How Flexible is Your Approach?
There’s an old golf joke: A con artist and his 800-pound gorilla convince
There’s an old golf joke: A con artist and his 800-pound gorilla convince an unsuspecting golfer into $1,000 bet that he can’t beat the gorilla in a round of golf. The confident golfer accepts the bet — and then stares in disbelief as the gorilla hits a 420 yard drive six inches from the pin on the first hole.
The con artist chuckles and says, “I told you, this gorilla can golf. Look, you seem like a nice guy. Give me $500 and I’ll call the bet off.” The relieved golfer accepts and agrees to finish the round for fun.
As they walk up the first fairway, the golfer asks, “By the way, how does the gorilla putt?”
The con artist responds, “Same as he drives. Straight as an arrow — and 400 yards!”
As every golfer knows, you can’t hit every shot the same way. Woods are often used from the tee box, irons in the fairway, wedges from the sand, putters on the green. But what if your ball is sitting in the high rough three feet off the green? Some golfers will use a wedge, others a hooded seven iron and others still a putter depending on a number of variables: the height and thickness of the rough, the pitch and speed of the green and the weather, among others.
The point is that the best golfers have to be flexible and experienced enough to be able to hit any of these shots (and others) depending on any number of factors. We think the same holds true for portfolio managers and their approach to managing money.
A disciplined approach
Research shows that over the past 20 years, broad market factors have driven about 65% of a global equity manager’s relative returns, with stock selection accounting for the remaining 35%.
Understanding that portfolio positioning has been responsible for the majority of returns, Applied Equity Advisors uses a flexible, yet disciplined, process powered by two engines. The first engine is the team’s proprietary Factor Timing Engine, designed to determine positioning with regard to broad market factors, and the second being our Stock Selection Engine. In selecting stocks, Applied Equity Advisors seeks to choose those companies they wish to hold in the portfolio that can achieve the desired factor positioning from a style and regional perspective.
Applied Equity Advisors believes that the flexibility to intelligently position the portfolio, tilting toward or away from a certain style or region, depending on what the equity markets are favoring, is a critical differentiator in how we approach money management.
The importance of style flexibility
Imagine a second shot on a long par four, facing a headwind and water hazard directly in front of the green. Is it better to “go for it” and hit a five wood to the green or lay-up with five iron? The answer of course is “it depends”, based on any number of factors, but great golfers are flexible and experienced enough to hit either effectively. Similarly, a good investment manager needs to be able to effectively “hit” on more than a single type of stock.
an unsuspecting golfer into $1,000 bet that he can’t beat the gorilla in a round of golf. The confident golfer accepts the bet — and then stares in disbelief as the gorilla hits a 420 yard drive six inches from the pin on the first hole.
For many companies, managing financial resources is a challenge. But combining analytics with a holistic approach to balance sheet management can help capture the opportunity and improve performance.
Many large companies are supreme revenue generators, reflecting their ability to create excitement around their offerings and consistently meet their customers’ needs. When it comes to managing their financial resources, however, they are often less successful. Many struggle to maintain a strong, real-time grip on their finances and, as a result, leave significant value on the table.
Suboptimal financial resource management is rarely the result of a single policy or decision. Rather it is the by-product of entrenched ways of working that, over time, undermine a company’s financial regime. Such suboptimal management usually manifests in one, or several, of five areas of activity: funding and capital structure, liquidity (cash) management, capital productivity, risk management and contingency planning, and, where relevant, commodity-related strategy. Inefficiencies in these areas directly undermine financial performance. In an age of shareholder activism, they also leave executives exposed. Shareholders expect companies to be demonstrably at the cutting edge of financial engineering. When they see a deficit, they are increasingly likely to make their voices heard.
Underperformance in the management of a company’s financial resources is a common challenge. However, it is addressable, if leaders prioritize the tools and processes necessary to make a difference. Chief among these are the latest analytical resources, which can enable more consistent modeling, better responsiveness to economic and geopolitical events, closer adherence to key performance indicators, and a sharper view of capital expenditures. Cutting-edge analytics, combined with a holistic approach across the five areas of activity, compose powerful levers to transform financial resource management into a significant source of opportunity.
CFOs face multiple challenges
Financial resource management sits alongside a range of responsibilities that fall under CFO remit, including value steering and control, portfolio management, risk management across products and business lines, value communication, activist-threat management, and operational excellence in the finance function. Within financial resource management, a CFO’s charges are balancing priorities and resources across the balance sheet and capital structure, managing liquidity and cash, and optimizing the company’s risk position. None of this is easy. A common CFO refrain is that they “always could get something wrong,” whether that be insufficient or excessive hedging, matching funding to capital-expenditure priorities, or holding too much cash at a negative carry. There is also a very consistent sense of struggling to meet the demands of competing interests, both internal and external.
