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McKinsey on Finance

The misguided practice of earnings guidance 1


Perspectives on
Companies provide earnings guidance with a variety of expectations—
Corporate Finance
and most of them don’t hold up.
and Strategy
Inside a hedge fund: An interview with the managing partner
Number 19, Spring
of Maverick Capital 6
2006
What should a company do when a hedge fund shows up among
its investors?

Balancing ROIC and growth to build value 12


Companies find growth enticing, but a strong return on invested capital is
more sustainable.

Toward a leaner finance department 17


Borrowing key principles from lean manufacturing can help the finance
function to eliminate waste.
McKinsey on Finance is a quarterly publication written by experts
and practitioners in McKinsey & Company’s Corporate Finance practice.
This publication offers readers insights into value-creating strategies
and the translation of those strategies into company performance.
This and archived issues of McKinsey on Finance are available online at
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Editorial Contact: McKinsey_on_Finance@McKinsey.com

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Editor: Dennis Swinford
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Cover illustration by Ben Goss

Copyright © 2006 McKinsey & Company. All rights reserved.

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1

The misguided practice of Our conclusion: to maintain good com-


munications with analysts and investors,
earnings guidance companies that currently provide quarterly
earnings guidance should shift their focus
away from short-term performance and
toward the drivers of long-term company
health as well as their expectations of future
Companies provide earnings guidance with a variety of business conditions and their long-range
goals.2 Companies that don’t currently
expectations—and most of them don’t hold up.
issue guidance should avoid the temptation
to start providing it and instead focus
on disclosures about business fundamentals
Peggy Hsieh, Timothy Koller, Most companies view the quarterly and long-range goals.
and S. R. Rajan ritual of issuing earnings guidance as a
necessary, if sometimes onerous, part of A dearth of benefits . . .
communicating with financial markets. The practice of issuing earnings guidance
The benefits, they hope, are lower share became more common during the latter half
price volatility and higher valuations. of the 1990s, after the US Congress protected
At the least, companies expect frequent companies from liability for statements about
earnings guidance to boost their stock’s their projected performance.3 Since then,
liquidity. the number of companies issuing quarterly
or annual guidance has increased—though
We believe that they are misguided. Our in recent years the trend has begun to
analysis of the perceived benefits of issuing slow. Our review of approximately 4,000
frequent earnings guidance found no companies with revenues greater than
evidence that it affects valuation multiples, $500 million found that about 1,600 had
improves shareholder returns, or reduces provided earnings guidance at least once in
share price volatility. The only significant the years from 1994 to 2004. The number of
effect we observed is an increase in trading companies that did so increased from only
volumes when companies start issuing 92 in 1994 to about 1,200 by 2001, when
guidance—an effect that would interest the rate of growth leveled off. The number of
short-term investors who trade on the news companies in our sample that discontinued
of such announcements but should be of guidance has also increased steadily, growing
little concern to most managers, except in to about 220 in 2004 (Exhibit 1).
companies with illiquid stocks. Our recent
1 “Weighing the pros and cons of earnings survey1 found, however, that providing In our survey, executives attributed several
guidance: A McKinsey Survey,” The McKinsey quarterly guidance has real costs, chief benefits to the practice of providing earnings
Quarterly, Web exclusive, February 2005 (www
.mckinseyquarterly.com/links/21063). The
among them the time senior management guidance, including higher valuations, lower
survey’s respondents included 124 CFOs, CEOs, must spend preparing the reports and an share price volatility, and improved liquidity.
and board members from around the world,
from nine industries and companies ranging in excessive focus on short-term results. Yet our analysis of companies across all
size from $10 million to $30 billion. sectors and an in-depth examination of
2 Richard Dobbs and Timothy Koller, “Measuring These results pose an intriguing question: two mature representative industries—
long-term performance,” McKinsey on Finance, if issuing guidance doesn’t affect valuations consumer packaged goods (CPG) and
Number 16, Summer 2005, pp. 1–6. (www
.mckinseyquarterly.com/links/21167). and share price volatility, why should a pharmaceuticals—found no evidence to
3 The Private Securities Litigation Reform Act company incur the real costs of issuing it support those expectations. The findings fell
of 1995. merely to satisfy requests from analysts? into three categories:
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����������������� (Exhibit 3). When we compared the TRS


