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Making adaptive managerial or national decisions

Posted by (Guest Contributor) on April 15th, 2013 - 5 Comments

 Handling uncertainty and strategic rivalry

 Companies and nations are nowadays forced to be more strategically astute than ever. Markets, technologies, financial structures and rivals have become more dynamic. Change is all around, from traditional industries such as retailing to high tech. Global economies are similarly undergoing fundamental transformations. The emergence of the internet has forced companies and nations to rethink their operating models. Companies and nations must embrace change, which presents both a threat and an opportunity. The risks companies or nations must take may be the cornerstone of their future success and prosperity or the very source of their failure and extinction. 

To succeed in today’s volatile economic environment, a company or nation must navigate strategically and adapt flexibly. The more turbulent the environment, the more important a sound and dynamic strategy becomes. Such a dynamic strategy will ensure that despite short-term storms and unforeseen major currents, leadership will keep eyes on course and maneuver the ship to the final destination. Strategy is hard to define, let alone control dynamically, especially when rival reactions are important.

 Most widely-applied tools of strategy development were designed for relatively stable environments. As a consequence, traditional strategy reasoning is prone to neglect a crucial aspect of strategy: adaptability. This implies that, even if designed with much care, strategy must be dynamically adapted to changing circumstances.

 That is why strategy development, as traditionally conceived, has a hard time providing a sufficient structure for dynamic decision making. There are today ways to realign strategy with the dynamics of the environment and the levers of managerial flexibility. A new approach uses a combination of concepts and tools from strategy, finance and game theory, within a “real options” perspective.

 Thinking flexibly

 Uncertainty and opportunity are two sides of risk taking and value creation. A surfer dreams of the ultimate wave to prove her unique skills. She needs a troubled ocean to perform exceptionally good moves, but if one move goes wrong she may be in trouble. The same holds true for innovative companies and nations. A dynamic environment brings about more or greater opportunities, which if exploited innovatively can be a source of unique competitive advantage. By adapting flexibly, companies and nations that are good at capitalizing on opportunities while limiting losses if adversity hits, will likely get leaps ahead of their rivals.

 This may sound self-evident. Good managers and national leaders like Abraham Lincoln have always been reasoning by taking into account flexibility, in an intuitive way. What is not as evident is the systematic translation of this thinking into rigorous analysis. If managers or leaders have flexibility in making decisions, a company or nation actually has valuable “real options” that it may develop and exercise at some future time under the right circumstances. This is what real options is about.

 Real options is a mindset and a way of thinking. It is about discussing contingent plans in a “what-if logic”. Instead of making rock-hard plans and irreversible long-term commitments, the main idea is to create flexibility by staging decisions and continuously adapting to developments. When a company must decide to build a new plant or a nation to build a liquefaction plant, for example, it is often tempting to try to realize the full economies of scale – but it may be wiser to first build a smaller plant (or opt for a less-costly floating LNG ship) that can be flexibly expanded later on. If demand or future prices should decline, fixed costs are lower, and the downside risk is limited to a smaller investment outlay. If things turn out better than expected (or if a partner is found to share the costs), an expanded plant can be later pursued.

 That is the first step, looking at decisions through an options lens. Besides the option to expand, there may be a options to scale down, stage or abandon operations. These options are most important when making new investments, because they limit downside risks. Instead of taking losses, it may be an alternative to scale down, reposition or sell the plant. Or, like in a gas producing field, there may be an option to temporarily not operate – the field should only be operated as long as the gas price is high enough to cover variable costs and make profits. With these options, you may sleep better when making important decisions. Other important options include the option to defer or wait and see how the future unfolds before committing resources, the option to switch inputs or outputs in a production process, and various growth options. Growth options exist when early investments open up the way for new or follow-on activities, such as basic research that yields patents for follow-on drugs. This mindset allows to think about and design investment projects and programs that can be better adapted to a changing environment.

