1/ A FINANCIAL READING OF STRATEGY

For a financial manager, these strategies, whatever they are, have a single goal – to enable the company to set itself apart on a competitive market in order to generate income, enabling it to generate higher earnings than its competitors, which in fact are no longer able to compete at the same level. Brands, patents, industrial barriers to entry (minimum size of factories, large advertising budgets, etc.) and legal barriers to entry (concessions, authorisations, etc.) are merely the instruments used to achieve this goal. For a financial investor, the most important role of an entrepreneur or a manager is to analyse the economic, industrial, commercial, technological and competitive environment of the company, in order to develop a policy that will lead to higher earnings.

But, like Penelope, the entrepreneur must continually redo today what was done yesterday. High returns will always attract new players to the sector. These new entrants will seek to get around or demolish the barriers to entry that protect the high earnings. Sooner or later they’ll succeed, which will lead to the reduction of margins following the resulting intensification of competition.

When risk is remunerated at too high a rate (for example, certain taxi markets prior to ride-hailing companies), new competitors will enter the sector, which will bring down earnings. When risk is remunerated at too low a rate, companies will abandon the sector, some firms will go bankrupt, the sector will consolidate or integrate (car parts makers, airline companies), which over time will reduce competition and increase earnings. We find here the same line of reasoning we saw for financial securities on which returns are too high or too low, given their risks.

On industrial markets, as on financial markets, a necessary relationship arises between risk and return. On financial markets, which, by definition, are a lot more liquid than industrial markets, the balance between risk and return is established a lot earlier than on industrial markets. Entering an industrial market involves a lot more than merely buying a share, as on financial markets, and exiting is a lot more complicated than selling a share.

Accordingly, there are some sectors where earnings generated may, over the long term, be higher than normal earnings, given the risk. However, let’s not delude ourselves – even if adjustments often take a long time, sooner or later they take place, and abnormally high returns will disappear, regardless of the strategy pursued by the company (see, for example, Siemens).

2/ STRATEGIES BASED ON INTERNAL GROWTH

The aim of an internal growth policy is to develop the activity and the profits of a company by leveraging its resources and capacities, without carrying out acquisitions of third-party companies. The company either plays the innovation card, in order to set itself apart from its competitors, or the cost-cutting card. These two strategies can be combined. Initially, a new market is created thanks to new products or new functionalities (for example, Apple with the iPod, iPad, iPhone and iWatch), then the cost price is reduced (electric cars, laptops).

Achieving the lowest possible cost prices enables the company to fight against the competition, even to eliminate it or to prevent it from entering its sector. Accordingly, the main aim of the industrial policy must be to minimise the cost price of stock keeping units of manufactured products.

In this context, corporate strategy consulting firms in the 1960s, and in particular BCG, demonstrated on the basis of sector studies that a statistical relationship exists between the accumulated volume of production and the unit cost. The greater the accumulated volume of production, the lower the unit cost will be.

The rather simplistic nature of the relationship has elicited some criticism. Nevertheless, in the majority of cases, all sectors can be characterised at a given time by an experience curve on which companies are found at a more or less low level. This type of relationship highlights the importance of the company’s growth rate, compared to that of its competitors, and, more generally, compared to its sector. The more a company grows compared to its sector (i.e. the more it increases its market share), the lower its industrial costs will be, and the better it will be able to withstand competition, and thus to survive. What it does is set up a barrier to entry to new competitors in the form of low earnings prospects. New competitors are obliged to align their retail prices more or less with those of the company already on the market, while their cost prices will obviously be much higher. This results in low, or even negative, margins! Thanks to the size of its market share, the company succeeds in dissuading new competitors from entering the market (e.g. general e-commerce companies up against Amazon). This model holds especially true for sectors that are undergoing rapid development.

