McKinsey on Finance

Perspectives on The right restructuring for US automotive suppliers 1

Corporate Finance In the next round of consolidation, scale should be a result of strategy—
and Strategy not a strategy in its own right.

Number 13, Autumn

Agenda of a shareholder activist 5
2004
Fund managers should be good owners, not just traders, believes the
head of Europe’s 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-growth
markets in Asia?
McKinsey on Finance is a quarterly publication written by experts and
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 1

The right restructuring suppliers have, on average, barely kept up.

The industry as a whole has been destroying
for US automotive suppliers 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
In the next round of consolidation, scale should be a result of returns on sales have fallen. Yet even this slight
improvement evaporates once the goodwill
strategy—not a strategy in its own right.
premiums for past acquisitions have been
accounted for (Exhibit 1).

Glenn A. Mercer, Is there anything US auto suppliers A thorough industry restructuring may be
Jean-Hugues J. Monier, and haven’t tried to counteract the enormous required to brighten the suppliers’ prospects
Aurobind Satpathy purchasing power of the handful of and bring needed balance to their relations
automakers that make up their customer with the automakers. Launching another wave
base? As the suppliers’ profit margins have of M&A activity will not suffice. To level the
been squeezed again and again, they have playing field, suppliers must become smarter
responded with an array of strategic initiatives, about how they choose to expand or trim their
including diversifying their customer base, product and customer mix and adjust their
going global, positioning themselves further portfolio structure. The way the suppliers
upstream in the value chain, and actively rise to the challenge could provide guidance
helping to design components in hopes of to other industries, such as retailing, where
capturing more value than they could by powerful customers also dominate the top of
simply bending metal. In the 1990s, the the customer base.
industry also went through an M&A wave
that many hoped would deliver the heft The consolidation that wasn’t
MoF #13 needed to push back against the automakers. Many suppliers believe that their industry
Auto industry consolidated dramatically during the 1990s.
Exhibit 1 of 3 Each of these steps helped some suppliers In fact, a broad-based consolidation among
in some ways, but for all their efforts the the leading players never took place, although
many mom-and-pop companies were cleared
exhibit 1
away at the bottom of the pyramid. Thus the
Falling behind
annual revenues of the smallest of the top
Ratio of sales to average invested capital for selected suppliers 100 automotive suppliers operating in North
3.5 America rose to some $400 million, up from
Excluding
3.0
goodwill
around $50 million in the early 1990s. But
2.5 consolidation within the top 100 itself has
2.0
Including actually slowed or gone in reverse, as the 25
1.5 goodwill
1.0
largest suppliers command a smaller share of
0.5 the market today than they did a decade ago.
0 Moreover, the industry’s shape has become
1970 1978 1986 1994 2002
broader at the base, not more concentrated at
Source: 2003–04 McKinsey survey of ~60 suppliers operating in North America; Standard & Poor’s; McKinsey analysis
the top. From 1992 to 2002, each quartile of
the top 100 suppliers had a higher compound

