Does enterprise risk management count?

Does enterprise risk management count?

Merkley, Brian W

Since the mid-1990s, managers of companies in North America, Europe and Australia have paid increasing attention to managing--holistically--the risks to which their organizations are exposed. Their intent, they say, is to apply a rigorous and coordinated approach to assessing and responding to all risks that affect the achievement of an organization's strategic and financial objectives, including both upside and downside risks. This is enterprise risk management (ERM).

While ERM may sound like a good idea in theory, the question still remains: does it matter to investors? Do shareholders see any value for themselves if individual companies incorporate enterprise risk management? After all, the shareholder value theory most of us were weaned on holds that company-specific risk can be diversified away by the investors themselves. Therefore, the management of company-specific risk is not "priced"--or especially valued--by the market.

The traditional model that determines the value of an investment, while conceptually elegant, seems counterintuitive and contrary to our real-world experience as managers and investors. But can we trust our intuition? If traditional theory is correct, for managers to invest time and resources in enterprise risk management is pointless and a misuse of assets from a shareholder standpoint. However, if our intuition is correct, then investing in enterprise risk management is very much to the point. It is what shareholders not only expect, but what they demand. Which course, then, should managers choose?

Based on recent studies of investor behavior, and a Tillinghast-Towers Perrin analysis of stock valuation, enterprise risk management is worth the investment. In fact, it may soon be considered a necessity for some companies.

Traditional value theory may be mathematically elegant, but it does not always account for the actual behavior and value choices of investors. When you understand what investors mean by "risk," it becomes very clear that they will pay a premium when they see it managed well.

The Problems Posed

The crux of the problem posed by the traditional capital asset pricing model (CAPM) is that it maintains that economic risk is managed by investors at the market level, not at the level of the individual firm. It assumes, therefore, that any attempt by individual firm managers to manage risk is irrelevant to investors.

CAPM is also based on the theory that investors are risk-averse. Given a choice between two assets with different variability in expected return, it says, they will choose the one with less variability. Conversely, given the choice between two assets with the same variability, they will choose the one with the higher return.

Finally, the traditional model supposes that investors are indifferent to whether the variability comes from losses or gains. What counts is the share variability itself, according to the theory. Moreover, the traditional model assumes that the variation in outcome is evenly distributed.

Thus, all that matters to investors, under the CAPM principles, is knowing the standard deviation from the mean of an expected return. If investors know that, they can make rational investment decisions when choosing assets. Investors manage the risk in making those choices, by diversifying their assets. That is, they choose individual stocks at the market level that have different risk profiles, in order to offset one from another. And they reduce variance in their total portfolio by adding more stocks to them.

There is a limit, of course, to reducing the total variance. That leaves the residual risk, also called the market or systematic risk. It is this residual risk alone that gets priced by the market according to the traditional theory. It shapes the discount rate, or cost of capital. It is used to calculate present value of future earnings. And, according to theory, it makes ERM absolutely irrelevant to investors.

Investor Behavior

Traditional theory is simple and clean on the surface, but it turns out not to match very closely to what investors actually do. In fact, recent theoretical work on how investors actually behave and make decisions demonstrates why ERM really is important to investors.

The behavioral-based theory of investment decision making holds that very few professional investors make decisions strictly on the basis of calculating the standard deviation from the mean. Instead, the new theory posits that investors make judgments from within their own frame of reference, using contextual and situational information that the purely mathematical model does not take into account. This information can include such intangibles as the investor's assessment of the quality of a company's management--especially whether management is likely to deliver on what it promises. The new theory also holds that investors are not indifferent to the direction of the variability of a return. It seems they care a lot more about incurring losses than they care about realizing gains.

Finally, the new theory affirms that actual investors do not assess risk in the same way the mathematical model does. The traditional model defines risk as "the known variability in distribution of a known expected return." But the new theory, which dates back to a concept articulated in the 1920s, says that the risk that matters to investors is uncertainty. Investors do not relish the prospect of making a judgment in the face of an unknown distribution and an unknown rate of expected return. What matters to them, according to the new theory, is more a matter of reducing uncertainty than simply hedging risk.