of CPG companies in the year they started
providing guidance with that of peers that
������������������������������������������������ �������������������������������������������������
������������������������������������������������ ���������������������������������������������
didn’t issue it, the distribution of excess
returns5 was centered around zero. This
����� ��� analysis supports our finding that the
����� market has no reaction to the initiation of
���
����� guidance. The absence of excess returns also
��� ��� holds for the year after guidance starts.
��� ���
Volatility. When a company begins to issue
���
�� earnings guidance, its share price volatility is
���
as likely to increase as to decrease compared
� �
���� ���� ���� ���� ���� ���� ���� ���� ���� ���� ���� ����� with that of companies that don’t issue
guidance. We looked at the ratio of the
�������������������������������������������������������������������������������� standard deviation of monthly TRS in the
�����������������������������
year of initiating guidance to the previous
� �����������������������������������
year and found virtually no difference
between companies that do or don’t offer it.
Of 44 CPG companies that began offering
earnings guidance, 21 experienced increased
Valuations. Contrary to what some volatility and 23 showed a decrease
companies believe, frequent guidance does compared with companies that don’t offer
not result in superior valuations in the it. What’s more, the findings were similar
marketplace; indeed, guidance appears regardless of company size.6
to have no significant relationship with
valuations—regardless of the year, the Liquidity. When companies begin issuing
industry, or the size of the company in quarterly earnings guidance, they experience
question (Exhibit 2).4 From 1994 to 2004 increases in trading volumes relative to
the median multiples for consumer-packaged- companies that don’t provide it.7 However,
4 We analyzed companies by size—small goods companies track one another fairly the relative increase in trading volumes—
($500 million to $2 billion), medium closely, whether or not they issued earnings which is more prevalent for companies with
($2 billion to $5 billion), and large (greater
than $5 billion)—and by industry, including guidance. While the median multiple for revenues in excess of $2 billion—wears off
consumer packaged goods and pharmaceuticals. companies that did issue guidance was the following year. Since most companies
5 Excess returns in this case are defined as the higher from 2001 to 2004, the underlying don’t have a liquidity issue, the rise in
TRS of a company issuing guidance minus the
distribution of multiples for both groups trading volumes is neither good nor bad
median TRS of companies in the same industry
not issuing guidance. was comparable. Indeed, the averages from a shareholder’s perspective. Greater
6 Although increases in volatility were larger than of the two distributions are statistically volumes merely represent an increased
decreases among small and midsize companies, indistinguishable. Our findings are similar opportunity for short-term traders to act on
the sample was too small to warrant stronger
conclusions. in other industries, though their smaller the news of the earnings guidance and have
7 We determined the relative effect by comparing
sample sizes create more scattered data. no lasting relevance for shareholders.
a trading-volume index for the guiding
company to the median index for nonguiding Moreover, in the year companies begin . . . but real costs
ones in the same sector. The index was
created by dividing the trading volume in the to offer guidance, their total returns to Analysts, executives, and investors
year guidance started (normalized by shares
shareholders aren’t different from those understand that the practice of offering
outstanding) by the trading volume in the
previous year. of companies that don’t offer it at all quarterly earnings guidance can have
���
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The misguided practice of earnings guidance 3
��������������
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���������
well. On February 1 of this year, Google,
���������������������� the Internet search engine highflier, saw
����������������������������������������������� its shares tumble by 7 percent when its
�������������������������� ������������������ fourth-quarter results fell short of the lofty
�� �� expectations bandied about in the days
�� leading up to the release. Some investors
��
blamed the sell-off on Google’s refusal
����������������

��

������������
�� to issue guidance that might have kept
��
expectations in check.
�� ��
��
�� Still, while most companies do offer quarterly

guidance, a number of respected and highly
� �
visible companies have announced that they
���� ���� ���� ���� ���� ���� � � �� �� �� �� ���
��������� will either minimize the practice—offering
only annual guidance—or abandon
��������������������������� �������������������������������
it altogether in favor of longer-range
���������������������������������������������������������������������������������� indications of their strategy and business
� �����������������������������������
conditions. In January 2006 alone, for
example, Citigroup and Motorola announced
that they would move away from quarterly
earnings guidance, and Intel, asserting that
intangible costs and unfortunate, unintended “updates were increasingly irrelevant to
consequences. The difficulty of predicting managing the company’s long-term growth,”
earnings accurately, for example, can lead to announced that it would end its midquarter
the often painful result of missing quarterly updates on sales and profit margins.
forecasts. That, in turn, can be a powerful
incentive for management to focus excessive But many companies that currently offer
attention on the short term; to sacrifice guidance are reluctant to stop: in our survey,
longer-term, value-creating investments in executives at 83 percent of them said that
favor of short-term results; and, in some they had no plans to change their programs.
cases, to manage earnings inappropriately These executives indicated that they fear the
from quarter to quarter to create the illusion potential for increased share price volatility
of stability. upon the release of earnings data, as well
as the possibility of a decrease in share
The practice also bears hard costs. In our prices, if guidance were discontinued. The
survey, executives ranked the demands on executives also worry that discontinuing
management’s time as the biggest cost of guidance will make their companies less
issuing frequent guidance, followed closely visible to investors and analysts.
by the indirect cost of an excessively short-
term focus. Respondents also cited demands But when we analyzed 126 companies
on employees as a cost. that discontinued guidance, we found that
they were nearly as likely to see higher
The risks of not providing earnings as lower TRS, compared with the market.
guidance Of the 126, 58 had a higher TRS in the
Of course, some investors would say that year they stopped issuing guidance, and
not issuing guidance can have real costs as 68 had a lower TRS compared with the
���
4
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McKinsey on Finance Spring 2006
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���� ������� ������� ������� ������� ������� ������� �������� �������� �������� �������� ���
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overall market. Furthermore, our analysis To guide or not to guide?


showed that the lower-than-market TRS With scant evidence of any shareholder
of companies that discontinued guidance benefits to be gained from providing
resulted from poor underlying performance frequent earnings guidance but clear
and not the act of ending guidance itself evidence of increased costs, managers should
(Exhibit 4). In our sample of 126 companies consider whether there is a better way to
that stopped issuing guidance, 79 did so as communicate with analysts and investors.
their return on invested capital was already
declining, 47 while their ROIC was rising. We believe there is. Instead of providing
Of the former group, 50 experienced a lower frequent earnings guidance, companies can
TRS than the market, while 29 had a higher help the market to understand their business,
one.8 Among those companies with a rising the underlying value drivers, the expected
ROIC, only 18 had a lower TRS than the business climate, and their strategy—in
market, demonstrating that the lower TRS short, to understand their long-term health
was correlated with a falling ROIC. Last, as well as their short-term performance.
academic research9 also shows that ending Analysts and investors would then be
guidance doesn’t lead to reduced coverage or better equipped to forecast the financial
8 Compared with the market in the year that
increased volatility and concludes that the performance of these companies and to
guidance was stopped.
negative shareholder returns of companies reach conclusions about their value.
9 Shuping Chen, Dawn A. Matsumoto, and
discontinuing guidance are the result of poor
Shivaram Rajgopal, “Is silence golden? An
empirical analysis of firms that stop giving expectations for future performance and A retailing company, for example, could
quarterly earnings guidance,” University of
of the decreased accuracy of forecasts after provide the components of revenue growth
Washington working paper, January 2006
(http://papers.ssrn.com). guidance stopped. (same- and new-store sales growth, volumes,
���
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�������������� The misguided practice of earnings guidance 5

