36/1 February 2003
Mike Lubatkin and Bill Schulze Theme Editors
Risk: the Interfaces of Strategy and Finance
Charles Baden-Fuller Editorial
I am delighted to introduce this special issue on Risk: the Interfaces of Strategy and Finance, edited by Mike Lubatkin and Bill Schultz. Mike and Bill have brought together some of the best scholars in the field of strategy who have for some time been engaging with the finance scholars about how our two disciplines should interface. Finance scholars occupy a world where time is measured in seconds, where information is diffused almost immediately, where prices are set openly and where economic modelling dominates. In contrast, strategists focus on firms and their managers, where the forming and executing of decisions takes time, where investments are lumpy, where the value of actions is not revealed for years and where cognitive, organisational people issues are always present and where strategic paradigms dominate.
The articles show that there is an uneasy fit between the fields. Of course there are broad areas of agreement. All the writers agree that investor wealth maximisation is an axiomatic goal for the firm, but our writers suggest that the timeworn practices advocated by finance texts need to be questioned. Beta, a favourite measure, should not be used in setting investment hurdle rates. Unrelated diversification can increase investor wealth. Firms should take care in thinking that beating the index means they are really doing well, especially in rising markets. Our papers show that many finance models are based on questionable reasoning and the conclusions offered are often not robust.
Thankfully, the papers do not just tear down the edifice; they also build new ones. We are offered advice on how to use real options, how to think of the quest for competitive advantage, how to build simple models to yield better risk measures and how to set the risk management agenda. I make no pretence that the pieces are all easy to read. Many will take some care to appreciate, even for those like me who hold an economics degree. But I assure you we have valuable thinkpieces for the CEO and board. The ideas should help sway the risk committee agenda. I commend the pieces to your attention.
Mike Lubatkin and Bill Schulze Introduction Mike@sba.uconn.edu
Since the field of strategy is about seizing competitive advantage and the field of finance is, at least in part, about capitalising upon those advantages, it would seem that these two fields should have a great deal to say to each other, and to you, about risk and risk management. Unfortunately, fundamental differences in the theoretical assumptions on which modern financial theory (and its empirical analogue, the Capital Asset Pricing Model) and strategy were based, caused their paths to diverge to a point where endorsement of one necessarily implied the irrelevance of the other.
Take, for example, their divergent views of a concept that plays a central role in both fields - risk. Finance scholars view risk as the degree of uncertainty associated with an investment. Because modern financial theory assumes investors are risk averse and can eliminate the risks (variance) associated with investing in any particular firm by holding a diversified portfolio of stocks, it presumes that the only risks that matter to investors are those that are systematically associated with market-wide variance in returns. Investors, it argues, should only be concerned about the impact that an alternative investment might have on the risk-return properties of their portfolio. Moreover, it assumes that because investors can eliminate the risks they do not wish to bear at low cost through diversification and other financial strategies, there is little need for managers to engage in risk-management activities. As a result, any risks that are specific to the firm are necessarily excluded from any financial theory, model or measure that is based on or derived from CAPM.
In contrast, the field of strategic management is based on the premise that to gain competitive advantage, firms must make strategic, or hard-to-reverse, investments in products and marketing, or in technologies, resources and people that create value for its customers in ways that rivals will have difficulty imitating. Such actions, it argues, isolate a firm's earnings from competitive pressure and allow firms to increase the level of future cash flows, while simultaneously reducing the uncertainty associated with them. The management of firm-specific risk therefore lies at the heart of strategic management's theories, research and pedagogy.
Noting the fundamental differences between the two fields, one of our authors of this special issue, Richard Bettis, concluded almost 20 years ago that if ‘the results of modern financial theory are to be assimilated into strategy research, then the theory underlying corporate strategy must be extensively revised' (1983: 409). Fortunately, strategy scholars, including Professor Bettis, have resisted this temptation, and instead searched for ways to unify these two world-views.
While early efforts met with only mixed success, as the paper by Phil Bromiley and Sharon James-Wade documents, theoretical and empirical developments in the field of finance concerning the use of options and derivatives to manage financial risk has sparked renewed interest by strategists in the application and implication of these techniques for strategic management.* The purpose of this special issue on Risk: The Interface Between Strategy and Finance, is to share with the LRP reader some of these insights. In this spirit, Professors Charles Baden-Fuller (Editor-in-Chief) and Guest Editors Bill Schulze and Mike Lubatkin invited a number of leading strategic management scholars to contribute their thoughts about risk.
