Wednesday, December 15, 2010

Strategic Planning Analogy #368: Managing Losses

Once upon a time, there was a man named Bill who liked to bet on horse races. After years of experimenting on ways to beat the odds at the race track, Bill finally found a way to assure that he would always make the winning bet.

His solution? Place a bet on every horse in every race. That way, no matter which horse won the race, Bill was 100% guaranteed to have placed a bet on it.

There was a slight drawback to this system, however. In addition to a 100% guarantee that he would have a bet on every horse that won, this system had a 100% guarantee that Bill would have a bet on every horse which lost. As it turns out, the losses on the losing bets were greater than the winnings on the winning bets. The system left Bill bankrupt.

Bill loved to boast that his system always picked the winners, but the boasts didn’t impress his friends after they learned this system was also path to bankruptcy.

In horse racing, only a small handful of horses win on any given day (only one per race). The vast majority of the horses end up being losers. Therefore, if you bet on every horse, you will end up losing your money, even though a few of the bets will be for winners.

Although Bill’s system is obviously a foolish way to bet on horses, it is not that different from the way many companies bet on their future. Many companies like to make lots of bets on lots of future growth projects, be that in R&D research, new product offerings, acquisitions, brand extensions, and other such investments.

And just as most horses fail to win their races, most new products, acquisitions, brand extensions, and R&D research fail to make a profitable return on investment. Sure, a few of the bets in these areas will produce winners. However, the losses on all the other bad investments can be so high that they wipe out the profits on the few winners. Worse yet, because so much money was poured into the losing bets, there is not enough money left to fully optimize the potential of the few winners. The potential winners become starved for lack of resources.

Yes, if a company bets on everything, they can boast like Bill that they have created some winners. However, if all the bad bets destroy the company (or destroy the ability to optimize the potential on the winners), then it is a rather hollow boast.

The principle here is that since most of a business’ strategic activities deal with failure, the strategic process should have a rigorous way to minimize the negative impact of failure.

Living With Failure
What do I mean when I say “most of a business’ strategic activities deal with failure”? Well, strategies are typically about finding and implementing the changes needed to reach a larger and more prosperous future. Many of the tactics used to create that change are associated with activities like those mentioned earlier:

a) Mergers and Acquisitions
b) Research and Development
c) New Product Introductions
c) Brand Extensions
d) Reaching out to New Customer Bases
e) Innovation Activities

Lots of studies have been done which measure the failure rates for these types of activities. Depending upon the research, the failure rates tend to be somewhere in the 75% to 95% range. In other words, the key tactics used in strategy usually fail.

The strategic path is a path dominated by opportunities to create negative returns on investment. It naturally comes with the territory, since most opportunities fail. The only way to avoid running into failures is by deciding to do nothing. But just as betting on every horse leads to destruction, betting on no horses will not lead to success, either. So we need to get comfortable living in a world where we use tools which usually fail.

Therefore, the strategic process needs to find a way to minimize the impact of inevitable failure while a company tries to find and nurture the few opportunities out there for success.

Learning From Research
Fortunately, recent research lends some insight into how to do this. My good friends at the Corporate Executive Board have been studying the characteristics of “elite” companies. These are defined as companies which performed above their industry median in both EBITDA margin and growth rates between 1995 and 2008. In other words, these companies successfully managed both the top line and the bottom line over an extended period of time and different parts of an economic cycle.

Starting with a list of more than 1,500 firms, they determined that there were 143 elite companies (less than 10% of the total). The Corporate Executive Board discovered a lot about these elite firms—more than we can comment on here. There was a good summary of some of their findings recently at Right now, we will focus on what they learned about how to succeed while living in a world of failure.

In general, we can learn two things.

1) Time Your Bets
The return on investment is a ratio. The return is the numerator and the denominator is the investment. Elite companies have found a way to optimize the numerator and the denominator by timing their activities relative to the business cycle.

The timing is as follows—buy at the bottom of the cycle (when the denominator is lowest) and sell at the top of the cycle (when the numerator is highest). This process will get you reasonable returns on even weak investment opportunities. And the losers will be less of a loss.

Yes, I know it can sound like a cliché—buy low and sell high—but elite companies actively monitor business cycles and proactively try to make the cliché a reality. Their strategies take into account the context of where they are in the business cycle. They boldly buy when the rest of the world is selling and sell when the rest of the world is buying.

This process has the added benefit of improving cash flow. Buy selling high, the elite firms have more money to invest when prices are low. You can afford the risk of a few more failures when flush with cash and buying when the cost is the lowest.

2) Exit Quickly
Instead of being like Bill in the story who bet all the time on every horse, elite companies are also quick to cash out when failure appears inevitable. Patient money is used for the potential winners, but the funding quickly stops for the losers.

This is done in two ways. First, elite companies set up specific, measurable criteria for success prior to making an investment (early warning signs). If the criteria are not met in these early stages, funding stops.

Second, these companies actively monitor investment performance throughout the entire lifecycle of the investment. This has two benefits. On one hand, it lets the elite firm quickly know when an investment is turning into a failure (so that investment can stop). On the other hand, it lets the company learn what works and what doesn’t work, so that they can make more intelligent investments in the future (ones that are less likely to fail).

Since most strategic activities fail, managing failure is the key to strategic success. The idea is not to avoid failure completely, but to make sure the impact of failure is minimal. This can be done by building strategies around business lifecycles and by actively monitoring investment performance against predetermined criteria throughout the entire investment lifecycle.

Those who bet on horse races do not have the ability to cancel their bet halfway through the race, when they can obviously see the mistake in their original bet. Businesses, however, can back off from their bets if they see failure in the early running of the investment. When things look bad, cut your losses early.

No comments:

Post a Comment