Tuesday, September 27, 2011

Which Comes First—Goals or Strategies? (Part 2)

In the last blog, we looked at why it can be a mistake to set financial goals prior to setting the action strategy. More specifically, we saw that setting financial goals prior to setting a strategy can increase the risk of:

1) Setting the Wrong Goal (wrong metric and/or wrong level)
2) Taking the Wrong Actions (if the goal is inappropriate than it will lead to doing inappropriate actions)
3) Increasing Undesirable Risks (Unrealistic goals can lead to desperate behaviors)
4) Sacrificing the Long-term to hit Short-term Goals (Sub-optimal Trade-offs)
5) Perpetuating Failed Strategies (Rather than shutting them down)

In this blog, we will look at suggestions for reducing these risks.

Before moving on, I’d like to make a clarification. Thanks to some feedback, I realize that I may have given the false impression that I am against having goals. On the contrary, I like goals. I’m reminded of an old Pogo cartoon. Pogo and his buddy Albert are running through the woods as fast as they can. Pogo asks his buddy Albert if there is any particular destination they are running towards. Albert says no. So Pogo replies, “Then why are we running so fast?”

The idea is that if you have no idea of where you are going, there is no reason to run. Strategy is like that. Strategic planning is the task of finding the best path to a goal/mission/objective. If you do not know where you want to go, you cannot design a path to get there.

My concern is that most of the goals I see are merely financial numbers, like a goal for sales, profits, etc. These are not destinations, they are hoped for outcomes. They provide little to no insight into what the company must become to be successful.

These financial “destination-less” goals are the ones which lead to the five problems listed above (if they are set prior to setting the strategy). In this blog, we will look at alternatives.

Here are four suggestions for how to avoid these problems.

Suggestion #1: Set Non-Financial Goals
There is no law that says all goals need to be a financial number. Successful financials do not magically appear out of nowhere. No, they are typically an outcome of a combination of the following actions:

a) Owning the right position in the marketplace.
b) Maintaining/Strengthening the core competencies, capabilities and capacities needed to hold/strengthen a winning position.
c) Leveraging a winning position in the marketplace.
d) Having enough productivity in order to profitably afford to the position.

If good numbers depend on first achieving these types of actions, why not set up goals around these types of issues? For example, you could have a goal of achieving a particular position in the mind of the targeted customer. You can measure this goal via consumer research. Or, if your strategy is centered around quality, you can set a quality level goal (which can also be measured). If success requires international expansion, then set that as a measurable goal.

The point here is that there are a lot of ways to achieve a financial target. These approaches may or may not have any correlation to the desired strategic actions listed above. In fact, some of those approaches can disastrous to a strategy.

For example, I know an executive who hit his financial target by completely ignoring the strategic mandate to invest in a repositioning of his business. Instead of taking cash flow and putting it into repositioning, he let the money fall to the bottom line as near-term profits. He made a great bonus that year because he hit the financial target. Soon thereafter, however, the business was sold at a great loss, because the strategic repositioning never occurred. The business was destroyed, because the leader took the wrong path to achieve the near-term financial goal.

The point is that if you want that repositioning to occur, then make the repositioning the goal, not a financial number that can be achieved while ignoring the strategy. In other words, if you want certain strategic behaviors or conditions to occur, than make these behaviors and conditions the goal. The only way to ensure that the right actions get done is to set the goal around the action. Reward doing the right thing rather than hitting a financial goal the wrong way.

And, of course, you cannot set these types of behavior or condition goals until you have an understanding of the proper strategy. That is why strategy work needs to be done before setting the goal.

Suggestion #2: Separate Planning Cycle From the Budget Cycle
Many companies intermingle the timing of the planning cycle with the budgeting cycle. I think this is usually a mistake.

Budgets tend to be very financial in their focus and goal orientation. And this is not necessarily a bad thing. But by formulating strategy at the same time as budgets are set, one tends to end up with strategies which are often little more than a budget with a slightly longer time frame (a sort of 3-year budget). And this can be a bad thing, leading to all the problems mentioned earlier.

