Is a share buyback right for your company?

Contrary to popular wisdom, buybacks don't create value by raising earnings per share. But they do indeed create value, and in two very different ways. First, a buyback sends signals about the company's prospects to the market--hopefully, that prospects are so good that the best investment managers can make right now is in their own company. But investors won't see it that way if other, negative, signals are coming from the company, and it's rarely a good idea for companies in high-growth industries, where investors expect that money to be spent pursuing new opportunities. Second, when financed as a debt issue, a buyback is essentially an exchange of equity for debt, conferring the traditional benefits of leverage--a tax shield and a discipline for managers. For such a buyback to make sense, a company would need to have taxable profits in need of shielding, of course, and be able to predict its future cash flows fairly accurately. Justin Pettit has found that managers routinely underestimate how many shares they need to buy to send a credible signal to the markets, and he offers a way to calculate that number. He also goes through the iterative steps involved in working out how many shares must be purchased to reach a target level of debt. Then he takes a look at the advantages and disadvantages of the three most common ways that companies make the actual purchases--open-market purchases, fixed-price tender offers, and auction-based tender offers. When a company's performance is lagging, a share buyback can look attractive. Unfortunately, a buyback can backfire--unless executives understand why, when, and how to use this powerful and risky tool.     

Trading and arbitrage in cryptocurrency markets

Cryptocurrency markets exhibit periods of large, recurrent arbitrage opportunities across exchanges. These price deviations are much larger across than within countries, and smaller between cryptocurrencies, highlighting the importance of capital controls for the movement of arbitrage capital. Price deviations across countries co-move and open up in times of large bitcoin appreciation. Countries with higher bitcoin premia over the US bitcoin price see widening arbitrage deviations when bitcoin appreciates. Finally, we decompose signed volume on each exchange into a common and an idiosyncratic component. The common component explains 80% of bitcoin returns. The idiosyncratic components help explain arbitrage spreads between exchanges.     

Beyond offshoring: assess your company's global potential

In the past few years, companies have become aware that they can slash costs by offshoring: moving jobs to lower-wage locations. But this practice is just the tip of the iceberg in terms of how globalization can transform industries, according to research by the McKinsey Global Institute (MGI). The institute's yearlong study suggests that by streamlining their production processes and supply chains globally, rather than just nationally or regionally, companies can lower their costs-as we've seen in the consumer-electronics and PC industries. Companies can save as much as 70% of their total costs through globalization--50% from offshoring, 5% from training and business-task redesign, and 15% from process improvements. But they don't have to stop there. The cost reductions make it possible to lower prices and expand into new markets, attracting whole new classes of customers. To date, however, few businesses have recognized the full scope of performance improvements that globalization makes possible, much less developed sound strategies for capturing those opportunities. In this article, Diana Farrell, director of MGI, offers a step-by-step approach to doing both things. Among her suggestions: Assess where your industry falls along the globalization spectrum, because not all sectors of the economy face the same challenges and opportunities at the same time. Also, pay attention to production, regulatory, and organizational barriers to globalization. If any of these can be changed, size up the cost-saving (and revenue-generating) opportunities that will emerge for your company as a result of those changes. Farrell also defines the five stages of globalization-market entry, product specialization, value chain disaggregation, value chain reengineering, and the creation of new markets-and notes the different levers for cutting costs and creating value that companies can use in each phase.     

Blinded by Growth

Everybody loves a growth story. But that does not make growth by itself a good investment thesis. Fast‐growing countries and their companies often produce low returns for investors, and slow‐growing ones sometimes produce high returns. In exploring this apparent paradox, this article argues that valuation plays a critical role. It matters not only how fast a country or company may grow, but also how much investors pay for that growth. Blinded by growth, investors often pay too much to participate in the prospective growth of both countries and companies; and as result, they earn low returns. This tendency to overpay for growth helps explain what the author describes as indisputable evidence that, over the long term, value investing beats growth investing. This article discusses growth from three different points of view. First, it looks into the relationship between general economic growth and equity returns. Second, it examines the relationship between corporate growth and equity returns. And finally, it compares value investing with growth investing.     

