JT: What are your favourite types of targets for companies to have? Growth, margin, return on capital, leverage, payout, cash flow or others? Any specific measures or metrics you think are best?
KH: In our expectation documents, we say that we want companies to have financial targets that drive long-term value creation, and which consider market trends and the positioning of the company's business. We believe there is no single set of targets that will be a universal fit for all companies, but rather that each company will have to identify and select a customised choice of targets that will work best for them. But we have defined four categories of value drivers, and we think it can be a good idea for all companies to have at least one target in each of these categories. The categories are return on capital, growth, cost of capital and capital structure. You might think of it as sort of a menu to choose from, and it is often natural to start with a target for your capital structure, and add targets in the other categories that are consistent with the balance sheet profile you think is best for your business.
Again, we do not dictate to companies what targets they should have. But we want them to have a defined and structured strategy process that includes financial targets, which are in turn consistent with the high-level strategic aims for the business.
JT: What sort of time horizon do you think is most useful for financial targets? A specific year for delivery? Long term? Over a cycle?
KH: We like companies to use financial targets to give medium- to long-term performance guidance. In our experience, this is the sort of time horizon for which the targets work best and are the most relevant. We have found one- to three-year time horizons to often be useful. But it may well make sense for companies to have a combination of long-term, medium-term and short-term goals. The long term can include and tie into sustainability goals, as we mentioned before. And the short term can include quarterly and yearly guidance for key metrics.
A specific example of short-term targets that we have found very helpful is when a company has made a major acquisition, and has given milestones for realising certain levels of synergies with the target. Guiding for specific levels of synergies in coming quarters makes the aim very concrete, helps maintain a sense of urgency, and should have a good level of visibility, given that the upside comes from internal processes that management is driving and, to a great extent, is able to influence.
Any set of results from a company will have been influenced by the economy, by the company's own actions, and by good or bad luck. We are, of course, always most interested in financial targets, which are largely influenced by management's actions and choices. Variability in performance from random factors can be greater in the short term, but short-term targets can nonetheless be quite useful as an 'early warning'. When things start moving in the wrong direction, you want to pick that up as early as possible, to discuss the causes and agree on a good way to address them.
JT: What level of ambition should companies have for their targets? Visionary, lowballing or realistic?
KH: We want financial targets to be ambitious, but realistic. The probability that targets can be attained should be high. This applies to most types of targets, but some other types should be more of the nature that they maintain the target metric securely within a certain limit. For strategic targets such as capital structure and dividend payouts, we are not looking for ambition, but rather an aim to keep leverage and payouts at levels with which the company is comfortable, and which do not jeopardise its financial health. These kinds of targets fall more under 'realistic' than 'ambitious', and could arguably be seen more as policy parameters. But targets such as revenue growth or return on equity should certainly have a strong element of ambition in them.
JT: How sensitive is failing to deliver on targets for you? Is it something management should fear?
KH: Setting an overly ambitious target creates something of a 'homemade' problem. As it will prove hopeless to reach the target, you will spend a lot of your time coming up with explanations for why you are unable to do so. This will not lead to particularly good or productive discussions, and is good for neither management nor the shareholders. This is why we believe targets should be ambitious, but realistic. If targets are not reached, we of course want to understand why. This is a natural and healthy discussion to have. If it is a discussion that you fear, you should not be in management. It is a very natural responsibility for management to analyse and understand performance, to be able to take actions to bring matters to the level where it should be for a healthy value creation. And it may even be necessary to have the discussion with shareholders to secure support for any more powerful or painful measure that might be needed to get there.
You could turn this around, and argue that management should arguably be more worried about being able to justify not having any targets, than fearing a constructive dialogue with shareholders about missing the mark at a given point in time, and the reasons behind it. No performance target at all is a much weaker message than some factors or circumstances preventing you from reaching a target you have set for a given year or quarter.
JT: Can you think of any good examples from your point of view of targets that have worked well or worked poorly in serving their purpose?
KH: I think that more widespread and better use of financial targets has made a big difference for capital-intensive and cyclical industries, which have historically had weak returns on capital. Having clear and stringent targets for return on capital and leverage have helped strengthen capex discipline and avoid new, big buildups of overcapacity that depress returns for years. I would point to UPM-Kymmene as a company that has made great strides forward here, with ambitious targets in all four types of value drivers we like to see, which are also consistent with and tie in to the overall group strategy. In Norway, Borregaard is also a company that has raised the bar and operates with a set of coherent and ambitious targets for capex, capital efficiency, return on capital and leverage.
Another example I mentioned earlier is short-term milestones for the realisation of synergies after acquisitions. Such targets strengthen the commitment to chasing and executing those synergies and ensuring continuous follow-ups.
I think it is worth highlighting financial services again, where regulatory pressure has helped make these companies early adopters and trendsetters in diligent target setting and reporting, both short term and long term. In the insurance sector, Tryg Forsikring is an example of a company we think has a high standard for targets and follow-up, including for synergies from acquisitions.