How Companies Have to Invest for the New Normal to Be BetterTIME TO INVEST FOR RECOVERY. THREE RULES FOR NOT REPEATING MISTAKES: DIVEST QUICKLY FROM UNPROFITABLE AREAS AND PRODUCTS, REALIGN STRATEGY AROUND THE NEW PRIORITIES OF BUSINESS INVESTMENT, AND ADOPT SUSTAINABILITY AS A CRITERION FOR CAPITAL BUDGETING AND MANAGERIAL ASSESSMENT
by Andrea Dossi, Associate Dean for Faculty, SDA Bocconi, Associate Professor of di Auditing and Control and of administrative systems in multinational groups, Bocconi University
Translated by Alex Foti
The quantity and quality of investments that companies will decide to implement is the most pressing management issue during the Covid-19 crisis. We know from research that the investment behavior of companies in times of crisis, especially in situations of financial constraints, is sub-optimal. It indiscriminately penalizes all categories of investment, and those who cut down the most recover the least in the post-crisis phase. The current situation has all these characteristics. The data tells us that at the beginning of 2020, 26% of world companies with more than $10 million in revenues had financial debt higher than their net worth. Of the remaining 31%, there was a high risk of a block in business cash flows which are vital for investments, especially in medium-sized companies, those that are strategic for the development of economic activity: 12% because of operating losses and 19% due to having an operating leverage greater than 5. The financial tension that most companies are experiencing therefore also depends on how companies were at the beginning of the crisis, on the investment errors they made, which they must not repeat, as it already makes the crisis more serious. Today, businesses and entrepreneurs must do the right thing. And to better manage the most critical aspect, i.e. investment behavior, three aspects are of great importance.
First, you need to quickly divest from products, markets, customers, projects that have proven neither profitable nor growth drivers, so to free managerial attention, the scarcer business resource of all, as well as financial resources to be devoted to priority investments. The efficiency of investment processes, which is one of the reasons for the superiority of the company as an organizational form with respect to the market, requires the setting of simple and automatic internal processes and rules to develop the ability to quickly exit investments with uncertain results. Any position of weakness that reduced the pre-crisis cash generation capacity and has imploded in the crisis phase, thus absorbing attention, remains weak in the post-crisis phase. Nothing is better than a crisis to intervene decisively to alter less than optimal situations.
Second, companies must have the courage to prioritize investments, by putting strategic quality first. There is no need to stress here how fundamental investments in digital technology and human capital are, which are inputs transversal to any type of investment. Here we want to underline three priorities for the three relevant business macro-processes: innovation management, operations management and customer management. First of all, data on global companies with revenues of more than $1 billion say that setting the value of 100 for total revenues at the beginning of 2020, the share of resources dedicated to customer management processes is relatively low, on average around 25%. In very few sectors this share is proportionate to resources devoted to business operations. It is a sign of the scarce attention paid to investments in customer proximity. As required by the principles of the digital economy, attention must be paid to maintaining a lasting relationship with the customer, not only on sales transactions. Relational commercial capital is the intangible asset tha can be least imitated by competitors, and protects an essential business resource, both for B2C and B2B. After experiencing the difficulty of maintaining a proactive business relationships during the lockdown, firms must prioritize investments in product, service and knowledge platforms to support the nurturing of relationships with clients, co-opting them in their management processes. The list of the100 best global brands in Interbrand rankings, which lists companies of different size, both B2B and B2C, offers a series of examples of how to move towards this direction.
Secondly, companies need to invest more in innovation processes. The average of R&D costs on the turnover of world enterprises is only a bit more than 2%. If knowledge-intensive sectors are removed from the calculation, the average is even lower. No business can survive without innovation in the long term. It's not just about increasing R&D budgets. You have to put it on the agenda of priority investments for the development of corporate entrepreneurship, through mechanisms and projects that have the ambition to activate all the potential for open innovation withing the corporate community and its reference stakeholders. Thirdly, we must invest in reducing the risk profile of the business, especially in the supply chain. In the last decade, the data show that all companies managed the supply chain more efficiently, recovering profit margins and cash flows. It is time to consider the supply chain from the perspective of intellectual capital, creating hubs of data and services to share operational and financial risks and co-design innovation. Take a look at how US group Aptar presents its online Supplier Portal as a distinctive competence of its business model.
Lastly, it is necessary to invest in the permanent adoption of sustainability as a key variable in the design of the strategic and organizational architecture of business models, and not just as a mere communication asset. If companies had adopted the ESG perspective in their strategic plans, the impact of Covid-19 on their business would have been more limited. It suffices to think that in the 5 most relevant issues that characterize "Business model and innovation" according to the materiality map compiled by the Sustainability Accounting Standard Board (www.sasb.org), a list which reflects the findings of academic research, the "Materials Sourcing and Efficiency" item looms large. It requires explicitly managing the "resilience of materials supply chains to impacts of climate change and other external environmental and social factors", especially for the impacts on "availability and pricing of key resources", through new policies of "product design, manufacturing and end-of-life management "and" screening, selection, monitoring and engagement with suppliers ". This issue is considered highly material for 7 macro-sectors out of 11. The reference KPIs are given for each sector. This mapping could have been very useful to limit the impact of lockdowns and resulting logistical difficulties in maintaining supply chains in operation. Companies must therefore avoid delaying the adoption of what research shows has value. To avoid further delays, today executives to act on two critical points of corporate decision-making processes. Sustainability performance must be included in capital budgeting processes as an additional investment analysis criterion. Enel, world leader in the energy industry and benchmark of innovation and sustainability, is doing it. And in accordance with the results of the research study, the cost of capital adopted in the calculation of NPV of an individual investment is reduced as a function of estimated ESG results. Furthermore, executive compensation packages must reflect sustainability performance, in order to trigger a cultural shift, which is more likely know, starting from the decisions of individual top managers. You can refer to the description of Alcoa's compensation system in the proxy statements of the last few years to understand how it is done and fine tune executive pay.
Adding speed to divestments, making strategic realignment the basic priority for business investment, and adopting sustainability as a substantial element of capital budgeting and managerial assessment are three key choices to be made today. Changing investment behavior is a decisive aspect for companies to avoid wasting the financial support for the recovery coming from the economic policies decided by various governments. This is crucial for the "new normal" to be not only different, but better than the old normal.