2 McKinsey on Finance
1Numerous research studies performed by
McKinsey, by commercial and investment banks,
and by academic researchers such as Patrick
Steinemann of MIT concur on the desirability of
such an emphasis.
MoF #13
Auto industry
Exhibit 2 of 3
exhibit 2
Hardly a major consolidation
Top 100 auto suppliers’ revenues1 from North American OEMs by
quartile, %
100% = $83 $171
billion billion
Compound
annual
growth rate
of revenues
67 Quartile 1
77
17 Quartile 2
14
9 Quartile 3
6 7 Quartile 4
3
1992 2002
1Excludes aftermarket revenues.
Source: Ward’s Auto World; McKinsey analysis
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 than
two 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 size’s sake, usually
horizontally, adding products in order to
provide 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
Autumn 2004
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
  6%
to win large contracts in order to maintain
their growth trajectory. Those holding broad
9%
product portfolios found it almost impossible
12%
to achieve excellence in their disparate lines.
17%
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 shouldn’t 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 wouldn’t
have survived the 1990s without such
programs. But those initiatives must be part of
a broader strategy of improving the industry’s
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
MoF #13
Auto industry
The right restructuring for US automotive suppliers
Exhibit 3 of 3
exhibit 3
Second-tier successes
Financial performance by tier, 1995–2000 average (estimated), %
Return on sales Return on invested capital Compound annual growth rate
Tier-1
4.3 10.4 8.7 20.3 11.1
supplier1
Tier-2
7.0 13.8 12.2 30.1 7.5 35.0
supplier1
• Tier-1 suppliers directly face high-performing OEM purchasing organizations Tier-1 suppliers benefit from increased OEM
• Tier-2 suppliers compete in existing niches outsourcing and fewer direct suppliers
1Tier-1 suppliers have >50% of sales with OEMs; tier-2 suppliers have up to 50% of sales with OEMs.
Source: 2003– 04 McKinsey survey of ~60 suppliers operating in North America; McKinsey analysis
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 material
to finished good. As a result, control of
more of the links in a product’s 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 departments—one for
basic 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
3
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
35.2
segments, thus freeing up cash for the kind
of targeted growth—organic or acquired—
that will build real leverage. This kind of
supplier-level realignment will also improve
the industry’s performance over time by
Best practice 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
product’s value chain are tied to specific
processes. Such skills give focused suppliers
another defense against powerful customers,
which can’t reverse-engineer products whose
processes are patented, highly unusual, or
based on years of specialized expertise. Our
research 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 big
automotive-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 SUV’s 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.
4 McKinsey on Finance
What role to play
Broadly speaking, second-tier suppliers—those
focused on selling as much to other suppliers
as to automakers—are, 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 world’s
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
points”—key parts that may be small in dollar
value but immense in their impact on the
performance of the system as a whole—all
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.
Autumn 2004
Of course, to identify these choke
points, companies must develop a deeper
understanding of each link’s 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
won’t 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 McKinsey’s Cleveland office,
Jean-Hugues Monier (Jean-Hugues
_Monier@McKinsey.com) is a consultant in
the New York office, and Aurobind Satpathy
(Aurobind_Satpathy@McKinsey.com) is a principal
in the Detroit office. Copyright © 2004 McKinsey &
Company. All rights reserved.

