Everything moves in cycles, from the seasons to the dominance of a particular sports team over their rivals. And although managers understand that the global economy is certainly no different, it can still dominate their decisions on how and when they invest capital.
When the economy is good, management teams tend to focus less on efficiency and more heavily on growth investments, and then do the opposite when times are tough. While companies certainly need to remain agile and responsive in unpredictable and fast-moving conditions, they don’t want to swing wildly from optimism to pessimism and back again.
An unbalanced investment portfolio created by this this kind of reactive thinking will hurt a company’s ability to grow efficiently and consistently over the long-term (see chart 1). To combat this issue, the finance team at one biopharmaceutical company in the list of 60 firms that CEB calls “efficient growth leaders” – for their ability to have consistently achieved simultaneous top- and bottom-line growth over the past 20 years – designed a portfolio review process that erases some of that more short-term thinking.
Chart 1: Industry growth rate versus level of investments for a typical company Illustrative Source: CEB analysis
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The process has helped senior executives balance their growth and efficiency investments throughout economic cycles, and has certainly proved successful. The firm has been able to grow revenue and earnings margin simultaneously in 14 of the last 20 years, which saw it outperform its peers and often by a sizeable margin. There are four major steps to it.
Use a linear scale to balance growth and efficiency: To help visualize what a balanced portfolio looks like, the finance team created an abstract linear scale with growth investments on one end and efficiency investments on the other (see chart 2).
The scale goes from -3 to 3, but you can adjust or change these values as your team deems necessary. The scale has two purposes: to help set a pre-determined target range for the entire portfolio, and to score individual investments.
Chart 2: Abstract linear scale to compare investment choices Illustrative Source: CEB analysis
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Set a target range for the portfolio: The finance team uses the linear scale to set a target range for its aggregate portfolio during different economic cycles to maintain the right balance between growth and efficiency.
As part of the investment strategy, managers decided that during times of expansion the portfolio should be slightly weighted toward growth investments. Therefore Finance set a target range between 0 and -1 on the linear scale (see chart 3). The same idea applies during times of recession, when the portfolio should be slightly weighted toward efficiency (target range between 0 and 1). And lastly, during times of peak and trough, the portfolio should be equally balanced between growth and efficiency (target range between -0.5 and 0.5).
Determining the current economic cycle and exact industry conditions isn’t an exact science, but these three sources should help:
Chart 3: Typical business cycle Illustrative Source: CEB analysis
Score individual investments: After setting a pre-determined target range for its portfolio, the finance team separately assigns each individual investment a score based upon the same linear scale. (see chart 4 for examples).
As teams continue to use this scale over time it becomes easier to assign individual scores to projects since they can see where on the scale similar projects were placed in the past.
Chart 4: Examples that guide future project placement Illustrative Source: CEB analysis
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Assess funding decisions: As the last step in the process, the finance team checks the balance of the proposed portfolio based on the pre-determined range and the assessment of individual investments.
Finance calculates the weighted average of all the proposed investments to see if it falls within the pre-determined target range for the current phase in the business cycle. If it doesn’t fall within that range, Finance swaps different investments in and out until they hit the right balance between efficiency and growth.