MoF Issue 13

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McKinsey onFinance

The right restructuring for US automotive suppliers 1

In the next round of consolidation, scale should be a result of strategynot a strategy in its own right.

Agenda of a shareholder activist 5

Fund managers should be good owners, not just traders, believes thehead of Europes leading shareholder-activist fund.

When payback can take decades 10

For capital-intensive businesses, the variables in portfolio decisions can

seem overwhelming. Streamlining can help.

The scrutable East 14

Valuations are linked to growth. So why are they lower in high-growthmarkets in Asia?

Perspectives on

Corporate Finance

and Strategy

Number 13, Autumn

2004

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McKinsey on Financeis a quarterly publication written by experts and

practitioners in McKinsey & Companys Corporate Finance practice. It

offers readers insights into value-creating strategies and the translation of

those strategies into performance. This and archive issues ofMcKinsey on

Finance are available online at www.corporatefinance.mckinsey.com.

Editorial Board: James Ahn, Richard Dobbs, Marc Goedhart, Keiko

Honda, Bill Javetski, Timothy Koller, Robert McNish, Dennis Swinford

Editorial Contact: [email protected]

Editor: Dennis Swinford

Design and Layout: Kim Bartko

Design Director: Donald Bergh

Circulation: Kimberly Davenport (United States), Susan Cocker (Europe),

Jialan Guo (Asia)

Cover illustration by Ben Goss

Copyright 2004 McKinsey & Company. All rights reserved.

This publication is not intended to be used as the basis for trading in the

shares of any company or for undertaking any other complex or significant

financial transaction without consulting appropriate professional advisers.

No part of this publication may be copied or redistributed in any form

without the prior written consent of McKinsey & Company.

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1

Is there anything US auto suppliers

havent tried to counteract the enormous

purchasing power of the handful of

automakers that make up their customer

base? As the suppliers profit margins have

been squeezed again and again, they have

responded with an array of strategic initiatives,

including diversifying their customer base,

going global, positioning themselves further

upstream in the value chain, and actively

helping to design components in hopes of

capturing more value than they could by

simply bending metal. In the 1990s, the

industry also went through an M&A wavethat many hoped would deliver the heft

needed to push back against the automakers.

Each of these steps helped some suppliers

in some ways, but for all their efforts the

The right restructuring

for US automotive suppliers

In the next round of consolidation, scale should be a result of

strategynot a strategy in its own right.

suppliers have, on average, barely kept up.

The industry as a whole has been destroying

shareholder value for years; margins have

sagged even as revenues have grown. Some

suppliers have offset this erosion in part by

making their capital work harder, boosting

returns on invested capital (ROIC) even as

returns on sales have fallen. Yet even this sligh

improvement evaporates once the goodwill

premiums for past acquisitions have been

accounted for (Exhibit 1).

A thorough industry restructuring may be

required to brighten the suppliers prospects

and bring needed balance to their relations

with the automakers. Launching another wave

of M&A activity will not suffice. To level the

playing field, suppliers must become smarter

about how they choose to expand or trim their

product and customer mix and adjust their

portfolio structure. The way the suppliers

rise to the challenge could provide guidance

to other industries, such as retailing, where

powerful customers also dominate the top of

the customer base.

The consolidation that wasnt

Many suppliers believe that their industry

consolidated dramatically during the 1990s.

In fact, a broad-based consolidation among

the leading players never took place, although

many mom-and-pop companies were cleared

away at the bottom of the pyramid. Thus the

annual revenues of the smallest of the top

100 automotive suppliers operating in North

America rose to some $400 million, up from

around $50 million in the early 1990s. Butconsolidation within the top 100 itself has

actually slowed or gone in reverse, as the 25

largest suppliers command a smaller share of

the market today than they did a decade ago.

Moreover, the industrys shape has become

broader at the base, not more concentrated at

the top. From 1992 to 2002, each quartile of

the top 100 suppliers had a higher compound

Glenn A. Mercer,

Jean-Hugues J. Monier, and

Aurobind Satpathy

Source: 200304 McKinsey survey of ~60 suppliers operating in North America; Standard & Poors; McKinsey analysis

Ratio of sales to average invested capital for selected suppliers

Falling behind

1

0

1970 1978 1986 1994 2002

0.5

1.0

1.5

2.0

2.53.0

3.5Excluding

goodwill

Includinggoodwill

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2 McKinsey on Finance Autumn 2004

annual growth rate (CAGR) in revenues

than the quartile above it (Exhibit 2). The

era did produce large suppliers, including

ArvinMeritor, from Arvin Industries and

Meritor Automotive; Dana Corporation,

which doubled in size after it bought Echlin;

and Lear, which quickly gobbled up more thantwo dozen smaller companies. Despite such

growth, however, industry-wide consolidation

has not occurred, and suppliers remain a mere

fraction of the size of their largest customers.

Why have such efforts at restructuring failed

to strengthen suppliers positions? As we

can see from the ongoing margin decline,

unfocused M&A was largely to blame.

Suppliers pursued size for sizes sake, usually

horizontally, adding products in order toprovide entire systems or modules to the

automakers. A seat maker, for example,

might add a carpet product line, or a maker

of springs might offer shock absorbers. Yet

the automakers are so much larger than the

suppliers that moving from $2 billion in

revenues in one product line to $4 billion

in two product lines did little to improve

the suppliers leverage with their customers.

