Strategy and how to evaluate it
Strategy is a broad description of a company's action plan to create value for its stakeholders. On a daily basis, the management of a company is faced with numerous decisions related to investments, product development, human resources, sales and marketing. The strategy is a sort of leitmotif that links the different areas of decision-making into a single whole. From an investor's perspective, the strategy provides an opportunity to examine the credibility of the plan to increase shareholder value.
Strategy is a company's recipe for value creation
A strategy is typically created for 3-5 years at a time with a medium-term horizon in mind. With strategy updates, listed companies tend to announce new financial targets that provide a clear, numerically measurable objective for the new strategy period. However, it is common for companies' strategy updates to largely repeat the tried and tested pattern of the past, without always seeing significant changes in the fundamental pillars of the business.
Evaluating the strategy
Evaluating a strategy requires the investor to understand the laws of business, both at company and industry level. When evaluating a strategy, an investor should pay attention to at least the following questions:
1. What is the company's desired position in the value chain and how does it seek to differentiate itself from the competition?
2. Do market megatrends support the strategy?
3. Is the strategy operationally implementable?
4. Are the financial objectives in line with the chosen strategy?
1. What is the company's desired position in the value chain and how does it seek to differentiate itself from the competition?
A good strategy clearly defines how the company will differentiate itself from its competitors and seek to create value within its industry. There are significant differences in value chains between industries. However, in a nutshell, the best return on invested capital is typically generated close to the customer, and large companies inherently have more bargaining power than small ones. For example, technological innovation, brands, operational efficiency, or the ability to attract the best employees can also give a company an advantage within the value chain.
Understanding the laws of the industry and the value chain is crucial for evaluating strategy but finding the relevant industry information can be challenging for investors. Companies may also exaggerate the strengths of their business, so an investor should try to take an objective view based on multiple sources.
2. Do market megatrends support the strategy?
From an investor's perspective, major megatrends that drive economic developments are easier to identify than sector-specific factors, as megatrends are discussed daily in the mainstream media and companies themselves highlight these themes in their communications. Typical megatrends affecting companies' businesses include climate change, an aging population and digitalization. In addition, legislation, regulation, and public opinion, among other things, can have an impact on a company's business.
For some companies, the impact of megatrends may be relatively small from an investor's perspective - for example, tackling climate change in the construction sector means that companies will have to pay more attention to reducing emissions from construction, but the underlying business fundamentals won’t change significantly. However, there are businesses that, at least in Europe, can be expected to shrink significantly as a result of megatrends, such as coal-fired power generation, oil refining, or the tobacco industry.
3. Is the strategy operationally implementable?
Even if the strategy allows for high value creation if successful and is also favored by long-term megatrends, the investor should ask what conditions the company has to succeed in achieving the desired strategic position. Does the strategy capitalize on the company's existing strengths, or will the company have to change significantly to reach the strategic position it’s aiming for? Too much need for change relative to the baseline may prove too difficult to implement, or at least lead to poor financial performance during the transformation phase.
Implementing a change program can require resources such as capital, skilled staff, and motivated and competent management. For example, expanding into new geographic areas is typically a challenging task and can take much longer than planned, as well as hampering the company's financial performance in the short term through increased costs. Moving to completely new business segments is also usually a slow process and can often end in failure.
Acquisitions can be used as a tool to accelerate change, but this option also carries risks, for example in terms of understanding the target and committing employees. In principle, the likelihood of a successful takeover is increased if the buyer has previous experience of takeovers and has a clear, proven model for M&A.
4. Are the financial objectives in line with the chosen strategy?
When updating their strategy, companies tend to inform investors of the financial outcome that the new strategy is intended to achieve. Targeted operational performance is often expressed in terms of turnover growth (percentage or absolute figure), profitability (EBIT or EBITDA as a percentage of turnover) or return on invested capital (important in capital-intensive sectors). Additionally, companies seek to define the desired balance sheet structure and dividend policy.
The investor should critically assess whether the objectives are compatible with each other and/or with the strategy. Unfortunately, it’s typical that targets are set in an over-optimistic manner in order to raise investor interest. In particular, it’s often difficult to achieve strong growth and high profitability at the same time. In our view, the credibility of a strong growth strategy will be enhanced if the company is able to describe the chronological progress of the strategy through different milestones and pro-actively communicate to investors possible "gap years" when, for example, profitability is expected to remain weak due to growth measures.
Below is an example of the planned trajectory of Qt Group's strategy and financial targets.
Summary
Evaluating the strategy requires the investor to understand the company, industry dynamics, and global megatrends. In principle, the credibility of the strategy is enhanced if the company can describe the critical elements and intermediate stages of the strategy in a credible and sufficiently detailed manner. In turn, overly vague financial targets and overly generic talk about strategy reveal that the company itself hasn’t necessarily done enough background work to create a strategy.
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