Tuesday, 30 December 2008

Too much of a good thing

We know companies can grow too fast; it gets out of hand, they lose control and, eventually, the whole thing comes tumbling down. My favourite examples are still the ancient case of People Express in the 1980s (one of the first, and initially most successful low-cost airlines ever) and, a few years ago, Dutch retailer Ahold.

However, companies can also try too hard to grow. Hence, it is not that there’s too much growth; there’s no growth at all and that’s precisely because they are trying to hard! Let me explain.

Pretty much everyone attempts to grow. And when we look at different “strategies for growth” – that is, where can growth come from – we usually get presented a list of options: You can diversify, innovate, add new products to your portfolio; partnerships can help you grow, etc. Do these well, and the resulting factor will be growth.

However, what we are often inclined to overlook is that growth in and of itself is simply a lot of work. That is, even when just doing more of the same thing – without adding company partnerships, innovations or diversifying into adjacent businesses – growth taxes a firm’s management capacity. For example, you have to find and manage new customer relationships, add distribution capacity, recruit and train new people and business leaders, develop management systems for a larger organisation and workforce, etc. Growing a firm is a heck of lot of work.

Yet, the options to bring about further growth (innovations, partnerships, etc.) tax your management capacity too. Finding and maintaining new collaborations is a lot of work and requires much attention. So does managing the process of innovation, and developing and commercialising its output. Diversification, internationalization and acquisitions equally are a lot of work; you have to get to know new markets, products and customers; you have to work on integration and a newly formed organisational structure, manage increasingly complex management processes, etc. Doing all of it might just be too much of a good thing.

In a recent research project I evaluated the growth rate of firms in the Chinese pharmaceutical industry. This industry is turbulent and fast-changing, with a lot of entry and exit into the market. There are large potential pay-offs, but the ongoing changes in the country’s economy, population and medical system also make it unpredictable. It’s a market with lots of opportunity for growth, but also quite a brutal one in terms of the uncertainty of how to do this.

I measured to what extent firms in this industry engaged in various strategic vehicles aimed at fostering growth: Diversification into adjacent markets, innovation, establishing partnerships and adding new product lines to one’s portfolio. The results showed that, in isolation, each of these initiatives indeed stimulated growth; yet when used excessively or in combination they actually had a negative impact and hampered a firm’s growth prospects.

Hence, stop trying so hard! You might do better...

Tuesday, 23 December 2008

CEOs and their stock options… (oh please…)

Do you know why we so often remunerate CEOs through stock options? Because we do; that 40-50 percent of a CEO’s pay consists of stock options is nothing unusual.

Of course it is to tie a CEO’s pay more closely to the performance of the firm s/he is heading. Inherent in the design of CEO pay packages is the assumption – driven by what is known as “agency theory” – that if you simply put them on a fixed salary, they will be lazy, won’t take any risks and certainly won’t do a thing that will only show up in the company’s results years from now (and hence only benefit their successor). No, these CEO types really need some pay incentives closely tied to the long-term performance of their firms.*

So, we use stock options to tie their rewards to the long-term performance of the firm. However, that could also be done through other means (e.g. shares), right? Correct; we specifically use options to also make these CEO buggers more risk-seeking.

Say what?! (you might think) More risk-seeking? Is that really what we need?! Yes, this agency theory stuff, which determines how we design CEO pay packages, assumes that CEOs are more risk averse than shareholders typically would want them to be. Therefore, in order to stimulate them to take more risks, we reward them through options.*

But what sort of risk-taking does this really lead to? Because what agency theory has not really acknowledged and explored is that there are various types of risk. Some risks may be good; some are not so good… Are we sure these stock options lead to sensible risk-taking?

No I am not so sure. Also because two strategy professors actually measured this stuff: Gerry Sanders from Rice University and Don Hambrick from the Penn State University. They examined 950 American CEOs, their stock options and their risk taking behavior. They found that CEOs with many stock options made much bigger bets; for instance, they would do more and larger acquisitions, bigger capital investments and higher R&D expenditures. That is, where CEOs with few stock options would prefer to invest $50m in a particular project, they would plunge in a $100m.