Growth outside the core

Growth in an adjacent market is tougher than it looks; three-quarters of the time, the effort fails. But companies can change those odds dramatically. Results from a five-year study of corporate growth conducted by Bain & Company reveal that adjacency expansion succeeds only when built around strong core businesses that have the potential to become market leaders. And the best place to look for adjacency opportunities is inside a company's strongest customers. The study also found that the most successful companies were able to consistently, profitably outgrow their rivals by developing a formula for pushing out the boundaries of their core businesses in predictable, repeatable ways. Companies use their repeatability formulas to expand into any number of adjacencies. Some companies make repeated geographic moves, as Vodafone has done in expanding from one geographic market to another over the past 13 years, building revenues from $1 billion in 1990 to $48 billion in 2003. Others apply a superior business model to new segments. Dell, for example, has repeatedly adapted its direct-to-customer model to new customer segments and new product categories. In other cases, companies develop hybrid approaches. Nike executed a series of different types of adjacency moves: it expanded into adjacent customer segments, introduced new products, developed new distribution channels, and then moved into adjacent geographic markets. The successful repeaters in the study had two common characteristics. First, they were extraordinarily disciplined, applying rigorous screens before they made an adjacency move. This discipline paid off in the form of learning curve benefits, increased speed, and lower complexity. And second, in almost all cases, they developed their repeatable formulas by studying their customers and their customers' economics very, very carefully.     

The growth crisis--and how to escape it

At a time when companies are poised to seize the growth opportunities of a rebounding economy, many of them, whether they know it or not, face a growth crisis. Even during the boom years of the past decade, only a small fraction of companies enjoyed consistent double-digit revenue growth. And those that did often achieved it through short-term measures--such as mergers and inflated price increases--that don't provide the foundation for growth over the long term. But there is a way out of this predicament. The authors claim that companies can achieve sustained growth by leveraging their "hidden assets," a wide array of underused, intangible capabilities and advantages that most established companies already hold. To date, much of the research on intangible assets has centered on intellectual property and brand recognition. But in this article, the authors uncover a host of other assets that can help spark growth. They identify four major categories of hidden assets: customer relationships, strategic real estate, networks, and information. And they illustrate each with an example of a company that has creatively used its hidden assets to produce new sources of revenue. Executives have spent years learning to create growth using products, facilities, and working capital. But they should really focus on mobilizing their hidden assets to serve their customers' higher-order needs--in other words, create offerings that make customers' lives easier, better, or less expensive. Making that shift in mind-set isn't easy, admit the authors, but companies that do it may not only create meaningful new value for their customers but also produce double-digit revenue and earnings growth for investors.     

SECURITIZATION: A LOW-COST SWEETENER FOR LEMONS

Since the launching of the mortgage backed market in the early 1970s, securitization has experienced extraordinary growth and spread to a remarkable variety of receivables. But financial economists in the tradition of Miller and Modigliani have been hard pressed to explain such growth. When viewed within the context of an M & M world of “perfect markets,” securitization appears to be simply another way—and a highly complex and costly one, at that—for a company to carve up its operating cash flows and repackage them for investors. This article seeks to explain the growth of securitization by identifying reductions in costs that M & M assume out of existence. For some types of companies, the largest sources of the cost savings are fairly obvious. Most mortgage securitizations are effectively subsidized by the U.S. government, which contributed greatly to the launching of the securitization movement. And commercial banks forced to meet regulatory capital requirements have found securitization of loans to be a low-cost compliance strategy. But securitization appears to offer more than regulatory benefits. For example, higher rated companies with a variety of financing options appear to use securitization to diversify their funding sources and arbitrage small price differences in financial markets. But if such arbitrage profits can be significant, the non-regulatory benefits appear to be largest for companies with few financing alternatives—those firms that face what economists refer to as a “lemons problem.” Available information about such companies is often limited (as in the case of smaller companies), unfavorable (companies in financial distress), or particularly difficult to appraise (companies in volatile industries, or facing unstable political environments or potentially large liabilities). Especially in the case of such “lemons” companies, securitization may reduce overall financing costs by carving up the evaluation of a company's securities into tasks amenable to greater specialization. In so doing, it may reduce aggregate information costs for all its securities and thus increase total value.     

Moving upward in a downturn.

