ParisTech Review

Among the many changes that have come with the opening up of the world in the last thirty years, financial globalization has been without doubt the single most important one. Within the span of a few years, we moved from a partitioned financial world to a largely open system in which companies compete with one another for investors from all over the globe. This globalization has been accompanied by an exponential growth in the financial professions and financial information, and by the generalization of the models and behavioral patterns born on Wall Street and in the City of London.

For the CEO of an industrial company, this evolution has led to a change of priorities, which even affects the daily work schedule. When I took over as head of Lafarge in 1989, relations with investors, the financial milieu and the financial press took up only a small portion of my time. This has increased considerably over the years, and points to the growing dependence that CEOs now have on the financial world. Here they are often confronted with a financial logic that differs from traditional industrial logic. I would like to illustrate these differences, which are at times complementary and at others conflicting.

In the aftermath of the excesses that led to the present financial crisis, it would be easy to focus on conflicts. However, I feel that it would be better to look at the underlying and structural differences that business leaders will continue to face, even if the excesses of the recent times are reversed, which is by no means certain.

The ‘15 per cent rule’
The greatest impact of the heightened influence of financial logic is a higher demand for performance. Toward the mid-eighties, American companies, basking in the aftermath of a glorious period of progress, dozed off slightly. It was a time when trade unions obstructed even the slightest changes, and management was more concerned with its own comfort level than confronting unions in the company’s interest. Companies were woken up abruptly by Japanese competition, on the one hand, and Wall Street investors, on the other, who aggressively stormed their way into several corporate citadels. This was the period toward the end of the eighties, described in the book “Barbarians at the Gate,” the story of the battle for Nabisco, the cigarette and food company. Nabisco was finally sold to Henry Kravis’ investment group at double the price of its initial stock market value, against a backdrop of financial extravagance and ego clashes.

At that time I was living in the United States where I headed the American business of Lafarge. As an industrialist preoccupied with the long term development of the company, I was worried about the impact of such staggering blows to American industry and what these assaults, upheavals and breakups, funded by junk bonds, would bring.
There is no denying that, 20 years down the line, American industry has become stronger, and companies such as General Motors, which were not threatened, have continued on a downward trend.

It was during this period that the “15 per cent rule” became a popular rule-of-thumb applied to company profits or growth. The financial world demanded that companies produce a 15 per cent return on equity and/or notch up 15 per cent growth per annum.

Many economists denounced this “15 per cent rule” as absurd, given that it far exceeded the growth of the economy.

In fact, there is nothing absurd about asking a few listed companies – the most successful ones, representing only a small portion of global economy – to register performance levels far higher than average. And the 15 per cent figure came up at a time when inflation was high and interest rates were eight or nine per cent. With the current interest rates, the objective of a “good” return on capital would be more like 10 per cent. Lafarge was considered a company with good profit worthiness though we never reached the 15 per cent threshold; in fact our maximum return on capital was 12 per cent. For us, at least, the 15 per cent rule was never more than a rule-of-thumb!
All said and done, I believe that the performance requirements imposed on companies by shareholders and financiers are in essence legitimate and lead to greater economic efficiency. Just as in any human endeavor, companies generally attain their maximum efficiency only if they are subjected to external pressure, which could be pressure from competition or pressure from shareholders.

This does not imply that it is easy to reconcile the demands of financial logic and industrial logic. Differences, some of which are manageable and others not, affect time management, the nature of business involvement and the extent to which herd mentality influences the sector.

Shareholders against shareholders
Financial markets are often accused of having a highly short-term approach that prevents companies from pursuing long-term strategies. Among the most important shareholders that a company director meets are pension funds – long hounded by the European press – and they have very long-term investment timelines, ranging from 30 to 40 years. Several pension funds held stakes in Lafarge for long periods, spanning good times and bad, highs and lows. Discussions with them were more about the fundamentals of the business and long-term strategies than about the results of the next quarter.

That said they are not the only shareholders. Mutual funds, even if they are more often than not medium-term investment vehicles, have a horizon dictated by comparisons with their competitors of their yearly – or, often, quarterly – performance. And hedge funds – it would be more appropriate to refer to them as speculative funds – compare their profit worthiness on timelines that are often extremely short, sometimes not more than a day’s trading. These “per day” shareholders are obviously interested in the long-term initiatives of the company only for the immediate impact they have on the market. As regular in-and-out stakeholders, they play a decisive role in fluctuations of share prices.

Even analysts, whose job it is to value a company and recommend the purchase or sale of its shares, find themselves in a complex situation. The time span of their recommendations is generally shorter than 18 months. Their job consists not only of passing judgment on the company, its strategy and its fundamentals, which they often manage to understand rather well, but also the more difficult task of whether, within a span of 18 months, the financial market will acknowledge the company’s value sufficiently in order for its share price to increase.

This relatively short-term valuation explains why the “price targets” given by analysts vary greatly over time, whereas the intrinsic value of a company does not.

Clearly financial players relate to time differently than industrial players for one basic reason: a financier is free to “enter” the company by buying shares and to “get out” of it, by selling them at will. An industrialist is engaged on a long-term basis. He can change his business from time to time, but in order to do this he has to go through a long, complex process that is contrary to his nature. And if he takes this path too often and does not maintain continuity, it would mean he has decided to adopt a financial strategy and is no longer an industrialist!

