Maintain a Holistic Viewpoint to Bolster Company Value
For directors, it’s essential to understand a company’s finances and anticipate future obstacles.
In a McKinsey & Co. survey of 1,597 public company directors in 2011, 34% of directors said they did not understand "industry dynamics" and 26% did not understand how the company created value. Just 10% said they knew the industry, and only 16% knew how the company created value. McKinsey studies through this July reinforce these numbers and conclude, "few say their boards are better at creating long-term value."
That means that on a corporate board with 11 members, one or two know enough to discuss issues knowledgeably with management, but two, three or even four, by their admission, cannot.
The board needs to understand what it knows, what it doesn’t and what isn’t even on its radar horizon. And this requires looking at the company holistically rather than being jolted by the bumpy ride of events and immediate concerns. Such a reframing of the board’s perspective better aligns the board's agenda with what creates value for investors.
Know the Balance Sheets
A director I know says the knowledge gap can be attributed to the limited information directors receive from management. “We see the gross profits and the gross margins, but we are unlikely to see the inventory turns that prove one business a much more efficient user of assets than another,” the director says.
The lack of knowledge on boards came to me during a presentation on CEO succession to the board of a $16 billion consumer-goods company. A terrible thought raced through my mind as I spoke from the boardroom podium: “The directors do not understand where the company makes money.”
I have never been known for my game face, and, at a break, the lead director came up to me, and said, “The board understands governance. But with a couple of exceptions, the board does not understand the company very well. They will not ask you questions because they cannot.”
The issues boards face have become multifaceted. It is no longer sufficient to grasp the bare facts of a business as presented in the financials; a director must understand extraneous forces and how they interact.
Harvard Business School professor Michael Porter created a framework for looking at businesses through competitive pressures. His competitive strategy of five forces — competitive rivalry, supplier power, buyer power, threat of substitution and threat of new entry — sired a consulting firm and still serves as a handy way of structuring an answer to “Am I missing anything?” Porter's factors expanded how companies and boards thought about businesses.
Over the past 40 years, however, we have learned that competitive analysis does not tell a complete story. For example, we have learned the importance of balance sheets in creating value. For directors, a working knowledge of the financials, particularly the balance sheet, underlies all else.
Recovering from mistakes can be costly, but getting balance sheets wrong can be fatal. For example, utilities have invested billions in power plants and transmission, and that investment is now at risk from distributed generation. Last year, 17% of California’s in-state generation portfolio was solar. The percentage will only grow, and how utilities recapture stranded costs matters significantly to investors. Relying solely on the good graces of state regulators may prove painful. Regulated, capital-intense companies move with care, but markets can outpace them.
Have a Vision of the Future
Boards must consider differing scenarios of what might happen. This includes global events like COVID-19 and the invasion of Ukraine. History provides triggers for thought. What happened during the oil shocks of the 1970s? During the last recession? The past may be prologue.
To be sure, developing strategies and taking actions are not the provenance of boards, but asking management, “Have you considered what happens if…?” is.
Companies are under increasing attack from the left and right, dragging them into the quicksand of culture wars. CEOs feel pushed to take positions on contentious issues. But some things matter, and some do not. Few are core and few change strategies, budgets or capital investments.
Society. Shifting demographics, habits and lifestyles will impact capital requests. Online ordering may eliminate two-step distribution and warehousing. The Tesla sales model may offer insights into what lies ahead.
Geopolitics. The scramble for semiconductors over the past several years may be the best example of the impact of geopolitics. Production of cars and trucks has dropped as manufacturers scramble for chips. The balancing of supply and demand will take investment and time.
Economics. Buoyant economies lift all but a few companies, and boards have approved many a dumb deal because the economy looked brilliant. It’s not just the forecasts; it’s also the assumptions behind them. Economists appear braced for the Federal Reserve to hike interest rates again and again to slow inflation. Guesses abound about how high interest rates might rise and the consequences. Debt costs less than equity. Therefore, companies have been aggressive borrowers. Some balance sheets may be under pressure in 2023.
Environment. Drought, fires, torrential rains, California, Texas, China, Mozambique, Pakistan. Lives lost. Property destroyed. Insurance premiums will rise. We can already see the direct impact on agriculture and transportation, but as populations migrate to adapt to climate change, geography matters more, and how infrastructure responds to change becomes less clear.
Technology. Gamers demanded greater computing capacity, which accelerated cloud computing. The metaverse may be fast upon us. What opportunities might this new world create? Will it be necessary to own production assets or simply control outcomes using technology?
Human capital. Workers have returned to their offices in smaller cities, but not in the largest cities. Office occupancy in Chicago's Loop averaged 46.3% in June, the Financial Times reported. The city’s offices were almost 100% occupied in the weeks before lockdowns hit in 2020. Banks, law firms and consultants still depend on apprenticeships to develop talent. They will have difficulty building camaraderie and growing their own talent if such large numbers stay home.
Leverage Your Company’s Data
A board can follow a few logical steps to gain a strategic perspective on the data it has and what it means.
Identify the variables most shaping the industry and the company. Not all exogenous variables have an equal impact on a business. Effects will vary by industry and circumstance.
As hypotheses, premonitions, anecdotes and hunches mount, the temptation will be to rely on opinions or expert judgment of what matters most. Since Paul Meehl wrote Clinical Versus Statistical Prediction: A Theoretical Analysis and a Review of the Evidence in 1952, we have known statistics outperform experts. It behooves a board to rely upon mathematical modeling when it can. A good econometrician can do the work.
Define the gaps in board knowledge. Having much information about variables of lesser importance tells a board as much as knowing too little about things that do. Yet, data alone are not knowledge, and more data alone may not be the answer for a board to understand the industry and the company.
Ensure a sustainable flow of information and perspectives. The board needs to govern the enterprise in the long-term interests of investors. The conversation about how the outside world shapes value will likely be iterative.
Too often, however, information flows straight to the board without thought. The information meets the legal, accounting and regulatory expectations, but that does not mean management has thought about the right things. It has simply reported the facts as required.
It is incumbent on boards to manage the information they receive and, in doing so, make management think about the outside forces that might affect the company. The increasing diversity of boards should foster more insights.
Where to Start
Much of having a well-informed board rests with the directors themselves. Strong directors understand the financials and learn about the company and its industry, but they have an insatiable curiosity. They read, they seek briefings, they take tours as they travel and they always want more. But in the boardroom, more is often not on the table. Many senior managers choreograph their presentations to the board, however, with no deviations allowed from the script. Compliance and committee reports consume enormous amounts of time, but they might be characterized as the business of the board rather than the business of the business. An understanding of what's most important in growing cash flow prioritizes the board agenda and allocates time appropriately.
Looking at a business holistically creates a framework for deciding what's important and what is not, and how the board sets its agenda. Answering the simple question of “What do we need to know?” focuses the time and talents of the board where it can have the greatest impact.
Gregory Carrott is chairman of the board of Celectiv.