As the recent bursting of the new economy bubble has shown, business cycles are still wih us. The question, then, is, what executives should do to help their companies weather these downturns. As in so many instances, there are conventional approaches that appear to make sense in the short term. But while these approaches seem reasonable in the heat of the moment, they can eventually damage competitive positions and financial performance. Drawing on extensive research of Fortune 500 companies that have lived through industry downturns and economic recessions over the past two decades, Darrell Rigby, a director of Bain & Company, reveals how companies need to go against the grain of convention and exploit industry downturns to harness their unique opportunities for upward mobility. The author explains that every downturn goes through three phases. He examines each phase and shows how successful players navigate the huge waves of a downturn. Smart executives, he says, don't panic: they look bad news in the eye and institutionalize an approach to detecting storms. Rather than hedge their bets through diversification, they focus on their core businesses and spend to gain market share. They manage costs relentlessly during good times and bad. They keep a long-term view and strive to maintain the loyalty of employees, suppliers, and customers. And coming out of the downturn, they maintain momentum in their businesses to stay ahead of the competition they've already surpassed. Every industry will face periodic downturns of varying severity, says Rigby. But executives with the vision and ingenuity to take unconventional approaches can buoy their companies to new heights.     

Solve the succession crisis by growing inside-outside leaders

In his analysis of 1800 successions, Harvard Business School professor Bower found that companies performed significantly better when they appointed insiders to the job of CEO. Other researchers, including Jim Collins in Good to Great, have come to similar conclusions working from different data sets. Yet Bower finds far too many companies have no succession plans; as a result, when the time comes to name a new chief executive, more firms turn to outsiders. Both insider and outsider CEOs have strengths and weaknesses at the start. Insiders know the company and its people but are often blind to the need for radical change. Outsiders see the need for a new approach but can't make the necessary changes because they don't know the organization or industry sector well enough. What companies must do, then, is find a way to nurture what Bower calls inside-outsiders--internal candidates who have outside perspective. Often such executives have spent much of their time away from the mainstream of the organization, and away from headquarters, living with new opportunities and threats. Before becoming CEO, Procter & Gamble's A.G. Lafley, for instance, worked for years building P&G's Chinese cosmetics operation rather than the core detergent business. IBM's Sam Palmisano was a champion of software and open systems at a time when Big Blue was essentially a closed-system, hardware-oriented company. Nascent inside-outsiders should enter the CEO-training process by the time they are 30 and be given the opportunity to manage a whole business, so that they become good insiders. But they also need to be mentored with an eye toward preserving their outsider perspective, so they learn how to turn their new ideas into great businesses and are protected from old-timers who might be inclined to teach them a lesson.     

Discrete versus continuous time models: Local martingales and singular processes in asset pricing theory

In economic theory, both discrete and continuous time models are commonly believed to be equivalent in the sense that one can always be used to approximate the other, or equivalently, any phenomena present in one is also present in the other. This common belief is misguided. Both (strict) local martingales and singular processes exist in continuous time, but not in discrete time models. More importantly, their existence reflects real economic phenomena related to arbitrage opportunities, large traders, asset price bubbles, and market efficiency. And as an approximation to trading opportunities in real markets, continuous trading provides a better fit and should be the preferred modeling approach for asset pricing theory.     

Breaking out of the innovation box

In most companies, investments in innovation follow a boom-bust cycle. For a time, the cash flows. Then, as the economy sours or companies rethink their priorities, the taps go dry. But when research budgets are slashed, the strong projects are often abandoned along with the weak ones. Promising initiatives are cut off just when they are about to bear fruit. Expensive labs are closed; partnership agreements costing millions in legal fees are thrown away. When disruptive changes in the competitive landscape come, companies are caught flat-footed. Sustainable innovation requires a new approach: Instead of being largely isolated projects, innovation initiatives need to gain access to the insights and capabilities of other companies. To be protected from the ax of short-term cost reductions and the faddishness born of easy money, the initiatives must become part of the ongoing commerce that takes place among companies. But how can businesses traffic in such sensitive information without giving their competitors an advantage? The answer, the author contends, lies in a practice that's been common since the Middle Ages: the use of independent intermediaries to facilitate the exchange of sensitive information among companies without revealing the principals' identities or motives and without otherwise compromising their interests. Executive search firms, for example, allow job seekers to remain anonymous during the early stages of a search, and they protect businesses from disclosing their hiring plans to rivals. A network of innovation intermediaries would be in a unique position to visualize new opportunities synthesized from insights and technologies provided by several companies--ideas that might never occur to businesses working on their own.     

