Strategy’s
strategist: An interview with Richard Rumelt PART II
The Quarterly: So how do we know which changes are important and
which resources to combine?
Richard Rumelt: That’s a very tough question. It is a key
issue—the next frontier. And it is underresearched, underwritten about, and
underunderstood. I call it “strategy dynamics.”
Most of the strategy concepts in use today
are static. They explain the stability and sustainability of competitive
advantages. Strategy concepts like core competencies, experience curves, market
share, entry barriers, scale, corporate culture, and even the idea of “superior
resources” are essentially static, telling us why a particular position is
defensible—why it holds the high ground.
If the terrain never changed, that would
be the end of the story. High ground is always high, and low ground is always
low. But in business, unlike geology, change happens in years rather than
millennia. In the modern business world, there are earthquakes all the time
that quickly take the low ground and raise it high and, at the same time,
submerge some mountain peaks below water.
Strategy dynamics studies how those
changes would shift each dimension of an industry. Would the industry become
more concentrated or less? More integrated or less? Would there be more product
differentiation or less? More segmentation or less? Given consumer desires and
available technologies, how should the industry or business look in, say, ten
years? Where are the economic forces trying to take you? Should your strategy
ride those forces or fight them?
There are tools and exercises that help
trigger inductive insights about dynamics. One is a list of common biases—the
kind of list that helps some people look beyond the standard consensus view of
what is happening. For example, most analysts overestimate the importance of
scale and underestimate the inertia of buyers, so what happens if we adjust our
views to control these predictable biases?
Another useful exercise is to rethink the
metaphor. During the telecom boom of 1997 to 2000, people were saying that
fiber optic cable was like the microprocessor: capacity was rising
exponentially while costs were fixed (as in Moore’s law.5 ) And just as the microprocessor
revolutionized the computer industry, optical fiber would totally restructure
telecom. But the metaphor was specious. Excess cable capacity has a very
different effect than excess PC capability. Because network capacity is a shared
resource, excess capacity can slam prices down to variable cost, which is
virtually zero. By contrast, overpowered PCs have no real effect on price,
because there is no market for using excess CPU cycles or excess memory. Once
you see the underlying metaphor, you can adjust your expectations.
The Quarterly: What’s another way to understand strategy
dynamics?
Richard Rumelt: I use another tool I call “value denials.” These
are products or services that are both desired and feasible but are not being
supplied to the market. The concept combines insights into demand and potential
supply. A classic example is an airline ticket guaranteeing that your luggage
will not be lost. It just isn’t supplied at any price. There must be a price at
which airlines would hand-carry luggage to the baggage compartment and even a
price at which they would strap it into the seat next to you! There are times
when we would pay the premium, but those services are not offered. That’s a
value denial.
A value denial is a business opportunity.
Every change and innovation creates new value denials. People wanted to buy
music à la carte and keep 10,000 songs on their computers. Well, they got that,
but there was a value denial: the digital music wasn’t portable. So along come
the MP3 player and the iPod. But those innovations uncovered a new value
denial: people also want to plug their players into their stereos. Well, this
was pretty easily fixed, but playing your MP3s on your stereo uncovers yet
another value denial: MP3s are compressed and just don’t sound as good as CDs.
Finally, even when I have immediate access to all music anywhere and anytime
through the “jukebox in the sky,” there will still be a value denial—how will I
know what to listen to? I will need a private tutor and disc jockey to help
arrange my listening and maybe to shape my tastes.
So one useful way to think about change is
to turn aside from the central innovation and ask yourself what value denials
it will uncover. How will they be fixed? And what value denials will then be
uncovered by that fix?
The Quarterly: What sort of group can analyze these kinds of
things?
Richard
Rumelt: A small group of smart people. What
else can I say? Doing this kind of work is hard. A strategic insight is
essentially the solution to a puzzle. Puzzles are solved by individuals or very
tight-knit teams. For that, you need a small group. With big groups and complex
processes you can select the better solution to the puzzle, and you can get
consensus and buy-in and even commitment.
One other thing. If I had my way, small
groups like this would be absolutely prohibited from doing PowerPoint
presentations! Using bullet points so much drives out thinking. One of the nice
features of PowerPoint is how fast you can create a presentation. But that’s
the trouble. People end up with bullet points that contradict one another, and
no one notices! It is simply amazing.
If you ask a group to put aside the bullet
points and just write three coherent paragraphs about what is changing in an
industry and why, the difference is incredible. Having to link your thoughts,
giving reasons and qualifications, makes you a more careful thinker—and a
better communicator.
The Quarterly: Shifting gears a bit, Richard, can you tell us
about your research on diversification and focus?
Richard Rumelt: Well, my first research on corporate strategy
showed that somewhat diversified but relatively focused companies tend to
outperform highly diversified companies. And that finding has held up fairly
consistently over the decades. Financial theory would say that companies
diversify to reduce risk, but in the business world diversification is done not
to hedge risk but to sustain top-line growth. The riskiest companies—the
start-ups and early-stage companies—are intensely focused. Companies begin
thinking about diversification only when their growth has plateaued and
opportunities for expansion in the original business have been depleted.