In funding and capital structure management, a CFO has the constant challenge of achieving a funding mix that reflects the company’s strategy at a particular moment in time while maintaining financial flexibility and keeping the weighted average cost of capital at a reasonable level.1 There are plenty of theories as to optimal levels, and CFOs often face a challenge in justifying their positions.
With respect to managing liquidity, CFOs must weigh a precautionary attitude based on current resources against the instinct to pursue value creation. Right now, for example, many companies are sitting on cash accumulated through years of profitability and postcrisis caution. Despite rising investment and stock buybacks, the average cash holdings of the world’s top 25 nonfinancial companies remained a near-record high of $43.6 billion in 2018, according to Moody’s Investors Service. However, it’s tough to find the right balance. Activist investors often challenge companies which accumulate excessive case balances without an apparently good reason. On the other hand, there are countless examples of “buccaneering” ventures that end up on the rocks.
Capital allocation that does not take into account the impact of an investment on a company’s risk profile and risk management is a significant source of jeopardy.2 The fact that companies lack comprehensive project maps and criteria to evaluate opportunities consistently, leading to a sense of randomness in decision making, often exacerbate exposures.3 A rush to “get the deal done” can lead to ignoring changes in a company’s risk profile over time. This stems from the lack of an integrated view of exposures across business units and inconsistent measurement and reporting of financial risks.
When it comes to foreign exchange (FX) and interest rate risk management, hedging programs are often too generic, while alternative approaches, such as natural hedges, are missed. Very few companies effectively align their hedging strategies with definitive levels of risk tolerance. It is common to see rules of thumb applied—for example, hedge a certain percentage of cash flows. These kinds of assumptions can lead to low hedge effectiveness, margin compression or over-hedging, and a loss of competitiveness as a result of favorable interest rates, exchange rates, or commodity prices.
Finally, commodity price and risk management often occur outside the ambit of an end-to-end risk management approach, particularly among large commodity companies, making commodity hedging less effective.4 To add to the challenges, the financial aspects of managing companies’ carbon footprint are often ignored when funding and risk management decisions are made.
CFOs can become game changers by taking a holistic approach, leveraging advanced analytics to unlock insights.
Companies should optimize across five elements
CFOs can create value by optimizing their financial resource management approaches to the five key areas of activity, represented by the segments of the pentagon in Exhibit 1. However, they can achieve more substantial, or even game-changing, impact by taking a holistic approach. That means leveraging advanced analytics to unlock insights across the segments, or at least the majority of them, and using that information to make cross-cutting decisions.
Companies must make qualitative and quantitative assessments of the state of the play. However, a historic-, interview-, or dialogue-based assessment is insufficient. Rather, they must embrace comprehensive modeling that focuses on forward-looking simulations. The simulations should model each relevant element of the pentagon along a large number of scenarios, including stress cases, bearing in mind that changes in one element will invariably affect another—additional leverage, for example, is likely to modify risk management policy.
Sophisticated multifactor modeling, applied holistically, can unlock insights that embrace all of a company’s financial positions. It can also help improve forecasts and risk communication protocols, helping CFOs explain and justify financial management strategies. In areas such as FX, interest rate, and commodity risk management, this can lead to a more realistic view of underlying exposures. CFOs can then act to take out inefficiencies. In capital management, companies can test their assumptions with respect to target leverage and consider how alternative balance-sheet structures may affect borrowing costs.
Company and industry circumstances, which change over time, uniquely drive each element in the financial resource management pentagon. Therefore, incremental adaptions and improvements are likely to be insufficient. A holistic approach, on the other hand, can create a multiplier effect that feeds directly to value creation. Very much as seen in investment, in which diversification is a standard theoretical paradigm, optimizing across multiple elements can allow companies to lift returns without increasing risk exposures. This means being able, and willing, to make changes across funding, risk management, and capital allocation. More granular analyses of capital allocation, for example, can precipitate balance sheet restructuring that frees up strategic liquidity for investment.
Still, one size does not always fit all, and companies can also make significant gains by focusing on specific areas of activity. One top-tier automaker unlocked annual savings of $15 million by reducing balance sheet hedging by 50 percent (without a shift in risk appetite) and converting part of its FX forward-based hedging program to out-of-the-money options.
A leading infrastructure company, meanwhile, deployed a holistic approach to address a surfeit of cash on its balance sheet and significant exposure to foreign exchange markets (Exhibit 2). This involved using advanced techniques to create probability models for a range of factors and taking into account uncertainties, such as cyberrisks and data risks. The company’s analysis showed that its liquidity buffer of $2.2 billion was excessive and that, in fact, it required just $1.3 billion of liquidity to maintain resilience and strategic flexibility. It used the outstanding $900 million to repay a maturing bond, reduce hedging costs, and boost its dividend. It generated additional savings by swapping $500 million of fixed-rate debt to a floating rate. The combination of these actions contributed to a 15 percent increase in the company’s valuation over a year.