��������������������������������������������������������������������������������

���������
growth initiatives, and M&A—not only on
�����������������������
earnings but also, more important, on value.
�������������������������������������������������������
����������������������������� Our approach has the additional advantage
��
of reducing intangible costs. When Coca-
�� Cola stopped issuing guidance, in late 2002,
�������������������������������
������������������������ its executives had concluded that providing
����������������������� ������
����������
short-term results actually prevented
���������� ��������� management from focusing meaningfully
����������� � ����������� � on strategic initiatives to build its business
and succeed over the long term. Instead
�� of indicating weak earnings, Gary Fayard
���������������������
�� (who was then CFO) believed that the move
���������������������������� �� signaled a renewed focus on long-term
��������������
goals. The market seemed to agree and did
����������� ����������
����������� � ����������� � not react negatively, holding Coke’s share
�������������������������������������������������������������������������������������������������������� price steady.10 Like Coke, companies that
���������������������������
reduce or discontinue guidance must clearly
� �����������������������������������
indicate that poor expectations of future
performance are not the reason.

prices, product mix, and currency effect)


and margins by business unit. It could The voluntary disclosure of financial
highlight the factors that drive volume information is a key component of high-
growth (disposable income, marketing functioning capital markets. The current
expenditures, weather patterns), margins trend—more and more companies discon-
(input costs, trade spending, corporate costs), tinuing quarterly guidance and substituting
and capital intensity (the number, age, and thoughtful disclosures about their long-
location of its stores and the efficiency of range strategy and business fundamentals—
its working capital) and explain how these is a healthy one. In this way, companies will
factors will likely change in the future. In better signal their commitment to creating
addition, the company could disclose the long-term, sustainable shareholder value and
drivers of its recent performance as well as encourage their investors to adopt a similar
management’s expectations for the future. outlook. MoF
Analysts could then build their own models
to predict earnings going forward. Moreover, Peggy Hsieh (Peggy_Hsieh@McKinsey.com) and
they would be better able to determine the S. R. Rajan (SR_Rajan@McKinsey.com) are
consultants in McKinsey’s New York office, where
impact of various corporate moves—for
Tim Koller (Tim_Koller@McKinsey.com) is a partner.
10 See, for example, David M. Katz, “Nothing but example, cost cutting, share repurchases,
Copyright © 2006 McKinsey & Company. All
the real thing,” CFO.com, March 2003. marketing expenditures, R&D, organic- rights reserved.
6 McKinsey on Finance Spring 2006

Inside a hedge fund: An interview Ainslie, a soft-spoken Virginian, was a


protégé of the storied investor Julian
with the managing partner of Robertson at Tiger Management, one of the

Maverick Capital most successful hedge funds in history. In


1993 Ainslie left Tiger to launch Maverick,
which had been set up with $38 million in
capital by the family of Texas entrepreneur
What should a company do when a hedge fund shows up Sam Wyly. On a recent afternoon, Ainslie
talked in Maverick’s offices overlooking
among its investors?
New York’s Central Park with McKinsey’s
Richard Dobbs and Tim Koller about the
direction of the hedge fund industry, the
Richard Dobbs and The hedge fund industry now comprises way Maverick works with the companies it
Timothy Koller more than 8,500 funds around the world invests in to achieve long-term returns, and
and continues to grow. Given the ability of how executives should handle relations with
many funds to buy and sell large amounts hedge fund investors.
of stock rapidly, it would seem natural that
CFOs and other executives would be highly McKinsey on Finance: Let’s cut right
attuned to the rising clout that hedge funds to the question so many executives have
can have with the companies they hold on their minds: when Maverick considers
stakes in. But many executives often don’t investing in a company, what makes you say,
understand how investing philosophies “Yes, we want to invest” or “No, we don’t”?
differ among funds or how to deal with
them as investors. Lee Ainslie: First and foremost, we’re
trying to understand the business. How
A case in point: Maverick Capital, with sustainable is growth? How sustainable are
$10 billion in assets under management, returns on capital? How intelligently is it
has long been known as one of the largest deploying that capital? Our goal is to know
and most consistently successful hedge more about every one of the companies
funds. Yet Maverick, with offices in New in which we invest than any noninsider
York and Dallas, is not what most people does. On average, we hold fewer than five
might think of as a typical hedge fund. positions per investment professional—a
Rather than taking big bets on currencies, ratio that is far lower than most hedge funds
bonds, and commodities, Maverick relies and even large mutual-fund complexes. And
on old-fashioned stock picking to generate our sector heads, who on average have over
its returns. Lee S. Ainslie III, Maverick’s 15 years of investment experience, have
managing partner, likes to say that typically spent their entire careers focused on
Maverick is more of a traditional hedged just one industry, allowing them to develop
fund, investing only in equities and long-term relationships not only with the
maintaining a balance of long and short senior management of most of the significant
positions. The 49 members of Maverick’s companies but also with employees several
investment team generate performance by levels below.
understanding which stocks will be the best
and worst performers in each sector and We spend an inordinate amount of time
region, rather than by trying to time trying to understand the quality, ability,
market movements. and motivation of a management team.
Inside a hedge fund: An interview with the managing partner of Maverick Capital 7