Indeed, the broad horizontal product

groupings of the largest suppliers became

easy targets for automakers price-cutting

efforts and were easily picked apart by

purchasing departments seeking the best price

in individual components. Furthermore, very

large suppliers became increasingly desperate

to win large contracts in order to maintain

their growth trajectory. Those holding broad

product portfolios found it almost impossible

to achieve excellence in their disparate lines.

Effective restructuring

In the next wave of restructuring, companies

must think about scale not as the primary way

of standing up to the automakers across the

board but as a means of finding the portfolio

and product leverage they need in specific

niches. Of course, they shouldnt abandon

efforts to improve their performance through

the kinds of specific strategic programs

already under way, such as the conversion to

lean production, globalization, and customer

diversification. Many companies wouldnt

have survived the 1990s without such

programs. But those initiatives must be part of

a broader strategy of improving the industrys

standing relative to that of its customers.

Individual suppliers must resist the temptation

simply to get bigger or to be a player and

instead focus on dominating their product

arenas. Then they must back up product

dominance (which influences volume and

price) with strong process skills (which drive

cost). The scale they achieve should be a result

not an input, of their strategy.

1

The way forward for successful automotive

suppliers centers on three strategic decisions.

What to own

Conventional wisdom may suggest otherwise,

but suppliers that focused vertically on

owning more of the value chain within a

Numerous research studies performed byMcKinsey, by commercial and investment banks,

and by academic researchers such as PatrickSteinemann of MIT concur on the desirability ofsuch an emphasis.

1Excludes aftermarket revenues.

Source: Wards Auto World; McKinsey analysis

Hardly a major consolidation

Top 100 auto suppliers revenues1 from North American OEMs byquartile, %

6%

Compoundannualgrowth rateof revenues

12%17%

9%

$171billion

67

97

17

Quartile 1

Quartile 3Quartile 4

Quartile 2

20021992

77

$83billion

14

63

100% =

2

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3

product line have outperformed those that

expanded horizontally across a broader range

of products. Why? Purchasing departments

are skilled at picking apart portfolios of

products, but evidence shows that they

are much less skilled at disaggregating the

sources of value within the many steps that

move a single product from raw materialto finished good. As a result, control of

more of the links in a products value

chain should generate larger profits.

Suppliers must therefore define a target

product range, ignoring industry chatter

about systems and modules and

cross-selling in favor of a more

sophisticated view of how their customers

really buy. If an automaker buys brake

systems through two departmentsone forbasic mechanical-brake devices and another

for antilock-brake electronics, for example

a sales pitch for a combined brake system

will face an uphill struggle. If an automaker

relies on its tier-one automotive-interior

supplier to specify a particular console

producer, then owning the console

production process may be more valuable

than adding interior product lines, such as

package shelves and pedal assemblies.

It will be important for suppliers to be

aggressive about divesting assets and

businesses outside their chosen product

segments, thus freeing up cash for the kind

of targeted growthorganic or acquired

that will build real leverage. This kind of

supplier-level realignment will also improve

the industrys performance over time by

encouraging smarter consolidation than has

been evident in the past. Most important,

a focus on products, value-chain links, and

processes will lead to optimal scale; starting

with an arbitrary volume target unrelated to

product economics leads nowhere.

What skills to develop

Very often, the most profitable links in a

products value chain are tied to specific

processes. Such skills give focused suppliers

another defense against powerful customers,

which cant reverse-engineer products whose

processes are patented, highly unusual, or

based on years of specialized expertise. Ourresearch shows that suppliers focusing on

excellence in manufacturing or engineering

processes, such as hydroforming (a type of

metal-forming process that relies on hydraulic

pressure rather than mechanical strikes to

create complex shapes without as many

expensive dies), have outperformed those

focusing on innovative products, such as

remote keyless entry. The reason is that

processes are much harder for OEMs to

reverse-engineer than products are. A bigautomotive-steel company, for instance, may

grab attention for its more visible product

innovations, but the maker of a special

grade of steel that solves an SUVs crash-

test problem will capture more value. It is

simply harder for automakers to shop

around for a set of processes than for a

group of products.

The right restructuring for US automotive suppliers

3

Second-tier successes

1Tier-1 suppliers have >50% of sales with OEMs; tier-2 suppliers have up to 50% of sales with OEMs.

Source: 200304 McKinsey survey of ~60 suppliers operating in North America; McKinsey analysis

Financial performance by tier, 19952000 average (estimated), %

Tier-1

supplier1

Return on sales

Tier-1 suppliers directly face high-performing OEM purchasing organizations Tier-2 suppliers compete in existing niches

Tier-1 suppliers benefit from increased OEM

outsourcing and fewer direct suppliers

4.3

Tier-2supplier1

7.0

10.4

13.8

Best practice

Return on invested capital

8.7

12.2

20.3

30.1

Compound annual growth rate

11.1

7.5

35.2

35.0

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McKinsey on Finance Autumn 20044

What role to play

Broadly speaking, second-tier suppliersthose

focused on selling as much to other suppliers

as to automakersare, on average, more

profitable than their tier-one counterparts that

deal exclusively with carmakers (Exhibit 3).

