Managing Director & Senior Partner
This article is an excerpt from Creating Value Through Active Portfolio Management: The 2016 Value Creators Report (BCG report, October 2016).
Ever since BCG introduced the growth share matrix, in the 1960s, executives have understood that portfolio management is a critical component of any strategy for superior value creation. As more and more companies must justify the value creation logic of their business portfolios in response to pressure from activist investors, portfolio management is more important than ever.1 Notes: 1 See “ Winning Moves in the Age of Shareholder Activism,” BCG Focus, August 2015. Partly in response to such pressure, spinoffs have become one of the most popular strategic moves in the increasingly active market for corporate transactions.2 Notes: 2 See “ Creating Superior Value Through Spin-Offs,” BCG article, February 2016.
And yet, despite the growing importance of portfolio strategy, it is striking how many large multibusiness companies do not have a systematic one. That is, they do not have a deliberate approach for determining what businesses they should and should not own, why their portfolio of businesses is worth more under common management than the sum of the individual businesses, and how to optimize the value the businesses generate for shareholders. In our experience, many senior executive teams are comfortable with the businesses they currently own simply because they have “always” owned them. They focus on being good operators of the current portfolio—running those businesses, making them better, and meeting plan—rather than savvy investors of corporate assets.
It is an understandable mindset, but it comes with a major strategic risk. Without a strategic portfolio roadmap, executives are not as prepared as they should be to create strong and sustainable TSR for their investors or to react quickly and responsibly to shocks in the business environment. When such shocks happen—as they increasingly do in today’s dynamic economy—executives often respond in a way that is too reactive or transactional. They rush to make a deal—any deal—to address their problems without thinking enough about the real sources of the company’s competitive advantage.
Between the extremes of doing nothing and doing too much, senior executives need to take a more measured and more strategic approach. It is no coincidence that many of the companies we have profiled in recent Value Creators reports have put the continual reshaping of the corporate portfolio at the center of their value creation strategies. (See “Portfolio Reshaping: A Common Contributor to TSR Success.”) There are three steps to doing so: defining an investment thesis, determining the value creation potential of the portfolio, and developing a robust portfolio strategy.
To get a sense of just how important active portfolio management is to value creation, one must look back at the companies we have profiled in recent Value Creators reports. In the five years since our annual report first included in-depth profiles of BCG clients that are leading value creators, we have featured six companies. In nearly every case, portfolio strategy has been a key factor in value creation performance. Consider the following examples.
Church & Dwight. A critical component of the winning value creation strategy developed by the consumer-packaged-goods company Church & Dwight (featured in the 2012 Value Creators report) was a transformation of its brand portfolio.1 Through a systematic process of investing in organic growth in its core Arm & Hammer brand, selling off weaker brands, and acquiring new ones with greater potential for high-margin growth, the company increased gross margins from 39.1% in 2006 to 44.2% in 2011, and operating margins from 13% to 18.1%. Today, eight of Church & Dwight’s brands deliver 80% of the company’s revenue and profit.
VF Corporation. Apparel company VF Corporation (featured in 2013) went through a similar portfolio transformation, shifting the company’s focus from large but relatively low-growth legacy apparel segments to smaller but faster growing businesses in so-called lifestyle brands.2 Before VF’s strategy could gain credibility in the capital markets, however, the company had to make itself more attractive to growth-oriented investors. The steps it took included hiring a senior M&A executive from General Electric to run its acquisitions process, providing investors with greater clarity about its M&A strategy and track record, reporting earnings separately for its lifestyle brands in order to emphasize their higher margins and growth potential, and creating an internal talent-management program to build the capabilities necessary to manage a stable of high-growth brands.
Gannett. Media company Gannett (featured in 2014) has increasingly shifted its portfolio from its traditional newspaper and publishing business into higher-growth media and digital businesses.3 In 2015, Gannett split its publishing and media businesses into two companies. The publishing business continues to use the Gannett name, while the broadcasting and digital company is called Tegna.
Alfa. The Mexican conglomerate Alfa (also featured in 2014) has become a top multibusiness value creator by going through two waves of portfolio transformation.4 The first, completed in the early 1990s, focused a collection of unrelated businesses on three sectors—steel, petrochemicals, and food—and a small group of diverse businesses. The second, in the early years of this century, focused on businesses with the greatest prospects for growth and profitability. For example, the company exited its legacy steel business in 2005 and in 2006 started a joint venture with Pioneer Natural Resources to explore for natural gas in Texas. By 2008, none of the businesses in Alfa’s original portfolio remained. In the process, the company greatly improved the value creation profile of its portfolio and shifted from being primarily in the Mexican domestic market to having a more international presence.
Managing a business portfolio for sustained value creation starts with an investment thesis. Senior executives should think about each business in the portfolio as a long-term investor would, asking the following questions: What are our core businesses and why are they good for us? Of the noncore businesses, which should we monetize and when? Where do we expect to take each business over the next three to five years?