Sometimes we get very excited about a metric, for instance. You have to recognize
business with an attractive valuation only that different sectors react to events in
to discover that the company has a weak different ways and should be analyzed
management team with a history of making differently. Part of the art of investing is to
poor strategic decisions or that is more be able to recognize which approach is the
concerned about building an empire than most appropriate for which situation over a
about delivering returns. We have made the certain period of time.
mistake more than once of not investing in
a company with a great management team As for returns, we target stocks that we
because of valuation concerns—only to look believe will under- or outperform the market
back a year later and realize we missed an by 20 percent on an annualized basis.
opportunity because the management team This can be a daunting goal in this lower-
made intelligent, strategic decisions that had volatility, lower-return world. Yet even in the
a significant impact. past year, 35 percent of all the stocks in the
S&P 500 either out- or underperformed the
MoF: How do you approach valuation, and index by 20 percent. So it’s our job to find
what type of returns do you target? the best and worst performers. In the end,
our success is driven by making many good
Lee Ainslie: We use many different decisions rather than depending upon a few
���� valuation methodologies, but the most big home runs. In the long run, we believe
������������������ common at Maverick is to compare this approach creates a more sustainable
��� sustainable free cash flow to enterprise value. investment model.
������������� But I believe it is a mistake to evaluate a
��������������������������������������� technology company, a financial company, MoF: What is the typical time frame that
and a retailer all with the same valuation you are thinking about when you look at an
investment opportunity?

Lee Ainslie: Usually, one to three years.


����������������
��������������������������������������� Having said that, we do evaluate each
�������������������������������������������� position every day to consider whether the
��������� current position size is the most effective use
��������������������������������������������������������������
of capital. Certainly, there are times when
�����������������������
������������������������������������������������������������� we are very excited about an investment and
����������������������� take a significant position only to watch the

� ����������������� rest of the world recognize the attractiveness
������������������
� ������������������������������������
of the investment and drive up the share
������������������������������ price, which of course lowers the prospective
� �����������������������������
������������������� return. Different firms handle this situation
� ������������������������������������������������������������� in different ways, but at Maverick, if we
� � ���������
have developed that longer-term confidence
���������� in a business and a management team, we
����������������������������������������������������������������
���������������������������������� will typically maintain a position—though
��������������������������������������������������������������
���������������������������������������������������������������
perhaps not of the same size.
������������������
������������������ ������������������������������������������������������
MoF: How much of a factor is a company’s
���������������
growth prospects?
8 McKinsey on Finance Spring 2006

Lee Ainslie: We work hard to deconstruct value creation of stock buybacks. In some
growth to judge its sustainability and to industries, especially in the technology sector,
understand the impact it will have on such a move is even viewed as an admission
capital returns. Of course, we’d like to see of defeat. It isn’t, of course. Buybacks reflect
organic growth, because its incremental executives investing in the company that
return on capital is far superior to that they know better than any other potential
of acquired growth. Occasionally we are investment or acquisition. And if they do
able to find a business and a management not believe that such an investment is
team with a strong industry position that worthwhile, then why should I?
enjoys ample acquisition opportunities and
where huge synergies are clearly going to Today investors face the bizarre juxta-
be recognized. Unfortunately, in today’s position of record levels of corporate cash in
world these opportunities are quite rare. In the face of incredibly low interest rates—this
our judgment, onetime acquisitions that past fall saw negative real interest rates
enhance earnings by cutting expenses do in the United States for the first time in
not represent sustainable growth and are 25 years. US corporations have the lowest
rarely as productive as either management levels of net debt in history, even though the
or investors expect. cost of debt has rarely been more attractive.
Companies with inefficient balance sheets
We also spend a lot of time trying to should recognize that if they do not
understand how executives value and address such situations, the private equity
analyze growth opportunities and what community and active hedge funds will take
motivations drive their decisions. It’s advantage of these opportunities.
not uncommon to see companies pursue
strategies that create growth but that are MoF: How forthcoming should companies
not very effective economically. This is be about where they are creating value and
particularly prevalent in today’s environment where they aren’t?
of incredibly cheap financing. Indeed, with
debt financing as it is today, companies Lee Ainslie: Obviously, the more infor-
can easily claim a deal is accretive—even if mation we have to analyze, the greater our
it makes relatively little strategic sense or confidence in our ability to understand
diminishes long-term returns. the business. As a result, we are far more
likely to be in a position to increase our
MoF: What about the high levels of cash investment during tumultuous events. When
that many companies have today? we consider return versus risk, increased
transparency greatly reduces the risk. Clearly,
Lee Ainslie: It’s quite frustrating as there are some companies in very narrow,
a shareholder that companies are not competitive businesses where the disclosure
using cash more productively for their of certain information could be damaging
shareholders, whether by buying back stock to the business itself. We understand that.
or by issuing dividends. To some degree, But we often find that competitive issues are
this probably represents a backlash to the more an excuse than a reality. I believe that
dramatic overinvestment that was prevalent often the unwillingness to share detailed
in many industries in the late ’90s, but I’m information is driven by the thought that
amazed at how many CFOs don’t truly this lack of disclosure gives them the ability
understand the long-term sustainability and to pull different levers behind the screen or
Inside a hedge fund: An interview with the managing partner of Maverick Capital 9