A couple of anecdotes helped me understand this irreconcilable difference. One day I was reading an analyst’s report that examined the growth potential of cement in certain emerging markets, and reached the paradoxical conclusion that a shareholder could benefit from greater growth by buying shares in a low-ranking American cement company rather than an Indian or Chinese cement firm because it gave them the chance to get out at the high end of the cycle, leaving the industrialist to manage fresh market downturns.

In another instance, during the growth phase of the Internet bubble in 2000, I was talking with a New York banker about the flourishing start-ups. With charming simplicity, he told me that, in most cases, the most important thing was knowing how to quit these companies at the right time: a definition of financial entrepreneurship far removed from the concept of creating an industrial enterprise!

Financial time, industrial strategies
This gap between industrial timeframes and financial timeframes can have far-reaching consequences for the success of industrial enterprises.

In the construction materials industry, for instance, British companies once occupied an enviable position, having expanded into the Commonwealth. When I joined Lafarge in 1975, the global leader in the cement industry was the English company Blue Circle.

Thirty years later none of these companies remains; all have been bought out by continental European competitors. In fact, Lafarge bought Blue Circle in 2001. I came to the conclusion this was because these companies subordinated their strategies to the short-term demands of the City of London.

There is no other place in the world besides London where company heads are as closely monitored by their shareholders. Managing directors come in contact with the financial world on a daily basis, and are subjected to permanent investigation by a highly aggressive financial press – “Napie must quit,” cried the headline of the Financial Times one fine day, referring to the head of an English company operating in our sector. Furthermore, managing directors are supervised by a chairman – the chair of the board of directors. This is an outsider who, in general, is not an expert in the company’s business, and whose sole legitimacy comes from the fact that he represents the shareholders, the City, on the board.

Under these circumstances, it is very difficult to preserve the continuity of a long-term strategy if it clashes with the financial modes of the time. The company may, for example, find itself enjoined to expand to the United States, even if it reaches there after its competitors, and is forced to pay a very high price. Or a company will be urged to go to Asia and, six months later, to leave the region, because the appraisal of the risk factor associated with Asia has changed. This is what happened to Blue Circle. After several strategy changes Blue Circle gave up its best geographical locations and even moved away from cement, only to get back into it again later. This happened to other companies in our sector where continuity and long-term undertakings are crucial for success. In most cases when companies were sold, shareholders benefited financially. I had bitter first-hand experience of this in 2000, when my first attempt to takeover Blue Circle failed because a handful of shareholders opposed the offer. They were insisting on their pound of flesh! In its financial logic, London is extremely effective indeed.

Herd Instinct

Last but not least, the most disconcerting characteristic of the financial world for an industrialist lies in the mimetism of behavioral patterns. Ever since the philosopher René Girard popularized the concept, we have understood the importance of mimetic behavior. In finance, however, this is stretched to the extreme because of the way players make their choices.

This came home to me clearly in 2001 when I was trying to raise capital to finance the acquisition of Blue Circle. An investor told me: “Your strategy is excellent and we support you, but at the moment, our clients are thinking of investing only in the Internet, and cement will be of little interest to them.” As the conversation continued, the investor explained that three months earlier he had found the price of one of the stocks related to the Internet sector – ST Microelectronics – highly inflated, and had refused to buy the shares. But the stock continued to rise, and had taken such a share in the index that, over the period of a quarter, the performance of the funds he administered was lower than the benchmarks by several percentage points. “At the current price,” he continued, “the shares still appear to be overpriced, but I have decided to buy them because I cannot afford another below-par quarter.” We all know what happened. In the end the investor was proved right, but he felt that it was better to be wrong with everyone else rather than be right all alone.

That a perceptive investor should thus feel obliged to follow the herd in its far-fetched behavior, at the risk of losing his clients before time proved to him right, explains why bubbles are ingrained in the very nature of the financial system, and why external intervention in the system – by a regulatory body, for example – is necessary to avoid making the situation worse.

One of the successive heads of Citigroup, Chuck Prince, put it this way in 2007, when he justified his bank’s participation in the excesses of the derivatives market saying, “As long as the music is playing, you have to dance!”

What, in the end, is performance?
So what conclusions should be drawn from these diverging investment logics in the financial and industrial worlds?

First and foremost, it is vain to think that they can be completely reconciled. More intelligent regulation – one that does not blindly believe in the self-corrective capability of markets – could undoubtedly avoid the recent hypertrophy of the speculative financial sector.

But above all, industrialists must manage their relations with the financial world fully aware of these differences. Failure to return minimum performance levels will obviously hurt in the long run, but they should not feel pressured to react instantly to variations in the market, and comply with the whims and fancies that affect it. This will also lead to failure, not least because of the inconsistency and incoherence of knee-jerk strategies.

Industrialists must steel themselves to face a lack of understanding, or even a lack of interest, at some point. Rather than optimizing their financial situation according to theoretical principles, they would do better to act in such a way that will make it possible for them to avoid being entirely dependent on the vagaries of markets during hard times.

An essential part of the role of boards of directors in corporate governance is to balance the legitimate interests of shareholders with the demands of the marketplace. In effect, directors have to act as buffers between financial logic, with its short-term demands, and the longer-term goals of the company.

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