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Corporate Competition from the Emerging Markets BCG [Boston Consulting Group] argues that this is because they have managed to resolve three trade-offs that are usually associated with corporate growth: of volume against margin; rapid expansion against low leverage (debt); and growth against dividends. On average the challengers have increased their sales three times faster than their established global peers since 2005. Yet they have also reduced their debt-to-equity ratio by three percentage points and achieved a higher ratio of dividends to share price in every year but one. “Nipping at Their Heels: Firms from the Developing World Are Rapidly Catching Up with Their Old-World Competitors,” The Economist, January 22, 2011, p. 80. Leadership in all companies, public and private, new and old, start-ups and maturing, have all heard the same threat in recent years: the emerging market competitors are coming. Despite the threat, there have been other forces at work that would prevent their advancing—or advancing too fast: the ability to raise sufficient capital at a reasonable cost; the ability to reach the larger and more profitable markets; the competition in markets that value name recognition and brand identity; and global reach. But a number of market prognosticators—the gurus and consultants—are now contending that these new competitors are already here. One such analysis was recently published by BCG, the Boston Consulting Group.1 BCG labels these firms the global challengers, companies based in rapidly developing economies that are “shaking up” the established economic order. Their list of 100 global companies, most of which are from Brazil (13), Russia (6), India (20), and China (33) (the so-called BRICs), and Mexico (7), are all innovative and aggressive, but have also proven to be financially fit. The value created by these firms for their shareholders is very convincing. The total shareholder return (TSR) for the global challengers between 2005 and 2009 was 22%; the same TSR for their global peers, public companies in comparable business lines from the industrialized economies, was a mere 5%. These firms have, according to BCG, been able to achieve these results by resolving three classic trade-offs confronting emerging players. These strategic trade-offs turn out to be uniquely financial in character. The Three Trade-Offs The three trade-offs could also be characterized as three financial dimensions of competitiveness—the market, the financing, and the offered return. Trade-Off #1. Volume versus Margin. Traditional business thinking assumes that large-scale, large-market sales, like that of Walmart, requires incredibly low prices, which in turn impose low margin returns to the scale competitors. Higher margin products and services are usually reserved for specialty market segments, which may be much more expensive to service, but are found justifiable by the higher prices and higher margins they offer. BCG argues that the global challengers have been able to have both volume and margin, relying on exceptionally low direct costs of materials and labor, combined with the latest in technology and execution found in the developed country markets. Trade-Off #2 Rapid Expansion versus Low Leverage. One of the key advantages always held by the world’s largest companies is their preferred access to capital. The advantages afforded companies in large market economies—capitalist economies—is access to plentiful and affordable capital. Companies arising from the emerging markets have often been held back in their expansion efforts, not having the capital to exercise their ambitions. Only after gaining access to the world’s largest capital markets, providers of both debt and equity, can these firms pose a serious threat beyond their immediate country market or region. In the past, access meant higher levels of debt and the associated risks and burdens of higher leverage. But the global challengers have again fought off the tradeoff, finding ways to increase both equity and debt in proportion, and therefore to grow without taking on a riskier financial structure. The obvious solution has been to gain increasing access to affordable equity, often in London and New York. Trade-Off #3 Growth versus Dividends. Financial theory has always emphasized the critical distinctions between what opportunities and threats growth firms and value firms offer investors. Growth firms are typically smaller firms, start-ups, companies with unique business models based on new technologies or services. They have enormous upside potential, but need more time, more experience, more breadth, and most importantly, more capital. Investors in these companies know the risks are high, and as a result, accept those risks in focusing on prospective returns from capital gains, not dividend distributions. Investors also know that these firms, often very small firms, will show large share price movements quickly with commensurate business developments. For that, the firm needs to be nimble, quick, and not laden with debt. Value companies—a polite term for mature or older, larger, well-established global competitors—are of a size in which new business developments, new markets, or new technologies, are rarely large enough to move share prices significantly and quickly. Investors in these companies, according to agency theory, do not “trust management” to take sufficient risks to generate returns. Therefore, they prefer the firm to bear some artificial financial burdens to assure diligence. Those financial burdens are typically higher levels of debt and growing distributions of profit as dividends. Both elements serve as financial disciplines, requiring management to maintain watchfulness over costs and cash flows to service debt, and generate sufficient profitability over time to supply dividends. The global challengers have arguably thwarted this trade-off as well, paying dividends at growing rates and similar dividend yields to more mature firms with stronger and sustained cash flows. This may actually be the easiest of the three to accomplish given their already substantial sizes and strong profitability. Continuing Questions Many still have doubts. If these global challengers can defeat these traditional financial trade-offs, can they overcome the corporate strategic challenges that so many firms from so many markets flailed against before them? As the Economist notes, “All this is impressive, but it seems implausible that these trade-offs have been ‘resolved.’ ”2 Many emerging market analysts and rapidly developing economy analysts argue that these firms not only understand emerging markets, but also they have demonstrated sustained innovation and remained financially healthy. Others argue that these three factors are likely to be more simultaneous than causal. It is clear, however, that most of these new global players are arising from large underdeveloped and underserved markets—markets that are providing large bases for their rapid development. One strategy being rapidly deployed by many of these firms is the use of strategic partnerships, joint ventures, or share swap agreements.3 In each of these forms, the companies are gaining a competitive reach, a global partner, and access to technology and markets without major growth on their part. Despite the use of these partnerships, this does not directly address the continuing debate as to whether firms can grow as successfully into different businesses in different markets—diversified global conglomerates. Although a strategy employed in the past, it is one not followed frequently today. Case Questions 1. How are the three trade-offs interconnected according to financial principles? 2. Do you believe these firms have truly resolved or conquered these trade-offs, or have they benefitted from some other competitive advantages at this stage of their development?

