Why You Need To Keep Changing Your Company’s Business Mix
Strategy & Corporate Finance PracticeWhy you need tokeep changing yourcompany’s business mixBecause the market is always moving, a static portfolio of businessestends to underperform. LEREXIS/Getty ImagesOctober 2020
Sean Brown: From McKinsey’s Strategy andCorporate Finance practice, I’m Sean Brown, andwelcome to Inside the Strategy Room. One of theperennial questions corporate leaders ask is whichbusinesses their company should be in? Our recentarticle, “Why you’ve got to put your portfolio onthe move,” suggests that regularly changing yourportfolio mix in response to market trends is thesurest path to outperformance. At our EuropeanM&A conference in London that took place earlierthis year, I spoke with two of the article’s authorsabout their research on portfolio transformation,which analyzed detailed financial results of morethan 1,000 of the world’s largest public companies.Andy West is the global leader of our M&A practice.And Sandra Andersen is an associate partner in ourNew York office and a leader in our M&A practice.Sandra, Andy, welcome.Andy West: Thanks, Sean.Sandra Andersen: Thank you, Sean.Sean Brown: So Andy, your presentation todaywas around portfolio transformation. Can you startby just sharing a little bit of the background onwhat drove the research and what underpins theconclusions that you came to?Andy West: Yeah, you know, about a year, year-anda-half ago, on the back of some really interestingexamples of companies making major divestituresand major acquisitions and actually being fairlyhandsomely rewarded in the market, we startedasking, “What is the role of portfolio overall? Whatis the way that strategy, market strategy where andhow to compete, how does that translate actuallyinto M&A? And what’s the link between the two?”And is there, you know, something there, are thererules of thumb that people should apply to bringstrategy and M&A together to actually better explainwhat’s happening in the market and actually getbetter returns going forward?Sean Brown: So let’s talk a little bit about what thebasis for the research was.2Why you need to keep changing your company’s business mixAndy West: Yeah. So what we basically did was, youknow, on the back of our global 1000 work, which issomething we’ve published over the last ten yearsaround programmatic M&A and the importanceof systematic deal making, we took that research,combined it with our beating-the-odds work basedon a book that was released last year that looks athow companies create economic profit over longperiods of time, so really our M&A data set plus ourstrategy beating-the-odds data set, we actually builta new data set, right, which actually looks at portfolioover time. And right now it’s around 200 companiesand growing, where we actually said, “What if wehad an apples-to-apples view of the businesses acompany was in from 2007 to 2017? What would thattell us about our portfolio?” Now, actually, that lastbit is actually quite hard because if you think aboutchanges in reporting, if you think about acquisitions,divestitures, reorganizations, we’ve had to rebuildall of those financials. But what we’ve tried to do ismarry those three data sets and say, “What doesit tell us?” What does it tell us about the portfoliosthat people are in, how much need to change andrefresh their portfolio, where they should invest,and how M&A can be a tool in driving some of thosecomponents of portfolio transformation?Sean Brown: So, what were some of the ways thatyou defined portfolio moves?Andy West: Well, we looked at portfolio from afew different ways. One, we looked at it from astrategic point of view where we looked at a thingcalled refresh rate. And, basically, that is just simplyhow much revenue moved from one industryclassification to another over a ten-year period.Right? The second thing we did is look at the thingwe called momentum, which was basically sayinghow did your exposure to market momentum ormarket tailwinds change over a ten-year period andwhat impact did that have on your overall value oryour valuation? And those are largely strategy levers,right? Then we applied M&A to that to say, givenyour refresh rate or given your market momentumor your ability to move towards market momentum,how is M&A used as a tool to actually deliver that