 Beyond merely being a mindset, however, the real options approach also provides a powerful valuation framework that applies financial option-pricing models to real asset investments. For example, the option to defer is like a financial call option. Wait for future information and exercise if it is worthwhile doing so at the future expiry time, acquiring the underlying asset if its value exceeds the exercise cost at that future time. That is what oil and gas companies do well. Real options valuation is the proper way to properly handle the above-mentioned flexibilities. Although quite valuable as a mindset, it is complemented by a valuation apparatus that helps provide a structure for investment discussions as well as attach price tags to alternative decisions.

 The recent convulsions of the new global economy underscore the need for a rational valuation of corporate or national growth options by investors, lenders and financial market analysts. For executives or national leaders, effectively managing a company’s or a nation’s portfolio of real options is critical. As a combined mindset and a valuation tool, options thinking can create substantial value. Option values often range between 20% and 70% of (gross) project values, and may go up to 80% or more. That is, the value of undeveloped gas reserves, for example, might be worth 50% or more than the value of producing gas reserves. If things go wrong (e.g., the reserves prove lower, a strategic alliance among rivals is made, another big player floods the market with gas supplies or for any other reason future gas prices drop), the oil & gas company does not need to (and will not) invest the €5 billion for development or the €10 billion for an expensive liquefaction (LNG) plant. In this ways uncertainty can increase, rather than reduce, the value of undeveloped gas reserves. Growth option values are incorporated into firm stock prices daily, which for volatile industries, such as information technology, pharmaceuticals and consumer electronics, range around 70-80% of total value. This suggests that choosing the right mix of investment opportunities through a proper real options analysis can substantially enhance company value or national wealth.

 Here are some examples of how companies in various sectors are deploying the above concepts in their businesses, whether thinking strategically alone or in anticipation of competitive responses. A leading pharmaceutical company was wondering whether to carry on with its R&D plan for a new drug which was just before the 3rd stage of clinical trials, or to sell the corresponding patent to a biotech firm. The decision whether to proceed with project development or to abandon, i.e. sell the patent to save a huge upcoming expenditure and obtain a salvage value, was partly dependent on a subsequent option to expand in a specialized niche market (hospitals), following the launch of the main product. The company decided to proceed on its own in a staged fashion, as the expected value thus obtained exceeded the alternative offer to sell the rights.

 A leading European automobile company was considering two investment alternatives for the production of a new vehicle, a rigid but less costly one, and a more expensive but flexible one. Production would be based entirely in only one country (Brazil) under the rigid alternative. Under the flexible alternative, the company would set up several production sites across continents as part of a multinational network, providing flexibility to switch production from the initial site to alternative sites (e.g., to an Eastern European country with competitive labour costs) as exchange rates or labour costs fluctuate. Admittedly, the overall cost of the flexible system for setting up production facilities in several countries would be higher. But it turns out that the value of the flexibility to shift production among countries, and the resultant expected cost savings and increased net profits, exceeded the incremental cost of the flexible over the rigid alternative. The value of switching flexibility in this case thus justified pursuing the flexible multinational operations strategy. 

 A European private equity investor agreed to buy a leading optical chain in Belgium. It subsequently made further acquisitions in Belgium and other European countries, all within the same industry. These transactions were part of a buy-and-build acquisition strategy to initially undertake a “platform” acquisition in an industry and then leverage core competencies or efficiencies onto follow-on acquisitions in a broadened geographical base. The initial platform acquisition generated options for further acquisitions. Real options in combination with competitive analysis can be used to provide a useful roadmap helping buyers to evaluate the likely competitive responses and their impact on the broader acquisition strategy.

 In all the above examples, the real options approach made it possible to integrate dynamic considerations into strategy discussions. Flexibility was exploited in an optimal way to assess and formulate dynamic future decisions. Real options valuation provided a meaningful way to quantify this flexibility.

 Dynamic strategy and competitive interactions

 So far in discussing real options and flexibility we mainly focused on optimal reaction to changes which could not be influenced by the company or nation, such as fluctuations in market demand, exchange rates or labour costs. Random entry of competitive substitute products could be handled similarly. However, strategy is to the core dynamic. The primary actions that matter to a chess player are the moves of her opponent (the chessboard itself or the rules of the game are given). Surviving in the new competitive corporate or national landscape requires adapted behaviour vis-à-vis rivals. Although firms or nations continue to compete for their share of growth opportunities in the global arena, they have also learned that cooperation can sometimes be the preferred route when there is joint benefit of creating new opportunities or when a situation of intensified rivalry may erode the value of growth opportunities for all. In corporate strategy, this dynamic aspect can be integrated into a flexibility-based strategy discussion by employing a real options analysis enhanced by game analysis principles.