They enjoy higher profits partly because

they are less exposed to some of the worlds

most aggressive purchasing departments and

partly because they typically manufacture

a key component of a larger system rather

than assembling the system itself.

Indeed, in most large automotive systems a

few core components, often produced by tier-

two companies, create much of the value. The

smaller companies that control these choke

pointskey parts that may be small in dollar

value but immense in their impact on the

performance of the system as a wholeall

tend to generate higher economic value and

shareholder returns than do the much larger

enterprises that ship the final system or

module. Such smaller companies make parts

such as the yaw-rate sensor, which provides

the most crucial data for the brain of an

electronic stability system; the washer nozzles

that make it possible for larger windshield-

wiper systems to help drivers see roads; and

the special balance shaft that prevents some

expensive engines from shaking themselves

to pieces.

Of course, to identify these choke

points, companies must develop a deeper

understanding of each links profitability

and its balance sheet and then make a hard

economic analysis of which links are most

valuable to control. This kind of focus on

value choke points is one reason the private

equity investment community, with its more

objective analysis of value creation, has

greater interest in second-tier suppliers than in

first-tier ones. Unfortunately, most suppliers

typically fixate on sales volumes rather than

profitability as the measure of success.

The winning auto suppliers of the future

wont try to fight size with size to gain

an advantage against their big customers

purchasing power. Only a restructuring

that focuses on excellent processes as

well as excellent products will provide the

precision-targeted leverage suppliers need

to fight back effectively and to preserve the

long-term health of their industry. MoF

Glenn Mercer (Glenn_Mercer@McKinsey

.com) is a principal in McKinseys Cleveland office,

Jean-Hugues Monier (Jean-Hugues

[email protected]) is a consultant in

the New York office, and Aurobind Satpathy

([email protected]) is a principal

in the Detroit office. Copyright 2004 McKinsey &

Company. All rights reserved.

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5

Agenda of a

shareholder activist

Fund managers should be good owners, not just traders, believes

the head of Europes leading shareholder-activist fund.

Paul Coombes Strong signs of shareholder activism have

come in the wake of the many corporate

scandals in the United States and Europe

over the past few years. Once treated by

management as a minor annoyance, activist

investors are now increasingly central in the

push for corporate-governance reform.

Hermes, a UK fund manager that is owned

by the BT Pension Scheme and serves more

than 200 clients, has long been at the forefront

of the shareholder-activist movement, which

urges shareholders to challenge managers

of companies about the way they are run.

Hermes employs some 45 people in its

corporate-governance workmore than twice

as many as any other institution in the world,

including the California Public Employees

Retirement System (Calpers), with which

Hermes enjoys a close relationship. It now has

44 billion ($80 billion) under management.

Back in the early 1990s, Hermes took on

the task of improving the performance and

governance of underperforming companiesin its index tracking fund (known as Index

Tracking Investments), which covers all major

markets and regions and holds more than

1 percent of the shares of every UK quoted

company. It has used its voting rights to

intervene on issues such as the composition

of boards, the independence of directors, and

executive pay. Although reluctant to name

names, the Hermes Focus Funds have been

associated with a management shakeout

at the telecommunications company Cable

& Wireless and with strategic changes at

Kingfisher, Premier Oil, Six Continents, Smith

& Nephew, Tomkins, Trinity Mirror Group,

and others.

In 2002 Hermes published the Hermes

Principles. These went beyond the mere

statement of what it expected from

companies by way of structural corporate

governance and laid out, in some detail,

what managements should be doing to

generate long-term shareholder value. The

Hermes Principles put a companys strategic

and ethical decisions, as well as the more

usual financial ones, under a spotlight.

David Pitt-Watson, the author of the Hermes

Principles and managing director of Hermes

Focus Asset Management (HFAM), runs the

UK Focus Fund, one of the Hermes Focus

Funds. In this interview, excerpted from

The McKinsey Quarterly, he spoke with

McKinseys Paul Coombes to explain theHermes philosophy as well as the challenges

and the future of shareholder activism.

The Quarterly: How does Hermes

manage its equities differently from other

fund managers?

David Pitt-Watson: Most fund managers

would say their key skill was buying and

selling shares and hence outperforming

their peers. We try to do something different.Although we do buy and sell from time to

time, Hermes tries to excel at being a good

owner of companies.

The aim is to create value. As fund managers,

were managing the investments of pension

funds and insurance companies, which in

turn are working for millions of beneficiaries.

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portfolios performance relative to the market.

So, for example, a fund manager who doesnt

hold many shares in a poorly performing

company might not mind terribly if that

company were to go bankrupt, sending marke

indexes lower. The likelihood is that he or she

might get a bigger bonus, as the fund would

outperform. Theres nothing wrong with this

kind of trading activity in itself. But it has little

to do with being a good owner. As responsible

owners, we try to articulate just what it is we

would like companies to be doing on behalf of

their owners to create long-term value. Hence

the Hermes Principles.

The Quarterly: Why was Hermes Focus

Asset Management established?

