Sunday, 24 February 2008

How well do you know your company? (my guess is not very well at all…)

In the 1970s, there was a series of academic studies which looked at managers’ perceptions of the “volatility” of their company’s business environments. These studies all found that different managers within the same organization usually had widely varying views on how volatile their business was: the correlation between different people’s assessments was virtually zero.

In addition, these studies found that there was hardly any relation between objective measures of business volatility and managers’ estimates of these measures (if anything, the correlations were negative; managers in stable environments thought their business was relatively turbulent and vice versa). Similar results were obtained for other variables. The researchers concluded that managers’ perceptions of their own businesses were usually plain wrong.

Two business school professors – John Mezias and Bill Starbuck; at the time at New York University – set out to examine this claim further (and published their results a few years ago) simply because they found it hard to believe; at least at first…

They thought “‘business volatility’, that’s a bit vague and abstract, let’s start with something simple” and they asked executives from a wide range of companies to tell them what their business unit’s sales were in the previous year. Then they looked up the units’ actual sales figures. The average answer was 475.7% wrong. That’s 475.5%...! Sales of their own business unit!!

Then John and Bill thought, “perhaps we should pick something they find really important”. So they approached a blue-chip company and asked them what the company’s absolute top-notch priority was: the CEO declared that the absolute top priority throughout the entire company was “quality improvement”.

And indeed, they had put their money where their mouth was: many managers attended quality improvement training courses, each division had a dedicated department focusing on quality performance and the company had developed various quality metrics. Furthermore, all managers received quarterly quality improvement reports, and 74% of them indicated in a survey that they expected to receive large increases in their personal rewards if their divisions managed to increase quality. Yep, “quality” was important to them!

Quality was measured in the company, following the specialist training techniques, in terms of “sigma” (a measurement of the error rate). When John and Bill asked the managers what the sigma of their department was, the average error in their answer was…(wait for it)... 715.1%. A whopping 715%! They really had no clue…

Note that these had even been managers brave enough to give any answer at all; 7 out of 10 managers, when asked, had refused to give any estimate, declaring “I don’t know”. It seems likely that they had realised they had no clue and rather than make a complete fool of themselves, they opted not to say anything.

Granted, when John and Bill finally asked the brave ones who dared to give an answer to express their unit’s error rate not in terms of the illustrious “sigma” but in the plain human terms of “what percentage of products have errors?” they did a lot better: almost 7 out of 10 managers managed to give an answer which was less than 50% off the mark.

Of course these people are not all fools. They are usually smart, well-trained and hard-working. It is just that they have no clue about the numbers describing their own business – and managers usually don’t. We spend a lot of time, money, effort and attention quantifying all sorts of aspects of our organisations but, at the end of the day, make decisions ignoring all these numbers, using our experience, qualitative assessment and gut instinct.

And that’s probably for the better; if we’d base decisions on our (alleged) knowledge of the numbers, we’d be prone to not only shoot ourselves in the foot, but also in the chin, the head, the back-side and the bodily parts of several of our neighbours.

Wednesday, 20 February 2008

Sirens and investment bankers – two of a kind?

Some time ago, I was interviewing a CEO of a FTSE100 company, which had acquired several dozens of companies over the past years, when we came to speak about investment bankers. He then asked me “do you know who the Sirens were, in Greek mythology?” I said “yes” (because I did and, of course, also because I did not want to appear ignorant).

Sirens were beautiful maidens located on a small island surrounded by cliffs and rocks. They would lure seamen who sailed near the island with their enchanting singing, to shipwreck to death onto the rocks.

“Well” this CEO continued, “investment bankers are just like Sirens”. That caught my attention…

“How’s that?” I asked. “They constantly try to seduce you into doing another deal, and they don’t care at all whether that deal actually make sense for the company”. Ok…

Of course, firms and their shareholders are not the only parties potentially benefiting from a transaction. A vast industry exists that initiates, values, negotiates, and closes deals. However, the interests of such parties, for instance investment bankers, may not always be aligned with those of the firm. Especially when M&A times are relatively slow, investment bankers may attempt to initiate deals from which it is not clear that they are to the benefit of the potential acquirer.

