In recent decades, we have lived through an era of optimisation, which was enthusiastically embraced by American executives, in particular. Under the banner of delivering shareholder value, companies contracted out manufacturing to suppliers on the other side of the world, ran down inventories – operating instead on a “just-in-time” basis – and replaced equity funding with debt. Optimisation boosted the components that determine return on equity (ROE): corporate profit margins, asset turns and leverage. US public firms boasted the highest returns in the world, reporting a 17% ROE last year, compared with just 9% for Japanese firms.
However, as Nassim Nicholas Taleb pointed out in his 2012 book Antifragile, the pursuit of optimisation creates instability. Thus, in recent years, we’ve witnessed a succession of “optimisation crises”. The global financial crisis of 2008 showed that undercapitalised banks were overly dependent on capital markets for liquidity. When Covid-19 struck many countries discovered their public health systems had too few hospital beds and inadequate staffing levels to cope with the pandemic. Vladimir Putin’s invasion of Ukraine has further exposed weaknesses in Europe’s energy system; not only was Germany hopelessly dependent on Russian oil and gas, but the country had also underinvested in its military.
Optimisation has rendered the corporate world more fragile. Companies with too much debt are vulnerable to unexpected downturns. Globalisation works wonders when all goes according to plan, but it’s a complex trading system prone to unexpected breakdowns. Pandemic lockdowns disrupted global supply chains, and those disruptions were still unresolved in late February when Russia unleashed the largest military operation in Europe since World War Two. Globalisation has been badly fractured – earlier this year an American ban on the import of goods manufactured in China’s Xinjiang region caused a pile-up of shipping in the port of Los Angeles.
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The easiest way to reduce fragility is to build more redundancy, or slack, into the system. For instance, after the global financial crisis regulators required banks to hold more capital. Now the UK government has announced that it will increase the number of healthcare staff available at periods of peak hospital demand. Germany is looking to construct terminals for imports of liquefied natural gas and has promised to spend more on defence. Slack is the new buzzword.
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The tide is turning for companies
The corporate world is also seeking to reduce fragility. Having experienced frequent supply disruptions, some companies are turning away from just-in-time production. Others are looking to bring manufacturing back onshore.
The era of optimisation sounded the death knell for vertically integrated companies which owned and controlled the entire production process. The tide could be about to turn. Companies will have to bring more key activities in-house, suggests Julien Garran of MacroStrategy in a note entitled “The End of Optimisation”. European luxury goods brands are already buying their suppliers, he says.
The return of inflation exacerbates this trend. Rising prices are often accompanied by supply bottlenecks, but also create uncertainty about input costs. Companies respond by hoarding stocks, which requires them to operate with more working capital. Higher inflation and interest rates also raise the cost of operating across overextended global supply chains.
The end of optimisation will produce winners and losers. So-called “platform” companies that have few physical assets face a bleaker future if they are required to invest in their own manufacturing facilities. Taleb observes that small firms are inherently less fragile than larger ones, while large corporations are doomed to break. These factors make it more likely that “value” stocks, which trade at low multiples relative to their underlying assets, will outperform more highly priced “growth” stocks, Garran predicts.
US companies sport the highest valuations in the world, but these companies have also taken on masses of debt in recent years in pursuit of financial optimisation. In future, it will be harder for companies to boost their earnings per share and stock price simply by borrowing to repurchase their shares. The US market will lose its premium rating.
The end of optimisation requires fewer financial engineers and more genuine engineers. That should be good news for Japan, one of the few developed economies to have retained its manufacturing base. The concept of shareholder value has always been viewed with suspicion in Japan, where companies have given priority to the interests of other corporate stakeholders: customers, suppliers, employees and society at large. Japan’s conglomeration of business organisations, known as keiretsu, also operates with plenty of redundancy. In the past, Japanese companies may have delivered suboptimal returns compared to their US counterparts, but they are less indebted and more robustly designed for uncertain times ahead.
A longer version of this article was first published on Breakingviews.
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