 In the late seventies, the introduction of different types of video recorders illustrated that tough positions and reciprocating reactions often result in intensified competition. Philips Electronics launched the V2000 system to compete with Sony’s Betamax and JVC’s VHS system. Instead of following one shared product standard, tough positions taken by these companies resulted in an intense market-share battle. This “winner takes all” attitude ultimately proved harmful for the players and turned out to be a so-called “negative-sum game”, shrinking the total pie.

 In today’s competitive landscape, firms and nations may choose to compete on one aspect while cooperating on another at the same time.  This was illustrated by the subsequent development of the CD technology a decade later. Philips recognized that the CD player would be more successful if other firms would also be willing to produce CDs and CD players with the same standard. Philips and Sony exchanged licenses to acquire an install-base for the CD player. The joint development of the CD and the DVD turned out to be a success, resulting in a range of subsequent growth opportunities. A couple of decades later, it appears that the development of the CD has been a far greater success than initially expected and the collaboration was beneficial for all players.

 Philips, in particular, had many options associated with the CD technology: an option to do further research on CD technology, to accelerate or abandon research, to introduce products in a test market, and to start large-scale commercialization. In such cases strategic decisions about technology investment should be based on an expanded view, taking into account the value of the portfolio of embedded options. Beyond this, the analysis must address an additional key aspect: the game-like interaction with rivals (Sony). Neglecting this dynamic aspect could have meant a disaster, like in the video recorder introduction. A proper strategy discussion, whether for a company or a nation, must take into account the interplay between rivals and their joint strategic “moves”, just like in a chess game.

 To do this, the decision maker must combine real options analysis for making decisions under uncertainty with elements borrowed from the field of industrial organization and game theory. Relatively simple models can help grasp the interaction between rivals and make it suitable for a strategy discussion that can handle both flexibility and rivalry dynamics.

 Implementing strategic real-options thinking

 The ultimate contribution of a practical strategic framework is to implement strategic reasoning and decision making that properly accounts for the interplay between uncertainty, decision-making flexibility and value creation through developing, staging, and executing strategic options.

 When preparing for growth or considering strategic investments, one should keep the following questions in mind: What are your sources of uncertainty, and what is your risk exposure? What are the sources of your competitive advantage and how can you maintain it? Are the benefits of your strategic investment proprietary or will they be shared with or impacted by rivals? How do you think your rivals will respond if you make such a strategic move or pursue another strategy? How can you limit downside risk and still capitalize on upside potential? Are there options that naturally go hand in hand with certain opportunities? Are there options you can acquire or actively design into new opportunities? When is a good time to invest – which options must be exercised now, and which decisions can wait for later when information is better? Are there blank spots in your options portfolio (or your mindset), or does it have the proper mix of cash-generating activities vs. future growth opportunities? Do you foster the right amount and type of options for your future?

 The real options approach, properly implemented, can be practically helpful in several ways:

  • As a mindset: Real Options thinking can yield valuable insights even before any quantitative valuation is applied. But it is essential to properly translate the qualitative discussion of project investments into an options structure and identify its strategic elements. The identified strategic options are like building blocks that must add up to a sound overall strategy and structure. Discuss the most important growth options in detail and identify possible causality links between them: Which options are mutually exclusive? Which options create synergies, or even spawn new (future or “compound”) options? Providing a clear structure is essential for effective strategic reasoning and decision making.
  •  As a valuation tool: While qualitative discussions can be useful, they are both a prerequisite for, and can be enlightened by, proper quantitative analysis and valuation. The valuation part can create additional value by quantifying the merits of strategic alternatives and helping assess tradeoffs and attach costs-and-benefits or price tags in investment decisions.
  •  As an integrated strategic support system: Leveraging on the insights and operating guidelines derived from a real options strategic analysis, the framework can provide clear recommendations and executable actions. When is the right time to invest or expand capacity, to build that LNG plant or extract and sell the gas? What actions can increase the value of future growth options (e.g. extending the lifetime of an option or modifying its future payoff structure)? How much capacity should you invest in to potentially preempt rivals and when is it optimal to compete or to cooperate with other players?