The six papers that follow represent a variety of perspectives on the relationship between risk, financial markets and competitive advantage. The papers by Heli Wang, Jay Barney and Jeff Reuer, and by Sayan Chatterjee, Bob Wiseman, Avi Figenbaum and Cynthia Devers frame the debate and present cogent arguments that place the management of firm-specific risk squarely at the heart of the link between competitive and financial advantage, and discuss tools used to accomplish it. The Chatterjee et al. paper is particularly interesting, making a powerful yet counter-intuitive case that competitive advantage is best achieved through continuous, rather than ad hoc, risk-taking. Their conclusion, that strategic advantage and financial advantage go hand in hand, complements Lubatkin, Schulze and McNulty, who provide an in-depth review of the hazards that attend the use of Beta and other measures derived from finance's capital asset pricing model. Lubatkin et al then make a strong case for the use of an alternative measure that is both easy to calculate and consistent with the evolving theory of strategic management.
While all of our authors acknowledge that real options can play an important role in risk management, we are grateful that Kent Miller and Greg Waller took on the task of showing us how to do it. In their paper they show how the complexities of using real options to manage risk can be simplified by blending it with a familiar management tool, scenario planning.
The Todd Alessandri and Rich Bettis paper tempers somewhat our excitement about the ability of firms to manage their risks successfully. They examined the performance of 54 large US firms during bear and bull markets and found that only a few were able to perform well in both environments. Finally, no special issue is complete without also offering some cautionary notes. To this, we look to the Phil Bromiley and Sharon Wade-James paper and their review of the behavioural finance literature to suggest what strategists can and should infer from finance, and what might better be left behind. The result is an intriguing list of practices that managers would be wise to adopt.
Strategic management's distinctive role among the social sciences is to integrate economic and behavioural theories with its own unique understanding about how organisations work in an effort to develop theory and provide insight and guidance to the individuals who manage them. We hope that you find these articles provocative and useful.
* In contrast to the Capital Asset Pricing Model, which excludes firm-specific risks from its calculations, option theory bases its estimate of future asset value on the volatility of asset prices. Firm-specific risks therefore play a central role in this theory's models and measures.
Todd M. Alessandri Richard A. Bettis Surviving the Bulls and the Bears: Robust Strategies and Shareholder Wealth email@example.com
This study examines the robustness of strategies over the course of changing economic conditions. The performance of firms, in terms of relative value creation/destruction, is analysed to determine elements of superior strategies across the most recent financial market cycle. This paper finds that the firms that did achieve superior performance over the market cycle employed innovative strategies that competitors struggled to imitate.
Philip Bromiley and Sharon James-Wade Putting Rational Blinders Behind Us: Behavioral Understandings of Finance and Strategic Management firstname.lastname@example.org
Theorists and scholars have long argued about what makes one company perform better than others. This paper argues that a behavioural perspective of strategic management offers a coherent framework for performance. It offers three guiding suggestions for managers that take into account the rational and equilibrium assumptions but adjusted to behavioural thinking.
Heli Wang, Jay B. Barney and Jeffrey J. Reuer Stimulating Firm-Specific Investment through Risk Management email@example.com
This article discusses a rationale for company risk management that has been largely ignored in literature. A company's stakeholders - its employees, suppliers and customers - make considerable investments that are only valuable to that particular company: these are firm-specific investments. However, stakeholders are often concerned about the risks related to such investments and a company's efforts to manage risk can therefore provide its stakeholders with incentives to make greater firm-specific investments.
Sayan Chatterjee, Robert M. Wiseman, Avi Fiegenbaum and Cynthia E. Devers Integrating Behavioral and Economic Concepts of Risk into Strategic Management: The Twain Shall Meet firstname.lastname@example.org
The concept of risk and reward holds true for companies as well as investors. Through risk-taking a company can carve out a competitive advantage over its rivals. This paper establishes a link between risk management and economic outcomes by showing how strategic choices involving risk impact both firm performance and market expectations for future performance. It develops an integrated framework of risk management and strategic competitive advantage that companies can use to assist their performance.
Michael H. Lubatkin, William S. Schulze and James J. McNulty But will it Raise My Share Price? New Thoughts about an Old Question Mike@sba.uconn.edu
There have been many attempts to answer the question of how a company can improve the odds that its investment projects will lift its share price. Many have relied on the traditional approach which bases an estimate of the company's cost of capital on the Capital Asset Pricing Model. This paper argues that this approach, and specifically beta which is derived from CAPM, places the company at risk. They offer an alternative measure, Total Risk, that brings the estimates of cash flows and shareholder value into closer harmony.
Kent D. Miller and H. Gregory Waller Scenarios, Real Options, and Integrated Risk Management email@example.com
Scenario planning, whereby managers envision plausible future states, has wavered in and out of fashion as a strategic management tool. The last decade has seen a move towards real option analysis as a way to value investments amid an uncertain environment. This paper argues that both techniques have complementary strengths and weaknesses as tools for managers making strategic investment decisions and it sets out a framework for practitioners to combine the two.
This issue is available in full on-line at www.sciencedirect.com