INVESTMENT PORTFOLIO MANAGEMENT HOW TO ALIGN INVESTMENTS PORTFOLIO AND BUSINESS STRATEGY JULIO ARNAUD
English Version
Jun, 23 of 2015
JULIO ARNAUD
INVESTMENT PORTFOLIO MANAGEMENT HOW TO ALIGN INVESTMENTS PORTFOLIO AND BUSINESS STRATEGY
“And a closer look reveals that most plans don’t contain a strategy at all but rather a smorgasbord of tactics that individually make sense but collectively don’t add up to a unified, clear direction that sets a company apart – let alone makes the competition irrelevant.” Blue Ocean Strategy W. Chan Kim / Renée Mauborgne
Introduction Every company is a set of tangible and intangible assets. It produces or distributes a utility (products or services) through coordinated processes and activities. The main purpose of a company is to create and distribute wealth, so the market must realize a higher value in its products than the costs involved in its creation. However, this is not enough; you must do it better than the competition. The customer should give a higher value to your products than to the competitor products regarding on price, effectiveness, quality, or any other product attribute. In order to achieve market recognition to the value of its products and the fair return on investment, a company shall face the competitive forces through the implementation of the strategy. The business strategy assumes a fundamental role in defining the company's position in its business environment determining the attributes to be valued in its products, and therefore defines the way to run and to integrate its processes and activities Also, as important as defining a strategy is to ensure its execution and the workforce commitment to it. In this sense, the model used for selecting, for deciding investment projects and for the resources allocation plays a key role in enabling the strategy implementation. Failure to observe the strategic objectives will keep the investment portfolio in a huge distance from the company's mission, its identity and therefore from the shareholders interest. Thus, the main objective of the investment portfolio management is to ensure the fulfillment of strategic objectives while keeping a healthy and profitable cash flow. So, a definition of a consistent strategy, focused, unique, with a clear message and simple understanding is a necessary condition for a good and effective 2
JULIO ARNAUD portfolio management. A company must evaluate the value perceived by its Customers in its products in order to develop an effective method for investment portfolio management. Although the company’s strategy defines the investments and actions for the future profitability of the company, on the other hand the company also needs a healthy cash flow that provides a sustainable economic and financial condition. The company will often be compelled to invest in its current operation, in order to create incremental value in their products and services, to ensure a competitiveness and profitability. Thus, one great challenge of investment portfolio management is to balance the investments of current operations with future operations. Although we can set some milestones for the portfolio management, this is a dynamic process.
Investment portfolio Projects under an investment portfolio can be classified according to the stage they are in. 1. Projects in operation: they are project already running and commercially active, generating positive or negative results. These projects generate the present cash-flow. However, they also receive resources, mainly for creating incremental value needed to their competiveness and to maintain their profitability. A project in operation is not same of a company, in fact companies are formed from one or more projects in operation.
2. Projects under implementation: They are in a foundation phase and they are usually large resources consumer, and also they still don’t generate revenue. They contribute to meeting the strategic objectives, to creating value and to the future profitability. At the moment a project in implementation becomes commercially active, it will be classified as a project in operation. 3. Projects in proposition: They are projects in the planning stages. They are proposals of investment which haven’t had its approval to be implemented yet. The basic premises for a project in proposal become a project in implementation are its strategic alignment and the existence of resources for its implementation.
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Selecting and passing projects in proposition to an implementation phase. When we inspect the company’s project in proposition portfolio, we often come to the conclusion there are not enough resources to develop all projects. We will need to choose a set of projects that maximize value creation and the future profitability of the company and at the same time it fits in the limitation of resources available for new projects. The first filter naturally required for an approval of a project in proposition is its alignment to strategy. New project approvals must meet its strategic role it must maximize the value attributes that make up the business strategy. Although the dominant speech in companies is the alignment to strategy we can often observe company’s staff appealing for projects that don’t contribute to creation of the values set in the strategy. They usually argue the project has an excellent profitability. But once the strategic objectives are met by the set of projects in operation and under construction, the practice of approving projects without adherence to strategy will keep the investment portfolio even more distanced from the strategic planning and it will make uncertain the creation of the expected strategic values, and therefore uncertain the company's competitiveness and a more perennial profitability. Strategic analysis (I) – Value Attributes For those unfamiliar with the use of the Matrix of Value Assessment and Value Curve, please refer to “Blue Ocean Strategy” by W. Chan Kim and Renée Mauborgne, teachers of strategy and management at INSEAD – France.