If you want people to think more strategically and create more strategic (less financial) long-term goals, it seems to work better if that process is not done simultaneously with annual budgeting. For example, if you do your budgeting in the fall, then do your primary strategy formulation in the spring. Not only does the separation allow for a better focus on strategy, it provides time between the two processes to understand the true ramifications of the strategy, so that strategy can better drive what is an appropriate budget.

Some of the intermingling is a result of placing strategic planning groups inside of finance or budgeting departments. Finance departments have a natural financial orientation, which can lead to goals that are too financial. If you want to reduce that bias, then you might want to consider taking strategic planning out of the finance group (if that is where it is today).

Suggestion #3: Just Don’t Do It
If setting a financial goal up front gets in the way of making great strategy later, then stop setting a financial goal first. It could be just that simple.

Suggestion #4: Add A Feedback Loop
If your company still insists on looking at financial goals first, then reply by insisting that the company also looks at these goals last. In other words, add a feedback loop to the end of the process to determine whether the original goal is still the most appropriate goal. If it isn’t, then reserve the right to change the goal at the end.

It may be that, after the strategic analysis, you conclude that some of your original assumptions during the goal-setting phase are no longer valid. Perhaps the best strategic path leads in a different direction from where your goal lies. If so, change the goal so that it fits your new reality.

Many companies use a strategic process where financial goals are set before the strategy is chosen. This approach increases the likelihood of bad results and missed opportunities. Four suggestions for reducing this problem are to:

a) Set Non-Financial Goals
b) Separate Planning Cycle From Budgeting Cycle.
c) Stop Setting Goals First
d) Add A Feedback Loop

Before running off to operate your business, be like Pogo and ask what the destination is. And don’t settle for a mere financial number. Ask for a real destination that is based on prior strategic analysis and rooted in specific activities.

Thursday, September 22, 2011

Strategic Planning Analogy #414: Which Comes First—Goals or Strategies?

Let’s assume that you want to race in the Olympics. Let’s further assume that they way you qualify for the Olympics is by agreeing (in writing) to guarantee achieving a specific time when you race (quick enough to win committee approval). And, if you fail to achieve that time, you will owe the Olympic Committee a large sum of money. Then, to make it even more interesting, the Olympic Committee does not tell you which type of race you will be competing in until after you commit to a specific time.

When making the time commitment, you do not know if the race is a short sprint or a long marathon. You don’t know if the race involves running, speed skating, swimming or bobsleds. Perhaps there are hurdles or other obstacles. Perhaps not.

It seems to me that committing to a race time before you knew what the race was would be an act of insanity. It’s a good thing the Olympics aren’t run that way.

Although the Olympics are not run that way, it seems that many businesses are run that way. When starting their strategic planning process, these companies begin with goal-setting. The goal could be a level of sales, or profits, or a percent return on investment, or a stock price. Setting these goals is a lot like setting the goal of the time you want to achieve in a race.

Then these companies get management to commit to hitting these goals, and tie their bonuses to achieving these goals.

It isn’t until all this is completed that these companies start looking for a strategy which can achieve that commitment. To me, choosing the strategy after committing to a goal is a lot like being told what race you are going to run after committing to a race time. It is often a process of foolhardiness. And, unfortunately, I think a lot of companies are on this foolish path.

The principle here is that long-term success is more likely to occur if goals are set after conceiving the strategy rather than before. In this blog we will look at some of the negative consequences of putting goals first. In the next blog we will look at some potential solutions to this problem.

When a company puts goal-setting ahead of strategy-forming they increase the likelihood of six bad outcomes.

Bad Outcome #1: The Wrong Goal is Set
Setting the goal before knowing what to do can lead to two types of improper goal setting. The first is choosing the wrong metrics. For example, at different stages of the lifecycle, different metrics may be more appropriate. Rapid sales growth targets may make more sense during the rapid growth phase but be inappropriate during the decline phase, when cost control may be a more appropriate metric. You cannot know what the most appropriate metric is until you understand the type of plan you are putting in place.

Even if the right metric is chosen, you might choose the wrong target level—too high or too low. How can you know what the appropriate target level is before you know what you are doing? Set it too low and you may miss opportunities (and reward too generously). Set it too high and you may encourage people to take on bad behavior (as we will see below).

