Having no targets sends a weak signal

Financial targets need to tie into the overall strategy and are a natural framing of the dialogue with management, which helps keep them strategic and long-term oriented. That’s according to Folketrygfondet CEO Kjetil Houg (KH). 

In this conversation with Nordea’s Johan Trocmé (JT), Houg also argues that targets should be ambitious but realistic, and that management should be more concerned about explaining why there are no targets, rather than the constructive discussion with shareholders that will inevitably arise if these have not been achieved.

JT: Should listed companies have financial targets? Do you have any sympathy for the management argument ‘if we do not promise anything, we can never be accused of having failed’?

KH: The quick and easy answer would be 'no', we do not have sympathy for any company's management not wanting to have any targets. We have worked with and formed a view on these issues over several years, and before I joined Folketrygdfondet, they were articulated in our expectation documents, which are public and available on our website. These aim to make our expectations clear and are used in our dialogue with corporate management to cover:

• Strategy, capital structure and financial targets
• Human rights
• Labour rights
• Environment
• Climate
• Anti-corruption
• Executive remuneration

So, we have specific expectations that management in the companies we invest in have a coherent and structured strategy process, for which financial targets are a necessary and important component. As we see it, targets are the expression of an ambition. They tell us what management is aiming to achieve, and what level of performance is expected to be within reach. Our mission is to generate the highest possible returns in our portfolio, and we always weigh the choice of investing in a company against investing in its peers, or in something else. Financial targets help us evaluate alternatives against each other, taking into account how we view the probability that targets will be achieved.

When a company does not have any financial targets, we see this as an implicit message of having a low level of ambition. And, this makes it more likely that we choose to put our money into another investment instead. Being willing and able to put into words and numbers what you are aiming to achieve with the business is a very important and positive signal to the outside world. If you intend to keep your business viable and future-proof, you should have financial targets for the future performance of the business that keeps it competitive and healthy. Not having any financial targets at all inevitably becomes a very negative signal.

We have seen different attitudes and approaches in different sectors. I think financial services is a sector which has been ahead of the curve in the use of targets. This has probably been greatly influenced by the big waves of regulation after the global financial crisis. New regulatory requirements, such as larger capital reserves for banks, have made financial services companies reconsider their financial targets, almost by default. I think this has to some degree spilled over into other sectors. In more cyclical, capital-intensive sectors, there is a lot of variation among individual companies. But taken as a whole, I think they have moved more towards the sort of use of targets we see in financial services.

It is also important to remember that targets are useful for many different stakeholders, not just for equity investors. If management has communicated clear, public targets for future financial performance, it will be much easier to find acceptance and buy-in from its own staff and organisation for the measures that need to be taken to reach those targets. And the same applies for suppliers, authorities and regulators.

JT: When companies have financial targets, how do you use them? Do they feature in your dialogue with companies, or in your own analytical view of them?

KH: Our view is that the companies need to determine on their own what specific financial targets and levels will work best for them. What we see as critical – as we outline in our expectation documents – is that they have a good process for this. We want the board of directors to be involved in the target setting. We want targets to be communicated throughout the organisation. We like to see a coherent strategy process where there are overarching strategic business goals, from which specific financial targets for the company are derived. If the company has high ambitions for growing through market share gains in a certain business or geography, a simultaneous profitability or return on capital target helps reassure us that this growth ambition will not be realised at the expense of profitability or cash flow.

When companies have financial targets, we can have a good dialogue with management about progress towards reaching these, where they stand and what remains to be done. Framing it in this way helps keep dialogue good and constructive. We can revisit assumptions behind target achievement, discuss headwinds and tailwinds and their implications and, of course, tools and initiatives available for reaching the targets.

From time to time, companies revise their targets. This may take place at very important inflection points. The economic reality may have changed, or management can change its level of ambition or strategy based on a new evaluation of how the business is positioned. When this happens, it is very important for us to understand how management is thinking and why it is changing targets. These are among the most important dialogues we have with the companies in which we are shareholders. The financial targets help us – as a large and long-term investor – to make our dialogues with management more strategic and more 'big picture'. It is worth mentioning that sustainability targets, particularly emission targets, have helped stimulate this dialogue. Emission targets are often very long-term in nature, for instance, the aim for net zero greenhouse gas emissions by 2050. Getting there needs to link to financial targets, as delivering on the emission targets is typically going to be a precondition for reaching the financial targets in the long term.

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.