Criticial Finance Issues: Financial Times Briefing

WH O’S DOIN G IT AND WHO HAS DON E IT ?

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Identifying success

Success is the mirror image of these failures – the business survives and prospers.

But can we recognise businesses whose management have managed risk and

made wise decisions as a result? Can we differentiate these from those that have

just been lucky? I think it is possible to make a hypothesis, at least by categories.

It is very noticeable that pharmaceutical companies tend to have relatively

low gearing. It is also noticeable that very successful companies tend to have

low gearing compared with rivals from the same industry. Now, it could be that

there are many successful pharmaceutical companies and therefore we can’t tell

whether it is success or industry that is making the difference. But maybe phar-

maceuticals is an inherently high-risk business. Forget about beta and volatility

of market returns: those businesses are vulnerable to major product failures fol-

lowed by hugely expensive lawsuits; they are vulnerable to their best-selling

products running out of patent protection; they are vulnerable to a sudden decline

in blockbuster new drug invention because you cannot plan for inspiration. They

are particularly vulnerable to Nassim Taleb’s Black Swan

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events – unpredicta-

ble and rare – that are not accounted for by risk measures that deal with normal

distributions of many occurrences of an event. Perhaps, because of this, their

managements accommodate operational risk by limiting financial risk.

In a different industry, Microsoft has relatively low gearing. It too could be

particularly vulnerable to Black Swan events: a sudden invention by a rival; a

dramatic product failure; crippling anti-trust action. If there are tax advantages to

debt – and studies suggest there are – then why operate at consistently lower

gearing than your rivals unless you are taking a view on risk and balancing it?

National Grid, an example of a utility business, does not really have to worry

about those Black Swans nor about volatility of returns because it is effectively in

a ‘cost plus’ business. As a result it can manage huge borrowings. My hypothesis

is that managers of all these businesses have thought about risk and have man-

aged it successfully.

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Nassim Taleb (2008) The Black Swan: The Impact of The Highly Improbable, Penguin.