to hide reality for a quarter or two. But such difficult times, the market usually interprets
realities come out eventually, and in this day this change to mean that the company is not
and age the consequences of such games giving guidance either because it would be
may be disastrous. so bad that they would prefer not to talk
about it or because they have no confidence
MoF: Boards and CFOs spend a lot of time in their own ability to predict the business.
worrying about whether or not to issue I would strongly advise that companies,
earnings guidance. As an investor, does it if they are going to discontinue giving
matter to you whether they do or not? guidance, do so after a great quarter—do
it from a point of strength, and it will be a
Lee Ainslie: That’s a difficult question, and much less destabilizing event.
you have some very thoughtful people on
both sides of the issue. Warren Buffet, for MoF: With so many funds out there, how
instance, has been a very strong proponent do traditional funds such as Maverick
of not giving earnings guidance, and I differentiate themselves from those that
understand his motivations. Personally, I create value by being interventionists—by
believe there is some value in earnings taking possession of a company and
guidance because it’s a form of transparency changing the management team?
and, if handled appropriately, should help
investors develop confidence in a company’s Lee Ainslie: Perhaps we put a greater
business. Investor confidence, in turn, can premium on the value of our relationships
reduce the volatility of a stock price, which with management teams than many
should lead to a higher valuation over the do. If we think we have invested in
longer term. But even within Maverick, a management team that isn’t acting
frankly, if you ask the 12 most senior people appropriately or is not focused on creating
in the firm, you would probably get six shareholder value, we don’t want to take
opinions on each side. our fight to the front page of the Wall
Street Journal—because that would not
Even when a company does provide earnings only permanently destroy our relationship
guidance, we don’t evaluate the success of with that management team but also have
a quarter simply by looking at whether a a detrimental impact on our relationships
company beat the market’s expectations. with other management teams.
Some investors who manage huge portfolios
with hundreds of stocks will often judge That doesn’t mean that we’re not going
a quarter simply by looking at reported to have suggestions or that we won’t
earnings versus expected earnings. But there communicate with the board. But when
are also many investors, like Maverick, we do so, we work very hard to make
that are going to dissect and analyze the sure the management team knows we’re
quarterly results every which way you doing so in the name of partnership. Unlike
can think of, compare our expectations to private equity firms, if we are unhappy
reality, and use these analyses to improve with management, we do not have the
our understanding of fundamental business responsibility to change management.
trends. When companies decide to stop Ultimately, if we believe that the management
providing guidance, that decision often of one of our investments is acting in an
induces volatility—often because companies inappropriate manner and our attempts to
do so during a moment of weakness. During convince the management and board of our
10 McKinsey on Finance Spring 2006

point of view are unsuccessful, we have the The harder part is to recognize which
luxury of simply selling the stock. investors are so thoughtful, intelligent, and
plugged in that a CFO should find time to
MoF: How do you maintain a good talk to them. At Maverick, for example, as
relationship with executives when you have part of our intensive research effort, we
a short position in their company? Do they maintain constant dialogues with the
even know? competitors, suppliers, and customers of the
companies in which we invest. As a result,
Lee Ainslie: Our short positions are not many management teams find our insights
publicly disclosed, but if an individual to be quite helpful.
management team asks what our position
is, we will answer honestly. This policy can MoF: Who should lay that groundwork?
be difficult in the short term, don’t get me
wrong, but I think most management teams Lee Ainslie: A company’s investor relations
appreciate and respect this integrity, which team can play a very valuable role in this
over time leads to a stronger relationship. regard. By constantly and proactively
meeting with shareholders and potential
I will point out that when we are short, investors and developing an understanding of
by definition we’re going to have to buy their knowledge and abilities, the team can
eventually. A short seller is really the only assess which investors a CEO or CFO should
guaranteed buyer that a company has. meet with. The better sell-side analysts can
Some companies disdain any interaction also be very helpful in this regard.
with short sellers. The more thoughtful,
intelligent companies take a different tack Management teams should seek out
and want to improve their understanding of the more thoughtful investors who
the concerns of the investment community. ask hard questions and have clearly
Sometimes they’ll listen and prove us wrong, done their homework. Over time such
and other times they will recognize that we dialogues will hopefully develop into
have legitimate points. With the intensity mutually beneficial relationships.
of our research and analysis and our strong
relationships with significant competitors, MoF: And finally, what’s going on in the
we may have insights or information that hedge fund industry today? Is there too
prove to be quite helpful to companies. much capital out there?