Empirical investigation of stock index futures market efficiency: the case of the Athens Derivatives Exchange

Pricing and trading practices in the Athens Derivatives Exchange, a newly established derivatives market, result in significant futures arbitrage profit opportunities for low-cost traders. We find that a large part of the mispricing is due to transaction costs, but additional factors, such as anticipated volatility and time to maturity, also contribute. Ex ante tests reveal significant arbitrage opportunities that could have been exploited up to 30 min after they had been identified. All different tests employed indicate that the derivatives market was inefficient during its early trading history because arbitrage opportunities persisted even after other market impact costs were taken into consideration.     

International tax arbitrage,financial parity conditions and preferential capital gains taxation

Using a finite-horizon general equilibrium model with uncertainty and money, we characterize situations where tax arbitrage opportunities may arise for international portfolio investors in an economy with heterogeneous capital income taxation when interest income and capital gains/losses are taxed differentially for some agents. We derive tax-modified uncovered interest parity conditions, Fisher conditions and forward prices similar to the no-tax ones, but augmented by tax-induced ‘risk-premium’ terms; covered interest parity and Fisher conditions remain unaffected by the introduction of capital income taxes as we bound tax-based arbitrage without restricting arbitrage per se.     

When to trust your gut

Many top executives say they routinely make big decisions without relying on any logical analysis. Instead, they call upon their "intuition," "gut instinct," "hunches," or "inner voice"--but they can't describe the process much more than that. What exactly is gut instinct? In this article, author Alden Hayashi interviews top executives from companies such as America Online and Johnson and Johnson to find out how they make decisions. Hayashi also presents the research of leading scientists who suggest that our emotions and feelings might not only be important in our intuitive ability to make good decisions but may actually be essential. Specifically, one theory contends that our emotions help us filter various options quickly, even if we're not consciously aware of the screening. Other research suggests that professional judgment can often be reduced to patterns and rules; indeed, truly inspired decisions seem to require an ability to see similar patterns across disparate fields. A CEO who possesses that ability can craft a perfect strategy by detecting patterns that others either overlook or mistake for random noise. But various traits of human nature can easily cloud our intuitive decision making. One potential pitfall is our tendency to see patterns where none exist. Thus, continual self-checking and feedback are crucial, and some organizations have made these processes part of their corporate culture.     

Divestiture: strategy's missing link

Although most companies dedicate considerable time and attention to acquiring and creating businesses, few devote much effort to divestitures. But regularly divesting businesses--even good, healthy ones--ensures that remaining units reach their potential and that the overall company grows stronger. Drawing on extensive research into corporate performance over the last decade, McKinsey consultants Lee Dranikoff, Tim Koller, and Antoon Schneider show that an active divestiture strategy is essential to a corporation's long-term health and profitability. In particular, they say that companies that actively manage their businesses through acquisitions and divestitures create substantially more shareholder value than those that passively hold on to their businesses. Therefore, companies should avoid making divestitures only in response to pressure and instead make them part of a well-thought-out strategy. This article presents a five-step process for doing just that: prepare the organization, identify the best candidates for divestiture, execute the best deal, communicate the decision, and create new businesses. As the fifth step suggests, divestiture is not an end in itself. Rather, it is a means to a larger end: building a company that can grow and prosper over the long haul. Wise executives divest so that they can create new businesses and expand existing ones. All of the funds, management time, and support-function capacity that a divestiture frees up should therefore be reinvested in creating shareholder value. In some cases, this will mean returning money to shareholders. But more likely than not, it will mean investing in attractive growth opportunities. In companies as in the marketplace, creation and destruction go hand in hand; neither flourishes without the other.     