An investment thesis is a clear view—grounded in the realities of a company’s competitive situation, strengths, opportunities, and risks—of how the company will allocate capital to compete and create value over time. In contrast to the typical strategic plan, with its lengthy list of actions and targets, a good investment thesis highlights three to six critical levers to deliver strong value creation over a specific period (usually three to five years).
By developing an explicit corporate investment thesis, much as professional investors do, senior executives can more effectively assess the tradeoffs among competing priorities and evaluate the performance of their company’s investments. A clear investment thesis also provides criteria for identifying and assessing acquisition and divestiture candidates.
A robust investment thesis establishes the high-level value creation logic of a company’s portfolio. But it should be informed by a granular understanding of the potential of each business in the portfolio. To develop such an understanding, it is important to evaluate each business from three different but complementary perspectives.
Market Perspective. The first perspective is the traditional domain of business strategy: What is the fundamental strategic potential of each business in the portfolio in terms of the economic attractiveness of the served markets, their growth potential, their margin potential, and the strength of the company’s competitive advantage in the business?
It is not enough that the business in question serve an attractive market. It needs to offer advantages that will give the company a leg up against rivals. Take the example of growth. Too often, in seeking to grow, companies in an industry look in the same places, chasing the same pockets of growth with me-too strategies, assuming that they will end up with strong positions. But investing simply to participate rarely creates meaningful shareholder value. Instead, a company should have a differentiated strategy that is based on defensible competitive advantages in terms of cost position, technology, brands, or scale.
Value Perspective. Many companies stop with the market analysis. However, while that analysis is necessary, it is far from sufficient. In parallel to addressing the strategic potential of a business, companies should also develop a perspective on the business’s performance as an investment and its ability to create value in the future.
BCG’s approach, called the Value Lens, helps companies understand the value creation profiles of their portfolio businesses by answering two fundamental questions: What is the value to the company of each business today? What is the likely contribution to TSR, share price, market capitalization, and the valuation multiple in the future?
The starting point is to develop a snapshot of how investors would value a business if it were an independent company listed on the stock market. For each business, we identify a peer group of similar businesses that are publicly listed and analyze the impact of various operational and financial drivers on valuation multiples in that peer group. We then apply this valuation model to the portfolio business in question. The result is an accurate estimate of what the business’s valuation would be if it were publicly listed.
A key insight that often emerges from this analysis is that the biggest businesses in the portfolio in terms of revenue are not necessarily the biggest value creators. For example, in the client example portrayed in Exhibit 1, division 1 is responsible for a full 27% of the company’s revenue but only 16% of the current share price. Division 4 is responsible for only 13% of revenue and 17% of the current share price. And two of the six divisions (2 and 3) account for 65% of their company’s total valuation. Clearly, investors value a dollar of revenue more highly in some of the businesses in this portfolio than in others.
To estimate the value creation potential of each business, BCG uses a metric we call internal TSR (or iTSR), a direct proxy for how a business is likely to create value and contribute to the company’s overall share price and TSR. (The components of TSR are described in the sidebar in “ Creating Value Through Active Portfolio Management.”) Exhibit 2 shows the output of one such analysis for a company with 19 independent business units. The bars show the iTSR of each business—that is, the sum of the business’s estimated revenue growth, margin improvement, multiple improvement, and generation of free cash flow. The end result of this analysis is a detailed picture of each business’s contribution to the company’s share price, free cash flow per share, and overall TSR.
The power of the iTSR analysis is that it reveals not only how much TSR each business is likely to contribute but also where that will come from—revenue growth, margin improvement, the generation of free cash flow, or an improving valuation multiple. Knowing the sources of each business’s contribution to TSR is critical for determining the role of the business in the company’s overall portfolio strategy. (See the discussion of portfolio roles below.) The iTSR approach can also be used within a business to estimate the impact of specific strategic initiatives on TSR.
Ownership Perspective. So far, we have focused on the value creation potential of each business in a portfolio. But it is not enough to consider a business in isolation. Its role in the portfolio as a whole, including strategic and operational linkages and synergies with other businesses, should also be examined.
This all-important ownership perspective is partly a matter of portfolio balance. Does the portfolio have an appropriate mix, for instance, of businesses that offer short-term growth and those that promise long-term growth? If access to capital is limited, are there enough cash-generating businesses to fund growth businesses? Is the portfolio sensibly diversified in terms of business risk?
Equally important is determining if a company is the best owner of the businesses in its portfolio. For example, do the businesses fit the company’s investment thesis and basic style of competition? Are there synergies across them? Can the businesses take advantage of certain assets or capabilities provided by the corporate center to create more value than they could on their own?3 Notes: 3 See First, Do No Harm: How to Be a Good Corporate Parent, BCG report, March 2012. Is the value of the portfolio, taken as a whole, truly greater than the sum of the parts?
