Risk-reward link the investment equation

WHAT makes a good return on investment? It is a question that can sometimes keep managers awake at night.

The simple answer is, there is no special formula to suit all industries. The time frame for the return on investment needs to be considered too. Is the investment required to start offering returns immediately or is it one that is expected to pay off in the long term.

Companies such as energy, transport, retail and agribusiness conglomerate Wesfarmers have return-on-investment standards set at several corporate levels within the group.

In the private investment world, until the recent stock market ructions, most managed funds were expecting a return of between 10 per cent and 15 per cent from the share market.

These days they are not expecting to see double-digit returns for some time.

Until two years ago most financial planners were saying a return of up to 15 per cent was probably the maximum an investor could expect.

Most investors and managers say the risk-reward link is something that needs to be taken into account. The higher the risk, then conversely, the higher should be the reward.

In the world of venture capital a return of between 10 per cent and 15 per cent would be considered a dismal failure.

Poynton Partners principal John Poynton said return on investment depended on risk.

“A venture capitalist, for example, will target doubling his or her money within two to three years if the venture is high risk,” he said.

“One thing people need to be taught is the risk-reward link. If you forget that you can often get into trouble.”

For people involved in the seed and pre-seed capital arenas the required return on investment is considerably higher again.

This is partially due to the risk associated with ventures that are not proven and also because of the longer lead time needed for the investment to be realised.

Funds in such ventures are tied up for between five and seven years and, if the investment is not managed properly, investors may not see any return from that at the end of the period.

Wesfarmers has benchmarks for its investments to meet, although in its case an investment usually equates to an acquisition.

The conglomerate’s managing director Michael Chaney recently told the Australian Graduate School of Management that the company worked to three basic principles:

p improve the business’s performance;

p expand those businesses; and

p manage the portfolio of businesses.

Wesfarmers targets a return on equity of 16 per cent after tax for the entire group because that would rank it in the top quartile of companies worldwide.

“At an operating division level we chose a measure called return on capital as the main performance indicator and set a target of 18 per cent before interest and tax – because if all divisions earned that amount, then as a group we would earn 16 per cent ROE,” Mr Chaney said.

When evaluating new projects, Wesfarmers sets a return on investment rate of 10 per cent after tax, which is slightly higher than its weighted average cost of capital.

BankWest manages its return on investment by setting hurdle rates for all of its investments – be they internal or external.

A BankWest spokesman said the bank used a weighted average cost of capital to set a minum hurdle rate for both types of investments.

The WACC is set by the bank’s finance department and is used in establishing businesses cases across the bank.

“External investments have short and long-term ROIs depending on the industry and sector the investment or company operates in,” the spokesman said.

“These investments are also considered in the context of the bank’s overall investment portfolio.”