No, we should not stop saying that the market is efficient. We should stop saying that, because the market is efficient, the most efficient firms prevail. Because they do not. And that is because there are always multiple markets going on at the same time.
Take a firm in any market of your choice, and then consider this firm’s internal labor market. It often is a very competitive race who is going to be the CEO of the company. Yet, the characteristics that make a person more likely to win this race do not necessarily make him or her a good person to lead the company. Let me explain.
An interesting line of research in social anthropology analyzed what type of person is more likely to rise through the ranks to become the headman of a tribe. Often, this would be the most fierce, ambitious and aggressive warrior, who would be willing to take on all his opponents in the quest for leadership. Yet, interestingly, although characteristics such as fierceness and ambition would be helpful in becoming tribe leader, these characteristics were not necessarily positive for the future of the settlement, since these type of leaders were prone to take the tribe to war. This would ultimately take its toll on the size, strength and survival chances of the tribe. Thus, the same characteristics that would make people more likely to become the headman were likely to get the tribe in to trouble.
CEOs might not be all that different. Those people who are ambitious, risk-seeking and aggressive enough to be able to rise to the ultimate spot of CEO, just might be the same people who, once they’re there, take their firm on a conquest. Take acquisitions. They often offer the thrill of the chase. You select a target, mobilize resources and lead the attack. Sometimes there are others eyeing your prey but skilful maneuvering and a fierce battle will make you come out victorious again. And another victory means pictures in the newspapers, popping champagne, and a larger tribe to rule and command.
Yet, we have seen many firms going on an acquisition spree, inspired by their ambitious new CEO, who not for long went down in a blaze without much glory. The aggressiveness, boldness, and risk-taking behavior of the person at the helm had brought him or her to that position, but it didn’t translate well into a sensible corporate strategy.
Markets are in some form or another efficient, whether they are internal labor markets or markets for corporate control. But they may not be aligned, and victory in one may very well lead to defeat in another.
Thursday, 25 June 2009
Should we stop saying that the market is efficient?
Can we please stop saying that the market is efficient?
The economist Jovanovic wrote, about a quarter of a century ago, “efficient firms grow and survive; inefficient firms decline and fail”. What he meant is that the market is Darwinian; it will rule out the least efficient firms, with habits and practices that make them perform comparatively badly, and it will make sure efficient firms prosper, so that only good business practices prevail.
Yeah right.
When you look around you, in the world of business, one sometimes can’t help wonder where Darwin went wrong… How come we see so many firms that drive us up the wall, how come we see silly business practices persist (excessive risk taking, dubious governance mechanisms, corporate sexism, grey suits and ties to name an eclectic few), and how come so many – sometimes well-educated and intelligent – people continue to have an almost unshakable belief that the market really is efficient, and that it will make the best firms prevail if you just give it time?
That’s because the logic is not entirely wrong. The market is Darwinian, and the firms with the highest level of “fitness” are the ones most likely to prevail. However, our Darwinian view of business is also so incomplete and simplistic that I am unsure whether it would make Mister Charles Robert Darwin cringe, burst out laughing, or pull the hairs from his famously bulging beard in agony. Darwinian mechanisms – or market mechanisms if you prefer – namely work at different levels. And sometimes they conflict. Let me explain.
Some business practices, like the ones mentioned above, will actually reduce the fitness levels of the firms that adopt them, and make them less efficient, yet they persist. That’s because these practices have a fitness level of their own. They survive just like viruses survive among humans. The flu kills many thousands of people every year, and at first glance it seems a slightly flawed strategy of this virus to kill one’s host, yet it persists. Why is that? That’s because it spreads quicker than it kills. It doesn’t matter much, for a virus, that it reduces the fitness of its host, as long as it jumps to someone else before the host snuffs it! And in a way that is what bad business practices do too. They spread easily and kill slowly and stealthily.
Moreover, the flu doesn’t kill everybody that gets it; it often just makes them perform worse. And that is what bad practices do too. Just like an extremely lethal virus dies out – because it kills its host before it can spread – terrible business practices also never quite see the light of day. It is these stealthy, annoying, nasty, creepy, sneaky, and irritating, pains-in-all-sorts-of-bodyparts practices that tend to persist. They don’t kill instantly, but gradually wear a firm down.
And there is another advantage to that – for the practice that is. Firms don’t quite know that the practice is bad. Very bad practices are easy to spot, so nobody adopts them, but not these ones! They’re like a sneaky virus – you catch it before you realize it, and the negative effects only become apparent in the long run.
