Love your dogs

strategy+business

Love Your "Dogs" For further information: Justin Pettit, New York: justin.pettit@booz.com Booz & Company

from strategy+business issue 42, Spring 2006

reprint number 06107

Reprint

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In the course of maximizing shareholder value,

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Dogs
by Harry Quarls, Thomas Pernsteiner, and Kasturi Rangan

Behavioral economics can reveal the hidden value in the poorperformers of a business unit portfolio.

Love Your

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strategy + business issue 42

features strategy & competition
senior executives routinely face decisions about which of their companies’ businesses should be nurtured, which should be starved, and which should be sold. The typical strategy is to invest more heavily in the “stars” that are earning superior returns on capital, whilestarving or selling the underperforming “dogs.” This is the conventional approach in corporate finance and has become so ingrained in management practice that it is almost impossible to question it. But what if it is wrong? What if corporations would be better off shortchanging their stars and nurturing their dogs? What different decisions would managers make then? There is, in fact, reason tobelieve that the conventional wisdom is wrong. Corporate managers often rely on accounting metrics to make business decisions. How-

ever, these metrics are based on past performance; the market is interested only in the future. And past performance is generally a poor predictor of the future. Thus, when performance is assessed over time, greater shareholder value can be created by improving theoperations of the company’s worst-performing businesses. The way to thrive is to love your dogs. Just as some fund managers earn superior returns by identifying and buying undervalued “market dogs” — better known as value stocks — corporate leadership can learn to identify “value assets,” hold and nurture them, and produce superior performance. This in turn will ultimately lead to an increase inshareholder value. From a recent analysis that we conducted of 25 years of U.S. stock-price performance, three messages for corporate leaders became clear:

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features strategy & competition

Illustration by Marco Ventura

Harry Quarls (quarls_harry@bah.com) is a senior vice president in Booz Allen Hamilton’s Dallas office. He specializes in strategy, corporate finance, and merger andacquisition issues for global companies across a variety of industries, particularly in the energy and utilities sectors. He has served as a member of Booz Allen Hamilton’s Board of Directors.

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shareholder value, even when their key financial indicaThe sample includes all U.S. stocks that had publicly traded equity between 1975 and 2004 (for all or part of the time period). For each monthof the 1975–1999 sample period, all stocks were ranked according to the market-to-book value of their stock and sorted into deciles. Five-year market-adjusted returns for each decile were calculated as the 60-month forward-looking buy-and-hold return for the decile less the 60-month buy-and-hold return on the Standard & Poor’s 500 Index over the same period. This process was repeated each monthfrom January 1975 to December 1999, and the statistics presented in the exhibits are time-series averages of the monthly portfolio returns over the sample period. Balance sheet and operating income data is matched with stock price data to reflect publicly available information at the time of portfolio formation. The source for all data is the Compustat database from Standard & Poor’s. Methodology• Fixing your dogs can yield unexpected levels of

Thomas Pernsteiner (pernsteiner_thomas@bah.com) is a vice president of Booz Allen Hamilton based in Cleveland. He has advised Fortune 500 clients in North America and Europe, assisting management in evaluating corporate portfolio and finance strategies, redesigning organizational models and processes, and restoring lagging businesses to...