As an ex-investment banker told me some time ago, “when times were slow, we’d all go through our address books and discuss ‘who hasn’t done a deal for a long time’, because we would usually be able to talk such a person into doing one”.

Yet, one could make a good argument that investment bankers are not necessarily to blame for this; they are supposed to follow their interests and it is up to the manager to say “no” to a proposed transaction.

Yet, deals – and investment bankers – can be seductive. Sometimes, CEOs who are inclined to at least listen to their investment bank would do well to do like Odysseus; Odysseus wanted to hear the mythical Sirens sing but was less keen on shipwrecking. So he asked his sailors to plug their ears with beeswax and to tie him firmly to the ship’s mast. They then sailed past the Sirens; Odysseus was overwhelmed by their music but, being restrained, could not free himself to follow his urges and run his ship onto the rocks.

All we need now are boards with beeswax and offices with a mast. I will bring the rope.

Monday, 18 February 2008

Right again! – managers and their self-fulfilling prophecies

Ok, I realise I might have given the impression to be slightly sceptical about the mental abilities of top managers of late. But that’s a faulty impression, honest! I am merely trying to point out that they, too, are only human.

Or, let’s say, near human (just like business school professors and other suspected mutations of the human genome) because the following academic study yet again did not quench but just fuelled my scepticism.

My former colleague at the London Business School, Olav Sorenson (now at the University of Toronto), together with his colleague David Waguespack, examined distributors in the US film industry. Distributors have certain pre-conceived ideas about what films will be a success at the box office – for instance, the number of stars in the film, the actors’ prior successes, previous experience of the production team, etc.

When Sorenson and Waguespack analysed data on over 5000 movies, they discovered that these distributors seemed correct in their beliefs; films that corresponded to their prior beliefs indeed reaped more revenues at the box office.

Yet, then Sorenson and Waguespack did a clever thing; they also analysed the scarce resources that these distributors assigned to their films, such as budget, promotion efforts, number of screens on opening day, favourable timing in the year (e.g. around Christmas many more people go to the cinema). What they found was striking: The reason why those films that the executives had high hopes for beforehand indeed did become successes could 100 percent be explained by the fact that the distributors in their subsequent allocation of resources very significantly favoured them.

When Sorenson and Waguespack, in their statistical analysis, corrected for the fact that distributors assigned so much of their scarce resources to those films, it turned out that the executives' assessments were completely wrong; those films usually did comparatively worse at the box office! The only reason why the films that they beforehand had thought would become successes indeed did reap "profits" is because they assigned more resources to them. Yet, they would have been better off assigning the scarce resources to the other movies. The executives' prior beliefs were false; they just seemed correct afterwards due to their own, self-confirming actions.

Do such self-fulfilling prophecies only exist in silly Hollywood? My guess is not. Self-confirming dynamics are abound everywhere. Human beings develop prior beliefs about what will work and what won’t, and subsequently (unconsciously) work hard to make sure they’re right. And, really, top managers are often almost human.

Wednesday, 13 February 2008

Customers…? Ah, forget about them

Some time ago, for an ongoing project about “organising for innovation”, I interviewed a guy called Farooq Chaudhry; a founder and producer of the Akram Khan Dance Company. The Akram Khan Company is a small but extremely innovative (and extremely successful…) company which focuses on creating contemporary dance.

Farooq had several interesting things to say about creating an organisation that excels in delivering continuing, successful innovation. One of them, that stuck to my mind, was “In order to be truly innovative, you have to forget about your customer”.

What?! I don’t know much about Marketing (and would prefer to keep it that way), but don’t these people always go on and on about “customer-focus”, “client-driven innovation”, “the customer always comes first”, and so on?