Finally, an important part of determining whether a portfolio as a whole is well designed is understanding how the company’s largest and most important investors view it. Many companies have a so-called bimodal portfolio, in which different businesses have different financial characteristics or risk profiles—and therefore attract different types of investors, whose priorities for the company may conflict. As a result, these companies often suffer from a valuation discount in the capital markets. The right move in such situations may be to reshape the portfolio so that the company’s business, financial, and investor strategies are aligned to appeal to a single investor type (for instance, growth-at-a-reasonable-price, or GARP, investors). Or, if senior management is confident in the long-term sustainability of the company’s investment thesis and portfolio makeup, then the answer may be to do a better job of communicating the underlying logic of the portfolio in order to attract the appropriate investor type.
This three-part analysis sets the stage for developing a robust and actionable portfolio strategy. To develop such a strategy, senior executives must first determine the precise role a business will play for the company and then act accordingly, setting the appropriate budgets, performance targets, and other measures.
Defining Portfolio Roles. A business in a company’s portfolio can play one of five roles:
Assigning roles should not be a mechanistic process. This analysis should be thought of as an initial stake in the ground that then needs to be debated and pressure-tested with business unit management. For each business, a detailed fact base should be assembled and debated. The goal of this debate should be to agree on the role each business will play in the portfolio.
In addition to defining the role of each business, this process identifies imbalances or gaps that must be addressed. For instance, a lack of sufficient growth engines to sustain the company’s TSR trajectory may call for the acquisition of additional growth businesses or increased investment in organic growth. In this respect, the exercise of assigning portfolio roles also serves as the foundation for the company’s M&A and capital allocation strategies. (See “Reshaping the Portfolio Through M&A: Lessons from Successful Serial Acquirers.”)
Sooner or later, actively managing the corporate portfolio requires reshaping it through M&A. In our study of the M&A practices of successful serial acquirers, we found that the factor that most often distinguishes these acquirers from the rest is their willingness to invest large amounts of leadership time, money, and organizational focus in support of their M&A strategy—in advance of any particular deal.1 More specifically, successful serial acquirers invest disproportionately in three key areas.
Building and Refining a Compelling Investment Thesis. When it comes to M&A, a clear and compelling investment thesis—a proprietary view of how the company creates value—is an indispensable guide. For a potential acquisition, an investment thesis helps answer the questions, Why us? Why now? and How do we get there?
An investment thesis should be specific enough to clarify where the organization should be looking for transactions and to help the company avoid me-too or off-strategy transactions that are unlikely to add value or do not match the company’s style of competition. A high degree of precision in the investment thesis empowers the organization to source transactions proactively, rather than just react to bankers’ pitch books (which almost always involve a public auction that drives down returns for acquirers). Finally, by defining precisely how the company will make the acquired business more valuable, an investment thesis gives the buyer confidence in future earnings power. This helps both to define the “walk away” valuation (the price above which a deal will not create value) and to identify situations in which paying an above-average premium will still result in attractive retained value for the buyer.
Investing in an Enduring M&A Network and Culture. Successful serial acquirers also invest continually in developing internal capabilities, building their M&A network, and cultivating potential sellers.
This investment starts at the top. The CEOs, presidents, and general managers of businesses are active “hunters” who are expected to spend a significant portion of their time exploring potential business combinations. These executive leaders often oversee the M&A process and mobilize the organization to identify and cultivate potential targets. In the process, they make deal sourcing and the patient cultivation of targets part of the organization’s culture.
Distinctive Principles for the M&A Process. Most executives today know that effective M&A requires a structured end-to-end process, from deal sourcing through integration. What distinguishes successful serial acquirers, however, is less the existence of such a process (“the letter of the law”) than the way that process is endowed with rigor and discipline by underlying principles and policies (“the spirit of the law”).
The best acquirers recognize that no two deals are exactly alike. Therefore, rather than develop detailed (and often highly bureaucratic) “cookbooks,” they run their M&A process according to a short list of principles designed to take time and cost out of the M&A process and to ensure that each acquisition delivers maximum value.
Such principles focus an organization’s M&A teams on the issues that matter most at each stage of the transaction process. For example, during due diligence, agree on the key deal breakers early on and focus the lion’s share of effort on resolving them. During bidding, establish a firm “walk away” value. During integration, allocate the majority of resources to activities (innovation, procurement, or pricing, for example) in which most of the value is expected to accrue.
Translating Portfolio Roles into Budgets and KPIs. Once a company has defined roles for its businesses, it must translate those roles into actions by establishing KPIs, performance targets, capital budgets, and, ultimately, detailed business and financial plans. Three factors are especially important:
Although the details will vary depending on the business and industry, we believe that all companies should go through some version of the steps outlined above: defining an investment thesis, determining the value creation potential of the portfolio of businesses, and developing a robust portfolio strategy.