Corporate Competition from the Emerging Markets

BCG [Boston Consulting Group] argues that this is because they have managed to resolve three trade-offs that are usually associated with corporate growth: of volume against margin; rapid expansion against low leverage (debt); and growth against dividends. On average the challengers have increased their sales three times faster than their established global peers since 2005. Yet they have also reduced their debt-to-equity ratio by three percentage points and achieved a higher ratio of dividends to share price in every year but one. “Nipping at Their Heels: Firms from the Developing World Are Rapidly Catching Up with Their Old-World Competitors,” The Economist, January 22, 2011, p. 80. Leadership in all companies, public and private, new and old, start-ups and maturing, have all heard the same threat in recent years: the emerging market competitors are coming. Despite the threat, there have been other forces at work that would prevent their advancing—or advancing too fast: the ability to raise sufficient capital at a reasonable cost; the ability to reach the larger and more profitable markets; the competition in markets that value name recognition and brand identity; and global reach. But a number of market prognosticators—the gurus and consultants—are now contending that these new competitors are already here. One such analysis was recently published by BCG, the Boston Consulting Group.1 BCG labels these firms the global challengers, companies based in rapidly developing economies that are “shaking up” the established economic order. Their list of 100 global companies, most of which are from Brazil (13), Russia (6), India (20), and China (33) (the so-called BRICs), and Mexico (7), are all innovative and aggressive, but have also proven to be financially fit. The value created by these firms for their shareholders is very convincing. The total shareholder return (TSR) for the global challengers between 2005 and 2009 was 22%; the same TSR for their global peers, public companies in comparable business lines from the industrialized economies, was a mere 5%. These firms have, according to BCG, been able to achieve these results by resolving three classic trade-offs confronting emerging players. These strategic trade-offs turn out to be uniquely financial in character. The Three Trade-Offs The three trade-offs could also be characterized as three financial dimensions of competitiveness—the market, the financing, and the offered return. Trade-Off #1. Volume versus Margin. Traditional business thinking assumes that large-scale, large-market sales, like that of Walmart, requires incredibly low prices, which in turn impose low margin returns to the scale competitors. Higher margin products and services are usually reserved for specialty market segments, which may be much more expensive to service, but are found justifiable by the higher prices and higher margins they offer. BCG argues that the global challengers have been able to have both volume and margin, relying on exceptionally low direct costs of materials and labor, combined with the latest in technology and execution found in the developed country markets. Trade-Off #2 Rapid Expansion versus Low Leverage. One of the key advantages always held by the world’s largest companies is their preferred access to capital. The advantages afforded companies in large market economies—capitalist economies—is access to plentiful and affordable capital. Companies arising from the emerging markets have often been held back in their expansion efforts, not having the capital to exercise their ambitions. Only after gaining access to the world’s largest capital markets, providers of both debt and equity, can these firms pose a serious threat beyond their immediate country market or region. In the past, access meant higher levels of debt and the associated risks and burdens of higher leverage. But the global challengers have again fought off