An example you say? Well, take ISO9000 and apply it in a very innovative industry. Research – by professors Benner from Wharton and Tushman from the Harvard Business School – has shown that ISO9000, in the long run, can have a severe negative impact on a firm because it hampers innovation. Yet, the short-term benefits are clear; adopting ISO9000 often comes with some good reputational effects, an immediate increase in customers, and satisfied stakeholders. However, the negative effect on innovation, in the long run, may outweigh all of this.
Nevertheless, firms adopt the practice because they do see the short-term benefits, but are quite unaware of the long run detrimental stuff. To managers in charge of improving their firms’ performance now, the practice seems attractive because they noticed that companies in other industries (perhaps not so reliant on innovation) benefited greatly at the time they adopted it, many of the firm’s competitors are currently adopting it, and they all see a surge in customer applications too! Of course it looks attractive!
Moreover, once we start to suffer from a shortage of internal innovation, many years will have passed, and no-one quite realizes that the creeping troubles were originally triggered by the adoption of the ISO9000 practice a long time ago. The practice gets adopted by many many firms and continues to persist, despite the fact that everybody would be better off without it.
The same may very well be true for quite a few of our popular governance mechanisms, the practice of excessive risk taking as we saw it in investment banking, many forms of performance management systems, and certainly for corporate sexisms, and pin-striped suits with purple ties on hot summer afternoon. It is not that Darwin is wrong – and the mechanisms he discovered do not rule our markets – it is just that they’re just as difficult to shake off as a common cold. And that they are just as annoying.
Is Your Company Brave Enough to Survive?
Wednesday, 24 June 2009
CEOs seek external advice – if you pay them for it…
There is ongoing debate whether performance related pay for top managers – in the form of stock ownership, options, or other types of financial incentives – actually works. We know it alters their behavior but does it improve it?
I’ve quoted some of the research in this area before but, in a way, whether or not it does, it remains a bit strange that top managers would need performance related pay. As I have said before, do you really want someone at the helm of your company if he or she only works hard and smart if they are directly rewarded for it? On the other hand, I have to admit, no matter how rhetorical this question is intended, I do guess it is only human…
It is only human that our behavior is altered due to performance related pay; and you and I are probably no exception. The trick then, of course, is to get the right measurement system, and perhaps to no overdo it; too much performance related pay may alter the behavior of top executives in ways you had not quite in mind when putting the measures in place! We’ve seen ample examples of that over recent years…
So, how might it bias top executives behavior in useful ways? Professors Michael McDonald from the University of Central Florida, Poonam Khanna from Arizona State University, and Jim Westphal from the University of Michigan examined an intriguing aspect of CEO behavior, and that is their inclination to seek advice from others.
CEOs often seek advice on strategic issues from executives of other firms. However, we also know from research that – just like humans – they are often inclined to solicit that “advice” from friends and other people who are just like them. In such cases, it is not really genuine advice-seeking, but it serves more in a self-confirmatory fashion; people seek confirmation that what they are doing is right, and what better way to get that by asking the opinion of your friends and look-a-likes.
To examine which CEOs engage in this pseudo-advice seeking and which ones truly turn to people who might actually disagree with them, McDonald and his colleagues surveyed 225 large American industrial and service firms. They managed to obtain information on how often their CEOs sought the input of other top managers outside their own firm and how well acquainted they were to them. Subsequently, they statistically correlated that to the extent to which these top managers received performance-contingent compensation packages, and found a very clear result.
Those CEOs who had a very small performance-related pay component in their compensation package sought very little true external advice. They relied on asking their friends – and perhaps their wife, uncles, and mother – whether they too thought that what they were doing was great, splendid, and spot-on. I guess it helps people feel more confident and self-assured…
In contrast, CEOs with a relatively large performance-contingent component in their remuneration package much more often sought advice from other executives who were not their friends and who had different backgrounds than themselves. These people may be slightly scary (they may actually tell you that what you’re saying is nonsense!) but perhaps also more useful. Moreover, McDonald and colleagues showed that this true advice-seeking significantly helped the financial performance of the CEOs’ companies, in the form of an increase in the company’s market-to-book and return on assets. Thus, the scary stuff actually led to hard cash!
The pay-for-performance construction paid off; it stimulated executives to repress their “it’s-only-human” inclination to avoid asking people’s opinion who might actually disagree with you. It is much safer and more pleasant to make sure to solicit advice from people who will say that you’re splendid, but it is much more useful – and lucrative – to really put yourself to the test. And if you reward them for it, and only if you reward them for it, CEOs – just like humans – will actually be brave enough to take this test.
Who can downsize without detriment?
Downsizing has always been a rather popular practice in the corporate world – even for firms not in distress, attempting to boost their share price – but my guess is that, at present, executive courses such as “how to downsize your company” are the last remaining strongholds in many business schools’ executive course offering. So I thought I might as well look into what we know about the effects of such programs from academic research, to see when they can be a good idea.