Agenda of a
shareholder activist
Fund managers should be good owners, not just traders, believes
the head of Europe’s 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 work—more 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 companies
in 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
5
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 company’s 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
McKinsey’s Paul Coombes to explain the
Hermes 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,
we’re managing the investments of pension
funds and insurance companies, which in
turn are working for millions of beneficiaries.
6 McKinsey on Finance
McKinsey Quarterly, Q2 2004
Hermes/Pitt-Watson interview
Biographical exhibit
1 of 1
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 and
with MA and MBA from Stanford
University
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
policies—need 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 they’re 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 performance
of a fund manager is generally judged on the
The shareholder’s advocate
Career highlights
• Braxton Associates, Deloitte Consulting (1980–97 )
– Cofounder, partner, and managing director
• The Labour Party, United Kingdom (1997– 99)
– Assistant general secretary
• Hermes (1999–present)
– Managing director, Hermes Focus Asset Management (HFAM)
Fast facts
• Visiting professor of strategic management, Cranfield University, Bedfordshire, 1990–95
• Served on various public bodies, including Literacy Task Force (responsible for devising
improvement program in UK schools), 1996–97; Co-operative Commission, 1999–2001;
Westminster City Council, 1986–90; Labour Finance & Industry Group, 1986–2004
• Currently serves as trustee for the Institute for Public Policy Research (IPPR)
Autumn 2004
portfolio’s performance relative to the market.
So, for example, a fund manager who doesn’t
hold many shares in a poorly performing
company might not mind terribly if that
company were to go bankrupt, sending market
indexes lower. The likelihood is that he or she
might get a bigger bonus, as the fund would
outperform. There’s 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 directors
of 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 believe
will 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 we’re invested in are as well
managed as we can make them.
Agenda of a shareholder activist
The Quarterly: Corporate executives often
say that their businesses aren’t 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 it’s
inappropriate for a fund manager to be telling
the board to do this or that. It’s for the board
to run the company, and it’s 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 believe
you 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, many
years. That strengthens our credibility with
companies. And because Hermes is so well
established, there is a certain trust that
we won’t do anything that will damage
its reputation. We won’t, for example,
give unattributed press briefings that
undermine management. That’s a hopeless
way of going about owning companies.
7
The fact that the investors in the Focus Funds
include the world’s 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 isn’t 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 2003—41 percent
above the FTSE total-return benchmark.
That’s 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 of
benefit 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
concerns—perhaps a falling share price,
perhaps questionable strategic actions. The
concerns might come from our analysts or
from the brokerage community. Very often
they come from other fund managers. We then
ask three things. Is it fundamentally a good
company? Usually, we don’t 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
8 McKinsey on Finance
1Paul Coombes and Mark Watson, “Three
surveys on corporate governance,” The
McKinsey Quarterly, 2000 Number 4 special
edition: Asia revalued, pp. 74–7 (www
.mckinseyquarterly.com/links/14564).
then ask whether resolving the problems
would make these companies worth at least
20 percent more. That’s 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, we’re 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, it’s amicable. It should be a
good ownership relationship. But of course it
doesn’t always work that way.
The Quarterly: The fund-management
industry’s 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 a
report 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 you’d be hard-pressed
to find more than about £8 million spent by
fund managers specifically on ownership
activities. I’m 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
Autumn 2004
companies, we can really add economic value.
So I don’t think there’s a serious problem
about whether, in aggregate, there’s 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
what’s put into improving governance.
The Quarterly: You’ve spoken about the
short-term performance pressure companies
face. Are you worried about the shorter
average tenure of chief executives—attributed
in large part to pressure from investors?
David Pitt-Watson: Yes, it’s an issue—it’s
an issue if good CEOs don’t feel supported.
Of course, sometimes executives should step
down. But it’s 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 isn’t like that. When chief
executives make decisions, it can take years
to see the results, and it’s very unclear to
people on the outside whether you’re 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
shouldn’t be the result of a story in a Sunday
newspaper. I’ve seen two or three stories in
Agenda of a shareholder activist
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. That’s
what will matter at the end of the day. Second,
understand the investment process. It’s usually
about the buying and selling of shares, which
doesn’t always relate to the reality of whether
you’re 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 we’ve discovered that is enormously
helpful is the importance of separating the
roles of chairman and chief executive. The
separation makes very clear that the chief
9
executive’s role is to run the company and the
chairman’s 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
it’s under debate in America right now, and
I thoroughly encourage companies there to
do the same. It stops this incredible—and I
think stupid—pressure on chief executives to
say that they’re imperial and responsible for
everything. We know the world isn’t 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 McKinsey’s
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. 62–71 (www.mckinseyquarterly.com/
links/14551). Copyright © 2004 McKinsey &
Company. All rights reserved.
10
When payback
can take decades
For capital-intensive businesses, the variables in portfolio decisions
can seem overwhelming. Streamlining can help.
Boris Galonske, For companies in capital-intensive
Stephan Görner, and industries, investments are more often than
Volker H. Hoffmann 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
MoF #13 for instance, the average new
industries,
Portfolio
project costs about $500 million and takes
Exhibit
20 to 301 years
of 3 to create value on a net present
value (NPV) basis.
exhibit 1
An analytical approach to portfolio decisions
Take all possible portfolio1
combinations . . .
+ +
Expected NPV 2
– Downside risk 2
1Clusters reflect variations on key drivers and discrete decisions; for example—should 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
scenario.
3Represents the highest return for a unit of risk.
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 factors—the
size, location, technology, and timing of
possible investments, as well as a variety of
future market scenarios—it 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
. . . eliminate those that are not . . . and analyze only those close to
feasible . . . the efficient frontier 3
+
Efficient
frontier
Expected NPV 2
Expected NPV 2
+ – Downside risk 2 + – Downside risk 2 +
Individual real asset portfolios
market