However, in addition, they would bet (that rather substantial amount of) money on things that had much higher variability. That is, if there was a project that could make them win or lose 20% of the sum invested and another project that could make them win or lose 50%, they would pick the latter; big bets with lots of variance.

Yet, I guess those could still be regarded “good risks”. Gerry and Don, however, also found something else: Option-loaded CEOs delivered significantly more big losses than big gains…! They would more often lose than win the big bets. Surely that is not something anyone would want.

And why is that? Well, through these stock options, you have created individuals at the helm of your firm who only care about upside, but can’t be bothered with the size of the downside; whether they lose 10 million or a 100 million, their stock options are worthless anyway.

And I guess that’s not something even the biggest risk-loving shareholder would applaud. Stock options lead to risk-seeking behaviour, but they’re not always the risks you’d like them to take.

* Although it always makes me wonder whether, even if these incentives would work fine, you would really want a person like that – someone who needs those type of incentives – to be heading up your firm, or whether you then shouldn’t look for someone who would also do the best they can if on a fixed salary...? But anyway; that’s besides my current point.

* Options – the right to buy the company’s shares at a pre-determined price – have large upside potential but very little downside risk; if by the time that the CEO can exercise the option the actual share price is £10 lower than what he can buy the share at, the option is worthless. Yet, it is equally worthless if the actual share price is £50 less. Worthless is worthless (no matter how far the share price has plummeted!). In contrast, if the actual share price is higher than the price at which he is allowed to buy, he makes money. If the share price is £10 higher, he makes 10; if the share price is £50 higher, he makes 50. Thus, stock options are thought to stimulate risk taking; the owner of the option has all the upside but very little downside.

Thursday, 18 December 2008

In a downturn, manage your revenues, not your costs

Here's a hypothesis:

In prosperous times, companies often fall victim to not being able to resist the many opportunities for growth that present themselves to them. In isolation, many initiatives with respect to new products, new markets or new customers look good but when pursued in combination they have a negative effect and hamper growth. Yet, wealthy firms find all these options difficult to resist precisely because in isolation they look so good. They have the funds to spare and therefore they are inclined to do too much of a good thing.

Andrew Grove, former CEO of Intel, understood this well. Their best-selling product – microprocessors – had endowed them with much cash to spare. However, he resisted temptations to spend it on other initiatives and entering adjacent businesses, telling his people “this is all a distraction; focus on job 1 [microprocessors]”. It made them one of the most successful companies ever.

In a down-turn, companies should look different

However, companies in distress – such as in a downturn – often do the reverse. In academic research, we call this the “threat-rigidity” effect. They focus on their core business, shedding all other things, doing more of what they did before, and which they consider their strongest points, while trying to reduce their cost base to weather the storm, till it all blows over and they can come out of hibernation.

By itself, minimising one’s cost base is never a bad idea (also in prosperous times!) but these companies forget one thing: You have to not only manage your costs; you also need to manage your revenues. And, what’s more, the composition of a revenue base in lean times will have to look different from its composition when times are good. Where in happy times firms are often seduced to spread out too much, while they would be better off focusing on job 1, in meagre times firms are often inclined to focus too much, when diversifying one’s revenue base makes more sense.

Accessing different pockets of revenue

So why does spreading one’s revenue base in meagre times make more sense? It is, among others, because no job will be big enough to sustain the whole firm. What keeps firms afloat is accessing a variety of smaller pockets of revenues. Hence, rather than focus on job 1, hoping it will be enough to sustain the firm, the company’s effort should be aimed at identifying and creating additional sources of revenue. In the downturn, none of these additional sources will be big enough by itself. Moreover, many of these sources would not be attractive in prosperous times, because the firm would not be able to make them grow. However, this is not a time of growth, but of survival.

A diversified revenue base will also reduce dependency and with it risk. In a downturn, the probability of individual sources drying up is large, so a firm can’t afford to be focused on just one or a few of them.