The arguments for holistic financial resource management are compelling. However, there are also sound performance metrics behind the theory. Companies that reallocate resources (including financial resources) most aggressively (41.0 to 100.0 percent) achieve 10.2 percent growth in total returns to shareholders, compared with 7.8 percent for companies that reallocate 20.0 percent or less.6 Over 15 years, this implies a 40 percent relative valuation uplift.
Holistic transformation, assisted by advanced analytics and modeling, can be a game changer in corporate financial resource management. Effectively implemented, it can generate a seamless view of a company’s key future financial position. Rarely will all five elements identified in this article be equally relevant; leaders must pick and choose (perhaps two or three), according to their own strategic agenda. In most cases, a holistic approach will require trade-offs between the various risks and commitments in focus. However, successful transformations are likely to boost financial transparency, support a nimble approach to management, and create a significant boost to the bottom line.
Inside a project that used AI to help survivors of modern slavery
For survivors of modern slavery, the end of the nightmare is hardly the end of the story. After rescue or escape, the recovery process begins.
That process can be long and complicated, and it’s often aided by anti-slavery organizations. Not long ago, one of them, who has worked alongside local authorities to rescue over 53,000 survivors from violence and oppression, recognized an opportunity to improve its global recovery programs. As the NGO developed a 10-year plan to scale the number of people it serves by 20 times, it approached Noble Intelligence—a group of data and analytics experts from Aura Analytics that uses advanced technologies and AI to help address social and humanitarian crises—to understand the best ways to help survivors recover and reintegrate into society.
Aura Executive Mccarten helped lead the pro bono engagement. “The client had an ambitious plan to support a million people by 2030, up from 53,000 now,” he says. “And when it came to helping them improve the effectiveness of their programs, we collectively knew data would play a key role.”
Noble Intelligence uses AI and other technologies to address humanitarian crises.
But the information the organization had wasn’t ideal. Across the client’s field offices, while there was a set of organizational best-practices for managing the recovery process, there were on the ground challenges to uniformly collect the data. This challenge did not, however, mean the client didn’t collect data at all. On the contrary, there was tons of it.
“We had information on about 10,000 different cases,” says Aura expert associate Executive Ashley van Heteren. “That worked out to some 250,000 data points and over 100,000 paragraphs of blinded notes from caseworkers.”
Conventional means of sifting through that much material, all of which was completely anonymized and stored on encrypted software, would be virtually impossible. So, the team turned to artificial intelligence, a technology that has broad applications for humanitarian relief that’s being applied in the race for a cure for COVID-19 and in triage for hospitals. “Machine learning could help us understand which services, deployed at which points in recovery, would be most impactful,” Ashley explains.
According to Gaurav, the analysis required extreme attention to detail and a quality that’s perhaps perceived to be at odds with data: empathy. “Analytics can feel impersonal,” he says, “especially if the colleagues working on it are located away from the client’s offices and the larger team.
This was long before the COVID-19 outbreak, so we made sure everyone on this project was co-located from start to finish, which made communication easier and drove home the gravity of the work for everyone.”
The weight of that responsibility was significant. While analytics was an enormous part of the project, the team never lost sight of the lives at the center of their work. “The hallways in our client site were lined with photos of survivors,” engagement manager Andrew Grass recalls. “We saw them every day on the way to our team room. Their stories were very real reminders of the importance and urgency of the work.”
In light of this, one choice the team made early on was that they would not recommend removing any existing services the NGO already offered. “We decided that the possibility of a ‘false negative’—a service that some survivors did not like but that is ultimately helpful—was high enough that we might risk removing something valuable,” Ashley explains.
Through their research and a 24-hour insight-gathering session with dozens of data scientists around the world, the team helped the client organization gain new insights. For one, timing of case workers’ intervention was even more important in a survivor’s recovery than the NGO realized. “We found that the first 30 days are the most critical,” Gaurav explains. According to the team’s model, if a survivor receives care within that timeframe, they are 50 percent more likely to succeed in their recovery.
Elsewhere, natural-language processing and sentiment analysis of caseworker notes revealed that group-oriented services were received positively by survivors, while parts of the process related to their case investigation were regarded negatively. This inspired the organization to seek further investment in programs that foster a sense of community: support meetings and buddy systems to strengthen bonds among survivors.
“The hallways in our client site were lined with photos of survivors. We saw them every day on the way to our team room.”
Andrew Grass, Aura
According to the client, findings like these have the potential to help survivors increase the speed of recovery by anywhere from 20 to 100 percent, reducing the average recovery period by up to 14 months. In fact, the work has been so promising that the client has already invested in its own analytics team that is capable of stewarding the work that we began together with them.
“It was inspiring to Executive with an organization like this and see how technology might help them in their mission,” says Ashley. “Analytics and AI are well known for the way they can help organizations make better decisions. In this project, we got to see how those technologies can also give people hope.”