The value attributes offered by the company's products or services, and also how they are perceived by the chain of consumption are issues inherent to the discussion and definition of the company’s strategy. The development of a value consumes company resources, and off course, these resources are limited. So it will be needed to choose those projects that best fit the values pursued by the company within a framework of an appropriate use of the company’s resources. Therefore, an investment portfolio management is effective only when it promotes the alignment of the portfolio with the strategy, provides the right balance in the generation of these values and in the company's capacity to use resources available. And also it must ensure a healthy and sustainable cash flow. It is more than a traditional analysis of Capex, profitability and risk used by many companies. In order to check if strategic value attributes is being met by the investment portfolio, it is necessary to compare the sum of each important values attributes of all projects in operation and under construction to the level of the value attributes designed in the strategy process. You can do that through the use of Values Curves. 4
JULIO ARNAUD When the sum of each value attributes of the portfolio has a perfect match to the strategic Values Curve, we have an optimal portfolio and a maximization of creating strategic value.
Chart 1 - Investment Portfolio perfect aligned to the strategy
However, gaps between attributes value of an investment portfolio with strategy Value Curve frequently arise as can be seen in the areas and in the chart below. When the investment in one value attribute of the portfolio is higher than the level set by the strategy (graph area), there is a waste of resources and therefore unnecessary cost. On the other hand when the investment in one value attribute is lower the level set by the strategy (graph area), there is a lack of investment and therefore the attribute will not reach the desired investment level.
Chart 2 - Investment portfolio misaligned to the strategy
The analysis of an opportunity to approve the implementation of a project should consider the project's contribution to the portfolio perfect match to the strategy. Thus, the analysis must seek: (i) strengthen value attributes with high importance in meeting the business strategy, especially those attributes with poor investment effort, and (ii) avoid unnecessary investment in the development of value attributes with lower importance. An approved project 5
JULIO ARNAUD must contribute to the strategic value attributes and invests on high valuated attributes. Furthermore, when as approved project invests on a low valuated attributes, there is no significant contribution in creating strategic values and there is a waste of resources. In fact, the more the project contributes to align the investment portfolio to the strategy Values Curve, the greater its suitability to strategy. Consider the scenario where the portfolio investments have a perfect alignment to the Value Curve of the company´s strategy, as area on chart 3 bellow:
Chart 3 - Project analysis in when the investment portfolio is aligned to the strategy
When a project in proposition invests more in a value attribute than it is necessary to comply with the needs defined in the strategy I , there is a waste of resources that will contribute to a misalignment to the strategy.
When a project in proposition invests less in a value attribute than it is necessary to comply with the needs defined in the strategy II , there is an insufficient investment to develop the attribute and also there is a contribution to a misalignment to the strategy.
Therefore, in the case of perfect alignment between the portfolio and the strategy, we should give priority to a set of projects that shows direct alignment to the strategy. Now consider the scenario where the portfolio investments exceed the strategic value as area on chart 4 bellow. This scenario shows the portfolio misaligned to the Value Curve of the company´s strategy, revealing waste of resources in developing attributes not well valued by the consumer chain.
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Chart 4 - Project analysis in when the investment portfolio exceeds the strategy
When a project in proposition invest less than it is necessary to comply with the needs defined in the strategy I , it should seem as an insufficient investment to the attribute. However, once there is an over investment in the portfolio and therefore a waste of resources II , this occurrence helps to align the portfolio with the strategy.