David Pitt-Watson: Hermes had long

believed we could make certain companies

in our portfolio more valuable in the long

term if we took initiatives that were aimed at

improving governance. The problem is that

this kind of activity becomes quite costly quite

quickly. In addition to investment managers,

you need teams that include former directorsof public companies, strategic consultants,

auditors, investment bankers, lawyers,

corporate-governance experts, and public

relations people. The Focus Funds gave us

the opportunity to assemble such a group

of people by earning a direct return on

their activities.

The funds take a stake in companies that are

already held in the Hermes core index fund.

We then intervene in a way that we believewill improve the value of the company, and

when that change takes place and the shares

are revalued we sell back down to the core

holding. It has proved to be a successful

investment idea. It also supports the Hermes

mission, which is to try to make sure that all

the companies were invested in are as well

managed as we can make them.

The shareholders advocate

Career highlights Braxton Associates, Deloitte Consulting (198097)

Cofounder, partner, and managing director

The Labour Party, United Kingdom (199799) Assistant general secretary

Hermes (1999present) Managing director, Hermes Focus Asset Management (HFAM)

Fast facts Visiting professor of strategic management, Cranfield University, Bedfordshire, 199095

Served on various public bodies, including Literacy Task Force (responsible for devisingimprovement program in UK schools), 199697; Co-operative Commission, 19992001;Westminster City Council, 198690; Labour Finance & Industry Group, 19862004

Currently serves as trustee for the Institute for Public Policy Research (IPPR)

David Pitt-Watson

Vital statistics Born September 23, 1956, in

Aberdeen, Scotland Married with 3 children

Education Graduated with BA in politics,

philosophy, and economics (PPE)from the University of Oxford andwith MA and MBA from StanfordUniversity

Some 70 percent of equities in the Anglo-

Saxon world are held by institutions on behalf

of pension, insurance, and other funds. In

Continental Europe, the figure is around 50 or

60 percent.

Our investments ultimate beneficiaries

those who hold pension and life insurance

policiesneed their funds to perform well for

a really long time: 30, 40, or even 50 years.

That kind of outperformance is unlikely to

be achieved just by buying and selling to

achieve relative performance. It requires the

companies we invest in to be well run and

achieve absolute performance. So if we have

a problem with a company, we are likely to

intervene. Hence, the overriding requirement

of Hermes is that the companies in which we

invest should be run in the long-term interest

of their shareholders.

Most fund managers have a different

perspective. If they discover theyre holding

shares in a company that is not terribly good,

they sell. If they see a low-priced share in a

good company, they buy. The performanceof a fund manager is generally judged on the

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7

The Quarterly: Corporate executives often

say that their businesses arent understood by

fund managers. What makes you feel you can

intervene?

David Pitt-Watson: I have considerable

sympathy with corporate executives. The

primary interest of most fund managers is

the value of a company, not whether it is well

managed. We take a different approach with

the Focus Funds. We would say that when we

buy a share it is probably fairly priced. But it is

priced in a way that reflects skepticism about

its future prospects. We try to change those

prospects, but the people we employ know its

inappropriate for a fund manager to be telling

the board to do this or that. Its for the board

to run the company, and its for the board,

ultimately, to make the decisions about what

should be done.

What it is legitimate for us to do, and

what our teams are well qualified to

do, is to ask questions and expect the

answers to make good business sense. So

we try very hard not to say, We believeyou should dispose of this or that.

Instead we ask, Why do you continue

to invest in an unprofitable business?

We have several other advantages that allow

us to engage companies in the way we do.

When the Focus Funds buy into a company,

Hermes will have been a shareholder in it

for many, many years through the index

fund. When the Focus Funds sell, Hermes

will remain a shareholder for many, manyyears. That strengthens our credibility with

companies. And because Hermes is so well

established, there is a certain trust that

we wont do anything that will damage

its reputation. We wont, for example,

give unattributed press briefings that

undermine management. Thats a hopeless

way of going about owning companies.

The fact that the investors in the Focus Funds

include the worlds largest pension funds also

forces us to think about this as an ownership

activity rather than about how we can make

money in the next quarter.

The Quarterly: To what extent have the

Focus Funds improved shareholder value?

David Pitt-Watson: There are different

ways you can think about this. Our

performance isnt on the public record. But the

BT Pension Scheme, an initial investor in the

Focus Funds, had almost a 49 percent return

up to the end of December 200341 percent

above the FTSE total-return benchmark.

Thats not bad over five years. It equals an

8 percent annual return, versus a benchmark

of 1.6 percent. At any one time, the UK Focus

Fund might hold 2 or 3 percent of the stocks

of 12 or 15 companies.

But our involvement actually improves the

performance of the whole company, not just

2 percent of it. Looked at this way, the value

of our activities is tens of billions of pounds ofbenefit to all other investors.

The Quarterly: How do you decide which

companies to include in the Focus Funds, and

how does your involvement unfold?