value and did it accelerate or decelerate or detractfrom that journey? And then finally, we try to look atcontext, right? Because it’s very important to noteall of these things are very, very context specific,meaning where you started from in terms of youroverall industry exposure and value creation, thedifferent levers you pulled, the industries that you’rein, all of those things matter. So we tried to apply acontext lens as well.Sean Brown: Let’s double click on that refresh ratein the research that you did, were there any definingcharacteristics of companies that really refreshedmore than others?Sandra Andersen: Yes, a refresh rate was actuallyone of the first things we looked at when weanalyzed our data set. Refresh rate is actually apretty simple concept, but a very important one. It isthe rate at which you change the sources of revenuein your company. It means the industries that areactually driving the bulk of the revenue that you’relooking at. One of the example companies switchedfrom being exposed to three different industries andhaving three major drivers of revenue to just two. Sothey used to have exposure in 2007, to logistics, toe-commerce and parcel delivery and retail banking,but by 2017, they’d actually narrowed that down tojust two. They’d fully exited the retail banking andtheir revenue was actually sourced from just twoplaces. The refresh rate was 16 percent, becausethat 16 percent was the part that used to bededicated to retail banking, but then went to zero.Andy West: Yeah, refresh was actually surprising tome because I didn’t expect to get much of a resultbecause all we’re looking at is revenue movementfrom A to B. It doesn’t really dictate where you movedit or how you moved it. And a few things came out ofthe research. One, most people don’t move. Fiftythree percent of our sample moved less than 10percent of their revenues over a ten-year period. WeWhy you need to keep changing your company’s business mixcall these people “ponds,” by the way, just kind ofas a metaphor for you’re in kind of a stagnant bodyof water. We then also looked at a category called“rivers,” which is companies that moved around 10to 30 percent. And by the way, we slid these rangesup and down and 10 to 30 seemed to be a reallyinteresting range. We call those rivers. And thenobviously, there’s “rapids”—so people who reallymoved a lot of their portfolio, greater than 30 percentof their revenue from one industry classificationto another over a ten-year period. So that’s howwe actually looked at the refresh rate overall.Interestingly enough, when you look at it, you findthat despite ponds making up 53 percent of the totalsample, the average annual TRS performance wasrelatively close to the global market average, right,at around 7.7 percent. And when you contrast thatwith rivers, which made up around 23 percent of thesample, the annual average TRS performance therewas around 11.7 percent, by far, the highest, right? Sopeople who were able to move revenue simply fromA to B outperformed. We looked at rapids. That wasanother 23 percent of our sample. Their performanceis only 5.1 percent—well below the global marketaverage. And so there is something here about thesweet spot around moving revenue from one point toanother that somehow seems to be related to overallmarket performance.Sean Brown: Thanks, Andy. Let’s talk a little bit abouthow it seems to relate to market performance and arelated question, did you double click on any of theindividual companies within each one of those groupsto sort of see what was driving that performance?Andy West: Yeah, just from a refresh rate point ofview, when you actually start talking to individualcompanies, what becomes clear to me is that theoutcome, this 11.7 percent, three rivers category,is not a function, so much of just moving revenue,because that kind of doesn’t make sense, but it is afunction of focus.3
Sean Brown: Okay.Andy West: If you think about what’s required, ina boardroom, within a management team, withina company, to move that much revenue over aten-year period, it requires a tremendous amountof fortitude, alignment, perseverance, I think all ofthese things, this conviction around where you’reheaded, is probably the substrate from which alot of these benefits come. But it is an interestingquestion, if you’re not moving that much, why not?Right? And what does that mean? And can we learnanything from maybe some of the things that areholding us back in terms of actually having that kindof conviction around you know where to go and howto migrate revenue over time?Sean Brown: Can you talk a little bit about what theperformance metrics were?Andy West: One of the things that we did onrefresh rate then as we combined these data setswas to look not only at the TRS performance, butthe TRS performance applied to an M&A style, oran M&A program. Right? And so remember that11.7 percent of folks who are a river, we said, “Well,what kind of M&A did they do to affect that river?”Were they programmatic? Meaning they did quitea few deals over this ten-year period that accrueto a meaningful amount of market cap around 15percent. Were they selective kind of hobbyists inM&A? Were they organic, right? And we lookedat that, and we actually saw quite a big differencebetween programmatic, where you look at the TRSof somebody who did rivers with a programmaticstrategy, that was around 13 percent. Selective wasmuch more closer to the global market average at9 percent. But if you’re actually organic, you’reable to move 10 to 30 per percent of your revenuewithout doing M&A. You’re at about the average;you’re about 11 percent. So nothing wrong withbeing organic. It’s just actually quite rare. Somost companies, if you actually have to, you know,get in the river and start moving your revenue,programmatic seems to be the best strategy