On the other hand, when a project in proposition invest more than it is necessary to comply with the needs defined in the strategy III , it will strengthen the waste of resources in the portfolio IV .
Consider the scenario of the area on chart 4 bellow, where the portfolio investments are insufficient to develop the strategic value.
Chart 5 - Project analysis in when the strategy exceeds the investment portfolio
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When a project in proposition invests more than it is necessary to comply with the needs defined in the strategy I , it should seem as a waste of resources. Nevertheless, considering the portfolio doesn’t invest enough resources to develop the strategic value, this occurrence helps to fix such portfolio failure and therefore it helps to align the portfolio with the strategy II .
Also, When a project in proposition invest less than it is necessary to comply with the needs defined in the strategy III , it will strengthen the lack of investment to develop the strategic value IV .
Based on the above considerations we can assume the misalignment between portfolio and strategy can be mitigated through the approval and implementation of new projects with prominent qualities to compensate portfolio deviations from strategy. Also, projects that contribute to appropriately strength the company’s strategy can be easily identified by a comparative analysis of investments on value attributes of the project, of the project portfolio and of the strategy. Moreover, we can easily identify projects that they need to be reviewed and those that should be eliminated from the portfolio. Strategic analysis II – Strategic objectives So far we have analyzed the projects regarding their contribution to align the investment portfolio to the strategic Value Curve. However, it is also necessary to investigate the contribution of each project in analysis to meet the strategic goals. As expected, all selected projects in proposition should reach or exceed the strategic goals along all projects already in implementation and operation. When the decision makers analyze a project in proposition, they should be aware of how much such project will contribute to the achievement of strategic goals and how much resources it will consume. The higher contribution and the lower resources consumption better will be the project. Important: resource is not just money, includes other sources such equipment, human resources, natural resources, knowledge, etc.
Decision makers should also compare the project in analysis to all other projects in portfolio (either in proposition, implementation or operation) in order to identify the best projects and then set their priorities for implementation. Graphical representation can be built to help the managers to compare projects in portfolio. For instance, a chart (chart 6) can be built where the vertical axis represents the contribution to the strategic goals and the horizontal axis represents the amount of resources consumed by the projects. Also, the minimum degree of project’s contribution and the maximum use of resources should be defined too splitting the chart into four parts. Then, the projects are plotted on the chart revealing projects with a high interest for its implementation (a high contribution to the strategic goals and low resources consumption), projects with some attractiveness (high contribution and high consumption of resources) and also disposable projects (poor contribution to the strategic goals). 8
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Chart 6 - Strategic and Resources Analysis of projects
If you have a more complex portfolio, it should be difficult to build a chart and plot all projects. Another approach is to create a matrix with all projects in portfolio that states how much each project contributes to the strategic goals and how much each projects consumes strategic resources. The matrix could be processed in spreadsheets, or simulation software or other automated process in order to evaluate priorities in investment and to maximize the strategic outcomes for the available resources. Financial and economic analysis Beside to addressing the projects’ contribution to the company's strategy, we must also address economic and financial evaluation and viability for all projects, including a detailed analysis of technical aspects of production, their potential financial return on investment and also their risks. The analysis of the project's cash flow and their key factors brings highly relevant information that will support their approval decision – for example their wealth creation (NPV), Internal rate of return (IRR or MIRR), payback, breakeven, opportunity cost, etc. The information elected to be used in decision making process and their eventual weights vary according to culture and needs of each company and moreover its business environment. Similar to the strategic analysis, the decision makers should be concerned about the comparison of the project in evaluation with all other projects in 9
JULIO ARNAUD portfolio. Such comparison helps to identify the most profitable projects, its risk exposure and the resources that will consume. Note: For each risk identified during the project planning and in its financial and economic analysis, a respective mitigation and contingency plan shall be submitted.