But will searching for additional sources of revenue not be costly? If will not be costless but, by definition, it should not be expensive. Paradoxically, firms should not be focused on winning any big accounts, major new products or customers; they should aim for many smaller ones. They are relatively cheap to access and often the firm will already have knowledge about them; they shunned them in the past considering them too small to advance at the time.

Concurrently, this strategy of exploring multiple smaller pockets of revenue will equip firms well for the economic dawn, which will inevitably come. Their diverse revenue base has laid the foundation for new sources of growth. The firm will be able to quickly benefit from the upheaval in the economy. Many of the smaller pockets of revenue will stay small – and the firm would do well to shed quite a few of them – but the newly formed strategic landscape will be conducive to different sources of revenue than before. Although you can’t tell beforehand which ones it will be, some of the small pockets of revenue will be the new stars on the firm’s firmament.

Monday, 15 December 2008

Mental models – let's all think within the same box

The illustrious former chairman of IBM, Thomas Watson, once said “Whenever an individual or a business decides that success has been attained, progress stops”. What he was speaking about was that successful firms find it very hard to change, for instance in response to changes in their business environment. (Unfortunately he is also the person who allegedly said “I think there is a world market for maybe five computers” so I would say “physician heal thyself”… but I guess that doesn’t make him wrong about the first bit!)

This rigidity-due-to-success effect is partly a mental thing. Once something has brought us much success for a sustained period of time, we sort of forget that there are other ways of doing things. It may even be so bad that we don’t spot the changes in our business environment at all anymore. However, let’s not make the mistake to think that such strong mental models of how we go about doing our business are all bad. They also bring some pretty strong advantages. Consider the following:

Aoccdrnig to rscheearch at an Elingsh uinervtisy, it deosn't mttaer in waht oredr the ltteers in a wrod are, the olny iprmoetnt tihng is taht the frist and the lsat ltteer are at the rghit pclae. The rset can be a toatl mses and you can sitll raed it wouthit a porbelm. Tihs is bcuseae we do not raed ervey lteter by itslef but the wrod as a wlohe.

All of the above is clearly nonsense; they’re not words at all, it is just gibberish. But something makes us able to read it without a problem; that’s because all the right pieces of information are there (all the letters) and roughly in the right shape. Plus, the context (the sentence) makes sense to us. Then, our brain does the rest. We can perfectly understand it precisely because we have seen the individual elements (the words) before and understand the context.

It is the same in business situations; we can quickly grasp and interpret a particular issue if we understand the context and have seen similar problems and situations before. We don’t have to reinvent the wheel every time we see a similar problem but can build on our experience.

Thus, forming mental models is how we learn; they enable us to make quick decisions without the need for complete information. This is a powerful thing to have for every organisation. You don’t want all people thinking out of the box all the time; a coherent group of like-minded people with lots of common experience can be a very useful asset indeed.

The negative effects of common mental models – blindness to changes and viewpoints that don’t fit the model; something known as “groupthink” – you can possibly overcome through smart organisational design. For example, I’ve seen large organisations that created multiple similar sub-units; each of them very coherent, but also very different from each other. They attempt to get the best of both worlds: coherence within units; diversity between them.

Hence, groupthink can be a good thing, as long as you make sure to have multiple groups…

Wednesday, 10 December 2008

“Framing contests”: What really happens in strategy-making meetings

One of the first series of strategy-making meetings I ever attended was in a large newspaper company. I was basically a fly on the wall, watching the process unfold with the mixture of curiosity, puzzlement and amazement, like a Martian watching a cricket game (or so I imagine).

It quickly struck me that there seemed to be a number of pre-formed sub-groups, with their own opinion and agenda. You had the people who wanted to take the company public, those who thought they should diversify into other areas of business, those who thought they should become a “green company”, and so on, and those who thought they shouldn’t care out of a matter of principle.

Of course there were some political motives at play but mostly these people seemed genuinely convinced that their opinion was what was best for the future of the company. And, rather than coming up with new ideas, the strategy meetings seemed to consist of the various people trying to convince each other of their view of the company, its future and the changes required.

