|Portfolio management: how can you monitor your performance?|
Portfolio management is a fundamental process within companies, aiming to channel their resources into units that add greater value. However, we have seen many cases where value creation and resource allocation were mismatched. This flaw becomes accentuated in an environment where the management system values the maximization of indicators such as market share, Ebitda, and accounting profit, among others. Though traditional and well-known, they neglect some factors which are important in creating value, such as asset risk and the cost of opportunity. Consequently, they often lead to decisions that make little economic sense, allocating capital to the least profitable units and missing opportunities – "starve the stars and feed the dogs".
A rigorous analysis must consider all of the invested capital, including fixed assets, working capital and investment capital assigned to research and development (R&D) or brand creation and maintenance, irrespective of accounting classification. Fairness and comparability are important in this measure, which should also reflect the manager’s rights to make decisions. Therefore, shared asset apportionment and the allocation of cash (or other accounting figures) should be made with extreme care – sometimes only at the corporate center or holding.
Based on this metric, it is possible to show individual contributions to the portfolio: "What was the created value for each real invested in each unit?". In our experience, it is often the case that some units contribute with a significant portion of the created value using little capital, while others use up much capital and add little value. At a certain food company, a single unit accounted for 62% of the created value, using only 10% of all allocated capital. On the other hand, three others used 76% of the capital, but contributed with only 30% of the added value.
To understand such a difference, we must dissect the value drivers of each unit, such as gross margin or working capital required per client. It is essential that the company understand the reasons for this difference. They may result from more efficient management or from the unit's business model.
In the former case, an internal benchmark can be applied to the underperforming units in order to compare and pursue improvements to their drivers. In the latter, the drivers must reflect the reality of the business and the strategy it follows. One recurring trap is attempting to equalize the drivers of different units, investing even more resources in underperformers.
Capital allocation should be based on realistic expectations, following three major pathways of value creation: 1) to grow, investing capital in the units whose expected return is higher than the cost of opportunity; 2) to pursue greater operating efficiency for a unit; or 3) to reassign capital from units whose expected returns are lower than the cost of opportunity.
Although these alternatives should be the basic principle of a financial decision, we cannot neglect the relevant role played by compensation systems. For instance, if a company's main target is to increase its Ebitda, there will always be a strong tendency to approve investments that will reduce the operating costs (Opex), even if the operating gain will not be enough to offset the opportunity cost of the invested capital.
Applying an economic metric which is in line with the compensation system is fundamental to monitor portfolio performance, since it identifies the effective value generated by each unit and directs capital toward the best opportunities. It also creates proper incentives by charging for the capital's cost of opportunity, paying managers only for created value.