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1
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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
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blamed the sell-off on Google’s refusal
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expectations in check.
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guidance, a number of respected and highly
� �
visible companies have announced that they
���� ���� ���� ���� ���� ���� � � �� �� �� �� ���
��������� will either minimize the practice—offering
only annual guidance—or abandon
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it altogether in favor of longer-range
���������������������������������������������������������������������������������� indications of their strategy and business
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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
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4
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McKinsey on Finance Spring 2006
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growth initiatives, and M&A—not only on
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earnings but also, more important, on value.
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����������������������������� Our approach has the additional advantage
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of reducing intangible costs. When Coca-
�� Cola stopped issuing guidance, in late 2002,
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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
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�� (who was then CFO) believed that the move
���������������������������� �� signaled a renewed focus on long-term
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goals. The market seemed to agree and did
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����������� � ����������� � not react negatively, holding Coke’s share
�������������������������������������������������������������������������������������������������������� price steady.10 Like Coke, companies that
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reduce or discontinue guidance must clearly
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indicate that poor expectations of future
performance are not the reason.
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: 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).
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Balancing ROIC and growth to build value 15
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the same group ten years later; companies
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with an ROIC of more than 20 percent had
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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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grateful to the accounting department for
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unearthing process problems on their end
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were asked about their key criteria for
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handling of delinquent accounts was never
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standing concern about losing customers
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was entirely misplaced.
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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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