 Good managers and national leaders have always been considering the key aspects and tradeoffs involving decision flexibility and strategic rivalry, at least intuitively.  They can now do so in a more systematic and consistent manner by applying an option-and-games strategic framework. The implementation and unfolding of strategic reasoning has become a complex and difficult task, since today’s dynamic environment imposes harder challenges to any strategy formulation, be it for a company or a nation. It is not a trivial task to navigate dynamically in our turbulent environment and to fully understand all possible strategic ramifications. These challenges can be met in a powerful way by the new strategic framework that takes into account flexibility options and games. It requires professional managerial attention.

 The proposed approach provides a framework and a structure to navigate dynamically in a complex global environment characterized by changing markets, technologies, political uncertainties andstrategic rivalry. It captures the impact of decision-making flexibility and strategic rivalry as a basis for framing insightful and robust strategy discussions, and provides a powerful framework for connecting such strategy discussions to the dynamic complexities encountered in corporate or national decision making. By providing a new grounding for making better and more dynamic strategic decisions, this framework promises to have a major impact on how we frame and resolve strategic discussions. Implementing this framework will be a key success factor in avoiding catastrophe and realizing future value-oriented growth

 Lenos Trigeorgis holds a PhD (DBA) from Harvard University and is the Bank of Cyprus Chair Professor of Finance at the University of Cyprus and President of the Real Options Group. He is the author of Real Options (MIT Press, 1996), Strategic Investment (Princeton University Press, 2004) and Competitive Strategy (MIT Press, 2011).

Categories → Οικονομία

  1. avatar
    Phil on April 15, 2013 - (permalink)

    A really useful and refreshing, albeit long, piece. It really goes to the heart of the dilemmas facing Cyprus’s energy strategy? Build an expensive liquification plant or go with a more flexible strategy, minimizing potential gains but also potential losses, if things change?

    Thank you Prof. Trigeorgis.

  2. avatar
    Κώστας on April 15, 2013 - (permalink)

    κ. Τριγιώργη, ευχαριστούμε για την ανάλυση. Το άρθρο θα πρέπει να απασχολήσει την πολιτική ηγεσία, που φαίνεται πεπεισμένη ότι πρέπει πάσει θυσία να γίνει τερματικό, ανεξαρτήτως κόστους.

    Μήπως όμως έχουν δίκαιο; Το τερματικό υγροποίησης συνδέεται και με την ασφάλεια του κράτους; Αν ναι, πόσο αξίζει η ασφάλεια;

  3. avatar
    Yiangos on April 15, 2013 - (permalink)

    Are corporations and nations comparable when it comes to how they behave? Is the structure of the principal similar enough to allow such comparisons? Do shareholders and voters have the same input in the process?

  4. avatar
    Επιλήσμων on April 15, 2013 - (permalink)

    Αυτά που μας προτείνει και εισηγείται ο κ.Τριγεώργης, προϋποθέτουν πάρα μα πάρα πολλά. Πρώτα απ’ όλα πρέπει να υπάρχει μιά ομάδα από ειδικούς επιστήμονες και τεχνοκράτες που να είναι εις θέση να κάνουν με επιτυχία όλες αυτές τις οικονομικο-πολιτικές αναλύσεις. Μιά ομάδα υποθέτω αρκετά πιό διευρυμένη από αυτή του κ.Πισσαρίδη.
    Και εάν υποθέσουμε ότι αυτή η ομάδα κάνει καλά την δουλειά της, πρέπει μετά να πείσει τους πολιτικούς, την Κυβέρνηση και τη Βουλή, να υλοποιήσουν το πρόγραμμα.
    Δεν θα ήθελα να είμουν στη θέση του τεχνοκράτη-ακαδημαϊκού που θα προσπαθούσε να εξηγήσει και να αναλύσει την πρόταση μας στους πολιτικούς. Γνωρίζετε, πχ, πολλούς Βουλευτές που θα αντιληφθούν τι τους λέμε όταν θα τους αναλύουμε το “dynamic strategy plan”? Την σημασία των “real options” και πως τα αναλύουμε με την χρήση της “game theory”?
    Και ο κ.Περδίκης το έκανε ξεκάθαρο (τον άκουσα το πρωί στο Τρίτο του ΡΙΚ). Λόγω της παρούσης οινομικής κρίσης (που μας έστειλε ο Θεός – εμείς εν τζιέ) η Βουλή πρέπει να είναι ενήμερη και να εγκρίνει τα πάντα.