Bad Outcome #2: The Wrong Actions Are Taken
People act based on how they are measured, so if you measure the wrong things, people will tend do the wrong things.

If the metric is inappropriate for the circumstances, it might force people to apply strategies consistent with the metric but wrong for the circumstance. For example, if a business has recently reached maturity but the goals are more appropriate for an earlier rapid growth stage, one might try to apply rapid growth strategies in order to try to reach the rapid growth goals. This could lead to investing in over capacity and money-losing sales strategies, in an attempt to try to achieve no-longer-realistic top line growth commitments.

Going back to the story, you might be best suited for running a marathon, but because you promised a quick race, you are forced to run a sprint. So instead of playing to your strengths—a place where you can win—you go with your weakness in a place where you will lose. Figure out the race you are most likely to win before committing to an outcome.

Bad Outcome #3: Undesirable Increase in Risks Are Taken
Many times, aggressive goals cannot be achieved by the core business. You end up with what is commonly called a “planning gap”—the difference between what the current strategy provides and what you want to achieve. The bigger the gap, the more one has to do to fill it. This can lead to taking on a lot more risks in order to fill the gap, such as diversifying further from one’s core or doing some hasty acquisitions.

We know most acquisitions fail, and if they are being done primarily to fill a gap rather than to fill a synergistic strategic need, the risk is even higher. In addition, so much focus could be placed on filling the gap that the eyes are taken off the core, increasing the risk of problems there as well.

Perhaps the only way to narrow the gap is to assume the best case scenario—everything has to go right. The best case scenario is rarely the most likely case scenario. As a result, your strategy takes on added risk for failure if you have to skew assumptions in order to make the strategy fit the goal.

Bad Outcome #4: Long-Term Prospects Are Destroyed
When the numbers come first, people’s priority is to try to hit those numbers—whichever way they can. There are lots of ways to hit a number, and a lot of those ways are destructive in the long run. To hit aggressive numbers in a short time span, one usually has to make trade-offs which hurt the long run. For example, to hit near term profits, future-oriented activities (like R&D or innovation) may get cut too much. To hit aggressive near-term sales, one may create costly promotions which merely steal away sales from the future. To hit near-term return on capital numbers, one may underinvest in long-term capital projects.

One of the first cases I had in business school was about a manager who made his numbers by cutting out all maintenance costs. Eventually, everything broke down and the long term costs of repair were much higher than those maintenance costs which were cut. This is an important lesson which can be lost if aggressive goals are put in place which can only be met by making bad trade-offs with the future.

A lot of Warren Buffet’s success is due to taking the long view. He knows that he will usually get more out of an investment if he manages it for the long term rather than a quick payback. But if goals come first, one can start managing for what’s best for the goals rather than managing for what’s best for the business. That usually means trouble for the long-term prospects.

Bad Outcome #5: Avoidable Failures Are Perpetuated
If you look at a business purely objectively, you might come to the conclusion that it should be shut down or sold. However, if you start with an inappropriate goal, you may be hesitant to retreat from the business, because you feel you need every bit of business possible in order to try to reach the target. For example, I worked with a company that had a business line which they probably should have gotten out of. They didn’t because they told me they “needed the sales” (even though they were unprofitable sales) in order to hit their sales growth targets. I had suggested a more profitable approach, but it produced fewer sales, so it was rejected. Instead, the failed approach was perpetuated.

If people commit to unrealistic goals, then they will not have a realistic way to achieve it. This inevitably leads to not achieving the goal. Disappointment and failure are the most likely result. All the stakeholders get angry. These “guaranteed” failures and disappointments could have been avoided if bad businesses were cut out sooner, and promises were made which had a high likelihood of success, because they were first grounded in doing the right things. If you choose the right strategy first, then you know which goals to promise, and then you can meet them.

Bad Outcome #6: New, Better Options Can Be Missed
If you don’t first have a strategy to help you set your goal, then often times the only thing you have to base the goal on is the past. And as we all know in strategy, the past is often not the best guide for what to do in the future. This backwards orientation (extrapolation of the past plus stretch), may keep us mentally oriented towards modified status quo strategies rather than new breakthrough strategies.