The new theory has been corroborated by research, including a recent survey, "Are Risk Premium Anomalies Caused by Ambiguity?" by Robert Olsen and George Troughton, that analyzes the responses of some three hundred investment managers.

Among the key findings of that research, published in the March/April 2000 issue of Financial Analyst's Journal, was the fact that investment managers rate variability in an asset's return (as measured by standard deviation) much lower in decision-making importance than the chance of incurring a large loss, uncertainty about the true distribution of future returns or the chance of earning less than the target return.

The authors also discovered that investment managers say that they do not treat securities with equivalent quantitative risk measures as all being equally risky. They claim one of the most important considerations in making projections or recommendations is the ability to tell a coherent story with the facts of a company's situation.

The ERM implication of the new theory and studies like the one reported by Olsen and Troughton is clear. If an individual company can manage uncertainty, which is how investors actually define risk, it will be rewarded by investors. That is especially true if the company can manage uncertainty concerning earnings by reducing earnings volatility, decreasing earnings ambiguity and lowering the probability of large losses--and tell a good, coherent story about how it is going to do all of this.

Market Reality

A new theory of investor behavior and opinion research still leaves one question: Can we see evidence for the theory in the reality of the market?

To answer that question, Tillinghast-Towers Perrin conducted a study examining: the independent and quantifiable role of earnings consistency in stock valuation; the role of consistent earnings in receiving higher valuation multiples; the existence of a "consistency premium" and its size; and how much an improvement in consistency could affect shareholder value.

Analysis of the empirical data analyzing the performance of over 675 companies from fifty industries showed that a consistency premium does exist.

The results revealed a 31 percent consistency premium. Broken down into specific levels of company growth and return, the study indicated:

44 percent premium for high return on equity (ROE) companies

20 percent premium for low ROE companies

88 percent premium for high growth companies

24 percent premium for low growth companies

The premium was also evident in specific industry segments. Among companies in the electronics, financial services and retail industries, the premium was especially large.

In a recent Tillinghast-Towers Perrin survey (conducted for The Institute of Internal Auditors (IIA) Research Foundation and in cooperation with The Conference Board of Canada) chief financial officers, chief risk officers (CROs) and chief audit executives, among others from over 130 leading organizations throughout the world, revealed an increasing recognition of the importance of earnings consistency. When asked to identify the top business issues they currently face and the top issues they expect to face in the next three years, "earnings consistency" showed the greatest increase in ranking, jumping from seventh to third in priority, ahead of such stalwarts as expense control and return on capital, and just behind earnings growth and revenue growth. Equally significant, two-thirds (67 percent) of respondents indicated they believe that ERM would help them address the important issue of earnings consistency.

The Status of ERM

Despite both the increasing relevance of earnings consistency and the role ERM can play in its success, there remains a clear need to build the business case for ERM within most organizations.

On the positive side, almost half of all respondents in the IIA survey indicated that their companies had at least partial, if not complete, ERM frameworks currently in place. At the same time, when asked about potential barriers to implementing ERM activities within their organizations, 55 percent cited "organizational culture" as the most significant impediment and 50 percent acknowledged that ERM was still not yet perceived as a priority by senior management.

Feedback from the marketplace clearly and powerfully demonstrates that consistency matters. Consistency has a strategically significant impact on market valuation. It does, in fact, make sense for senior managers to practice enterprise risk management because it will help them manage the risk that matters most to investors: earnings volatility, earnings ambiguity and the fear of large losses. If managers can ease those concerns among investors, they will be handsomely rewarded.

But many of these same managers face a more immediate challenge in terms of convincing their own corporate management of the advantages of ERM. The challenge, then, is clearly for CFOs and CROs, among others, to advance the cause of ERM within their respective organizations, using the marketplace intelligence outlined above to support their case.

Not until senior management is fully committed--and a formal ERM framework is in place--can companies begin to package a coherent story for their external (investor) audience and begin to reap the premiums an ERM program promises.

The author wishes to acknowledge Peter A. Watson, Jr. for his assistance in the valuation work and his guidance in developing the consistency analysis methodology.

Brian W. Merkely ("Does ERM Count?" p. 25) is a consultant with Tillinghast-Towers Perrin in Dallas, Texas. (merkleb@towers.com)

Copyright Risk Management Society Publishing, Inc. Apr 2001
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