Capital is no longer cheap. And if today’s higher rates are here to stay, business leaders will need to relearn old ways of thinking about capital allocation. After all, many of today’s CEOs and CFOs grew up—and many of today’s corporate portfolios were built—in an environment of exceptionally low interest rates.

A look at the last 150 years of economic history shows that our recent low-rate environment was atypical. Since the 2007–2008 financial crisis and until recently, nominal long-term interest rates were about 2%. But we have seen sustained rates at such a low level only once before in US history: to support the wartime economy of the 1940s. (See Exhibit 1.) Over the rest of the period, nominal interest rates averaged 4.9%—and the average remains above 4%, even if you exclude the period between 1975 through 1986, when the Federal Reserve pushed rates up substantially to combat entrenched expectations of inflation.

In a higher-rate environment, corporate hobbies that have not fulfilled their initial promise are suddenly expensive. And companies without a thoughtful corporate portfolio strategy will fall short of their full value creation potential as they continue throwing cash after marginal positions in pursuit of growth while underinvesting in their long-term winners. It’s therefore essential to know which parts of your business portfolio are creating value and which are destroying it, and to reallocate resources from marginal positions to winning ones.

With Higher Rates, the Marginal Competitor Becomes…Marginal

Any stable, competitive system comprises a leader, followers, and marginal competitors. The leader and followers have strong and sustainable economics and generate cash returns in excess of their investments. Typically, in a stable sector with low regulatory intervention, leaders and followers are relatively few.

By contrast, marginal competitors have less advantaged economics, and they borrow to invest. While they may show an EBITDA profit, they typically generate returns above the cost of capital only in boom times, when their capacity and products are welcomed because the sector’s leader and followers are sold out.

The era of declining and ultralow rates was kind to marginal competitors. They could finance investments easily as low rates decreased both return requirements and financing costs. All that was needed was a bit of incremental volume, and massive fiscal stimulus was fueling extra demand and growth. In such an environment, it became easier for management to convince itself to add marginal positions to the portfolio, particularly if those positions offered growth prospects that the stock market might value highly.

But with higher rates, marginal competitors will lose their luster. Slower growth will result in customers shifting their business back to leaders and followers. Increased financing costs will weigh on cash profitability. And the market will no longer blindly reward growth prospects in corporate valuations. The bill is coming due for the marginal competitor.

The Imperative for Portfolio Discipline

Are there marginal competitors in your portfolio of businesses? Based on our experience, the answer is very likely “yes.” In fact, they’re hiding in plain sight.

A look at the $1 trillion of annual capital investment by the nonfinancial companies in the S&P 1500 makes the point. Each column in the bar chart in Exhibit 2 represents a company’s most recently reported return on investment. At a weighted-average cost of capital of 8% to 11%—a reasonable estimate for many companies in the current interest rate environment—about half the companies, on average, are earning below-cost-of-capital returns. The picture will only worsen should rates rise higher.

Given the risk that marginal businesses pose to your future valuation, it’s essential to assess the competitive position and cash consumption of each element in your portfolio of businesses dispassionately—and to make hard choices. The moment heralds a revival of the classic discipline of portfolio management.

A Three-Part Action Agenda for Leaders

Expensive cash calls for strategic clarity and decisive action. In our experience, getting there requires three steps.

De-average your portfolio’s current performance. It’s critical to start with a granular, creative disaggregation of your business. Too often, organizations combine activities—for example, looking at manufacturing and service operations together, or grouping country operations at a regional level—that are better looked at independently from a return-on-capital perspective. The objective is to recluster your operations and capital allocation into a set of natural strategic segments, each with a coherent customer set, competitor set, and basis of competition, in order to gain a deeper understanding of each element’s strategic position.