So I tried, “Farooq, do you perhaps mean that you should only have the customer in the back of your mind?” “No, no, I mean, customers – just forget about them altogether”. Ok…

What (on earth) did Farooq Chaudhry mean – after all, this is one of the most innovative companies of their kind, since… well, like ever?

According to him, if you want to be truly innovative, you have to purposely not try to give the customer what he wants. Because, as he argued, if you set out to develop what you think the customer will like, you end up satisfying existing needs and tastes; you follow the customer, rather than that you lead him. True innovation, according to him, is about changing the tastes of customers, and giving them something that they have never seen or even imagined before.

Sunday, 10 February 2008

Getting lucky – fortune favours the prepared firm

Ok, let me tell you one more story. Once upon a time there was a plumber, called Geoffrey Ward, who lived in London. One day a local government official told him he would have to vacate his workshop and office because it was located in an area reserved as a retail zone.

Geoffrey decided to place an old, slightly exotic-looking, artistically shaped radiator, which he had removed for a client because it was broken, in the window of his workshop, just to make it look like a shop. Yet, in the following days and weeks, people kept knocking on this door asking whether they could buy that funny-shaped radiator. Not for long, Geoffrey realised that he could have made quite a lot of money had he been able to sell such a “designer radiator” and decided to change profession. This was how the company Bisque, who produce and distribute designer radiators, was founded.

Luck you say? Of course but, as said before, many people don’t take advantage of luck even when it is staring them into the face; Geoffrey did.

Andy Grove, former CEO of Intel, called it “strategic recognition capacity”. He could have said “know it when you got lucky” (but I’m sure you agree that that wouldn’t have sounded as fancy). Intel, who of course became one of the most successful companies ever by producing microprocessors, also got lucky. In the early 1980s, they were working on microprocessors when they did not have a clue what they would be able to use them for.

They even made a list of potential applications – which had anything on it ranging from handheld calculators to lamp-posts. Yep, lamp-posts. What was not on it was: the computer. It was not until IBM kept persistently knocking on their door that they said “alright then, you can put our product in this thing you call a PC”.

Yet, was this all down to luck? Of course not, Andrew Grove and his partners recognised the opportunity when it came knocking on their door (in the shape of Big Blue’s rather sizeable fist). But there’s more to it.

“Fortune favours the prepared mind”, Louis Pasteur famously said. He got lucky several times, making important yet serendipitous discoveries (such as a rabies vaccine). Yet, it was not mere chance that it was Pasteur who made these discoveries: 1) he recognised opportunities that presented themselves to him, but 2) also had the skill, knowledge and ability to turn them into something useful. That required many years of careful practice and training.

Moreover, and importantly, he wasn’t sitting in his kitchen waiting for lucky events to fall into his scientific lap. He was actively experimenting with lots of things. Most of them were bogus; others not.

And that is what Intel did: running many experiments in the margin. Most of them failed and wasted money. But one sunny day, one of these experiments just might result into a thing called “microprocessors” and, believe me, you won’t shed a tear about all the other ones that failed.

Wednesday, 6 February 2008

“Time compression diseconomies” – too much, too fast

I started playing the cello when I was nine. And ever since, I have worried about time compression diseconomies. Yes really. I didn’t know they were called time compression diseconomies, but I did worry about them.

As a child, I used to have cello lessons on Saturday morning. I would play a certain piece in front of my teacher and then she would give me a new piece to practise for the next week.

Some weeks, I practised for half an hour on Sunday, then half an hour on Monday, the same on Tuesday, etc., so that when my next lesson would be up, I would have practised for a total of three hours (6 days; half an hour each). And I usually would be able to play the piece in front of my teacher reasonably well.

Some weeks, however, I did not practise on Sunday because I was out playing football. On Monday, I was at the Boy scouts, on Tuesday playing at a friend’s house, on Wednesday I forgot about it altogether, and so on. By the time it was Friday, I would realise, “oops, it’s my cello lesson tomorrow, and I haven’t practised at all yet…!”

