MANAGEMENT SPECIAL.... How to put your money where your strategy is PART I

How to put your money where your strategy is PART I

Most companies allocate the same resources to the same business units year after year. That makes it difficult to realize strategic goals and undermines performance. Here's how to overcome resource-allocation inertia.

Picture two global companies, each operating a range of different businesses. Company A allocates capital, talent, and research dollars consistently every year, making small changes but always following the same broad investment pattern. Company B continually evaluates the performance of business units, acquires and divests assets, and adjusts resource allocations based on each division’s relative market opportunities. Over time, which company will be worth more?

If you guessed company B, you’re right. In fact, our research suggests that after 15 years, it will be worth an average of 40 percent more than company A. We also found, though, that the vast majority of companies resemble company A. Therein lies a major disconnect between the aspirations of many corporate strategists to boldly jettison unattractive businesses or double down on exciting new opportunities, and the reality of how they invest capital, talent, and other scarce resources.

For the past two years, we’ve been systematically looking at corporate resource allocation patterns, their relationship to performance, and the implications for strategy. We found that while inertia reigns at most companies, in those where capital and other resources flow more readily from one business opportunity to another, returns to shareholders are higher and the risk of falling into bankruptcy or the hands of an acquirer lower.

We’ve also reviewed the causes of inertia (such as cognitive biases and politics) and identified a number of steps companies can take to overcome them. These include introducing new decision rules and processes to ensure that the allocation of resources is a top-of-mind issue for executives, and remaking the corporate center so it can provide more independent counsel to the CEO and other key decision makers.

We’re not suggesting that executives act as investment portfolio managers. That implies a search for stand-alone returns at any cost rather than purposeful decisions that enhance a corporation’s long-term value and strategic coherence. But given the prevalence of stasis today, most organizations are a long way from the head-long pursuit of disconnected opportunities. Rather, many leaders face a stark choice: shift resources among their businesses to realize strategic goals or run the risk that the market will do it for them. Which would you prefer?

Weighing the evidence

Every year for the past quarter century, US capital markets have issued about $85 billion of equity and $536 billion in associated corporate debt. During the same period, the amount of capital allocated or reallocated within multibusiness companies was approximately $640 billion annually—more than equity and corporate debt combined. While most perceive markets as the primary means of directing capital and recycling assets across industries, companies with multiple businesses actually play a bigger role in allocating capital and other resources across a spectrum of economic opportunities.

Capital allocations were essentially fixed for roughly one-third of the business units in our sample.

To understand how effectively corporations are moving their resources, we reviewed the performance of more than 1,600 US companies between 1990 and 2005.² The results were striking. For one-third of the businesses in our sample, the amount of capital received in a given year was almost exactly that received the year before—the mean correlation was 0.99. For the economy as a whole, the mean correlation across all industries was 0.92.

In other words, the enormous amount of strategic planning in corporations seems to result, on the whole, in only modest resource shifts. Whether the relevant resource is capital expenditures, operating expenditures, or human capital, this finding is consistent across industries as diverse as mining and consumer packaged goods. Given the performance edge associated with higher levels of reallocation, such static behavior is almost certainly not sensible. Our research showed the following:

·         Companies that reallocated more resources—the top third of our sample, shifting an average of 56 percent of capital across business units over the entire 15-year period—earned, on average, 30 percent higher total returns to shareholders (TRS) annually than companies in the bottom third of the sample. This result was surprisingly consistent across all sectors of the economy. It seems that when companies disproportionately invest in value-creating businesses, they generate a mutually reinforcing cycle of growth and further investment options.

·         Consistent and incremental reallocation levels diminished the variance of returns over the long term.

·         A company in the top third of reallocators was, on average, 13 percent more likely to avoid acquisition or bankruptcy than low reallocators.

·         Over an average six-year tenure, chief executives who reallocated less than their peers did in the first three years on the job were significantly more likely than their more active peers to be removed in years four through six. To paraphrase the philosopher Thomas Hobbes, tenure for static CEOs is likely to be nasty, brutish, and, above all, short.

Companies with higher levels of capital reallocation experienced higher average shareholder returns.

