It is accepted wisdom that change is the only constant, yet companies spend an inordinate amount of time trying to manage the market’s ups and downs. How important is controlling volatility to overall performance?
Consulting firm McKinsey looked at this question and found that in terms of investor returns volatility is not as important as is often assumed. In fact, efforts to iron out the peaks and troughs in earnings can actually hurt a company, according to the firm.
McKinsey bases this heresy on a study of shareholder returns. Bin Jiang, a consultant in McKinsey’s New York Office, and Tim Koller, a partner with the firm, explain their analysis in the Winter 2011 issue of the McKinsey Quarterly. They argue that if investors prefer smooth earnings, then the companies that deliver such stability can be expected to generate higher total returns to shareholders (TRS) and have higher valuation multiples. But their analysis shows that many low-volatility companies have a low TRS, while many on the high side of this measure achieve high returns.
One reason for this counterintuitive result is that in reality few companies have smooth earnings growth, the authors maintain. This is borne out by their analysis of how some 500 large companies performed from 1998 to 2007. Only a handful of the enterprises reviewed succeeded in holding their earnings steady over a four-year period.
The conclusion: Investors are well aware that the world does not follow a smooth, predictable path, and make investment decisions accordingly.
The McKinsey research also suggests that diversification is not a reliable strategy for taming the earnings curve or becoming a favorite target pick for investors. The theory is that in a broad portfolio of businesses, low earnings in one unit will be counteracted by high earnings in another. Again, the assumption is that the stock of companies with smoothed earnings streams commands higher prices from investors. But the McKinsey consultants found no evidence of such a correlation for diversified enterprises.
Another danger of becoming fixated on volatility management is trying to second guess market movements to take advantage of the fluctuations. For example, as TMC’s Kevin McCarthy has argued in past blogs, shippers that follow a policy of cutting transportation costs by anticipating changes in freight rates are engaging in a futile exercise. First, it is impossible to predict where future rates will be with certainty, and second, rates tend to trend upwards over the long term.
Seesawing fuel prices is another source of volatility that concerns freight managers, particularly when prices are in an upswing as is currently the case. Although hedging against the cost of fuel is an acceptable practice, it is important to keep these market gyrations in perspective.
An analysis of fuel cost fluctuations carried out by Dr. Chris Caplice, Executive Director of the MIT Center for Transportation & Logistics, shows that from 1994 to 2004, the diesel price line was relatively flat, but from 2004 was much more erratic. The average weekly change in the first period was about one penny per gallon, but more recently was almost 5 cents. Caplice shows that the industry consistently gets its fuel price predictions wrong. Even the regular outlooks published by the US Energy Information Agency are often significantly out of line with reality.
The takeaway is that fuel price volatility is part and parcel of today’s freight market. Also, it is virtually impossible to accurately predict movements in the price of fuel on a consistent basis; even experienced market diviners get it wrong. Besides, as McCarthy points out, as prices climb the added costs become a smaller part of the total freight rate. A price hike of 20 cents when the cost of a gallon of diesel is $3.00 is less significant as the same increase when a gallon costs $1.20.
Managing volatility is part of the freight professional’s responsibilities, but the task has to be kept in context. Managers would do well to heed the advice offered to companies by the McKinsey consultants in their recent article: “Investors expect the natural volatility associated with the industry in which a company participates. Instead of trying to manage volatility, senior executives should spend their time making decisions that fundamentally increase a company’s revenues or its returns on capital.”