MoF: If I’m a CFO, how do I decide Lee Ainslie: If you look at the pricing of
which institutional investors to develop a all assets—financial and real—one could
relationship with? argue that there is simply too much liquidity
chasing too little return. To put the explosion
Lee Ainslie: For a CFO, whose time is a of hedge fund assets into context, today
limited and valuable resource, this is a very the hedge fund industry manages roughly
important question. Unfortunately, there is $1 trillion in capital. This compares with
no magic list of the funds that do thoughtful an investment universe in stocks, bonds,
and in-depth analysis. It’s not too hard to currencies, real estate, commodities, and
figure out that a CFO should develop a so forth well north of $50 trillion. Some
relationship with an institutional investor people have concluded that the dramatic
that owns millions of his company’s shares. growth of hedge funds will lead to shrinking
Inside a hedge fund: An interview with the managing partner of Maverick Capital 11

returns. However, I believe the impact of this may come to different conclusions about
capital will differ among different hedge fund investment opportunities. In other words,
strategies. For almost any arbitrage strategy, one fund may be long a stock when another
for example, the opportunity set is relatively is short, and as a result incremental capital
limited, and virtually every dollar that is does not force spreads to close. Indeed, if
invested is deployed on the same side of each you look at the spread between the best- and
trade. So by definition the incremental capital worst-performing quintiles of the S&P 500,
will negatively impact the arbitrage spreads. for example, you can see that the annual
spread has averaged around 70 percent over
The opportunity set for long-short equity the past 15 years—which was almost exactly
investing is quite different. At Maverick, we the spread in 2005. At Maverick, we are
define our investment universe as all stocks very excited about the potential to extract
that have an average daily volume greater value from this spread to deliver returns to
than $10 million—there are roughly 2,500 our investors. MoF
such stocks around the world. Since we
may hold long or short positions in any of Richard Dobbs (Richard_Dobbs@McKinsey
these stocks, we have about 5,000 different .com) is a partner in McKinsey’s London office, and
Tim Koller (Tim_Koller@McKinsey.com) is a partner
investment opportunities. Unlike arbitrage
in the New York office. Copyright © 2006 McKinsey
strategies, different long-short equity funds
& Company. All rights reserved.
12 McKinsey on Finance Spring 2006

Balancing ROIC and growth to observed the same pattern for the groups
from 1975, 1985, and 1995. In other words,
build value ROIC tends to remain stable over time
(Exhibit 2).

Growth, by contrast, is fleeting. The median


inflation-adjusted growth in revenues for
Companies find growth enticing, but a strong return on invested the top 500 companies in 1965 started
out at 7 percent and steadily declined to
capital is more sustainable.
2 percent over the next 10 years, hitting
a cyclical low of 0 percent by year 17.
Growth might be the lifeblood of a For the next 20 years, growth hovered
Bing Cao, Bin Jiang, and business, but it isn’t always the best or at around 2 percent—a figure below the
Timothy Koller most sustainable way to create value for level of US GDP growth.2 We observed
shareholders. Return on invested capital a similar general pattern of decay in
(ROIC) is often just as important—and median real growth for the top 500
occasionally even more so—as a measure of companies in 1975, 1985, and 1995.
value creation and can be easier to sustain at
a high level. Moreover, pattern analysis at the industry3
level further shows the importance of
When a company’s ROIC is already high, managing ROIC. A comparison of ROIC4
growth typically generates additional value. for the top 500 companies of 1965 shows
But if a company’s ROIC is low, executives that it remained steady in most sectors and
can create more value by boosting ROIC even increased in some—particularly those
than by pursuing growth (Exhibit 1). A with strong brands or patent-protected
close look at companies with high price-to- products (household and personal goods,
earnings multiples shows that many have for example) and pharmaceuticals and
extraordinary returns on capital but limited biotechnology (Exhibit 3, part 1). Growth,
growth. This scrutiny suggests that, contrary by contrast, almost always declined, except
to conventional wisdom, investors recognize in pharmaceuticals (Exhibit 3, part 2).
(and will pay more for) the anticipated
returns of companies with a strong ROIC, A close look at individual companies finds
despite their limited growth prospects. This similar patterns; companies with high levels
observation doesn’t mean that growth is of ROIC tend to hold on to that advantage,
undesirable; unless companies keep up with whereas high-growth companies rarely
their industries, they will likely destroy value. do. Exhibit 4 looks at the probability that
But they shouldn’t pursue growth heroically a company will migrate from one level of
at the expense of improvements in ROIC. ROIC to another over the course of a decade.
A company that generated an ROIC of less
After identifying the largest publicly than 5 percent in 1994, for instance, had
1 The performance of each set of companies was
listed companies in the United States (by a 43 percent chance of earning less than
tracked as a portfolio until 2004. revenues) in 1965, 1975, 1985, and 1995, 5 percent in 2003. As the exhibit shows,
2 Real GDP growth averaged around 2.5 to
we examined their long-term patterns of low and high performers alike demonstrate
3.5 percent a year from 1929 to 2005.
3 Defined by the Global Industry Classification growth and ROIC.1 The median ROIC for consistency throughout the 40-year period.
Standard (GICS).
4 Measured by the median ROIC of companies the 1965 group remained stable, at about Companies with an ROIC of 5 to 10 percent
that survived in subsequent years. 9 percent, over the next 40 years. We had a 40 percent probability of remaining in
(continued on page 16)
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Balancing ROIC and growth to build value 13
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14 McKinsey on Finance Spring 2006
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Balancing ROIC and growth to build value 15
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16 McKinsey on Finance Spring 2006
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the same group ten years later; companies
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with an ROIC of more than 20 percent had
�������������������������������������������������������������������������������������������������������������� a 50 percent probability.