overall.4Why you need to keep changing your company’s business mixSean Brown: So momentum is something you alsotalked about and the disparity between leadersand laggards. Can you talk a little bit more aboutthat, please?Sandra Andersen: Yeah, momentum is a reallyinteresting concept. Principle investors tend to talkabout tailwinds and headwinds in the industries thatthey play in. The concept of momentum is just theunderlying energy effectively behind the industriesthat you are exposed to. The company that welooked at in the refresh rate example had threeindustries that they were exposed to—logistics,post, and banking. The logistics example wasinteresting. Because of the rise of Amazon andother delivery services, you actually saw majortailwinds in that industry, because everything youorder needs to get delivered. That industry drives 67 million in incremental economic profit perfirm that has exposure to it, which is actually quiteimpressive. Post stayed relatively flat. This is sortof your run of the mill, sending a letter or paying abill. But banking, as most of us also experiencedfrom the consumer perspective between 2007 and2017, took a major hit. 590 million were at stakefor folks who were exposed to banking. The powerof changing your exposure to momentum is prettyimpressive. The example company that we lookedat that changed their refresh rate, also changedtheir exposure to different industries in a meaningfulway, and changed their momentum profile. Theyincreased, in 2017, their exposure to logistics. Theirpost-exposure seemed relatively flat, but theyactually fully exited banking. Just by doing that theyactually grew their economic profit by 99 million.They gained 94 million in incremental economicprofit just by exiting an industry that actually hadheadwinds instead of tailwinds.Sean Brown: They cut their losses, in other words.Andy West: Yeah. And I think this is a reallyinteresting illustration of the value of divestitures.We struggle as advisors, too, to materially describethe value of exiting a business. Usually we do it in
terms of managerial focus, the ability to changeyour strategy, the ability to better apply resourcesto businesses that are not alike. All of these thingsare absolutely true. But in some cases, it also meansyou’re just fundamentally changing your exposureto areas that have real headwinds. And sometimesthere are better owners just for companies with aheadwind. But it is an interesting question that’soften overlooked and rarely quantified. And so Ithink this concept of momentum is a really importantone for managers as they think about their portfoliogoing forward.Sandra Andersen: The context around momentumis really important. And it actually changes a lot overtime. So something that used to be a tailwind, maybe a headwind, and vice versa, and it’s not entirelycyclical. So when you look at the industries that hadpositive tailwinds in 2007, they changed materiallyby 2017. The most interesting thing about that is thatthere’s a major cost to pay for standing still. So if youwere standing on the edge of a decision in 2007, anduse the same framework to think about where youget your tailwinds and headwinds in 2017, there’s areally good chance that you’d be wrong. And whenyou look at 2017, the industries that outperformand underperform relative to 2007, were actuallyvery difficult to predict for people who didn’t makechanges or make decisions in that space.Sean Brown: So keeping things moving is sort ofmore important than knowing where things aregoing, I guess?Andy West: I think it means that staying still orassuming that tomorrow is going to look like todayis a real fallacy, right? Especially when you look ata ten-year time horizon. And yet every single daymanagers need to make decisions that are goingto move them towards tailwinds. Right? So how doyou break this day-to-day bias, this impossible cycleof, “Well, let’s just put that off till tomorrow, or theheadwinds aren’t affecting me today.” You actuallyhave to be very, very active in terms of how you thinkabout it. The one other thing I would add just aroundWhy you need to keep changing your company’s business mixmomentum in general—and there’s a big differencebetween strategic buyers and, typically, privateequity or other investors—which is the amount oftime diligence in an asset is very, very high when youdo M&A. The amount of time diligence in a marketthat you’re already in is typically very, very low. Ithink everyone would recognize their market’s goingto face headwinds, or they may have challenges overthe next ten years, but nobody really focuses ongetting aligned on that particular market and thoseparticular assumptions, which is very, very different.In a private-equity firm, they have very rigorous,healthy, regular debates about market exposure,and in some ways that helps them manage this risk.Sean Brown: Would you mind commenting juston some tips and tricks that folks who are thinkingabout taking a more active look at headwinds andtailwinds can employ?Andy West: It is probably the most important partof being an effective