What then I would usually do, is think, “I will just practise for three hours in a row now; that’s the same amount of time as half an hour each day for six days, and I am sure I will be fine”. But I never was.... It never worked. The noises coming out of my cello would be outright terrifying, reducing innocent passers-by to tears; with my teacher’s ears (and mine) hurting for hours after she'd hastily sent me away.

And I wondered, as a nine year old, how is that possible? Three hours is three hours, right? Why does this not work: three hours on Friday instead of half an hour each day for six days in a row?!

Of course, as adults, we realise that our brain needs rest in between practice sessions. It needs to recuperate before you can put new information and skills into it, and the periods of “inactivity” are just as important as the practice itself. Practice sessions are much less effective if you don’t have the slow periods in between them.

Yet, nowadays, examining corporate strategy, I see many firms who have set themselves ambitious growth targets fall into the same trap. In order to catch up with competitors, for instance, they enter new markets at double the speed, undertake twice as many acquisitions, or hire double the number of employees. But, unfortunately, it doesn’t work that way. Just like me practising the cello, organisations need rest and time in between growth spurts to recuperate, and digest the effort. Trying twice as hard does not mean you’ll get twice the benefits. There are limits to how fast you can grow, without starting to suffer from it.

We call this “time compression diseconomies” – a term cornered by professors Dierickx and Cool from INSEAD. When you, as an organisation, try to compress lots of effort and growth into a short period, it will not be as effective as when you spread it out over a longer period of time (which is why we call them “diseconomies”).

A large research project I undertook examining the growth strategies of 25 multinational companies showed exactly this: growing at a moderate yet steady pace increased profitability much more than did short outburst of rapid expansion. And, unlike the effect of my youthful cello efforts on my teacher’s auditive organs, these firms’ performance really was music to their shareholders’ ears.

Sunday, 3 February 2008

Toads and acquisitions – where does CEO “hubris” come from?

The famed investor, Warren Buffet, once said that many corporate acquirers think of themselves as beautiful princesses, sure that their kisses can turn toads into handsome princes. The acquirers pay substantial premiums over market value, believing that they can release the imprisoned princes. But, as Buffet said, “We’ve observed many kisses but very few miracles”.

Because, as you may know, when a firm acquires another company, it usually pays a rather hefty premium. That is, the firm pays quite a bit more for the company’s shares than the price it is trading at on the stock market before the take-over, just to be able to obtain a majority and hence a controlling stake.

According to academic research, this premium usually lies somewhere between a thoroughly whopping 50-70%, dependent on the industry, the size of the firm, etc.

The justification for paying such a significant premium is the idea that the acquiring firm will be able to get much more value out of the company than the seller does. As I’ve said before, the facts show that they’re usually wrong, but firms still do!

It gets interesting when you analyse who pays the biggest premiums. My former colleague at the London Business School, Mathew Hayward, now at the University of Colorado, together with his colleague Don Hambrick performed a slightly mischievous analysis. Because they figured that CEOs who are rather full of themselves would pay higher premiums – because they suffer from “hubris” and are more likely to overestimate their own ability to turn around “failing” companies – they counted the number of favourable articles that had appeared about them in the business press (such as the Financial Times, Business Week, etc.).

Subsequently they computed whether CEOs who had received more media praise paid more for their acquisitions. The answer was: absolutely YES!!

To be precise, each highly favourable article about a company’s CEO would increase the premium paid with no less 4.8%. For an acquisition of a billion, this would be 48 million… And that is for every article!

And this really is 48 million down the drain, because Hayward and Hambrick also showed that CEOs with more favourable press were completely unable to create additional value out of those acquisitions. They had simply overestimated themselves.

It is tempting to blame these stupid, arrogant executives, and their silly companies and boards. However, what I find equally interesting is that this research also indicates where hubris comes from: It comes from us!

We glorify top managers, print their pictures in newspapers and magazines, praise their decisiveness and vision, give them awards and treat them like superstars. All they’re guilty of – the poor bastards – is believe the BS we write about them.