Let me start by saying: not very often. On average, they simply don’t work. For example, professors James Guthrie, from the University of Kansas, and Deepak Datta, from the University of Texas at Arlington, examined data on 122 firms that had engaged in downsizing and statistically analyzed whether the program had improved their profitability. And the answer was a plain and simple “no”. The average company did not benefit from a downsizing effort, no matter what situation and industry they were in.
So why do they usually not work? Well, for starters, as you can imagine, it is not a great motivator for the survivors. Academic studies confirm that usually organizational commitment decreases after a downsizing program and, for example, voluntary turnover rates surge. Hence, downsizing is not something to be taken lightly, and should be avoided if at all possible.
But sometimes, of course, a company’s situation may have become so dire that it may not be at all possible. What then? Who might be able to get away with?
Professors Charlie Trevor and Anthony Nyberg from the University of Wisconsin-Madison decided to examine exactly this question, surveying several hundreds of companies in the US on their downsizing efforts, voluntary turnover rates, and HR practices. As expected, they too found that for most companies, voluntary turnover rates increased significantly after a downsizing program. Many of the survivors, earmarked to guide the company through its process of recovery, decided to call it a day after all and continue their employment somewhere else – a nasty and unexpected aftershock for many slimmed-down company; they became quite a bit leaner than intended!
Next, however, professors Trevor and Nyberg examined who could get away with a downsizing program or, put differently, what sort of companies did not suffer from such an unexpected surge in voluntary turnover after their downsizing program. And the answer was pretty clear:
Companies that had a history of harboring HR practices that were aimed at assuring procedural fairness and justice – such as having an ombudsman who is designated to address employee complaints; confidential hotlines for problem resolution; the existence of grievance or appeal processes for nonunion employees, etc. – did not see their turnover heighten after a downsizing effort. Apparently, remaining employees were confident that, in such a company, the downsizing effort had been fair and unavoidable.
Similarly, Trevor and Nyberg found that companies with paid sabbaticals, on-site childcare, defined benefit plans, and flexible or nonstandard arrival and departure times did much better in limiting the detrimental effects of a downsizing program. The surviving employees were more understanding of the company’s efforts, had higher commitment, or simply found the firm to good a place to desert!
In general, it shows downsizing can work, but only if you have always taken commitment to your people seriously. Instead, if your employees sense that you may be taking the issue rather lightly, they will vote with their feet. And you may end up losing rather more people than you had bargained for. Or as Fortune Magazine once observed, most firms that downsize, “rather than becoming lean and mean, often end up lean and lame”.
Stock options, CEO risk taking, and earnings manipulations
Any idea why we continue to reward top executives with stock options? We accept it, nowadays, as a given, but why do we have that practice in the first place?
You might say “because it constitutes performance-related pay; through them, you financially reward top managers for their achievements”. Fair enough. Because for many of us mortals our pay depends to some extent on our performance. However, do realize that for CEOs, for example, this component is often as high as eighty percent. Eighty percent! Do you know many people (employed in the same large corporations that these executives head) whose salary is eighty percent dependent on some measure of their achievements? Not many I suspect.
But, in theory, these large corporations that reward their top managers through stock are right – and I am saying “in theory” for a reason. This practice – of offering CEOs stock-based pay – is a recommendation straight out of something called “agency theory”. It is one of the few academic theories in management academia that has actually influenced the world of management practice. It is basically a theory that stems from economics. It says that you have to align the interests of the people managing the firm (top executives) with those of its shareholders, otherwise they will only do things that are in their own interest, will be inactive, lazy, or plain deceitful. Yep, these economists have an uplifting worldview. But that is why we have such a huge performance-related component in the pay of most top executives.
But are you really sure you want people like that managing your firm? People who will be lazy and only operate in their own interest if given a chance? Do you really want a CEO who really needs performance-related pay and who otherwise, if put on a fixed salary, wouldn’t do much and just hang about? In case you missed it, I intended this as a rhetorical question…
But anyway, we give them stock – and lots of it – to incentivize them. But the question still lingers: why stock OPTIONS? And that’s a story in itself.
Agency theory doesn’t only say that people will be lazy and deceitful if given a chance; it also says that managers are inherently risk-averse; much more risk-averse than shareholders would like them to be. And the theory prescribes that you should give them stock options, rather than stock, to stimulate them to take more risk.
More risk!? you might think. Do we really want CEOs of large corporations to take MORE risk?! Is it not, given recent events in the world of business, that we would like our top executives to be a little less risk taking for a change…? Ah, that’s what you might think now, but it is not what agency theory thinks, and it is not what the incentive structure of most public corporations nowadays is geared to do.