David Pitt-Watson: The Focus Funds

look for companies whose performance raises

concernsperhaps a falling share price,

perhaps questionable strategic actions. The

concerns might come from our analysts orfrom the brokerage community. Very often

they come from other fund managers. We then

ask three things. Is it fundamentally a good

company? Usually, we dont get involved with

the worst companies; it would be daft to risk

losing our clients money. The companies we

pick are often very strong but have particular

issues that we feel we can help resolve. We

Agenda of a shareholder activist

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1Paul Coombes and Mark Watson, Threesurveys on corporate governance, The

McKinsey Quarterly, 2000 Number 4 specialedition: Asia revalued, pp. 747 (www.mckinseyquarterly.com/links/14564).

then ask whether resolving the problems

would make these companies worth at least

20 percent more. Thats the sort of hurdle

we set. And finally, we ask if the boards and

shareholders of these companies would be

willing to have a dialogue with us. Therefore,

we tend to invest in strong companies with

boards we believe are open-minded enough to

accept change.

Once invested, were very up-front about

the nature of our investment and the issues

we want to discuss. Successful involvement

usually goes on for two or three years before

we sell. Usually, its amicable. It should be a

good ownership relationship. But of course it

doesnt always work that way.

The Quarterly: The fund-management

industrys profit margins are under long-term

pressure. Can fund managers afford to engage

in shareholder activism?

David Pitt-Watson: The active trading of

shares clearly has a role. It is a huge industry.

According to Paul Myners, who drew up areport on the investment industry for the UK

government in 2000, roughly 8 billion a

year is spent in fees, commissions, and taxes

to facilitate share trading. Right now in the

United Kingdom I think youd be hard-pressed

to find more than about 8 million spent by

fund managers specifically on ownership

activities. Im rather proud that more than half

of this figure is spent by Hermes.

How much value do these activities add?As regards share trading, this is pretty

controversial territory. As regards good

management, McKinsey has looked at the

difference between the value of a well-

governed company and a poorly governed one

and said that the gap comes out somewhere

from 15 to 30 percent, depending on the

country.1 If we improve the governance of

companies, we can really add economic value.

So I dont think theres a serious problem

about whether, in aggregate, theres enough

money to pay for a substantial step forward

in governance. Even a trivial transfer of

1 percent of the money that we spend trading

shares would result in a tenfold increase in

whats put into improving governance.

The Quarterly: Youve spoken about the

short-term performance pressure companies

face. Are you worried about the shorter

average tenure of chief executivesattributed

in large part to pressure from investors?

David Pitt-Watson: Yes, its an issueits

an issue if good CEOs dont feel supported.

Of course, sometimes executives should step

down. But its daft to fire the chairman or

chief executive as an immediate reaction to a

short-term problem. You need to understand

why the problem has arisen. Getting rid of

someone makes a good story in the press; it

may even move the share price in the short

term. But it can be very unhelpful when it

comes to managing a company well.

When fund managers make a decision, it

takes them a nanosecond to trade millions

of pounds worth of shares. Running

a company isnt like that. When chief

executives make decisions, it can take years

to see the results, and its very unclear to

people on the outside whether youre being

successful. Which is why I constantly return

to the need to raise the level of debate about

the responsibility of share ownership.

The departure of a CEO needs to be the

result of a proper discussion, over time,

among people who are fully briefed on

what the long-term issues are and can

ask appropriate probing questions. It

shouldnt be the result of a story in a Sunday

newspaper. Ive seen two or three stories in

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9

the press in recent months speculating on

the departure of various executives. The

journalists concerned knew nothing about

the problems within the company. These

stories probably came from fund managers

who themselves may not have understood that

there were more fundamental things being

worked on by the company at the time.

The Quarterly: How can companies best

deal with the short-term pressures they feel

from investors?

David Pitt-Watson: First and foremost,

stick to delivering long-term value. Thats

what will matter at the end of the day. Second,

understand the investment process. Its usually

about the buying and selling of shares, which

doesnt always relate to the reality of whether

youre doing the right thing in your company.

Companies need the confidence and

entrepreneurship to generate value. They

also need independence to listen to and

incorporate constructive criticism. Something

else weve discovered that is enormouslyhelpful is the importance of separating the

roles of chairman and chief executive. The

separation makes very clear that the chief

executives role is to run the company and the

chairmans role is to run the board and to

make sure that the right issues are raised for

the board to consider. That way, you get

independence of thought, and boards can act

as mentor to chief executives, making sure

they are doing the right thing and helping

them resist undue pressure.

The separation of the roles has worked very

well for us in the United Kingdom. I know

its under debate in America right now, and

I thoroughly encourage companies there to

do the same. It stops this incredibleand I

think stupidpressure on chief executives to

say that theyre imperial and responsible for

everything. We know the world isnt really like

that. Chief executives can be the most fantastic

people, but they work best when they have

boards that function as good teams. Having a

separate chairman is an important component

of that. MoF

Paul Coombes, formerly a director in McKinseys

London office, is now an adviser to the firm. This is

an excerpt from his article Agenda of a shareholder

activist, The McKinsey Quarterly, 2004 Number 2,pp. 6271 (www.mckinseyquarterly.com/

links /14551). Copyright 2004 McKinsey &


Agenda of a shareholder activist

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10

When payback

can take decades

For capital-intensive businesses, the variables in portfolio decisions

can seem overwhelming. Streamlining can help.