Over and above the experience curve, researchers have also observed that an innovation or a new strategic activity field will result in phased growth. The growth rate is initially low, then becomes very sharp before falling to a lower level again in the maturity phase, and becomes negative in the phase of decline. There are specific financial strategies that correspond to each phase of this lifecycle. For example, during the launch phase, the company will require a lot of financing and will have to make use of equity capital. On the other hand, during the maturity phase, the aim is to milk the rent, and debt is very useful at this stage.

The role of the financial manager here is to provide the company with the financial resources it needs for this internal growth policy. In order to implement this strategy, the company sets a target growth rate for the activity, which, to be achieved, requires spending on R&D (innovation), marketing (aggressive sales policy) and on tangible and operating elements (cost price), which is why financing is needed. These financing requirements can be partially, fully or excessively covered by resources that the company generates (its earnings). From a financial point of view, an internal growth strategy will necessarily involve an analysis of the relationship between the growth rate of the operations (measured by the change in sales) and the company’s profitability, as we saw in Chapter 36.

We showed that the internal growth rate that the company can bear, without calling on its shareholders or modifying its financial structure, is equal to the return on equity (ROE) multiplied by (1 – payout ratio).

Accordingly, the role of financial policy is to:

• better manage the company’s need for funds, by ensuring that their growth rate does not exceed that of the activity, through very tight inventory control, customer monitoring, best practice in the use of supplier credit and avoiding investments that are not directly productive;
• ensure that ROE is high, notwithstanding a possibly low ROCE (due to heavy investments), by using the leverage effect;
• reduce the cost of credit through rigorous debt management;
• possibly open up the capital (entry of new shareholders) on the basis of a high valuation.

Although, for the purposes of internal growth, industrial policy involves upstream spending in order to reduce production unit costs or bring out innovation after innovation; financial policy, however, requires rigour and continuity.

3/ STRATEGIES BASED ON EXTERNAL GROWTH

On the other hand, an external growth industrial policy is based mainly on opportunities that arise – the opportunity that a given company is for sale and can be bought, which will require the mobilisation of substantial financial resources within a short timeframe. In these cases, the aim of a financial policy behind an industrial strategy of external growth is to provide the company with access to large reserves of cash, either existing (share issues, bank loans, bonds, etc.) or potential (confirmed but undrawn credit lines, high share prices that will facilitate possible share issues or share exchanges if a merger takes place, etc.). There is the example of LVMH, which built its strategy around regular external growth acquisitions, and had around €6bn in cash at the end of 2019, and had been authorised by its shareholders to carry out capital increases up to a maximum amount of €60bn, without counting its undrawn credit lines (€5.9bn).

4/ THE IMPACT OF STRATEGY ON BREAKEVEN POINT

As we saw in Chapter 10, the notion of a breakeven point is very important because it links profit sensitivity to a variation in activity. The closer a company gets to its breakeven point, the more sensitive it is to a drop in sales. On the other hand, the further off the company is from breakeven, the less sensitive it is to a change in its activity. It is thus more financially stable.

Accordingly, any strategy, whatever it may be, should be appreciated on the basis of its implications for the company’s breakeven point.

If the strategy results in raising it faster than the level of activity increases, the company runs a heightened industrial risk. If, on the other hand, the strategy lowers the breakeven point, the company’s industrial risk decreases, unless there is a more rapid fall off in activity.

This strategy cannot be considered independently from the sector in which the company operates. If the sector is cyclical, the company must minimise its fixed costs in order to remain as far from its breakeven point as possible, and to be able to withstand the unavoidable downturns in the cycle. In some sectors, upstream integration (control over suppliers) is a mistake, as it considerably raises the level of the company’s breakeven point and, accordingly, of its industrial risk. On the other hand, in a growing sector, industrialisation is not a bad idea, as generally the activity will grow faster than the increase in the level of breakeven. But care should be taken not to make mistakes when assessing the duration of the period of growth. Hence, in 2018 Burberry bought its main leather supplier.