We should note the importance of a long-term view: over time spans of less than three years, companies that reallocated higher levels of resources delivered lower shareholder returns than their more stable peers did. One explanation for this pattern could be risk aversion on the part of investors, who are initially cautious about major corporate capital shifts and then recognize value only once the results become visible. Another factor could be the deep interconnection of resource allocation choices with corporate strategy. The goal isn’t to make dramatic changes every year but to reallocate resources consistently over the medium to long term in service of a clear corporate strategy. That provides the time necessary for new investments to flourish, for established businesses to maximize their potential, and for capital from declining investments to be redeployed effectively. Given the richness and complexity of the issues at play here, differences in the relationship between short- and long-term resource shifts and financial performance is likely to be a fruitful area for further research.

Why companies get stuck

Why do so many companies undermine their strategic direction by allocating the same levels of resources to business units year after year? The reasons vary widely, from the very bad—companies operating on autopilot—to the more sensible. After all, sometimes it’s wise to persist with previously chosen resource allocations, especially if there are no viable reallocation opportunities or if switching costs are too high. And companies in capital-intensive sectors, for example, often have to commit resources more than five years ahead of time to long-term programs, leaving less discretionary capital to play with.

For the most part, however, the failure to pursue a more active allocation agenda is a result of organizational inertia that has multiple causes. We’ll focus here on cognitive biases and corporate politics, but regardless of source, inertia’s gravitational pull is strong—and overcoming it is critical to creating an effective corporate strategy. As author and Kleiner Perkins Caufield & Byers partner Randy Komisar told us, “If corporations don’t approach rebalancing as fiduciaries for long-term corporate value, their life span will decline as creative destruction gets the better of them.”

Cognitive biases

Biases such as anchoring and loss aversion, which are deeply rooted in the workings of the human brain and have been much studied by behavioral economists, are major contributors to the inertia that prevents more active reallocation. Anchoring refers to the tendency to use any number, even an irrelevant one, as an anchor for future choices. Judges asked to roll a pair of dice before making a simulated sentencing decision, for example, are influenced by the result of that roll, even though they deny they are.

Within a company, last year’s budget allocation often serves as a ready, salient, and justifiable anchor during the planning process. We know this to be true in practice, and it’s been reinforced for us recently as we’ve played a business game with several groups of senior executives. The game asked participants to allocate a capital budget across a fictitious company’s businesses and provided players with identical growth and return projections for the relevant markets. Half of the group also received details of the previous year’s capital allocation. Those without last year’s capital budget all allocated resources in a range that optimized for the expected outlook in market growth and returns. The other half aligned capital far more closely with last year’s pattern, which had little to do with the potential for future returns. And this was a game where the company was fictitious and no one’s career was at risk!

In reality, anchoring is reinforced by loss aversion: losses typically hurt us at least twice as much as equivalent gains give us pleasure. That reduces the appetite for taking risks and makes it painful for managers to give up resources.

Corporate politics

A second major source of inertia is political. There’s often a tight alignment between the interests of senior executives and those of their divisions or business units, whose ability to attract capital can significantly influence the personal credibility of a leader. Indeed, because executives are competing for resources, anyone who wins less than he or she did last year is invariably seen as weak. At the extreme, leaders of business units and divisions see themselves as playing for their own “teams” rather than for the corporation as a whole, making it challenging to reallocate resources significantly. Even if a reduction in resources to their division benefits the company as a whole, ambitious leaders are unlikely to agree without a fight. As one CEO told us: “If you’re asking me to play Robin Hood, that’s not going to work.”

Overcoming inertia

Tempting as it is to believe that one’s own company avoids these traps, our research suggests that’s unlikely. Our experience also suggests, though, that taking steps such as those described below can materially improve a company’s resource allocation and its connection to strategic priorities. These imperatives apply not just to capital but also to other scarce resources, such as talent, R&D dollars, and marketing expenditures . All of these also are subject to the forces of inertia, which can undermine an organization’s ability to achieve its strategic goals. Consider one company we know that prioritized expanding in China. It set an ambitious sales growth target for the country and planned to meet it by supplementing organic growth with a series of acquisitions. Yet it identified just three people to spearhead this strategic imperative—a small fraction of the number required, which is typical of the problems that arise when the link between corporate strategy and resource allocation is weak. Here are four ideas for doing better.

Inertia may affect the distribution of other scarce resources, such as advertising spending.

CONTINUES IN PART II