Strategy to beat the odds PART I
If you internalize the real odds of strategy, you can tame its social
side and make big moves.
Several times a
year, top management teams enter the
strategy room with lofty goals and the best of intentions: they hope to assess
their situation and prospects honestly, and mount a decisive, coordinated
response toward a common ambition.
Then reality intrudes. By the time they
get to the strategy room, they find it is already crowded with egos and competing
agendas. Jobs—even careers—are on the line, so caution reigns. The budget
process intervenes, too. You may be discussing a five-year strategy, but
everyone knows that what really matters is the first-year budget. So, many
managers try to secure resources for the coming year while deferring other
tough choices as far as possible into the future. One outcome of these dynamics
is the hockey-stick projection, confidently showing future success after the
all-too-familiar dip in next year’s budget. If we had to choose an emblem for
strategic planning, this would be it.
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In our book, Strategy Beyond the Hockey Stick (Wiley, February 2018), we set out to help companies unlock the big moves needed
to beat the odds. Another strategy framework? No, we already have plenty of
those. Rather, we need to address the real problem: the “social side of
strategy,” arising from corporate politics, individual incentives, and human
biases. How? With evidence. We examined publicly available information on
dozens of variables for thousands of companies and found a manageable number of
levers that explain more than 80 percent of the up-drift and down-drift in
corporate performance. That data can help you assess your strategy’s odds of
success before you leave the strategy room, much less start to execute the
plan.
Such an assessment stands in stark
contrast to the norms prevailing in most strategy rooms, where discussion
focuses on comparisons with last year, on immediate competitors, and on
expectations for the year ahead. There is also precious little room for
uncertainty, for exploration of the world beyond the experience of the people
in the room, or for bold strategies embracing big moves that can deliver a
strong performance jolt. The result? Incremental improvements that leave
companies merely playing along with the rest of their industries.
Common as that outcome is, it isn’t a necessary
one. If you understand the social side of strategy, the odds of strategy
revealed by our research, and the power of making big moves, you will
dramatically increase your chances of success.
The
social side of strategy
Nobel laureate Daniel Kahneman described
in his book Thinking, Fast and Slow the “inside view” that
often emerges when we focus only on the case at hand. This view leads people to
extrapolate from their own experiences and data, even when they are attempting
something they’ve never done before. The inside view also is vulnerable to
contamination by overconfidence and other cognitive biases, as well as by internal politics.
It’s well known by now
that people are prone to a wide range of biases such as anchoring,
loss aversion, confirmation bias, and attribution error. While these
unintentional mental shortcuts help us filter information in our daily lives,
they distort the outcomes when we are forced to make big, consequential
decisions infrequently and under high uncertainty—exactly the types of
decisions we confront in the strategy room. When you bring together people with
shared experiences and goals, they wind up telling themselves stories,
generally favorable ones. A study found, for instance, that 80 percent of
executives believe their product stands out against the competition—but only 8
percent of customers agree.
Then, add agency problems, and the
strategy process creates a veritable petri dish for all sorts of dysfunctions
to grow. Presenters
seeking to get that all-important “yes” to their plans may define market share
so it excludes geographies or segments where their business units are weak, or
attribute weak performance to one-off events such as weather, restructuring
efforts, or a regulatory change. Executives argue for a large resource
allotment in the full knowledge that they will get negotiated down to half of
that. Egos, careers, bonuses, and status in the organization all depend to a
large extent on how convincingly people present their strategies and the
prospects of their business.
That’s why people often “sandbag” to avoid
risky moves and make triple sure they can hit their targets. Or they play the
short game, focusing on performance in the next couple of years in the
knowledge that they likely won’t be running their division afterward.
Emblematic of these strategy-room dynamics is the hockey-stick presentation.
