Father Christmas does not exist?


Father Christmas does not exist? Tell that to investors who seem unable to ask how much value certain business really add

Every year, millions of children believe that Father Christmas comes down the chimney to deliver presents, in return for nothing more than a glass of warm milk. Every year, some of these millions of children suffer a rude shock. They learn that Father Christmas does not exist, and the men with red robes and white beards whom they see in the week before Christmas are all impostors.

Something similar is true in business. There is no Father Christmas there either, and those who wear his clothes are either deceivers or themselves deceived. Yet there are many who believe otherwise, and each year some of them, ruefully, discover their mistake.

So Christmas 1994 was the last of childhood illusion for Peter Baring and his colleagues. It was remarkably easy, he had assured the Bank of England, to make profits by arcane arbitrage trades in derivatives in Far East markets. He didn’t know exactly how Father Christmas got down the chimney, but regular as clockwork, the present arrived. Until Father Christmas took a plane ticket to prison.

There is only one way in which firms make profits on a sustained and sustainable basis, which is to add value for their customers and to do so in ways that other people can’t. That simple and obvious truth is easily forgotten by those who would like to believe that at least for them, Christmas has come round early.

Investors, who may know very little about the businesses to which they commit their funds, are the most readily taken in. They believed that Polly Peck could build a £2 billion company out of putting North Cyprus fruit into cardboard boxes. And they were attracted to the excess of loss syndicates in Lloyd’s of London, or to providing mortgage indemnity guarantees. After all, what could be a better investment than an insurance business that took premiums but had never had to pay anything out.

These examples seem easy enough to see through, though they were not easy enough to see through for those investors, by no means all of them unsophisticated, who lost money in the activities concerned. But they do illustrate the two fundamental questions which anyone is business should ask when they think they have met Father Christmas. Does this activity add value to customers that corresponds, at least roughly, to the profits which are earned from it? And if this is such a rewarding business, is there a reason why the opportunity is specifically available to me? If you can’t answer yes to both these questions, then the story you are being told either isn’t true, or won’t last.

You don’t, for long, make more money than you add value. Take GPA, the aircraft leasing company which, from a small office in Shannon, borrowed money from the world’s major banks to lend to the world’s major airlines. I don’t know how you can add value of hundreds of millions of pounds a year doing that, and nor, when it came to the point, did the investors who were asked to take shares in the company’s flotation. Indeed it is hard to see how you can ever add much value as financial intermediary between large companies or governments. With hundreds of banks trying to do just that, this may be the reason why it yields them prestige and expands their balance sheets while doing nothing for their profitability.

The fallacy is to think that by simply interposing yourself in a transaction you can collect a return, like those usherettes in French cinemas who must be tipped before they will get out of your way. Yet people in business go on thinking that by vertical integration they can acquire the “manufacturer’s profit” or the “retailer’s turn”, or that they will do better to “cut out the middleman”. Or that they will make more money if they cross-sell, or offer a one-stop shop.

But in a competitive market, what manufacturers, retailers and middlemen earn is exactly equal to both the cost and the value of the services they provide. It follows that restructuring the value chain will give you nothing unless you either enhance that value, or there is some specific and particular reason why you can provide these same services at lower cost. Or, of course, you may not be operating in a competitive market.

So regional electricity companies still have their “supply business”, and argue with their regulator about the return they should earn on it. When you have a monopoly, you can charge for “supply”, but once you are in a competitive market – which they will face from 1998 – there is no margin for supply because there is no value-adding activity. You can earn a return for generating electricity, or sending it through your wires; you can recover the cost of sending a bill; but there is no % margin for supply. And there is no longer 15% for helping a householder fill in an insurance proposal form. Direct writers have shown that traditional retail broking is as valuable as the French usherette.

So when you tell your children that there is no Father Christmas in Lapland, tell them that there is none in commerce either. And when someone describes the projected returns from a business to you, measure it in close relation to the value which you yourself will add.

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