Taken together, the uncertainty and the

complexity make it particularly difficult

for companies to sort through myriad

combinations of prospective investments and

select the most promising ones. If a power

company, for example, considered only limited

variations of the most obvious factorsthe

size, location, technology, and timing of

possible investments, as well as a variety of

future market scenariosit would still end

up with more possible portfolio combinations

than it could evaluate easily (Exhibit 1).

As a result, executives typically opt for an

overly simplistic approach: They evaluate

investment opportunities intuitively,

considering the two or three most obvious

risks and uncertainties rather than conducting

a systematic analysis. They also usually

assess options on a stand-alone basis,

overlooking how a group of assets might

affect a single portfolio. And they rank

investment prospects by the ratio of NPV

to investment volume, in effect shaping

their corporate portfolio for the next several

decades simply by ticking down the list of

Boris Galonske,

Stephan Grner, and

Volker H. Hoffmann

For companies in capital-intensive

industries, investments are more often than

not of the supersized variety. The utility that

builds new plants that employ a variety of

power-generating technologies, for example,

handles an investment volume of a daunting

size and complexity. Then there is the

uncertainty: once a company embarks on an

investment, decades can pass before it actually

creates value. In the basic-materials and energy

industries, for instance, the average new

project costs about $500 million and takes

20 to 30 years to create value on a net present

value (NPV) basis.

1

An analytical approach to portfolio decisions

1Clusters reflect variations on key drivers and discrete decisions; for exampleshould plant be fueled by coal, gas, or lignite?2Expected NPV is additional NPV vs a do-nothing option; downside risk is difference between expected NPV and NPV in worst-case marketscenario.

3Represents the highest return for a unit of risk.

E

xpectedNPV2

Take all possible portfolio1

combinations . . .

. . . eliminate those that are not

feasible . . .

. . . and analyze only those close to

the efficient frontier3

+

+Downside risk2

Individual real asset portfolios

Efficientfrontier

E

xpectedNPV2

+

+Downside risk2

E

xpectedNPV2

+

+Downside risk2

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11

possible investments until their funds are

exhausted. At that point, few executives give

much consideration to financial constraints

that might emerge as the target portfolio

is implemented, which can be decades.

Our work with clients in capital-intensive

industries in Europe suggests a better

approach to structuring portfolios. For it

to be effective, companies must overcome

three common obstacles. First, they must

understand the relevant risks and uncertainties

and how they are linked. Second, companies

need to systematically sort through an infinite

number of possible portfolio configurations.

Last, they must apply that perspective to

identify the most appropriate candidates

for future portfolios. Once under way, this

approach can help companies avoid locking

themselves into todays vision of a single

portfolio that must last 20 years. Instead, they

can retain the flexibility to adapt to changing

market conditions over time.

Which uncertainties are most relevant?

Most managers have a qualitativeunderstanding of the uncertainty of planned

capital investments. But because so many

variables are involved, they ultimately

make decisions according to their own

biases and predispositions, thus needlessly

broadening and distorting the universe

of risks. Many managers consider the

demand for electricity to be a crucial risk

factor for a power company, for example,

because of its considerable impact on the

markets development. Demand in Westerncountries is quite predictable, however, so

while it may be an important variable in

forecasting prices, in most cases it should

not be considered a key driver of risk.1

Companies can limit the number of possible

portfolio configurations they need to consider

seriously. First, managers should rigorously

define those factors that lead to the biggest

commercial risks and have a potential impact

on the markets developmentand hence

on the investments value.2 In the power

industry, fuel prices for hard coal or gas are

key because their future development is highly

uncertain and because they determine plant

competitiveness on a short-term marginal-cost

basis. While the necessity of defining these

factors may seem obvious, in our experience

many companies neglect to do so. As a

result, they fail to rule out the least relevant

uncertainties. One company we worked with

had no systematic risk assessment and little

consensus among different divisionsand

even within departmentsaround which

factors were the most crucial. Once managers

began conducting such assessments, they

realized that while their short-term

analyses were correct, they needed to

revise completely their assumptions for the

long term.

Second, managers should determine which

uncertainties are mutually exclusive. The

point is not trivial; eliminating somecombinations reduces the number of different

scenarios that need to be considered. What

are the chances that a country might force a

power company to reduce both its reliance

on nuclear energy and its CO2 emissions

at the same time, for example? Its not

an implausible scenario in Europe, given

environmental movements currently under

way, but is it likely? Nuclear capacities are

so large that they couldnt be replaced by

solar and wind power alone. The only optionwould be to rely more heavily on fossil fuels,

which unfortunately would also increase

emissions. Therefore, executives might come

up with a plan to meet either requirement

separately, but they might well think it

unlikely that the government would require

both actions simultaneously, since to do so

would endanger a secure supply of energy.

1Demand may be a key driver in the developingeconomies of Asia and Eastern Europe, for

instance, where forecasts are less reliable.2This result can be calculated by quantifyingthe impact of each driver on the companys

financial performancefor example, on earningsbefore interest and taxes (EBIT). Typically,this calculation involves performing sensitivity

analyses on a financial model.

