Investment Theory of Capital Flow Analysis: Corporate executives, the asset-lite movement and return on equity.
Investment Theory: The Asset-Lite Movement and ROE
The Asset-Lite Movement
On May 11, 2020, at the apex of the Great Stock Bubble, Joseph Albaugh, President (Space and Communications) of The Boeing Company, spoke at the AIAA Global Air and Space Conference, reminding fellow executives of the significance of asset-lite management:
First if you look at business today, businesses are not rewarded for asset-heavy endeavors. … Today businesses are rewarded for transforming raw information into usable data … and for increasing the efficiency of so-called transactional activity – searching for information, coordinating events, and monitoring performance. This kind of business is inherently asset-light and it's very different from many of ours.
A sociological clue to the Great Bubble.
We note this particular executive’s speech, not because it merits special praise or criticism, but as an exemplar of business thinking of the time — a sociological clue to the Great Bubble.
Mr. Albaugh’s phrase, 'businesses are not rewarded', touches one of the sensitive spots in asset-lite thinking.
It was not so much that businesses — i.e., shareholders — might be deprived of profits or sales, but that business executives might miss out on rich stock options, bonuses, and the acclaim of Wall Street.
McKinsey, Enron, and the Asset-Lite Movement
Addled notions about what is good-for-business contributed to the fantasy of speculators who crowded the equity markets.
Among the most ardent drummers in the asset-lite movement was McKinsey & Co., premier consultants to big business and intimately linked to the intellectual design of the Enron Corporation.
Moving production from the power plant to the trading desk.
In Enron’s case, asset-lite meant moving production from the power plant to the trading desk – what Boeing’s Mr. Albaugh might have meant by 'increasing the efficiency of … transactional activity'.
Jeffrey Skilling, a top graduate at Harvard Business School, had succeeded as a partner of McKinsey before becoming CEO at Enron.
David Campbell, a principal in McKinsey’s Dallas office, and Ron Hulme, a director in the firm’s Houston office that worked on the Enron account, wrote in 'The McKinsey Quarterly, 2001':
Enron has built a reputation as one of the world’s most innovative companies by attacking and atomizing traditional industry structures – first in natural gas and later in such diverse businesses as electric power, Internet bandwidth, and pulp and paper.
In each case, Enron focused on the business sliver of intermediation, while avoiding the incumbency problems created by a large asset base and vertical integration.
Enron no longer produces oil and gas in the United States, no longer owns an electric utility, and has never held a large investment in telecom networks. Yet it is a leading value creator in each of these industries.
This article appeared only months before Enron entered into what was, at the time, the largest bankruptcy in American history.
Asset-lite, as suggested by McKinsey executives, meant 'avoiding the incumbency problems created by a large asset base and vertical integration'.
However, as Enron was soon to demonstrate, those who benefited from this apparent efficiency were not the company’s employees, suppliers, creditors, or long-term investors, but rather its managers.
Enron became an archetypical example of the dead falls that line the asset-lite trail.
Indices Instead Of Money
During the Great Bubble, corporate executives asked to be judged not only by the market price of their stocks, but also by mathematical abstractions of uncertain validity that they could control and influence.
Merit measured in terms of stock prices is easy to counterfeit.
Merit measured in terms of manipulated stock prices and specious accounting is easier to counterfeit than the obvious reality of cash dividends honestly delivered into the hands of investors.
Strange as it may seem, this preposterous switcheroo of values – indices and illusion instead of money – was accepted by investors, long benumbed by the proclamations of the Nobel gods, the mysteries of GAAP, and the Common Stock Legend.
In addition to the dubious utility of unrealized paper profits embedded in total returns, there was another ethereal number that became important in confusing investors.
This proffered measure of performance was known from Wall Street to Main Street as return on investment (ROI) and was derived by dividing accounting profits by corporate net worth.
For the stock market, the relevant index was called return on equity (ROE).
Worshipping ROE
The higher the return on equity, the more shareholders would honor and praise executives.
If each year's book profits could be made to grow just a little, while equity accounts were shaved and diminished, managers could reap rewards from options and stock buybacks while earning respect as captains of efficient growth from conflicted fund managers, business school professors, and the financial press.
Stock buybacks and options were the dark side of the asset-lite movement.
This was the dark side of asset-lite management.
The ultimate corporate owners – long-term shareholders – received little that could be used as legal tender and stood on the sidelines, ignored and befuddled by glittering ratios and non-cash gains.
In North America and Europe in the 1980s and 1990s, the investment perceptions of stockholders and managers had long ago been molded by the prejudices of their fathers, grandfathers, and great grandfathers.