portfolio manager or trader Ithink because the number of biases that exist, thatprevent management from acting, are extremelyhigh. Whether it’s stability biases, things like thestatus quo bias thinking that where you are todayis going to be where you are tomorrow, whether it’sa short-term bias around, you know, you’re solvingfor short-term gains at the expense of the rightanswer for the long run. Right? Whether it’s interestbiases, thinking about your individual incentives asopposed to company incentives, or misalignmenton corporate goals like, “What are we here to doand achieve?” Or whether it’s just selective hearing,right? That’s another bias that we hear, which is justplacing more importance on relevant and availableinformation. This is what I know. So this is what I’mgoing to act on as opposed to maybe compellinginformation you’re not as comfortable with, right?So in terms of what you do, you’ve got to cut throughthis noise. There’s a tremendous amount of noise.What we see companies do that do this effectivelyare a few things. I think one, they really focus onalignment, right? Meaning market and momentumalignment. They take the time to build the fact base5
around industry trends, industry forces, growththemes, how those things are going to affect theirbusiness, so they can constantly evaluate theirportfolio as opposed to doing a snapshot or evenworse, an incomplete snapshot, once a year or everythree years as part of a strategy review. They’revery, very clear also about boundary conditions.Because if you need to go from A to B, right? If youneed to be in a river, right? Or if you actually needto move a meaningful amount of your capital, itis actually pretty easy to do the math to see howmuch capital you have to redeploy. Just putting anumber on it and understanding, is that in line withthe amount of cash we have? Is that in line withinvestor expectations? Is that in line with what theboard expects? Those kinds of things are reallyimportant to understand, and yet people typicallydon’t do it. So I think just being honest around someof these boundary conditions and getting alignmentis probably the single most important thing to driveboth your refresh rate and get focus on momentum.Sean Brown: Sandra, anything you’d like toadd there?Sandra Andersen: I think there are actually twothings that distinguish the experience for a strategicversus for principal investor that are interesting totalk about as well. One is that there is an expectationthat strategic players know their industry insideand out. They’ve been in it for a long time. They’veworked in it in a long time. They’ve created value init. And so it is difficult for those leaders to overcomethe urge to say, “I know it very well,” and say, “I’dactually like to ask some questions.” And prettybasic ones like, “Do I still want to be in this space?”By contrast, private-equity investors reinventthat every single week, and they can reinvent itfor a fund or for a deal. And I think we can actuallytake something and learn it from the principalinvestor perspective, and apply it to the corporatelens, which combined with the long-term lens thatcorporates have is actually a very powerful tool. Thesecond thing that’s different is that our corporateleaders have to rally a lot of different stakeholders6Why you need to keep changing your company’s business mixwhen they get alignment around a certain idea orconcept or a potential change. They have investors,they have their day-to-day managers, their board.Those are a lot of people with a lot of divergentviews. Principle investors have it by comparisonquite a bit easier. And so I think that there’s actuallypower in the conviction and strength of youropinion that you have to have as a corporate orstrategic player versus a principal investor that’sworth exploring.Sean Brown: Let’s talk a little bit just about thevalue of changing lanes and how do leaders ofcompanies do it most effectively.Just to anchor us in an interesting data point.Companies that are in the fast lane and stayed inthe fast lane of momentum, had excess TRS, havealmost 12 percent, which was double what the TRSwas for the global average. Very impressive. So youreally see the effect those tail winds have. But thenumber of companies in that bucket is actually quitesmall. So it’s less than a third of the total companiesthat we looked at. The other two thirds have somechanging of lanes to do. The question as to what’sthe cost of doing nothing? Companies that are stuckin the slow lane have TRS of about 4 percent, quitea bit lower than the average globally. But companiesthat changed lanes, added 7.7 percent of TRS.Andy West: And when you then take that, thosethree categories, right —start in the fast lane,change
Strategy & Corporate Finance Practice Why you need to keep changing your . Why you need to keep changing your company’s business mix 3 value and did it accelerate or decelerate or detract from that journey? And then finally, we try to look at . function of focus. 4 Why you need to keep changing yo
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