When payback can take decades

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Narrowing portfolio choices

Today most executives analyze their

investments on a case-by-case basis. Few

companies go beyond a projects NPV, and

they rarely connect the predicted cash flowsof a new project to the future cash flows

of the rest of the portfolio. Without such a

link, however, it is at best difficult to draw

conclusions about the financial performance

of the whole company. One corporation found

that while a specific proposal would not on

its own generate positive NPV, synergies with

other plants would make the investment quite

attractive. Executives would not have realized

which conditions would be necessary to make

this investment a success if they had paidattention only to the stand-alone view.

It is possible, however, to construct a

spreadsheet-based model to evaluate the

financial performance of each future real

assetalone and in combination with

othersin each future market scenario.3

This analysis should plot each particular

portfolio combination that meets both

acceptable levels of risk (Exhibit 2) and

executives expectations of returns. Obviously,

a portfolio with high NPV and low risk is

more favorable than one with low NPV and

high risk. The most desirable portfolios have

a higher NPV than all other portfolios but

with the same or a lower level of risk.4

In our experience, the process of defining

key performance indicators for value and

risk and developing a detailed description of

constraints for investments can be challenging

since often there are many possible indicators

and implicit constraints that are difficult

to reconcile. In each case where a company

made these assumptions explicit, however,

the right course to pursue with a given

portfolio option became clearer to executives.

One power-generation company found an

explicit definition of its risk tolerance useful

as a way to sharpen its perspective on risk

and return trade-offs in near-term portfolio

decisions. In the end, the company adjusted

its industry perspective toward emission

trading, changed its midterm investmentplan to defer some projects while speeding

up others, and incorporated risk exposure

in its criteria for strategy development.

Making individual portfolio decisions

With a range of portfolios clearly identified,

an eager management team might be tempted

to narrow the pool furtherdown to the

most attractive single portfolio. The benefit of

identifying the best portfolio is questionable,

however, because time will inevitably alter theoutcome. When the company achieves its ten-

year aspirationsa reasonable duration, given

the time it takes to bring a plant on line

those goals could be five years out of date.

Adding one more layer of analysis can solve

that dilemma. Because the most promising

individual assets are likely to be part of a

2

Explicitly define risk tolerance

1Expected NPV is additional NPV vs a do-nothing option; downside risk is difference between expected NPV and NPV inworst-case market scenario.

2Represents the highest return for a unit of risk.

A moderate risk tolerance eliminates high-riskportfolios. For example, companies might choose toanalyze only portfolios with positive NPVs in allmarket scenarios.

Individual real asset portfoliosEfficient frontier2

Low risktoleranceeliminates allportfolios

High risktoleranceincludes allportfolios

Lowtolerance

Moderatetolerance

Hightolerance

ExpectedNPV1

+

+Downside risk1

3Such a model should include a detaileddescription of each existing asset and of

each potential project and should calculateeach projects future technical and financialperformance, depending on the developmentof each key risk driver. Furthermore, it should

include a mathematical analysis that selects thebest combination of assets, using performanceindicators, such as NPV or downside risk, that

management prefers.4In theory, a company could safely pursue anyportfolio configuration that sits on the efficient

frontier, because all are equally desirable, aslong as a company has no precise preference forthe level of risk or return.

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13

large number of possible future portfolios,

companies can use a straightforward analysis

to review all of the acceptable options. If a

certain investment project were part of, say,

98 percent of all portfolios close to the efficient

frontier, then managers could confidently

invest in that asset as a short-term, no-regrets

move (Exhibit 3).

The benefit of this type of spreadsheet

model is that managers can rerun the model

periodically to alter investment decisions as

conditions change instead of committing

themselves to a single portfolio of investments

for the long term. Executives can see a

portfolio as a strategic direction rather than

as a fixed plan to be followed for decades to

come, thus allowing for periodic revisions

while making individual short-term investmen

decisions. A power-generation company

might make decisions to invest in gas-fired

power plants today, for example, but could

reasonably postpone investments in coal-

fired plants until uncertainties with respect

to the Kyoto Protocol have been resolved. Of

course, it is wise to confirm the profitability

of all individual projects before becoming

committed to them.

Companies in capital-intensive industries

face incredibly complex investment

decisions. An approach using thorough

optimization-based analysis can clarify trade-

offs between risks and returns, produce a

flexible portfolio strategy that responds to

uncertainty, and ensure that investments

are recouped in the long term. MoF

Boris Galonske (Boris_Galonske@McKinsey

.com) is a consultant in McKinseys Dsseldorf

office, Stephan Grner (Stephan_Goerner@

McKinsey.com) is an associate principal in the

Munich office, and Volker Hoffmann (Volker

[email protected]) is a consultant in the

Stuttgart office. Copyright 2004 McKinsey &


3

Without regret

1Near term defined as over next 5 years; efficient frontier representshighest return for unit of risk.

2Stand-alone evaluation of profitability to be calculated separately.

Combined-cycle gasturbine plant

100

98 No-regrets moves

for near-term

investments

Project

Coal plant

Gas turbine plant

10

25

Wait and see

Lifetime extension forexisting coal plant

% of modeled portfolios (near efficient frontier) that contain given

project as near-term investment

When payback can take decades

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14

The scrutable East

Valuations are linked to growth. So why are they lower in

high-growth markets in Asia?