1Demand may be a key driver in the developing
economies of Asia and Eastern Europe, for
instance, where forecasts are less reliable.
2This result can be calculated by quantifying
the impact of each driver on the company’s
financial performance—for example, on earnings
before interest and taxes (EBIT). Typically,
this calculation involves performing sensitivity
analyses on a financial model.
When payback can take decades
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 today’s 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 qualitative
understanding 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
market’s development. Demand in Western
countries 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
11
define those factors that lead to the biggest
commercial risks and have a potential impact
on the market’s development—and hence
on the investment’s 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 divisions—and
even within departments—around 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 some
combinations 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? It’s not
an implausible scenario in Europe, given
environmental movements currently under
way, but is it likely? Nuclear capacities are
so large that they couldn’t be replaced by
solar and wind power alone. The only option
would 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.
MoF #13
Portfolio
12 McKinsey on Finance Autumn 2004
Exhibit 2 of 3

exhibit 2
portfolio combination that meets both
Explicitly define risk tolerance
acceptable levels of risk (Exhibit 2) and
Low Moderate executives’ expectations of returns. Obviously,
tolerance tolerance
a portfolio with high NPV and low risk is
+ Low risk
tolerance more favorable than one with low NPV and
eliminates all high risk. The most desirable portfolios have
portfolios A moderate risk tolerance eliminates high-risk
portfolios. For example, companies might choose to a higher NPV than all other portfolios but
analyze only portfolios with positive NPVs in all
High with the same or a lower level of risk.4
Expected NPV 1

market scenarios.
tolerance

In our experience, the process of defining

High risk
tolerance
includes all
portfolios
– Downside risk 1
1Expected NPV is additional NPV vs a “do-nothing” option; downside risk is difference between expected NPV and NPV in
worst-case market scenario.
2Represents the highest return for a unit of risk.
3Such a model should include a detailed
description of each existing asset and of
each potential project and should calculate
each project’s future technical and financial
performance, depending on the development
of each key risk driver. Furthermore, it should
include a mathematical analysis that selects the
best combination of assets, using performance
indicators, such as NPV or downside risk, that
management prefers.
4In theory, a company could safely pursue any
+
Efficient frontier 2 Individual real asset portfolios
Narrowing portfolio choices
Today most executives analyze their
investments on a case-by-case basis. Few
companies go beyond a project’s NPV, and
they rarely connect the predicted cash flows
of 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 paid
attention 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
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 investment
plan 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 further—down to the
most attractive single portfolio. The benefit of
identifying the best portfolio is questionable,
however, because time will inevitably alter the
outcome. When the company achieves its ten-
year aspirations—a reasonable duration, given
the time it takes to bring a plant on line—
those goals could be five years out of date.

portfolio configuration that sits on the efficient
frontier, because all are equally desirable, as
long as a company has no precise preference for
the level of risk or return.
asset—alone and in combination with Adding one more layer of analysis can solve
others—in each future market scenario.3 that dilemma. Because the most promising
This analysis should plot each particular individual assets are likely to be part of a
MoF #13
Portfolio
When payback can take decades
Exhibit 3 of 3
exhibit 3
Without regret
% of modeled portfolios (near efficient frontier) that contain given
project as near-term investment¹
Project
Coal plant 10
Gas turbine plant 25
Combined-cycle gas
98
turbine plant
Lifetime extension for
100 investments
existing coal plant²
1Near term defined as over next 5 years; efficient frontier represents
highest return for unit of risk.
2Stand-alone evaluation of profitability to be calculated separately.
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
13
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 investment
decisions. A power-generation company
might make decisions to invest in gas-fired
Wait and see power plants today, for example, but could
reasonably postpone investments in coal-
fired plants until uncertainties with respect
‘No-regrets’ moves
for near-term 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 McKinsey’s Düsseldorf
office, Stephan Görner (Stephan_Goerner@
McKinsey.com) is an associate principal in the
Munich office, and Volker Hoffmann (Volker
_Hoffmann@McKinsey.com) is a consultant in the
Stuttgart office. Copyright © 2004 McKinsey &
Company. All rights reserved.
14