Many years later, I read the PhD dissertation work of Sarah Kaplan, a former McKinsey consultant turned Professor at the Wharton Business School. Sarah described such strategy-meetings as “framing contests”. Framing contests, she said, concern “the way actors attempt to transform their personal cognitive frames into predominant collective frames through a series of interactions in the organization”. And although I had to read that sentence a couple of times (before I endeavoured to even begin to believe that I had any clue what the heck she was talking about) it gradually struck me as quite accurate.

In strategy meetings, people try to convince each other by painting a mental image of the future; what would happen if they’d continue as is, and what could happen if they’d follow the course of action proposed by them. They might throw in some numbers based on “research” (put together long after they had made up their mind), and engage in spirited debate, complete with raised voices, rolling eyes and the occasional hand gesture.

And you would win the contest if, through a series of debates, you managed to convince others and get your view of the company and its future adopted as the dominant frame, defining how the organisation sees itself and what it is trying to achieve in the market.

And this may not be a bad way of doing things. I saw the same process unfold – quite successfully – in model train maker Hornby, where the debate centred on divesting, diversifying, investing more or outsourcing production to China (the latter faction won). Similarly, it famously led Intel, over the course of several years, to abandon its memory business in favour of microprocessors.

Former Intel chief executive Andy Grove said about this: “The faction representing the x86 microprocessor business won the debate even though the 386 had not yet become the big revenue generator that it eventually would become”.

Stanford professor Robert Burgelman (who spent a life-time studying Intel), wrote about this same episode: “Some managers sensed that the existing organizational strategy was no longer adequate and that there were competing views about what the new organizational strategy should be. Top management as a group, it seems, was watching how the organization sorted out the conflicting views.”

Later, Andy Grove concurred that that is what happened, and quite deliberately so: “You dance around it a bit, until a wider and wider group in the company becomes clear about it. That’s why continued argument is important. Intel is a very open system. No one is ever told to shut up, but you are asked to come up with better arguments”.

So next time you find yourself debating your company’s strategy and future, realise you’re in a framing contest. Your powers of persuasion will only be as good as your mental imagery.

Sunday, 7 December 2008

Spinning clients – the McKinsey effect

Some time ago I was having lunch with three McKinsey consultants and they started talking about how different all the people in their organisation were. I was watching them during this conversation and couldn’t help but notice that they even looked alike... They spoke alike, dressed alike and, clearly, thought alike. What seem like huge differences within a group may be miniscule (or even non-existent) if you’re an outsider looking in.

It actually reminded me of a scene in Monty Python’s “Life of Brian”, in which Brian looks out of his window and sees this huge crowd gathered in front of his house waiting for him to speak. And he shouts “you are all different!” After which they dutifully reply in chorus “yes, we are all different”.

[Brian] “You are all individuals!” [Chorus] “Yes! We are all individuals!”
(I particularly like the guy who subsequently says “I’m not”...)

Anyway, McKinsey, like many highly successful individuals and organisations – my great colleague Professor Dominic Houlder tends to call them the most successful religious order since the Jesuits – attracts scorn and admiration in equal measure. And I too believe they do many things right. One of them is that although the average person only stays with McKinsey for barely three years, when you join, you pretty much become a McKinsey person for life. If you "leave", you become an alumnus.

And that is a great feeling to foster if you, as an organisation, lose most of your employees to your customers. Because those people become great advocates for The Firm. McKinsey, for instance, proudly showcases them as alumni (although they have been able to keep remarkably quiet the fact that Enron’s Jeff Skilling was among their most high-rising offspring…). Importantly, what do these alumni do, as soon as they start to work in the real world? Yep, they hire McKinsey consultants…

And these type of beneficial effects do not only accrue to McKinsey; mere mortal organisations can reap them too. Professors Deepak Somaya, Ian Williamson and Natalia Lorinkova, for example, examined the movement of patent attorneys between 123 US law firms and 109 Fortune 500 companies from a variety of industries. Indeed, they found that if one of those Fortune 500 firms recruited a patent attorney from a law firm, subsequently that law firm would start to get significantly more business from that company. And I am sure it works that way for many other types of companies too.