Hockey sticks recur with alarming frequency, as the experience of a
multinational company, whose disguised results appear in Exhibit 1,
demonstrates. The company planned for a breakout in 2011, only to achieve flat
results. Undeterred, the team drew another hockey stick for 2012, then 2013,
then 2014, then 2015, even as actual results stayed roughly flat, then trailed
off.
To move beyond hockey sticks and the
social forces that cause them, the CEO and the board need an objective,
external benchmark.
The
odds of strategy
The starting point for developing such a
benchmark is embracing the fact
that business strategy, at its heart, is about beating the market; that is, defying the power of “perfect” markets to push
economic surplus to zero. Economic profit—the total profit after the cost of
capital is subtracted—measures the success of that defiance by showing what is
left after the forces of competition have played out. From 2010 to 2014, the
average company in our database of the world’s 2,393 largest corporations
reported $920 million in annual operating profit. To make this profit, they
used $9,300 million of invested capital,which earned a return of 9.9 percent.
After investors and lenders took 8 percent to compensate for use of their
funds, that left $180 million in economic profit.
Plotting each company’s average economic
profit demonstrates a power law—the tails of the curve rise and fall at
exponential rates, with long flatlands in the middle. The power curve reveals a
number of important insights:
·
Market forces are pretty
efficient. The average company in our sample
generates returns that exceed the cost of capital by almost two percentage
points, but the market is chipping away at those profits. That brutal
competition is why you struggle just to stay in place. For companies in the
middle of the power curve, the market takes a heavy toll. Companies in those
three quintiles delivered economic profits averaging just $47 million a year.
·
The curve is extremely
steep at the bookends. Companies in the top quintile capture
nearly 90 percent of the economic profit created, averaging $1.4 billion
annually. In fact, those in the top quintile average some 30 times as much
economic profit as those in the middle three quintiles, while the bottom 20
percent suffer deep economic losses. That unevenness exists within the top
quintile, too. The top 2 percent together earn about as much as the next 8
percent combined. At the other end of the curve, the undersea canyon of
negative economic profit is deep—though not quite as deep as the mountain is
high.
·
The curve is getting
steeper. Back in 2000–04, companies in the top
quintile captured a collective $186 billion in economic profit. Fast forward a
decade and the top quintile earned $684 billion. A similar pattern emerges in
the bottom quintile. Since investors seek out companies that offer
market-beating returns, capital tends to flow to the top, no matter the
geographic or industry boundaries. Companies that started in the top quintile
ten years earlier soaked up 50 cents of every dollar of new capital in the
decade up to 2014.
·
Size isn’t everything,
but it isn’t nothing, either.
Economic profit reflects the strength of a strategy based not only on the power
of its economic formula (measured by the spread of its returns over its cost of
capital) but also on how scalable that formula is (measured by how much
invested capital it could deploy). Compare Walmart, with a moderate 12 percent
return on capital but a whopping $136 billion of invested capital, with
Starbucks, which has a huge 50 percent return on capital but is limited by
being in a much less scalable category, deploying only $2.6 billion of invested
capital. They both generated enormous value, but the difference in economic
profit is substantial: $5.3 billion for Walmart versus $1.1 billion for
Starbucks.
·
Industry matters, a lot. Our analysis shows that about 50 percent of your
position on the curve is driven by your industry—highlighting just how critical
the “where to play” choice is in strategy. Industry performance also follows a
power curve, with the same hanging tail and high leading peak. There are 12
tobacco companies in our research, and 9 are in the top quintile. Yet there are
20 paper companies, and none is in the top quintile. The role of industry in a
company’s position on the power curve is so substantial that it’s better to be
an average company in a great industry than a great company in an average
industry.
·
Mobility is possible—but
rare. Here is a number that’s worth mulling:
the odds of a company moving from the middle quintiles of the power curve to
the top quintile over a ten-year period are 8 percent. That means just 1 in 12
companies makes such a leap. These odds are sobering, but they also encourage
you to set a high bar: Is your strategy better than the 92 percent of other
strategies?
CONTINUES
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