, entities underthreat respond to the near term effects by going into adefensive posture and either downplaying the costs ordenying the risks when they would be better served by beingopen about the dangers and what they are doing to protect

against them. The third factor is understanding the audienceandconstituencies that you are providing the response for;Johnson and Johnson recognized that they key group thatneeded reassurance was not analysts worried about thefinancial consequences but potential future customers.Rather than downplay the threat, which would have been theresponse that reassured investors, the firm chose to takethe highlight the potential dangers and its responses. Whileno one template works for every firm, the most successfulrespondents to crisis maintain a balance betweenstockholders, customers and potential or actual victims ofthe crisis. In effect, it is not just that you respond quickly tocrises, but the appropriateness of the response thatdetermines whether you succeed in weathering the crisis andemerging stronger from the experience. The organizationalstructure and culture of firms also seem to play a role inhow effective they are at responding to challenges. Anexamination of the practices of Japanese manufacturersconcluded that firms that responded quickly to marketchanges tended to share information widely across theorganization and its partners and to have small teams thatwere allowed to make decisions without senior managementoverview. A study of the decision processes at four firms inthe microcomputer industry, with the intent of uncoveringthe determinants of the speed of this response, found thatfirms that succeeded were able to straddle paradoxicalpositions: they were able to make decisions quickly butcarefully, they had powerful CEOs who co-existed with apowerful top management team, and they made innovative andrisky decisions while providing for safe and incrementalimplementation.