������������ But when it comes to growth, companies


� �� ����� ������ ������ ���� are very likely to experience substantial
�����
������� declines (Exhibit 5). Of companies that
� �� �� �� �� � �� grew by more than 20 percent in 1994,
for example, 56 percent were growing at
����� �� �� �� � � real rates of less than 5 percent ten years
������ �� �� �� �� �� later. Only 13 percent of the high-growth
companies maintained 20 percent real
������ �� �� �� �� �� growth ten years on, and acquisitions
���� �� � �� �� �� probably drove most of it. MoF
������������
������������� �������������������� �������������������� �������������������� Bing Cao (Bing_Cao@McKinsey.com) and Bin Jiang
�������������� ���������������� ������������������������ ����������������������� (Bin_Jiang@McKinsey.com) are consultants and
�������������������������������������������������������������������������������������� Tim Koller (Tim_Koller@McKinsey.com) is a partner
����������������� in McKinsey’s New York office. Copyright © 2006
McKinsey & Company. All rights reserved.
���������

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17

Toward a leaner finance department at all levels of an organization.1 Industries


as diverse as retailing, telecommunications,
airlines, services, banking, and insurance
have adopted parts of this approach in order
to achieve improvements in quality and
efficiency of 40 to 70 percent.

Borrowing key principles from lean manufacturing can help the We have seen finance operations achieve
similar results. At one European
finance function to eliminate waste.
manufacturing company, for example,
the number of reports that the finance
department produced fell by a third—and
Richard Dobbs, Herbert Pohl, Waste never sleeps in the finance the amount of data it routinely monitored
and Florian Wolff department—that bastion of efficiency for analysis dropped from nearly 17,000
and cost effectiveness. Consider the reams data points to a much more manageable 400.
of finance reports that go unread and the
unused forecasts, not to mention duplicate Borrowing from lean
computations of similar data, the endless In our experience, the finance function
consolidation of existing reports, and eludes any sort of standardized lean
mundane activities such as manually entering approach. Companies routinely have
data or tailoring the layout of reports. different goals when they introduce the
concept, and not every lean tool or principle
The impact is significant. In a recent exercise is equally useful in every situation. We
that benchmarked efficiency at consumer have, however, found three ideas from
goods companies, the best finance function the lean-manufacturing world that are
was nine times more productive than the particularly helpful in eliminating waste
worst (exhibit). Production times also and improving efficiency: focusing on
varied widely. Among the largest European external customers, exploiting chain
companies, for example, it took an average reactions (in other words, resolving one
of 100 days after the end of the financial problem reveals others), and drilling down
year to publish the annual numbers: the to expose the root causes of problems.
fastest did so in a mere 55 days, while These concepts can help companies cut
the slowest took nearly 200. This period costs, improve efficiency, and begin to
typically indicates the amount of time move the finance organization toward a
a finance department needs to provide mind-set of continuous improvement.
executives with reliable data for decision
making. In our experience with clients, many Focusing on external customers
of these differences can be explained not Many finance departments can implement a
by better IT systems or harder work but more efficiency-minded approach by making
by the waste that consumes resources. In a the external customers of their companies
1 Anthony R. Goland, John Hall, and Devereaux
manufacturing facility, a manager seeking the ultimate referee of which activities add
A. Clifford, “First National Toyota,” The to address such a problem might learn from value and which create waste. By contrast,
McKinsey Quarterly, 1998 Number 4, pp. 58– the achievements of the lean-manufacturing the finance function typically relies on some
66 (www.mckinseyquarterly.com/links/21094);
and John Drew, Blair McCallum, and Stefan system pioneered by Toyota Motor in the internal entity to determine which reports
Roggenhofer, Journey to Lean: Making
1970s. Toyota’s concept is based on the are necessary—an approach that often
Operational Change Stick, Hampshire, England:
Palgrave Macmillan, 2004. systematic elimination of all sources of waste unwittingly produces waste.
���
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18
�������������� McKinsey on Finance Spring 2006

���������������������

��������
grateful to the accounting department for
�����������������������������������
unearthing process problems on their end
����������������������������� that delayed payment. When customers
were asked about their key criteria for
��������������
�������������� �������� ��������������� ������ �������� selecting a manufacturing company, the
handling of delinquent accounts was never
����������������� ��� ��� mentioned. The sales department’s long-
�������������������� ��� ��� ���
standing concern about losing customers
��� ��� ���
was entirely misplaced.
��� ���

In the end, the two departments agreed


������������ that accounting should provide service for
��� ��� ��� ��� ���
��������������� all customers and have the responsibility
for the outstanding accounts of most
��� ��� ��� ��� ���
of them. The sales department assumed
responsibility for the very few key
accounts remaining and agreed to conduct
������������ �������������
regular reviews of key accounts with
����������������������� the accountants to re-sort the lists.

Better communication between the


departments also helped the manufacturing
Consider, for example, the way one company to reduce the number of reports
manufacturing company approached its it produced. The company had observed
customers to collect on late or delinquent that once an executive requested a report, it
accounts. The sales department claimed would proceed through production, without
that customers were sensitive to reminders any critical assessment of its usefulness.
and that an overly aggressive approach Cutting back on the number of reports
would sour relations with them. As a result, posed a challenge, since their sponsors
the sales group allowed the accounting regularly claimed that they were necessary.
department to approach only a few, In response, finance analysts found it
mostly smaller customers; for all others, effective to talk with a report’s sponsor
it needed the sales department’s explicit about just how it would serve the needs of
approval—which almost never came. The end users and to press for concrete examples
sales department’s decisions about which of the last time such data were used. Some
customers could be approached were neither reports survived; others were curtailed.
challenged nor regularly reviewed. This But often, the outcome was to discontinue
arrangement frustrated the accounting reports altogether.
managers, and no one would accept
responsibility for the number of days when Exploiting chain reactions
sales outstanding rose above average. The value of introducing a more efficiency-
focused mind-set isn’t always evident from
The tension was broken by asking customers just one step in the process—in fact, the
what they thought. It turned out that they payoff from a single step may be rather
understood perfectly well that the company disappointing. The real power is cumulative,
wanted its money—and were often even for a single initiative frequently exposes
Toward a leaner finance department 19

