Some state that COVID-19 will change the world forever. The cynic in me, who believes in the fundamental immutability of human nature, would heavily discount such sensationalist claims. Indeed, transient effects tend to be confused with lasting ones during moments of stress and anxiety. Essentially, it cannot be expected that rational economic actors drastically change their behavior in anticipation of black swan events.
That said, a more nuanced assessment of the potential implications from this crisis would suggest that it will, at a minimum, accelerate certain existing trends. These include greater government budget deficits backed by the Modern Monetary Theory (see ‘The MMT Detonator’), enhanced protectionism, the further regionalization of supply chains and, with it, the rise of automation and robotics. All of this without forgetting the growing importance of ESG factors as firms are increasingly called for higher social and societal contributions.
In addition, COVID-19 will raise leadership teams’ and investors’ risk aversion level for an indeterminate period of time as a natural psychological response. Capital structure policies will remain conservative and working capital levels will rise to de-risk future supply chain disruptions, with vertical integration moves representing a potential mitigating strategy. The pursuit of high returns on equity in the short term will be sacrificed on the altar of long term resilience and sustainability with the blessing of shareholders. ‘Growth’ (quality) stocks will continue to enjoy a substantial premium over ‘Value’ (cyclical) stocks (see ‘Shifting the Goalposts’ in July ’19).
New, disruptive technologies will be adopted at a faster rate as decision makers seek to compensate for the negative impact on labor and capital productivity caused by the new constraints outlined above. ‘Crossing The Chasm’ by Geoffrey Moore explains that many technologies embraced by ‘early adopters’ fail to be espoused by the majority in part due to different expectations and preferences between the two groups. The chasm between them will likely narrow under the growing pressure to innovate.
Could a boosted preference for conservatism lead to a premium for scale and diversity in the corporate world, slowing down or even reversing the trend towards more focused industrial groups? I have long believed and passionately argued that diversified companies have a ‘raison d’être’. An outstanding article published by M.I.T. Sloan entitled ‘A new playbook for diversified companies’ (2018) provides some welcomed support. In it, the authors show that many diversified firms, including private equity firms, perform as well as any other, if not better. This, provided they rely on ‘related diversification’ by operating in similar product and services market ideally alongside a single business model. Furthermore, the ‘parenting strategy’ and the degree of autonomy of the divisions must be appropriately calibrated according to the homogeneity of the portfolio, the degree of parent support required by the divisions alongside the value chain, and the parent’s actual skills. There is definitely a blueprint for large, successful diversified industrial companies when strategy, competencies and organizational structure are aligned.
Switzerland’s 1848 constitution (partially inspired by the Constitution of the United States of America) provides incremental supporting evidence. The Swiss nation employs eight million and runs a portfolio of 26 divisions in the form of ‘cantons’. The cantons are highly diverse from an economic, linguistic and cultural point of view. From a core competencies perspective, there are a number of clusters such as private banking in Geneva, pharma in Basel, watch-making in Neuchâtel, agriculture in Bern, etc. A direct democracy system including referendum initiatives allows for stakeholders’ activism. The adequate balance between the Federal State and the cantons contributes to Switzerland’s competitive advantages across a broad array of sectors.
Diversified companies have the potential to be formidable machines that may benefit from investor preferences in a post COVID-19 crisis world. There is one critical caveat: The authors of the M.I.T. Sloan report stress the need for such groups to implement a perfectly disciplined capital allocation strategy, including through active portfolio management. In this regard, the preamble of the Swiss Constitution states an important principle which is relevant to any diversified company when considering its activities: ‘The strength of a people is measured by the well-being of its weakest members’.