Putting all together The projects’ economic and financial analysis itself does not guarantee the effective implementation of business strategy, regardless the criteria used. So it isn’t enough to ensure a proper selection of projects to constitute the company portfolio. On the other hand, the strategic analysis of the projects does not guarantee the profitability and it could create a future situation of low profitability, or even the loss of sustainability. Therefore, to identify and select the best investment projects – those with better contribution to strategic and profitability goals, it is necessary to consider both analyzes together. In order to ease the comparative assessment between projects, you can use charts or graphs like the strategic analysis chart - goals x resources presented earlier modified with the inclusion of profitability information – represented by the size of the circle for each plotted project.
Chart 7 - Strategic and financial analysis.
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JULIO ARNAUD Alternatively, for an evaluation that demands more complexity, you can build a project matrix stating the project’s contribution for each strategic goals, the resources needed and the most important economic and financial information. The matrix analysis is usually made with the aid of mathematical tools that can generate an optimal set of investment projects that maximize the strategic and financial results (regarding the criteria used) The use an evaluation that considers at the same time the economic and financial analysis and the strategic goals and resource constraints, as well, creates valuable conditions to mitigate the risk of a loss-making portfolio or a failure in the strategy execution. It’s creates a breeding ground for value creation in behalf of the company and its shareholders.
Projects under implementation The projects being implemented should be reviewed periodically to endorse its strategic adherence, profitability and risks, despite the investments already made. So, it is necessary to periodically update of the analysis performed at the time of their approval or their last update – using the same criteria developed for project in proposition. The update of an analysis may indicate that a specific project does not contribute adequately to create value, or even destroys the value of the investment portfolio, either profitability and / or strategic value. Such projects are not intended to remain in the portfolio, but that decision cannot be taken solely considering this analysis. You will need a further investigation to identify and compare all viable alternatives like suspend, sell, shut, transform, etc. In order to select the best alternative, you will need to compare all alternatives through strategic analysis, and financial and economic analysis of each alternative, including the identification and mitigation of the risks involved.
Projects in operation Projects in operation should suffer periodic reviews as the projects under implementation. They can be divided into four groups:
Projects that deliver profitability equal to or above the minimum acceptable rate of return (MARR), and effectively contribute to the achievement of the strategic goals and value attributes. Those are projects that deliver value to the company and must remain in the company's portfolio.
Projects without profitability or projects less profitable than the MARR and at the same time do not contribute to the achievement of the
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JULIO ARNAUD strategic goals and value attributes. Those are projects that destroy value and, if possible, should be removed from the company's portfolio. 
Projects without profitability or projects with lower profitability than the MARR, but effectively contribute to the achievement of the strategic goals and value attributes. These projects should be reviewed. The first question to be answered is if there is an incremental investment that can raise profitability to the desired level. If so, the project should remain in the portfolio and the incremental investment is expected to compete for company resources. If not, you should identify the alternatives and perform a comparative analysis of alternatives (like in projects under implementation).
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Projects that deliver profitability equal to or above the MARR, but do not contribute to the achievement of the strategic goals and value attributes. Those projects should also be investigated. Is there any incremental investment that can create value and contribute to the achievement of strategic goals? We should also investigate whether the resources generated by the project contribute to the support projects under construction or projects proposition. If the project does not meet any of these requirements, it would be removed from the portfolio.
Important: If the portfolio contains a substantial number of projects in operation with suitable profitability that do not contribute to the construction of the desired strategic value, the portfolio is misaligned with the business strategy. Therefore is strongly recommended to consider selling some these projects in order to bring focus on the strategy execution.
Project in Operation Analysis STRATEGIC ADHERENCE
PROFITABILITY
Yes
No
Yes
KEEP
REVIEW
No
REVIEW
ELIMINATE
Present profitability Vs. Future profitability Although an adequate management of a projects investment portfolio seek incessantly to achieve the targets set in the business strategy, it is essential that the portfolio guarantees the economic and financial conditions necessary for the survival of the company. Investing in projects in operation generates the incremental value necessary to compete and maintain or enhance the company's profitability. Those projects in operation are an extremely important generation source of the resources to support projects under implementation and future projects.