the tradeoff, finding ways to increase both equity and debt in proportion, and therefore to grow without taking on a riskier financial structure. The obvious solution has been to gain increasing access to affordable equity, often in London and New York. Trade-Off #3 Growth versus Dividends. Financial theory has always emphasized the critical distinctions between what opportunities and threats growth firms and value firms offer investors. Growth firms are typically smaller firms, start-ups, companies with unique business models based on new technologies or services. They have enormous upside potential, but need more time, more experience, more breadth, and most importantly, more capital. Investors in these companies know the risks are high, and as a result, accept those risks in focusing on prospective returns from capital gains, not dividend distributions. Investors also know that these firms, often very small firms, will show large share price movements quickly with commensurate business developments. For that, the firm needs to be nimble, quick, and not laden with debt. Value companies—a polite term for mature or older, larger, well-established global competitors—are of a size in which new business developments, new markets, or new technologies, are rarely large enough to move share prices significantly and quickly. Investors in these companies, according to agency theory, do not “trust management” to take sufficient risks to generate returns. Therefore, they prefer the firm to bear some artificial financial burdens to assure diligence. Those financial burdens are typically higher levels of debt and growing distributions of profit as dividends. Both elements serve as financial disciplines, requiring management to maintain watchfulness over costs and cash flows to service debt, and generate sufficient profitability over time to supply dividends. The global challengers have arguably thwarted this trade-off as well, paying dividends at growing rates and similar dividend yields to more mature firms with stronger and sustained cash flows. This may actually be the easiest of the three to accomplish given their already substantial sizes and strong profitability. Continuing Questions Many still have doubts. If these global challengers can defeat these traditional financial trade-offs, can they overcome the corporate strategic challenges that so many firms from so many markets flailed against before them? As the Economist notes, “All this is impressive, but it seems implausible that these trade-offs have been ‘resolved.’ ”2 Many emerging market analysts and rapidly developing economy analysts argue that these firms not only understand emerging markets, but also they have demonstrated sustained innovation and remained financially healthy. Others argue that these three factors are likely to be more simultaneous than causal. It is clear, however, that most of these new global players are arising from large underdeveloped and underserved markets—markets that are providing large bases for their rapid development. One strategy being rapidly deployed by many of these firms is the use of strategic partnerships, joint ventures, or share swap agreements.3 In each of these forms, the companies are gaining a competitive reach, a global partner, and access to technology and markets without major growth on their part. Despite the use of these partnerships, this does not directly address the continuing debate as to whether firms can grow as successfully into different businesses in different markets—diversified global conglomerates. Although a strategy employed in the past, it is one not followed frequently today.

Case Questions

1. How are the three trade-offs interconnected according to financial principles?

2. Do you believe these firms have truly resolved or conquered these trade-offs, or have they benefitted from some other competitive advantages at this stage of their development?

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