Breakthrough strategies typically come from starting with a clean slate, not extrapolations from the past (which at best, only gives you incrementalism).

In fact, by setting goals prior to setting strategy, management is in essence telling people that the old strategy is good enough. After all, how can you realistically set a future goal before considering strategic change unless you believe no meaningful change is necessary?

Many companies use a strategic process where goals are set before the strategy is chosen. This approach increases the likelihood of bad results and missed opportunities. Committing to a race time before you know what the race is sounds backwards. The same is true of setting numeric performance goals before you know what strategy will be performed. In the next blog we will look at ways to minimize this problem.

Setting the goals first sounds like wishful thinking. Last time I checked, you don’t automatically get what you wish for. I could wish I was taller or younger, but it isn’t going to happen. No, we should start first by optimizing what is in the realm of the possible and set our goals from there.

Tuesday, September 20, 2011

Strategic Planning Analogy #413: Should Strategists be Certified?

What if someone in the Middle Ages had decided that, henceforth, all artists would have to be certified? Under this scenario, only certified artists would be allowed to create art, and the art must be produced exactly in accordance with the accepted style and process found in the Middle Ages.

If this had happened, there would have been no artistic reformation and no modern art. In painting, there would be no Degas, no Monet, no Chagall, no Picasso, and so on. New media and new styles would have been banned—no photographic or digital art. The only music would be traditional classical music. No Rock and Roll, not even creative “classical” works by the likes of Stravinsky. Books would have to be hand written. There wouldn’t be much use for all those cool Apple products, because there couldn’t be much of any digital content. Not allowed, because it wasn’t certified.

Under this certification scenario, there would be a lot less artistic chaos…and a lot fewer artistic experiments gone bad. But think of all the great creativity which would be lost. It’s not a very good trade off.

Certification may be a good thing for accountants, but it’s not a very good idea for artists. And I don’t think it’s a very good idea for strategists, either.

From time to time, someone comes up with the idea of trying to certify strategic planning. I understand the motivation of wanting to eliminate bad strategic planning through certification. But certification implies that it is easy to identify what good strategic planning looks like and to codify a single way to do it for all situations.

That’s like saying that it is easy to identify what good art looks like and codify it, and freeze it for all situations. The quality of art is not based on a particular certifiable technique that can be codified. No, the quality of art is based on how the work of art impacts the emotions of the audience (something that cannot be codified). Similarly, the quality of a good strategic plan is not based on the technique, but how well the strategy is received in the marketplace.

There are three reasons why I believe that certification of strategic planning is a bad idea.

Reason #1: There is No Agreement on the Proper Approach to Strategic Planning
There are many different schools of thought on how to do strategy. In the book Strategy Safari by Mintzberg,Ahlstrand, and Lampel, the authors list 10 distinctively different schools of thought on strategy. These are not just small variations on a common theme. No, some of these approaches tend towards being exact opposites of each other. The approaches come from such wildly different perspectives that it sounds like they are all living on different planets.

For example, there are those in the positioning/deterministic camp which is very much a top-down approach. The idea is to first choose a position and then let the tactics follow by default. On the other extreme is the emergent approach where you look for tactical openings which then boil up into a position by default. This is a bottom’s up approach. I talked more about these approaches in an earlier blog. These approaches are so radically opposite that it would be difficult to certify both as correct, for to do one approach is to violate the principles of the other.

Depending on who is doing the certification, there will probably be a bias towards a small subset of the ten approaches (and a discounting of the rest). Otherwise, there would be no guiding principles to certify against. But which ones would you choose?

Strategic Safari also shows that each school of thought on its own has weaknesses. There is no one single best way. Good strategic planning should borrow from them all. This is starting to sound more like an art than a science. Artists are okay with lots of schools of thought. They see no reason to narrow the field to one way of doing things. And that’s why you cannot certify artists.