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

The scrutable East two reasons.

First, from a growth perspective, the returns

from investments in Asia just aren’t going to
be that large—at least over the next decade.
Even under optimistic ten-year forecasts for
Valuations are linked to growth. So why are they lower in these fast-growth markets, in most industries
the real value for shareholders will still lie in
high-growth markets in Asia?
the United States and Europe (Exhibit 1).

At current growth rates, corporate investment

Marc H. Goedhart, Most investors and executives want a in Asia1 will not have a tremendous impact
Timothy Koller, and piece of the booming Asian market for the on the short- or medium-term growth
Nicolas C. Leung right reasons. With vigorous growth in the and profitability of multinationals. One
region, getting into China, India, and other Western conglomerate, for example,
countries should position companies well for recently announced its goal to double its
the expected groundswell of shareholder value. revenues from China over the next five
And for many sectors, such as high technology years—a 15 percent annualized rate of
and manufacturing, the advantages of going to growth. That figure may sound weighty,
Asia, particularly China, have so changed the but since China currently represents only
competitive dynamics that there’s little choice 5 percent of the company’s revenues, the
but to join the rush. impact would increase the conglomerate’s
overall growth rate by a mere 0.6 percent.
But the decision to go to Asia can be unsound
1We analyzed the four key northern Asian
as well. Many executives who invest in China Second, one useful way of looking
markets of China, Hong Kong, Japan, and South
MoF#13
Korea, which account for about 75 percent of or India believe that these markets will at Asia is from a capital markets
Asian capital markets
Asia’s GDP.
2The Institutional Brokers Estimate System suddenly kick-start stalled growth at home, perspective. Corporations can learn
Exhibit
monitors1approximately
of 4 200 Chinese companies. reviving their companies’ sagging prospects. what to expect upon entering the Asian
market by analyzing the region’s listed
companies in terms of their valuation and
exhibit 1
underlying performance. From this angle, the
How much of a shake-up?
Asian market contains complications that any
Forecast GDP, $ billion company would be wise to consider.
2010 2050
China 3.0 44.5 While some companies have
United States 13.3 35.2
demonstrated high growth and profit
India 0.9 27.8
margins, for example, Asian companies
Japan 4.6 6.7
Brazil 0.7 6.1
trade at a consistent discount compared
Russia 0.8 5.9 with their US and European counterparts—
United Kingdom 1.9 3.8 the sole exception being Chinese stocks
Germany 2.2 3.6 on the Shanghai and Shenzhen exchanges,
France 1.6 3.1
many of which are also tracked by the
Italy 1.3 2.1
IBES index2 (Exhibit 2). Investors could
well be skeptical of these companies, since
 The scrutable East 15
MoF #13
Asian capital markets
Exhibit 2 of 4

exhibit 2
So if a direct link exists between a company’s
The Asia penalty? long-term market valuation and its underlying
Median market-to-book ratio for selected markets growth, why do Asian companies suffer
5 from valuations that are considerably lower
than those in many other parts of the world?
4
Several reasons are apparent.