1/ THE FAMILY-RUN COMPANY

Along with the confusion between the status of the manager and that of the main shareholder, there is also the overlap between the personal assets of the manager and the assets of the company, even though these are legally separated through a limited liability company. In these circumstances, the company’s financial policy is merely a tool for achieving the aims of the shareholder whose undiversified portfolio does nothing to put into practice the teachings of theory! Convinced that their activity is the best area for investment, such shareholders also do very little to diversify their family businesses (Gerdau, AB InBev, Lactalis etc.).

On the other hand, why have groups such as Bouygues or Reliance diversified? They were unable to diversify their wealth (which was mainly concentrated in the family business), as this would have meant selling the business; so the family shareholders diversified their businesses and thereby retained control over them.

For the family-run business, the dilemma is often between growth, control and financial risk. A company that wishes to grow – but whose shareholders wish to avoid being diluted by capital increases to which they are unable to subscribe – is condemned to borrowing and will be fragile in times of crisis (HeidelbergCement, Porsche, Bourbon etc.). Alternatively, it will not grow or may be marginalised on its market and go bankrupt or be bought out.

Audacious but wise entrepreneurs will convince their families of the necessity of diluting control in order to give the company the equity capital it needs to enable it to implement its strategy. And if the strategy is well managed, they will be able to retain control which no one will dispute, notwithstanding their small (10–20%), but well-valued, stake. This is the wager won by the Pernod and Ricard families, who, in the space of 46 years, turned the French pastis leader (with a stock market value of €280m and controlled by the Pernod and Ricard families) into the second-largest spirits group in the world, with a stock market value of €46bn, and in which they now hold only 15.6% of the shares.

There are, of course, companies with margins so high that they are able to finance their own growth without taking out too much debt or without issuing shares that will dilute the founding shareholders too much (Google, Heineken, Richemont, etc.), but these are the exception rather than the rule.

The fifth section of this book may have convinced readers that the resources of financial engineering can always be used to put off the fatal moment by disconnecting the share capital from voting rights, or by bringing minority shareholders into the subsidiaries or the controlling holding company. But let’s not fool ourselves. Although these financial arrangements help to save time and to relaunch the development of a group, they always come at a cost, which takes the form of a discount on the share or, amounting to the same thing, a higher cost of capital. They lead away from the basic principle of one share, one voting right. In the long run, they could end up blocking the way forward. Our experience has shown that in such cases they should be scrapped. Pernod Ricard no longer has treasury shares held by one of its controlled subsidiaries, L’Oréal no longer has shares without voting rights or with double-voting rights, and AXA no longer has a controlling holding company that owns its brand.

2/ THE COMPANY WITH A MINORITY MANAGING SHAREHOLDER

Financial theory is no more applicable when the manager is a minority shareholder. The situation can be relatively complex. The aim of minority managers is to retain control over their companies and also to retain control over their status as managers. They often use financial policy in order to secure the loyalty of their shareholders, by paying out generous dividends, preferring debt to capital increases which would reduce their control over the company, as they generally do not have the financial resources to subscribe to them, etc.

3/ THE COMPANY WITHOUT A LARGE SHAREHOLDER

The problem is quite different when the manager is not a shareholder or only holds a tiny stake in the capital. The risk is that they could pursue goals that are different from those of the shareholders who have given them a mandate to manage the company, involving power, material advantages, popularity in the media (Carlos Ghosn at Renault, Wang Jianlin at Wanda, etc.). In some extreme cases, the goals of the manager could run contrary to those of the shareholders. In terms of financial policy, such managers could:

• be tempted to pay out high dividends in order to hypnotise shareholders and get them to forget the value of their shares (which will have little chance of increasing);
• be reticent to take out debt, knowing that debt will increase the risk of the company going bankrupt which will result in the loss of their jobs;
• be reluctant to carry out share issues that would bring in new shareholders who may challenge their mandates.

The Board of Directors, if it is doing its job properly, should prevent such practices, even if this means getting rid of the manager (Bank of America, SAP).