Can you imagine if accounting had all of these major variations in thought? How would you certify someone as a CPA if the profession had no agreed upon philosophy or approach? No, the CPA works, because there is enough unity in the profession to point to an agreed upon way to get things done. That does not exist in strategic planning, so you cannot apply what works in accounting to strategic planning.

The book Strategic Safari is dedicated to those "who are more interested in open fields than closed cages." Certification tends to close the cage, which is a mistake.

Reason #2: The Best Approach Varies Based on Circumstances
Another problem with certification is the tendency to standardize approaches—a sort of one-size-fits-all prescription. My experience, however, has taught me that different companies can have extremely different strategic needs. As a result, they require extremely different approaches.

For example, let’s consider two different firms. One is in a mature, capital intensive industry with high barriers to entry and exit. The other is a start-up in a rapidly growing new field without barriers to entry or exit. The situations are so different that the strategic concerns would be very different. Therefore, the optimal approach would probably be very different (I spoke about this in more detail in an earlier blog).

For example, the mature company should probably be most concerned with two strategic issues: optimizing the productivity of the core business and watching for activities on the fringe which would threaten the entire core industry. By contrast, the start-up should probably be most concerned with establishing a position, finding funding, and figuring out how to survive the oncoming industry consolidation.

The strategic planning process for the first firm would likely be more regimented and financially oriented. The process for the second firm would be more free flowing and perhaps more marketing oriented.

This isn’t a case of one approach being right and one being wrong. It is a case of which approach is more appropriate for the situation at hand.

There’s a reason why there is a different certification for doctors of humans and doctors of animals. Their patients are too different to make one process apply to both. We have a similar level of differences in the variety of business patients.

Reason #3: Strategic Success is Based on Differentiation, Not Conformity
One of the goals in certification is to create greater conformity in the practice of the profession. Normally, conformity for a profession sounds pretty good. After all, rogue accountants can get you into a lot of trouble. However, we have already seen that strategists cannot agree on what to conform to. Worse yet, conformity itself might be a disadvantage for strategists.

Think about those artists again. If I create one unique painting, it may be highly valuable. However, if you have a thousand artists are all forced to make copies of that painting, you render all those paintings as practically worthless. A great deal of the value in art is the very fact that each piece is unique. Mass production diminishes the value. Therefore, making all artists conform to painting the same item the same way destroys value rather than creating it.

A similar situation occurs in strategy. If you find a unique, differentiated approach to the market, you may create a lot of value. However, if thousands of others identically copy your position and approach to the market, the value of being in that position plummets.

Strategy thrives on differentiation, not conformity. It is difficult for each company to find its unique position if they are all using an identical approach to strategic planning. Conformity in approach tends to limit outcomes, not increase them.

Strategists like Gary Hamel look for strategic success by destroying conventional wisdom rather than by conforming to it. Almost every great leap forward in business has come by those who rewrite the rules. I suppose you could write rules to standardize an approach for how to destroy standardized approaches so that you can re-write the rules, but I think it sort of misses the point of where one should focus their energies.

Although those who want create a certification process for strategic planning have good intentions, I don’t think certification of strategists is a good idea. The problems with certification of strategists are that:

a. There is no agreement in the industry as to what is the right way to do strategy.
b. The right strategic approach varies significantly between companies.
c. Conformity tends to hurt, rather than improve, strategic outcomes.

Even if it is impossible to certify a strategic planning process, could one perhaps certify a toolkit of strategic planning tools? Maybe, but consider this…great art depends more on the caliber of the artist holding the tool than on the quality of the tool itself. Willam McKnight, former head of 3M used to say, “Hire good people and them leave them alone.” To paraphrase this quote, perhaps we could say, “Hire good strategists and let them use their own approach to strategy.”

Wednesday, September 14, 2011

Strategic Planning Analogy #412: It’s Rational To Me

There’s an old story about a champion swimmer who lost one of his little pinky fingers in an accident. After the accident, the swimmer said that he was unable to swim anymore and refused to get back into the water.

His fans thought he was acting crazy. Okay, maybe his swimming might be a tiny bit slower without that finger. But to claim that he couldn’t swim any more at all? This didn’t make any sense to them.