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Chart 8 - Projects' resource allocation
So, one of the big questions to be answered in the investment portfolio management is: how much resources I allocate for projects in operation at the expense of projects under implementation or proposition. Quantification In order to balance the allocation of resources in projects in operation, under implementation and proposal stages in the portfolio, it is necessary to know and quantify the resources available in the company and the resources needed to implement such projects as well. Resources is all necessary and relevant inputs to the correct execution of projects, it isn’t limited to financial resources, it can be equipment availability, skilled labor, management capacity, among others. Notice that that both the availability and the need for resources changes in time. Thus, quantifying these features means determining the distribution of availability and need over a period of time. The identification and quantification of available resources should consider the own resources as well the resources offered by third parties, such as financing, partnerships, service contracts, leases, among others. On the other hand, the identification and quantification of the resources required to implement projects requires a careful analysis of the requirements and needs of each of these projects. An especial attention is necessary regarding projects in proposition. Since some projects in proposal stage will be approved and others won’t, and also new project proposals will appear and will be added in portfolio, the portfolio behaves in a very dynamic way. There is lot of uncertainty about the implementation of projects under this category. Thus, it´s too difficult to predict exactly the total amount of resources needed to implement all good projects in the proposal stage. One good approach to estimate the resources to be 13
JULIO ARNAUD reserved to such projects is to identify and quantify the resources needed to remove the gaps between: i) the projects in operation and under implementation; ii) and the strategic goals and values, taking into account the present projects in proposition portfolio, the projects execution and business opportunities history. Finally, the total amount of resources required for the portfolio is obviously the sum of: i) resources required for the execution of projects in operation and under construction; ii) the projection of resources earmarked for new projects in proposition stage. Resources analysis Once we have identified and quantified the resources available and needed, the next step is to match the availability with the need over time. Very often this analysis will point to a situation that the need for resources will exceed availability, revealing a momentary incapacity to run the projects portfolio. Other times this analysis will identify an excess of unused available resources, revealing waste of resources. Both situations indicate the need for adjustments in the portfolio. Such adjustment can be done anticipating or postponing projects, or through a scope or technology review, identifying new sources of resources, and so on. However, you must analyze the impacts of such adjustment in the portfolio regarding economic and financial perspective, and strategic goals achievement, as well. Important: Normally companies tend to review only projects in proposition. Those projects are easier to be changed since they have not started yet. However, these projects are essential to long-term strategy. To sacrifice only them can mean sacrifice the whole strategy. Consider ever reviewing the entire portfolio.
In the extreme case, we can have a situation that the portfolio is infeasible because the resources needed to meet the strategic goals exceed the available resources most of the time. In this case, you must rethink the projects portfolio to ensure its feasibility and adherent to the strategy. Sometimes, you will need to review the strategic goals for more consistent values compatible the company reality and its market position.
Final considerations An effective projects portfolio management should not be focused solely on profitability and on the use of financial resources. It is critical that the selection, maintenance and implementation of projects are taken to achieve the company´s strategy, since the execution of the portfolio will lead to the future positioning for the company. In other words, the portfolio must objectively contribute to the strategic goals achievement and to strengthen the value attributes defined for the company’s products and services.
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JULIO ARNAUD Also the strategic resources essential to run the portfolio are more than solely the financial resources available. All essential resource needed to run the portfolio must be considered. Moreover, bearing in mind the frenetic changes in business environments, the market volatility, the frequent launch of innovations, the deviations in projects execution, among other factors, it is essential manage your projects portfolio in a very dynamic way otherwise you will increase the risk of profitability loss and failure in the strategic objectives achievement. Thus, we finally conclude that an effective portfolio management must necessarily be a dynamic activity and supported by the Strategy-ResourcesProfitability tripod.
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