deeper problems that, once addressed, lead warehouse to deal with complexity and
to a more comprehensive solution. increase efficiency. While such moves may
indeed help companies deal with difficult
At another manufacturing company, for situations, they seldom tackle the real issues.
example, the accounting department The experience of one company in the
followed one small initiative with others services industry—let’s call it ServiceCo—
that ultimately generated cost savings of illustrates the circuitous route that problem
60 percent. This department had entered solving takes.
the expenses for a foreign subsidiary’s
transportation services under the heading Everyone involved in budgeting at ServiceCo
“other indirect costs” and then applied complained about the endless loops in the
the daily exchange rate to translate these process and the poor quality of the data in
figures into euros. This approach created budget proposals. Indeed, the first bottom-
two problems. First, the parent company’s up proposals didn’t meet even fundamental
consolidation program broke down quality checks, let alone the target budget
transportation costs individually, but the goals. The process added so little value that
subsidiary’s costs were buried in a single some argued it was scarcely worth the effort.
generic line item, so detail was lost. Also,
the consolidation software used an average Desperate for improvement, ServiceCo’s
monthly exchange rate to translate foreign CFO first requested a new budgeting tool to
currencies, so even if the data had been streamline the process and a data warehouse
available, the numbers wouldn’t have to hold all relevant information. He also
matched those at the subsidiary. tried to enforce deadlines, to provide
additional templates as a way of creating
Resolving those specific problems for more structure, and to shorten the time
just a single subsidiary would have been frame for developing certain elements of the
an improvement. But this initiative also budget. While these moves did compress
revealed that almost all line items were the schedule, quality remained low. Since
plagued by issues, which created substantial the responsibility for different parts of
waste when controllers later tried to analyze the budget was poorly defined, reports
the company’s performance and to reconcile still had to be circulated among various
the numbers. The effort’s real power departments to align overlapping analyses.
became clear as the company implemented Also, ServiceCo’s approach to budgeting
a combination of later initiatives—which focused on the profit-and-loss statement
included standardizing the chart of accounts, of each function, business, and region, so
setting clear principles for the treatment the company got a fragmented view of
of currencies, and establishing governance the budget as each function translated the
systems—to ensure that the changes would figures back into its own key performance
last. The company also readjusted its IT indicator (KPI) using its own definitions.
systems, which turned out to be the easiest
step to implement. To address these problems, ServiceCo’s
managers agreed on a single budgeting
Drilling down to root causes language, which also clearly defined who
No matter what problem an organization was responsible for which parts of the
faces, the finance function’s default answer budget—an added benefit. But focusing the
is often to add a new system or data budget dialogue on the KPIs still didn’t get
20 McKinsey on Finance Spring 2006

to the root problem: middle management process end to end and thus illuminate
and the controller’s office received little various types of waste, much as it would
direction from top management and were in manufacturing. Every activity should be
implicitly left to clarify the company’s examined to see whether it truly contributes
strategic direction themselves. The result value—and to see how that value could be
was a muddled strategy with no clear added in other ways. Checking the quality
connection to the numbers in the budget. of data, for example, certainly adds value,
Instead of having each unit establish but the real issue is generating relevant, high-
and define its own KPIs and only then quality data in the first place. The same kind
aligning strategic plans, top management of analysis can be applied to almost any
needed to link the KPIs to the company’s process, including budgeting, the production
strategic direction from the beginning. of management reports, forecasting, and
the preparation of tax statements. In our
Getting to the root cause of so many experience, such an analysis shows that
problems earlier could have saved the controllers spend only a fraction of their
company a lot of grief. Once ServiceCo’s time on activities that really add value.
board and middle management determined
the right KPIs, the strategic direction and The challenge in developing value stream
the budget assumptions were set in less than maps, as one European company found,
half a day, which enabled the controller’s is striking a balance between including
office and middle management to specify the degree of detail needed for high-level
the assumptions behind the budget quickly. analysis and keeping the resulting process
The management team did spend more time manual to a manageable length. Unlike
discussing the company’s strategic direction, a 6-page document of summaries or a
but that time was well spent. The result was 5,000-page tome, a complete desk-by-
a more streamlined process that reduced desk description of the process, with
the much-despised loops in the process, some high-level perspective, is useful.
established clear assumptions for the KPIs up So too is a mind-set that challenges
front, and defined each function’s business one assumption after another.
solution space more tightly. The budget was
finalized quickly.
Ultimately, a leaner finance function will
Getting started reduce costs, increase quality, and better
It takes time to introduce lean- align corporate responsibilities, both within
manufacturing principles to a finance the finance function and between finance and
function—four to six months to make them other departments. These steps can create
stick in individual units and two to three a virtuous cycle of waste reduction. MoF
years on an organizational level. A new
mind-set and new capabilities are needed Richard Dobbs (Richard_Dobbs@McKinsey
as well, and the effort won’t be universally .com) is a partner in McKinsey’s London office, and
Herbert Pohl (Herbert_Pohl@McKinsey
appreciated, at least in the beginning.
.com) is a partner in the Munich office, where
Florian Wolff (Florian_Wolff@McKinsey.com)
Integration tools can be borrowed: in is an associate principal. Copyright © 2006
particular, a value stream map can help McKinsey & Company. All rights reserved.
managers document an entire accounting
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