EVA,not EBITDA: A New Financial Paradigm for Private Equity Firms

Private equity firms have boomed on the back of EBITDA. Most PE firms use it as their primary measure of value, and ask the managers of their portfolio companies to increase it. Many public companies have decided to emulate the PE firms by using EBITDA to review performance with investors, and even as a basis for determining incentive pay. But is the emphasis on EBITDA warranted? In this article, the co‐founder of Stern Stewart & Co. argues that EVA offers a better way. He discusses blind spots and distortions that make EBITDA highly unreliable and misleading as a measure of normalized, ongoing profitability. By comparing EBITDA with EVA, or Economic Value Added, a measure of economic profit net of a full cost‐of‐capital charge, Stewart demonstrates EVA's ability to provide managers and investors with much more clarity into the levers that are driving corporate performance and determining intrinsic market value. And in support of his demonstration, Stewart reports the finding of his analysis of Russell 3000 public companies that EVA explains almost 20% more than EBITDA of their changes in value, while at the same time providing far more insight into how to improve those values.     

Multinationals in the Middle Kingdom: Performance,Opportunities, and Risks

For many U.S. companies, China is the most promising growth opportunity in the business portfolio. The interest of managements and boards has been backed up with action, making China the preferred country for foreign direct investment in the last several years. Yet the experience also shows that many companies were unprepared to operate in a developing economy and with a foreign culture. The normal start‐up problems have been aggravated by unfamiliar joint venture partners, large regional differences in purchasing power, language, and regulation, and weak enforcement of intellectual property rights. The first wave of China investment by U.S. multinationals, corresponding roughly to the decade of the 1990s, was marked by poor performance. But in the last five years, multinationals have made significant adjustments—particularly, the “localizing” of suppliers, the workforce, and the products offered. And recent data indicates much improved profitability. Still, there remain substantial challenges to further growth, including increasing local competition, a thin human resources market, the lack of prime acquisition candidates, and continued low rates of consumption. The different experiences of multinationals such as Procter & Gamble, Anheuser‐Busch, and Wal‐Mart are used to illustrate these challenges and provide some important lessons for companies now evaluating their opportunities in China.     

Disruptive change. When trying harder is part of the problem

When a company faces a major disruption in its markets, managers' perceptions of the disruption influence how they respond to it. If, for instance, they view the disruption as a threat to their core business, managers tend to overreact, committing too many resources too quickly. But if they see it as an opportunity, they're likely to commit insufficient resources to its development. Clark Gilbert and Joseph Bower explain why thinking in such stark terms--threat or opportunity--is dangerous. It's possible, they argue, to arrive at an organizational framing that makes good use of the adrenaline a threat creates as well as of the creativity an opportunity affords. The authors claim that the most successful companies frame the challenge differently at different times: When resources are being allocated, managers see the disruptive innovation as a threat. But when the hard strategic work of discovering and responding to new markets begins, the disruptive innovation is treated as an opportunity. The ability to reframe the disruptive technology as circumstances evolve is not an easy skill to master, the authors admit. In fact, it might not be possible without adjusting the organizational structure and the processes governing new business funding. Successful companies, the authors have determined, tend to do certain things: They establish a new venture separate from the core business; they fund the venture in stages as markets emerge; they don't rely on employees from the core organization to staff the new business; and they appoint an active integrator to manage the tensions between the two organizations, to name a few. This article will help executives frame innovations in more balanced ways--allowing them to recognize threats but also to seize opportunities.     

Scanning the periphery

Companies often face new rivals, technologies, regulations, and other environmental changes that seem to come out of left field. How can they see these changes sooner and capitalize on them? Such changes often begin as weak signals on what the authors call the periphery, or the blurry zone at the edge of an organization's vision. As with human peripheral vision, these signals are difficult to see and interpret but can be vital to success or survival. Unfortunately, most companies lack a systematic method for determining where on the periphery they should be looking, how to interpret the weak signals they see, and how to allocate limited scanning resources. This article provides such a method-a question-based framework for helping companies scan the periphery more efficiently and effectively. The framework divides questions into three categories: learning from the past (What have been our past blind spots? What instructive analogies do other industries offer? Who in the industry is skilled at picking up weak signals and acting on them?); evaluating the present (What important signals are we rationalizing away? What are our mavericks, outliers, complainers, and defectors telling us? What are our peripheral customers and competitors really thinking?); and envisioning the future (What future surprises could really hurt or help us? What emerging technologies could change the game? Is there an unthinkable scenario that might disrupt our business?). Answering these questions is a good first step toward anticipating problems or opportunities that may appear on the business horizon. The article concludes with a self-test that companies can use to assess their need and capability for peripheral vision.