Novel Deployment of Modern Portfolio Theory

Ethanol represents approximately 80% of revenues for a dry-grind plant—a glorious proposition when margins are positive and a perilous one when they are not.

The heavy weight of an ethanol-dependent revenue structure results in earnings instability and enterprise value erosion when exposed to commodity volatility. Further, earnings volatility translates to financial risk which must reward investors commensurately. Without meaningful diversification, ethanol producers absorb idiosyncratic risk. Idiosyncratic risk is diversifiable risk and therefore not rewarded by the market; however, diversifiable risk does erode earnings and asset value. We deploy the Sharpe Ratio to show the devaluating impact of diversifiable risk on public ethanol companies vs. stock market benchmarks.

To make matters worse, the industry concedes to commodity volatility vis a vis high liquidity, debt aversion and a short investment horizon reducing capital efficiency and stunting growth. Capital allocation plans reflect a stubborn indifference to the value of stable earnings and overemphasize operational effectiveness, i.e. cost containment, at the expense of diversified revenue

expansion initiatives.

Indeed, the compounding, devaluating effects of a sub-optimal revenue structure against the caprice of commodity volatility has cost the industry billions from lost earnings and inefficient capital. Efficient capital sourcing begins by being a superior investment against competing alternatives. The inability to attract efficient capital poses an existential threat to the dry-grind, fuel ethanol business model.

To overcome this difficult challenge, we expand our thinking beyond process to the enterprise level. Accordingly, the goal of sustainability for fuel ethanol producers begins with the end in mind—a strategic vision framed by revenue forecasts and potential markets served. However, with limited insight into what is possible, many producers struggle to identify market opportunities let alone generate reasoned revenue forecasts.

To offer insight into what is possible, we leverage the industry’s high volume/low-cost fermentation of glucose and yeast--the most tractable substrate/organism platform in biotechnology--to access a half-trillion-dollar renewables market. We consider Organic Acids, Flavors & Fragrances, Cosmetics, Food & Beverage and Renewable Chemicals as market candidates for meaningful diversification.

By considering revenue structure as an investment portfolio, we can apply Modern Portfolio Theory, or MPT as a novel, yet powerful tool to illuminate a viable strategic vision. MPT—specifically the Markowitz Model--is a quantitative diversification tool ubiquitously applied by financial planners to optimize the risk/return of an investment portfolio. Markowitz simultaneously identifies the ideal combination of target markets and revenue weights to create an optimal revenue structure with the highest expected return for the risk incurred.

At n2 (n-squared) Solutions, we interrogate market opportunities through the lens of the Markowitz Model to provide insight into what is possible and attain meaningful, sustainable diversification for the dry-grind ethanol producer.

Markowitz reveals we don’t value markets based on individual risk/return characteristics; rather, we consider how the select market optimizes the risk/return of the entire revenue structure.

Modern Portfolio Theory is a rudder for dry-grind fuel ethanol producers to steer efficiently towards sustainability with low comparative cost. By knowing the destination, ethanol producers can efficiently align innovation activities to enable business strategy, avoid extended revenue gaps from falling prices and maintain a strong balance sheet to source efficient capital.