Marc H. Goedhart,

Timothy Koller, and

Nicolas C. Leung

Most investors and executives want a

piece of the booming Asian market for the

right reasons. With vigorous growth in the

region, getting into China, India, and other

countries should position companies well for

the expected groundswell of shareholder value.

And for many sectors, such as high technology

and manufacturing, the advantages of going to

Asia, particularly China, have so changed the

competitive dynamics that theres little choice

but to join the rush.

But the decision to go to Asia can be unsound

as well. Many executives who invest in Chinaor India believe that these markets will

suddenly kick-start stalled growth at home,

reviving their companies sagging prospects.

On that score, we think caution is in order, for

two reasons.

First, from a growth perspective, the returns

from investments in Asia just arent going to

be that largeat least over the next decade.

Even under optimistic ten-year forecasts for

these fast-growth markets, in most industries

the real value for shareholders will still lie in

the United States and Europe (Exhibit 1).

At current growth rates, corporate investment

in Asia1 will not have a tremendous impact

on the short- or medium-term growth

and profitability of multinationals. One

Western conglomerate, for example,

recently announced its goal to double its

revenues from China over the next five

yearsa 15 percent annualized rate of

growth. That figure may sound weighty,

but since China currently represents only

5 percent of the companys revenues, the

impact would increase the conglomerates

overall growth rate by a mere 0.6 percent.

Second, one useful way of looking

at Asia is from a capital markets

perspective. Corporations can learn

what to expect upon entering the Asian

market by analyzing the regions listed

companies in terms of their valuation and

underlying performance. From this angle, the

Asian market contains complications that any

company would be wise to consider.

While some companies have

demonstrated high growth and profitmargins, for example, Asian companies

trade at a consistent discount compared

with their US and European counterparts

the sole exception being Chinese stocks

on the Shanghai and Shenzhen exchanges,

many of which are also tracked by the

IBES index2 (Exhibit 2). Investors could

well be skeptical of these companies, since

1We analyzed the four key northern Asian

markets of China, Hong Kong, Japan, and SouthKorea, which account for about 75 percent of

Asias GDP.2The Institutional Brokers Estimate Systemmonitors approximately 200 Chinese companies.

1

How much of a shake-up?

Forecast GDP, $ billion

China

United States

India

Japan

Brazil

Russia

United Kingdom

Germany

France

Italy

2010

3.0

2050

44.5

13.3 35.2

0.9 27.8

4.6 6.7

0.7 6.1

0.8 5.9

1.9 3.8

2.2 3.6

1.6 3.1

1.3 2.1

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15

their high valuations reflect not only

their underlying strength but also theimmaturity of the markets and a lack

of investment alternatives in China. For

some companies tracked by the IBES and

also traded in Hong Kong, where

investors enjoy more investment options,

the Hong Kong price can be a half to a

third lower than the price in mainland

China.

So if a direct link exists between a companys

long-term market valuation and its underlying

growth, why do Asian companies suffer

from valuations that are considerably lower

than those in many other parts of the world?

Several reasons are apparent.

Capital returns. Despite high margins in

most sectors and product markets, the

average return on capital in the four

northern Asian markets we analyzed is

well below the US and European average

(Exhibit 3). Thats caused in part by poor

discipline. Banks, through their uneven

underwriting and their high levels of

nonperforming loans, allocate capital

in an inefficient manner. Companies

that allocate their capital better than the

average Asian corporation does might see

an opportunity, but the fact that Asian

competitors can operate with lower average

capital returns could also pose a threat to

them. Family ownership of companies also

inhibits efficient allocation of capital.

Governance. Companies looking to

compete directly in Asian markets or to

enter them through joint ventures and other

partnerships should keep in mind that Asian

companies have not been particularly kind to

minority and public shareholders. Numerous

publicly listed companies have seen their

share price drop amid accusations that the

controlling shareholders manipulated the

relationship between listed and privately

held subsidiaries. Admittedly, we can lookonly at the second-order effect of how

much institutional investors are willing to

pay for better governance. Yet a 22 percent

premium for Asian equities is significantly

higher than the 13 or 14 percent that

these stocks enjoy in the United States and

Europe. Poor governance contributes to

market inefficiencies, which in turn lead to

3

Asian returns suffer

Median return on equity (ROE) for selected markets

1500 largest European companies by market capitalization.2Based on median ROE of companies in Nikkei 225 (Japan), KOSPI (South Korea), Hang Seng (Hong Kong), and IBES (China).

20

15

10

5

0

1993

Asia average2

S&P 500

Europe top 5001

1995 1997 1999 2001 2003

2

The Asia penalty?

Median market-to-book ratio for selected markets

1Institutional Brokers Estimate System.2500 largest European companies by market capitalization.

4

3

5

2

1

0

1993

Hang Seng (Hong Kong)Nikkei 225 (Japan)

KOSPI (South Korea)

IBES1 (China)S&P 500

Europe top 5002

1995 1997 1999 2001 2003

The scrutable East

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16 McKinsey on Finance Autumn 2004

4

Asian markets are more volatile

Performance of selected markets; index: Dec 1985 = 100

1Measure of assets risk relative to market; a giv en stocks beta is >1.0 if, over time, it moves ahead of market and

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Copyright 2004 McKinsey & Company

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