Suddenly, they have more cash flow than they know what to do with.
The Quarterly: Why are the highly diversified companies less
profitable?
Richard Rumelt: It seems that the more complex an organization
gets, the more likely it is that inefficient and unproductive businesses
accumulate in the nooks and crannies and back alleys—and sometimes right up there
in center aisle. These businesses are subsidized by their cousin, brother, and
sister businesses that are doing well, and they stick around for too long
because there’s a bias against shutting things down. Often we’ll find that
these are pet projects of senior management and cutting them would cause a huge
ego blow. It’s extremely unrewarding to a person’s career to weed the garden
inside a company. It is much easier and more popular politically to grow the
company than it is to go around and disrupt everybody’s neighborhood.
One of the things we see happening in
private equity is highly incentivized people assuming this very unpleasant task
of taking a company private, weeding its garden, and then taking it public
again. It hasn’t happened with highly diversified companies yet, but we see
that, essentially, something like that is happening as relatively complex
organizations are cycling through private equity.
The Quarterly: In addition to not weeding the garden, are there
other significant problems that you see senior executives failing to handle?
Richard Rumelt: Another one is the stock market. When I’m talking
to CEOs, the subject that comes up over and over again is stock prices: how
should CEOs deal with the pressures of the market?
There are two big problems with managing
for stock prices. The first is that stock prices are extremely volatile—too
volatile, really. Research has shown that lots of variation in stock prices has
little to do with corporate or economy-wide performance. An engineer would say
that the signal-to-noise ratio is very low.
The second big problem is that stock
prices respond to changes in expectations, not to performance. When you improve
your profits, the stock price does not necessarily move at all. It goes up only
if the increased profit was a surprise. And if profits are up but not as much
as expected, you can get dinged.
Now, that is simply not how most people
think about performance. It violates our basic notions of fairness. If I
treated my students that way, they would revolt! Suppose that at the beginning
of the term I projected each student’s final-exam grade, taking into account
IQs, grades in other courses, anything I could get my hands on. Then when the
final rolled around, suppose that their students’ grades for the whole course
reflected how well they did on the final relative to my initial expectations.
Say that Alan scored 50 and Barbara scored 80 on the exam but that I gave Alan
an A and Barbara a B because Alan did better than the 40 I expected and Barbara
did worse than the projected 90. The students would riot, waving signs saying
“unfair!” But that’s how the stock market works.
As a CEO, living with the stock market as
a constant factor in your life takes iron nerve and an ability to be detached.
You have to remind yourself that it is not measuring your recent performance;
it is speculators adjusting their expectations about what will happen next.
The Quarterly: Instead of these distractions, what should CEOs be
focusing on?
Richard Rumelt: The most important job of any manager is to break
down a situation into challenges that subordinates can handle. In essence, the
manager absorbs a good chunk of the ambiguity in the situation and gives much
less ambiguous problems to others.
In a focused company, the CEO does this
for the entire organization by examining the overall competitive situation and
providing enough guidance to let the organization get to work. The CEO defines
the business problem for everyone else.
In a diversified corporation, the CEO’s
job is to keep the individual business units healthy. We know that the locus of
success and failure is the business unit, not the corporation. The evidence
shows that an average multibusiness corporation has little if any systematic
effect on the businesses that it owns and manages. This is hard for many to
hear, but it is a fact. So the senior management of the corporation should
provide the resources and knowledge that each business needs to be healthy.
What makes a business unit healthy?
Operating efficiently and having a good strategy. A good strategy, in turn, is
one that is responsive to change and that builds, builds upon, and stretches
the resources that yield competitive advantage.
The Quarterly: The resource-based view.
Richard Rumelt: Yes, the resource-based view, which at one level
looks obvious. It says you’ve got to have good resources in order to have good
results. But it’s really a theory about what’s the locus of success. Where is
it coming from? It’s coming from having, within a company, difficult-to-replicate
and usually intangible resources. Things that generate and sustain competitive
success—things like reputation, a good customer group, network externalities,
experienced and competent people performing your processes.
The Quarterly: How do you accomplish this in a world that’s
changing so quickly? Does the very notion of a proprietary resource or a
structural advantage have the same meaning that it used to?
Richard Rumelt: No, it doesn’t really. From the old learning-curve
era—the experience curve era—we know that companies get good at something by
doing it. It appears that by distributing and collecting DVDs, Netflix is
getting good at doing that. Now, that doesn’t mean it was always good at it. We
create our competencies by making bets and putting the right resources in place
to develop those competencies. We have to understand that competencies are
created by activity. If you internalize enough of those activities, you
actually get good at them, and they give you a sustainable advantage for a certain
period of time.
The Quarterly: Which is less than it used to be.
Richard Rumelt: Yes, and then the advantage evaporates on you.
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