Finally, one of the fans asked the swimmer why he couldn’t swim any more. The swimmer responded, “I use my pinky finger to get the pool water out of my ear after I swim. Without the pinky finger, I can’t get the water out, so I can’t swim anymore.”

To an outsider, a lot of actions look irrational. The fans in the story thought that the swimmer was acting irrational. They didn’t understand how losing a finger prevented the act of swimming.

The problem was that the fans didn’t see the big picture. They were only looking at what happens in the pool. In the pool, the finger loss was not such a big deal.

The swimmer, however, saw the bigger picture. He knew that after he was out of the pool, that finger was essential to maintaining ear health. Without that finger, his ear would get infected and he would not be able to swim in the future.

So, even though the fans thought his refusal to swim was irrational (because they only looked in the pool), the swimmer felt he was being very rational, because he saw the larger implications.

It seems that a similar problem frequently occurs in business. Executives are constantly making decisions. Many times outsiders will look at these decisions and question the rationality of the decision. They will think the executive was crazy or misguided.

Literature in recent years has referred to this supposed irrationality as “decision bias.” The argument for decision bias goes something like this:

1) The decision maker has biases;
2) The biases in the mind of the decision maker triumph over logic;
3) Therefore, the decision maker makes an illogical decision.

However, I’m not so sure this is always the case. Executives don’t make it to the top because of a propensity for illogic. I think there is often something else going on. The ones claiming this so-called illogic are like the swimmer fans. Their view of the decision is too narrow (just looking in the pool). The executive may be looking at a larger scope (outside the pool) and see a reason why his decision is very logical (at least from their larger perspective). So before making a quick judgment about someone’s rationality (or supposed lack thereof), try to understand the perspective of the one making the decision.

The principle here is that if you want someone to make the right strategic decision, then you have frame the decision within the context of the framework used by the decision maker. In other words, don’t blame bad decisions on irrational biases. Blame bad decisions on having created a system where the decision maker’s logic is contrary to the success of the strategy.

This is an important distinction. For if you believe the problem lies with illogical beings, you will try to fix the problem by trying to change the way people think. However, if you believe that the person is very rational, but has been put into a system where his/her personal logic is contrary to business goals, then you will try to change the system.

The Pool Example
Think of the business executives as being like that swimmer and the business environment as being like that swimming pool. As an investor in that business, you focus on what is happening in that pool and how well the swimmer is performing in that pool. You don’t care about what happens outside the pool.

The swimmer (the executive), however, has a life outside the work environment (the stuff outside the pool). In the story, this caused him/her to stop swimming.

The investor thinks this is illogical, since they see nothing in the pool to cause concerns. The investor sees the solution as trying to change the way the swimmer thinks about swimming (try to replace the so-called swimming illogic with logic). Since all the investor looks at is the pool, they try to find the solution within the pool (the way the person performs relative to the business). For example, they might focus on telling the swimmer that, logically, the hand stroke in the water still works with a missing finger (and to think otherwise is crazy).

However, had the investor assumed that the swimmer had a logical reason for his/her actions, the investor would have looked outside the pool at the swimmer’s concern for getting water out of the ear. They would have then come up with a replacement for the pinky to get the water out of the ear. With such a replacement, the swimmer would gladly get back into the pool and do what the investor wants. In other words, the best way to fix what was happening in the pool was to take care of a systemic issue outside of the pool. No amount of lecturing on the best way to swim would have fixed that issue.

The Real Example
I was reminded of this concept in a recent article from September 2011 in the McKinsey Quarterly. The article was entitled “A Bias Against Investment?”. The article was based on a recent survey of executives. According to the survey, executives claimed that their companies were not investing enough in their businesses. And the folks at McKinsey felt that underinvesting at this time was illogical.

McKinsey blamed the illogic on “well-known biases.” As “proof” of these biases, they pointed to some hypothetical questions in the survey. One hypothetical scenario was about a doing a deal with the potential of a small loss or huge reward. Many of the executives refused to do the deal. McKinsey claimed that this was mathematically illogical, in what they referred to as the “loss aversion bias”. McKinsey thought this illogical bias was even more tragic when applied to smaller investments (which were also looked at in the survey and had similar results). To quote the article, “Even if it made sense to be so loss averse for larger deals, it still wouldn’t make sense to be as averse to loss for smaller ones.”