    Βρήκα πολύ ενδιαφέρουσα την επιλογή (option) “what if logic” που επιτρέπει επιλογές αναλόγως εξελίξεων. Κάτι σαν το “By trial and error”. Από τις λίγες εξαιρέσεις που προτιμώ την αγγλική ορολογία αντί της ελληνικής: “Διά δοκιμής και επιτυχίας” που υποθέτω την υιοθετήσαμε μετά που χάσαμεν το μέτρον.

  5. avatar
    Σάββας Τταντής on April 15, 2013 - (permalink)

    Ακόμα ένα πολύ καλό άρθρο απο τον Κύριο Τριγεώργη.

    ΚΡΕΤΥΚ = Holding company με το Κράτος να κατέχει το 100% .

    ΒΗΜΑ 1. Μετά την δευτερη επιβεβεωτική διάτριση στο οικόπεδο 12 δημιουργούμε μια θυγατρική εταιρεία της ΚΡΕΤΥΚ με την ΚΡΕΤΥΚ να έχει αρχικά το 100%.Της δίνουμε τα δικαιώματα μας του οικοπέδου 12. Κάνουμε εκτίμηση της σημερινής αξίας της σε ενημερωτικό δελτιο και κάνουμε αίτηση η Θυγατρική να ενταχθει στο Αμερικάνικο χρηματιστήριο η στο LSE. Πουλούμε το 30-40% σε ξένους θεσμικούς επενδυτές.

    ΒΗΜΑ 2. ΚΡΕΤΥΚ είναι φορτωμένη ευρω (απο τη πώληση του 40% της θυγατρικής. ) . Δίνει στο κράτος για εξοφλήσεις δανείων προς ΤΡΟΙΚΑ. και συνησφέρει στην κατασκευή του τερματικού οπου γίνεται μεγαλομέτοχος. Το τερματικό προσφέρει υπηρεσιές έναντι αμοιβής στις θυγατρικές (ολα τα οικόπεδα ξεχωριστες εταιρειες οπως πιο πάνω.)

    ΒΗΜΑ 3 . Η Κρετυκ είναι μεγαλομέτοχος σε ολες τις Θυγατρικές και στο τερματικό.
    Μαζευει ευρω.

    ΒΗΜΑ 4. Μετά απο 2-3 χρόνια περνά η βουλή νομοσχέδιο σημαντικής αυξησης της φορολογίας στις Κυπριακές εταιρείες εξόρυξης φυσικού αερίου και τους αφερεί το δικαίωμα να θεωρήται ώς έξοδο το depletion των αποθεμάτων. Οι μετοχές των θυγατρικών καταποντίζονται , η Κρετυκ μπαίνει αγοραστής και αγοράζει ολη την προσφορά μετοχών σε πολύ χαμηλότερες τιμές απο οτι τις πουλήσαμε και ξανααποκτούμε σχεδόν ολες τις μετοχές πίσω.

    ΑΠΟΤΕΛΕΣΜΑ. Ξοφλήσαμε την ΤΡΟΙΚΑ με λεφτά των ξένων θεσμικών και έχουμε ολες τις μετοχές μας πίσω .

    Μας τα πήρανε απο τις τράπεζες μας , να τους τα πάρουμε πίσω με το φυσικο αέριο……..

    Το ίδιο γίνεται με ΑΗΚ , ΑΤΗΚ, Αρχή Λιμένων. 5-10 χρόνια να τις ξαναπιάσουμε πίσω. Λίγο μυαλό και καλή οργάνωση…….

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