The beauty of the asset-lite proposition was that it seemed so logical and esthetically pleasing– a combination of modern pragmatic efficiency, Protestant-ethic frugality, and the elegance and simplicity of form that had dominated much of intellectual and artistic landscape of the twentieth century.
Polishing the ROE Apple
A Chief Financial Officer (CFO) is taught in business school that certain ratios are appropriate to measure the performance of an enterprise and, consequently, the merit of executives who run the company.
Of these ratios, return on equity (ROE) holds the position of honor.
The CFO, in order to please his boss, must find ways to enhance ROE.
For over a generation, CFOs have learned how to deconstruct ROE, using what is known as the Dupont model to clarify thinking as to the factors controlling this performance measure.
The Dupont model is a break-out of the various elements that make up return on investment:
In the second formula, after cross-eliminating sales and assets, we return to the original definition of ROE: income over equity.
The CFO understands that performance can be approved by increasing income relative to sales, or sales relative to assets, or assets relative to equity.
The Dupont model can be further deconstructed into many subsidiary ratios, such as inventory turnover, receivables turnover, fixed asset turnover, leverage, debt to equity, debt to capital, and so forth.
Pushing ROE Too Far
Conservative CFOs know that it is not prudent to push performance by attempting to enhance these ratios willy-nilly.
Increasing the ratio of income to sales beyond a certain point results in ‘overtrading’; sales are supported by too few assets.
Raising the ratio of assets to equity increases leverage and risk of insolvency.
Followers of the asset-lite philosophy often succumb to the temptation of trying to improve ROE by taking on debt.
In this case, asset-lite may become a synonym for debt-heavy.
Asset-lite may become a synonym for debt-heavy.
The business graveyard is replete with the remains of endeavors that tried too hard to improve ROE by increasing debt.
This was precisely the fate of Long Term Capital Management, the famous experiment in the practicality of the Black-Scholes model that blew up in 1998.
ROE can also be polished by cutting expenses, sometimes unwisely.
A business with too many temporary employees may reduce costs of pensions and health plans, while decreasing staff quality, security of technical know-how, and loyalty.
Reliance on third parties to supply inventories ‘just-in-time’ may cut carrying costs while leading to a shortage of vital materials at a critical juncture.
All of this is to say that, for a rational shareholder, enhanced ROE should not be the sole or even the primary measure of performance.
Increasing ROE and decreasing assets involves risks, some measurable and well-known, others less well-defined but important, especially as to operational security, financial solvency, and long-term market share.
Temporary enhancement of ROE is no substitute for cash dividends.
Tools of Asset-Lite Management
In the last fifty years, a number of management techniques have been invented that allow a company to produce the same level of sales, with less equity:
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Just-In-Time Inventories: By controlling delivery of inventories, working capital requirements can be reduced.
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Asset-Backed Securities: By selling accounts receivable, without recourse, while keeping the service relationship with clients, working capital requirements can be reduced.
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Temporary Employees: By hiring workers on a temporary basis, companies can more easily adjust the labor force to requirements, thereby reducing capital needed to sustain a certain level of operations.
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Contract Manufacturing and Outsourcing: By arranging to use production facilities of another firm for a specific purpose, a company can reduce capital needed for plant, equipment, and maintenance of a work force.
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Franchising: By using facilities of third parties, controlled by franchise agreements, a company can reduce capital required to distribute goods or services.
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Use of Offshore Facilities: By building factories in developing countries, an American company can reduce labor costs and expenses resulting from over-regulation of industries in the U.S., while gaining tax advantages. The net result is a reduction in the need for capital.
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Supply-Chain Management: By sophisticated computerized management of multiple contract manufacturers and outsourced suppliers, a company can significantly reduce equity requirements.
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Leasing and Renting: Investment required to have the use of productive assets can be reduced by leasing or renting. By carefully skirting accounting rules, leasing assets allows liabilities to be kept off balance sheet, thereby disguising the financial condition of a venture.
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Licensing: By concentrating on the creation, engineering, marketing, and branding of a product, a company can license others for production and distribution, thereby reducing the need for capital.
All this moves towards the theoretical Virtual Corporation, a firm consisting only of a few lawyers and MBAs, running a vast manufacturing enterprise entirely by computer and telephone, with virtually no capital.
Before proceeding, check your progress:
Self-Test
The asset-lite movement favored management policies that:
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According to the Dupont Model, other factors remaining unchanged, Return on Equity can be improved by:
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Which of these practices is (are) consistent with the asset-lite movement?
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The Asset-Lite Movement : continued >