In addition, by the way, Deepak, Ian and Natalia also found the reverse: if the law firm would hire a person from one of the Fortune 500 firms, the business it received from that company tended to go up too! Moreover, if the law firm would poach an attorney from one of its competitors, it would see business go up from the companies that were on the books of that attorney’s previous employer. Apparently, customers often follow a job-hopping attorney to his new law firm.

Therefore, like McKinsey, perhaps you shouldn't be too frightened of people moving. You want to hire people from your competitors and your clients, but you may also want your clients to hire yours. Rather than vilify them for leaving and cut all strings, keep them on the books as alumni, and actively cultivate relationships with them, in the form of clubs, Christmas cards and summer-evening barbeques if necessary! The only thing you don’t want is for your people to move to your competitors… They too may take business with them.

Hence, people will move; if they do, just make sure it is to a (potential) client – that’s the McKinsey way. And, of course, make sure to keep it quiet if they mess it up over there (like alumnus Skilling did at Enron) – that’s also the McKinsey way.

Tuesday, 2 December 2008

Tunnel vision – “in the end, there is only flux”

“Tunnel vision is caused by an optic fungus that multiplies when the brain is less energetic than the ego. It is complicated by exposure to politics. When a good idea is run through the filters and compressors of ordinary tunnel vision, it not only comes out reduced in scale and value but in its new dogmatic configuration produces effects the opposite of those for which it originally was intended.” Tom Robbins, in “Still Life with Woodpecker”.

We know, from running statistics on the performance of companies over time, that especially very successful firms have trouble staying successful, and adapt to changing industry conditions. We call this the “success trap”, “competency traps” or the “Icarus paradox” in business.

But where does it come from? What is causing it? There are various parts to the explanation but one of them pertains to how the top managers of those very successful companies perceive the changes in their business environment.

Research by professors Allen Amason from the University of Georgia and Ann Mooney from the Stevens Institute of Technology, for example, showed that CEOs from firms with relatively high performance were significantly more likely to interpret changes in their business environment as a threat than the CEOs of poorly performing companies, who more often interpreted the changes as a positive thing.

And this is understandable. If you are the top performer in your industry, any change looks like a threat, because things can only get worse; you like things just the way they are, thank you very much! In contrast, if you currently look like a sucker because you're the CEO of a company that is not performing very well at all in comparison to your peers, any change is welcome. It represents an opportunity for things to be altered, and your only way is up.

Allan and Ann also showed that, as a consequence, the top managers of the high performing companies were much less comprehensive in formulating a response to the strategic change; they didn’t spend much time evaluating potential alternative courses of action, they didn’t do much research and analysis, and they sure as hell didn’t seek any outside help or opinion.

Most likely, executives in such a situation are going to try to continue as is, resist the change or minimise its impact. However, if the environmental change is profound, ignoring it is likely not going to work! And this is a problem of all times. In the 1970s, The Swiss watch industry, which was superb at making mechanical watches, invented the quartz watch but they didn’t do anything with it. And when companies from Hong Kong and Japan flooded the market with cheap quartz watches they denied the relevance of the change till they had a near-death experience. Around the same time, tyre maker Firestone responded to the introduction of radial technology by trying to beef up its production of bias tyres (they had a genuine death experience). More recently, traditional newspaper companies fought news-reporting on the internet by suing dot-coms and naively copying and pasting their own paper on a website, while Kodak for a long time tried to ignore digital photography mourning its spectacular margins on photo-film.

I guess you could call it old-fashioned tunnel vision. When your company is hugely successful, you don’t want to see that the world is changing. And if you then, eventually, are forced to incorporate the new technology (or whatever it is that is rocking your world), you try to squeeze it into your own version of reality, rather than accept that reality has changed. But reality is that one day the likes of industry dominants like Google, Intel, or Microsoft will go down. Because as Heraclitus already said some five centuries BC: “In the end, there is only flux, everything gives way”.