Portfolio of One

The fundamentals of Modern Portfolio Theory have been in place for 60 years and continue to drive fund managers and individuals investment strategies. We all want low risk / high returns on our investments. In our "efficient" markets this is not possible, but what Markowitz put forward in 1952 is that one should not look at the risk and return of one particular stock, but rather through diversification in a portfolio. Commonly put, dont put all your eggs in one basket! Essentially, we want an investment portfolio that pays off no matter what happens in the market. While the perfect portfolio does not exist (there are some that apparently disagree on this point), a well-structured diversification strategy provides inherent hedging and risk-reduction benefits with an expected higher rate of return. For evidence according to Markowitz, read "Portfolio Selection: Efficient Diversification of Investments."

 

So where does this leave the entrepreneur with all of his eggs in his company, which he has been building for years? Ultimately, the entrepreneur is rich; he owns a substantial share of a valuable company with the capability to generate present and future cash flows. Additionally, his investment is in a company that he understands better than anyone else. However, the entrepreneur is in the position of having a portfolio of one. No matter how well performing, technologically attractive, and valuable the company, the market exposure is as risky as it gets. He must consider how his individual company will fare through thick and thin, such as the current erratic market in this likely continuing recession.

 

A company typically has in its coffers an amount of cash and a credit facility to counter the troughs in the market cycles in which it operates. What we are experiencing today is less certainty about how low these troughs will be and how short the period of time will be between them. In addition, there is significant risk today that debt providers to SMEs will recall portions of their credit facility or will have no ability to extend them in time of need.

 

What is an entrepreneur to do? He has grown his business for years beyond the startup phase and is sustaining forecasted profitable growth. If he loves his business and cant imagine doing anything else with his life, then quite clearly he must hang on and keep doing what he loves. For those that see an exit as the end-game of this particular entrepreneurial activity, initiating the process towards an M&A makes a great deal of sense.

We all wonder how valuations are affected in this current market, and quite likely they could slip in certain industry or vertical categories. However, the best method to evaluate the market and get a perspective of the "true value" of your company is to test the waters. Ultimately, the decision to sell or stick it out comes down to balancing factors such as the cash you could possibly walk away with today, the discounted future cash adjusted for risk that you could bring home in the future, and your own personal motivations and goals.

Posted by , Vice President on 16 September 2011
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