3 S&P 500
IBES1 (China) Capital returns. Despite high margins in
Europe top 5002
2 most sectors and product markets, the
Nikkei 225 (Japan)
Hang Seng (Hong Kong) average return on capital in the four
1 northern Asian markets we analyzed is
KOSPI (South Korea) well below the US and European average
MoF
0 #13 (Exhibit 3). That’s caused in part by poor
1993 1995 1997 1999 2001 2003
Asian capital markets discipline. Banks, through their uneven
Exhibit 3 of 4
1Institutional Brokers Estimate System.
2 underwriting and their high levels of
500 largest European companies by market capitalization.
nonperforming loans, allocate capital
in an inefficient manner. Companies
exhibit 3
that allocate their capital better than the
Asian returns suffer average Asian corporation does might see
Median return on equity (ROE) for selected markets an opportunity, but the fact that Asian
competitors can operate with lower average
20
capital returns could also pose a threat to
15 them. Family ownership of companies also
S&P 500
inhibits efficient allocation of capital.
Europe top 5001
10
Asia average2
Governance. Companies looking to
5
compete directly in Asian markets or to
0
enter them through joint ventures and other
1993 1995 1997 1999 2001 2003 partnerships should keep in mind that Asian
companies have not been particularly kind to
1500 largest European companies by market capitalization.
2Based on median ROE of companies in Nikkei 225 (Japan), KOSPI
minority and public shareholders. Numerous
(South Korea), Hang Seng (Hong Kong), and IBES (China).
publicly listed companies have seen their
share price drop amid accusations that the
controlling shareholders manipulated the
their high valuations reflect not only relationship between listed and privately
their underlying strength but also the held subsidiaries. Admittedly, we can look
immaturity of the markets and a lack only at the second-order effect of how
of investment alternatives in China. For much institutional investors are willing to
some companies tracked by the IBES and pay for better governance. Yet a 22 percent
also traded in Hong Kong, where premium for Asian equities is significantly
investors enjoy more investment options, higher than the 13 or 14 percent that
the Hong Kong price can be a half to a these stocks enjoy in the United States and
third lower than the price in mainland Europe. Poor governance contributes to
China. market inefficiencies, which in turn lead to
MoF #13
16 McKinsey on Finance Autumn 2004
Asian capital markets
Exhibit 4 of 4

exhibit 4
been more pronounced over the past ten years.
Asian markets are more volatile
The lone exception has been Japan, which
Performance of selected markets; index: Dec 1985 = 100 didn’t create any value over this period either
1,000 (Exhibit 4).
900

800 Beta¹ Together, these aggregate analyses illuminate

Hang Seng 1.2 the challenge outsiders face as they seek
700 (Hong Kong)
KOSPI
to invest in Asia. While both Asian and
600 1.1
(South Korea) multinational companies have been extremely
500 S&P 500 1.0
successful in these markets, the number of
400 poorly managed performers is far greater than
300 the number of successes.
200

100 Nikkei 225 0.8

(Japan)
0
Dec 1985 Dec 1988 Dec 1991 Dec 1994 Dec 1997 Dec 2000 Dec 2003 In Asia, the outlook is favorable for companies
looking to build long-term value and improve
1Measure of asset’s risk relative to market; a given stock’s beta is >1.0 if, over time, it moves ahead of market and <1.0 if it moves
behind market.
manufacturing efficiencies. But Asian markets
may not be the easy answer for companies
attempting to boost their short-term growth.
Those investing in Asia should take a careful
volatile markets that have to make larger look at what really affects returns to public
corrections periodically in order to adjust shareholders. MoF
for gaps in information and in perception.
Marc Goedhart (Marc_Goedhart@McKinsey
Volatility and risk. Asia has been volatile. .com) is an associate principal in McKinsey’s
Amsterdam office, Tim Koller (Tim_Koller@
Volatility alone would not result in lower
McKinsey.com) is a principal in the New York office,
valuations, but the higher betas associated
and Nicolas Leung (Nicolas_Leung@McKinsey
with it increase the cost of capital for Asian .com) is a principal in the Hong Kong office.
companies. Compared with US and European Copyright © 2004 McKinsey & Company.
equity markets, volatility in Asian markets has All rights reserved.
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