Because stock options do stimulate risk seeking behavior, as we know from academic research. Options, as you might know, represent a right to buy shares at a certain price at some fixed point in the future. If you are given the right to buy a share in company X for $100 in January 2010 and by then the share price of X is $120, you will have made 20 bucks. However, if the company’s share price by then has dropped to $90, your option is worthless; we say it is “out-of-the-money”: you’re not going to exercise your right to buy at 100 when the market price is merely 90.
In that situation, if the CEO of X has many stock options, it stimulates him to be very risk seeking. For example, if by August 2009 the share price is 90, he will be inclined to engage in risky “win or lose” moves. If the risk pays off and the share price rises well above a 100, the stock options will become worth a lot of money. However, if he loses, and the share price plummets even further, say to 60, no worries; it doesn’t matter. The stock options to buy at $100 were worthless anyway; whether the stock trades at 90 or at 60.
And, as said, research by for example Professors Gerry Sanders from Rice University and Don Hambrick from the Penn State University showed that these things work. 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
However, they also showed that they weren’t always very good bets… The option-loaded CEOs delivered significantly more big losses than big gains. That’s because they didn’t care much about the losses (their options were worthless anyway); all they were interested in were the potential gains.
Moreover, Professor Xiaomeng Zhang and colleagues, form the American University, examined the relationship between stock options and earnings manipulations; plain illegal behavior. They investigated 365 earnings manipulation cases and showed that CEOs with many “out-of-the-money” options were more likely to misrepresent their company’s financial results (and get caught doing it!).
Hence, even if as a board member or shareholder you’d want to stimulate your CEO to take more risks – and I guess that is a big IF – I am not so sure that stock options will get you the kind of risk you’re after…
When knowledge hurts
Over the last decade or so companies have been told till it was a nuisance that their knowledge is their ultimate (if not only) source of competitive advantage. They have been encouraged – by management gurus, academics, and ample management consultants alike – that they should invest in knowledge development, protect it, and makes sure it gets identified, codified, and even put on the balance sheet.
The advice was to carefully identify best practices and make sure that you have systems that help these practices to be shared throughout the organization. This way, you will make optimal use of the great good and surely a healthy return will follow – or so the preachers said.
Many companies responded, as advised, by setting up internal systems that could be used to store and access all sorts of documents, as well as systems to aid the identification of experts in the organization and ways to contact them for advice.
But have these knowledge management systems turned out to be as good as was promised to us? Well… let’s say that a few caveats have emerged.
Because what we sort of forgot in the torrent of knowledge euphoria is that this stuff can also come at a cost. The cost of actually finding it, for example, in the jungle of corporate databases, but also the cost that comes with the fact that re-using prior knowledge doesn’t necessarily make you very original. And that’s a problem, especially when you need to stand out from the crowd.
Professors Martine Haas from the Wharton School and Morten Hansen from INSEAD, for example, examined the use of internal knowledge systems by teams of consultants in one of the big four accountancy firms, trying to win sales bids. They measured to what extent these teams accessed electronic documents and how much they sought personal advice from other consultants in the firm. They figured that, surely, accessing more knowledge must be helpful, right?
But they proved themselves wrong; to their surprise they found that the more internal electronic databases were consulted by these teams the more likely they were to lose the bid! Likewise for seeking advise from colleagues. This effect was especially pronounced for very experienced teams. These guys were much better off relying on their own expertise than trying to tap into experiences by others, whether it was in the form of electronic stuff of external advice.
Haas and Hansen figured that the opportunity costs of accessing all this prior knowledge must be huge; big enough to offset any potential benefits. Searching through the plethora of documents and soliciting advice from colleagues actually withheld the teams from making substantial investments into putting together a truly original and suitable proposal.
Things were even worse in situations in which competing firms were simultaneously bidding for the same lead, and being able to differentiate yourself from these rivals became crucial. In these cases, utilizing prior knowledge seemed to lead teams to develop cookie-cutter solutions when being original and innovative was what was really needed. As a result, they lost the bid.
The only times that a team benefited a bit from accessing internal knowledge sources was when it concerned a very inexperienced team. In such instances, talking to a few internal experts improved their chances of putting together a winning proposal. However, the internal document databases were always useless at best. The more these rookies tried to tap into the mountain of electronic documents available to them, they worse their chances of coming up with the winning bid.
The advice to derive from this research? Shut down your expensive document databases; they tend to do more harm than good. They are a nuisance, impossible to navigate, and you can’t really store anything meaningful in them anyway, since real knowledge is quite impossible to put onto a piece of paper. Yet, do maintain your systems that help people identify and contact experts in your firm, because that sometimes can be helpful. But make sure to only give your rookies the password.
