You can't predict, but you can prepare!

Citation

Gentle, C. (2006), "You can't predict, but you can prepare!", Journal of Risk Finance, Vol. 7 No. 1. https://doi.org/10.1108/jrf.2006.29407aaf.001

You can't predict, but you can prepare!

You can’t predict, but you can prepare!

How major events like Katrina and Rita impact the value-creation process

The tragic events witnessed in the Southern US continue to grab the headlines. Hurricanes Katrina and Rita have had a huge human and business impact. They provide a microcosm of the great variety and types of unpredictable, one-off risks companies face today and may increasingly face in the future. The resilience of companies’ share price to the impact of major events is something executives need to understand better – by continually refreshing risk-management and value-enhancing strategies.

Investors and executives share a mutual desire for the success of their company, but they also harbor a common fear: a significant drop in share price. Unfortunately, unlike many concerns, this phobia is grounded in reality. Steep market drops affect a significant percentage of companies, encumbering them with negative repercussions that can last for years.

Indeed, over the last decade, almost half of the 1,000 largest global companies suffered declines in share prices of more than 20 percent in a one-month period, relative to the Morgan Stanley Capital International (MSCI) World Index. By the end of 2003, around one-fifth of these companies had still not recovered their lost market value. Another quarter took more than a year for their share prices to recover.

Although each of these companies experienced unique circumstances that contributed to its loss of value, there are several common underlying risk factors that resulted in a negative effect on value.

The process of value creation is central to building a dynamic and competitive economy. Three major trends tend to influence the value-creation process:

1. 1.

   volatile market conditions have had a polarizing effect on the ability of companies to create value;

2. 2.

   there is a stark difference between the strategies of value creators and those companies prone to destroying value; and

3. 3.

   market liquidity tends not to restrict growth.

Further analysis of the response of UK-listed companies to one-off events is particularly instructive[1].

1. 1.

   Foundations for success based upon relentless value-creation aspirations. The last ten years have proved extremely turbulent for UK-listed corporations. The lesson for their managers is that value is and always will be at risk from unexpected, unavoidable (internal and external) events. Our study shows, however, that value can still be created in this volatile environment, and it is critical to access a value-creating rather than value-destroying spiral. From an analysis of UK-listed companies compared with a global basket of listed stocks between 1995 and 2005, we found that the most value-creating, resilient UK companies focus on long-term risk-management strategies that build material value for their stakeholders, e.g. brand, reputation, and unique organizational practices and strategies. These value-creating corporations go on not only to recover any value lost, but also to add further value. By contrast, value destroyers, the least resilient UK companies, focus on short-term tactics that may shield them from outside risks, but do not build long-term value for their stakeholders. They lack the capability to build and manage the resilience-creating intangible assets, such as unique business practices, strong brand, and robust information flows. In fact, 80 percent of value destroyers have never fully recovered their lost value. The contrast between value creators and value destroyers could not be starker. The future success of UK corporations rests on careful integration and equal treatment of tangible and intangible assets within a value-oriented strategy.

2. 2.

   UK markets have been more volatile than global markets over the last ten years. UK-listed businesses in the FTSE 100 and FTSE 250 experienced more volatility than their counterparts in the MSCI World Index. However, there is an intrinsic volatility for smaller listed companies that could raise governance issues. This makes long-term communication strategies with stakeholders – investors, employees, and suppliers – particularly important.

3. 3.

   It takes a long time for firms to recover, if they ever do. The value losses for UK companies were generally greater than those for their international counterparts. British equities were also less likely to recover their value within a year. Even more important, research found that one-quarter of UK firms that suffered a one-off shock have yet to recover their lost value – which helps explain why life at the top has become increasingly perilous for Britain’s executives.

4. 4.

   Companies in the FTSE 250 index are most vulnerable. Our research shows that smaller listed UK corporations have experienced the greatest volatility. Over the past ten years, nearly half of FTSE 250 companies experienced one or more events in which they lost at least one-third of their value – compared to roughly one-quarter of the FTSE 100 companies. As a consequence, some FTSE 250 corporations may find themselves sucked into the vicious spiral of dependency on short-term share-price movements – a dependency that makes them overly risk averse, and ultimately perpetuates their volatility. (This may appear an odd discussion for those who are familiar with the UK market. Recently, the FTSE 250 has hit record levels. This merely emphasizes the point that senior executives should not rest on their laurels.)

In the boardroom

Running a major business has never been more challenging. Over the last decade, for instance, UK-listed companies endured greater volatility than their global counterparts – making it exceedingly difficult to achieve their business goals and deliver sustained performance. Running a FTSE 250-listed corporation in the UK has been even tougher. Not only has the FTSE 250 experienced more volatility, but smaller corporations are even less likely to recover their lost value. Overall, one-quarter of the firms we studied never regained their original value. For most boards, this is an unacceptable result – and is likely to make the position of CEO or CFO tenuous at best.

In summary, now is the time for a serious debate around the issue of why value is more at risk for corporations in the face of extreme events. For instance, why is it that UK corporations are more prone to value loss due to market volatility and how do other major markets compare? It is imperative to understand in greater detail what best practices can be deployed by listed corporations to ensure that the value-creation process becomes less risky in the face of extreme events. You can’t predict, but you can prepare.

Chris Gentle

NotesSee Deloitte’s recently published Risky Business? Creating Value in a Volatile World, available at: www.deloitte.co.uk/research