Robert Kugel's Analyst Perspectives

Effective capital planning and capital investment are vital to a company’s long-term success. The choices a company makes – how much to invest and in which facilities or projects – have a profound effect on its long-term success. For that reason, companies take pains to ensure that these decisions support their long-term strategies and are made as rationally as possible. Because Ventana Research is frequently involved in software acquisition discussions, return on investment is a topic we frequently see raised.

Long-range planning is a process and discipline that companies use to ensure they have the right strategy to succeed in the markets they serve and the right assets to support their strategic objectives. To do that they must allocate their investments in those assets as optimally as feasible and  possess sufficient resources (both financial and other elements, such as personnel with the appropriate skills) to support those investments. The key activities in the long-range planning process are:

• Establishing the best strategic course based on a company’s current market position, its resources, the competitive landscape and external factors such as economic and demographic trends, the legal and regulatory environment and technology trends.
• Determining what assets will be required over the planning period to support the company’s strategy.
• Identifying the ongoing operating activities, such as research and development projects or brand advertising, needed to support the strategy.
• Ensuring that there is adequate funding to support investments and ongoing operating activities over the planning period.
• Ascertaining that the capital structure is adequate and optimized to support the needed investment.

The time span covered by “long-range” planning can differ significantly from one company to the next and especially from one industry to the next, but in almost all cases it exceeds one fiscal year. The actual length is in part a function of the natural business cycle of the industry. For many manufacturing and services companies it is typically three to five years. For industries that have long development cycles, such as pharmaceuticals and aerospace, it can be as long as 15 to 20 years. Even businesses that are notoriously unpredictable and that have short business cycles benefit from having a strategic planning discipline. Decades ago, when I was interviewing with investment banks, I had a standard business-school set of questions prepared, including one about their strategic planning. Some Wall Street companies did have a strategic planning process, but most didn’t – dismissing it as impossible in what they saw as a “highly opportunistic” business. Two that did were Goldman Sachs and Morgan Stanley. Two that didn’t were the now defunct Bear Stearns and Lehman Brothers.

Companies face multiple challenges in managing their long-term planning processes. These include:

• Determining the appropriate methods for assessing plans and their constituent investments.
• Achieving alignment between company strategy and the long-range plans of the constituent parts.
• Ensuring consistency in the preparation of long-range plans across the organization.
• Optimizing investment decisions consistent with long-term strategy.
• Maximizing the productivity of the long-range planning process, which means minimizing the amount of time required to execute the purely mechanical aspects (acquiring data, validating it, creating, maintaining and running the appropriate analytical model) to enable more time to be spent on the analytical and assessment aspects.
• Performing more comprehensive what-if scenario planning.
• Reducing cycle times to allow for a more nimble process.

In capital spending decisions the burden of proof is heavily on the side of the proposer. Project champions must jump through hoops to make a convincing case that an investment is not only worthwhile but also better than alternatives. Strangely, though, once a capital project is approved, a vanishingly small percentage of companies assess whether the projected returns were ever realized. In the decades that I have been asking the question, I have yet to find a single company that does any post-investment measurement of specific projects. Since I’m a rational numbers guy, I’ve long wondered why. One reason might be that, acknowledged or not, one of the main objectives of the capital spending decision-making process is not necessarily optimizing capital investments. Rather, it’s simply to separate the obviously bad ideas from the rest. Applying any rigorous methodology to quantifying potential returns from a capital project is bound to expose many or even most of those with limited potential, faulty assumptions or too much risk. Yet I think this approach sets a very low bar. Having a more rigorous post-investment analytical process would enable companies to do a more effective job of allocating resources.

Ultimately, the success of a company’s long-range planning and investment process can be measured over time in its gross return on assets relative to its competitors’ and, if it’s publicly traded, partly by the company’s share price. A gross rather than net asset approach is useful because it reduces accounting distortions in cases where companies may have written off poor investments or used different reported depreciation approaches for similar asset classes.

Companies – even small businesses – should have a rigorous long-term planning and capital spending discipline in place to ensure that they successfully manage for the long term. Companies that already have such a process in place should reexamine it regularly to determine where it is falling short or failing to identify the right path and the appropriate investments for their strategic direction.

Regards,

Robert Kugel – SVP Research