But I think there may be a lot more going on here. There may be some sense here after all. I think those executives may be very logical. They are just using logic from outside the pool. These executives are not only worried about the health of the business, but the health of their career (like the swimmer who cared about the health of his ear).

The executive may have logical reasons to believe that being seen as responsible for losses, even small ones, could put their career at serious risk. They may get fired, not get a bonus, or never see a promotion because of that loss. However, if the upside occurs, the amount of the profits on a small deal may not be large enough to cause any personal benefits to the executive. They were already expected to do well, so doing well does not trigger extra bonuses or promotions.

Given that logic, the executive doesn’t just see what’s in the “pool”—big profit gains versus the risk of a small loss. Instead they see it as gaining nothing personally versus potentially losing their job. No wonder executives have a tendency to be averse to these types of options. From outside the pool, rejection of the deal looks very logical.

The Implications
Depending on which of us is correct (me or McKinsey) there is a major difference as to how to solve the problem. McKinsey’s approach would lead to the conclusion that companies should focus on getting people to change the way they think—to root out those nasty biases—or at least downplay them during decision making.

My approach would be to understand what is happening outside the decision at hand (outside the pool) which is causing a logical person to “rightly” (for them) make the “wrong” choice for the business (inside the pool). Once that is determined, then change the system so that the two are compatible. For example, in the scenario above, the company may need to change compensation and rewards/punishment policies which cause people to act contrary to what is in the best interests of the company. The companies need to get personal risks to be consistent with business risks.

Although luck may be a contributing factor, I believe most people make it to the top of a business because they logically made the right choices regarding what it takes to get to (and stay at) the top. The real problem is that the logical choice for getting to or staying at the top is not always consistent with the most logical choice for the business. If you want to fix some of the bad decisions, look at how to get the logic behind personal and business decisions to be more similar.

Don’t automatically assume that bad decisions are caused by illogical executives. Instead, start by assuming that the executive is being perfectly logical from their perspective. Then try to figure out why the current system is causing personal logic to be out of sync with business logic and fix the system. Otherwise, your “logical” strategy may not get implemented, because it conflicts with the personal logic of the people implementing it.

A personal benefit from looking for a solution by changing the system is that it keeps you from having to go to senior executives and tell them to their face that they are illogical.

Monday, September 12, 2011

Strategic Planning Analogy #411: Strategic Pep Rallies

Back when I was in high school, we used to hold a big pep rally for our football team. All of the students would leave their classes to go to the gymnasium and sit on the bleachers. The band would play peppy music.

There would be speeches about how wonderful the football team was. The team would come out on the gymnasium floor. The students would scream with excitement. It was a fun time of camaraderie filled with inspiring speeches and things designed to boost everyone’s emotions regarding the coming football season.

These pep rallies were done because it was felt that it built up fan support and made the team feel more confident about winning. All of this was to help increase the success of the football season.

High School football teams are not the only ones looking for success. Businesses want their strategies to succeed as well. So maybe companies should also hold pep rallies.

In a way, many companies do. Think about those annual strategy retreats. They’re a lot like pep rallies. People leave their offices to congregate together. There is lots of camaraderie and lots of inspiring speeches. People get more emotionally tied to the strategy. Enthusiasm to win is increased.

A lot of people complain about these types of strategy retreats. They think they are a waste of time because not a lot of serious strategic activity takes place. But consider this…you don’t see the football coaches doing serious planning activities at pep rallies. They aren’t sitting there at the pep rally developing their playbook. They are not designing their plan of attack against the next opponent.

I’m not even sure that such activities could even be possible with the band playing loudly and the students screaming in the background. Yet schools continue to hold pep rallies because they see value in the activity.

So maybe there is even value in a strategy retreat when strategy is not created at the event.

The principle here is that strategic success requires more than just a well thought out mission and viable plan of attack. At the end of the day, strategies have to be properly implemented by people in order to succeed. Ignore the people element, and even well thought out plans are usually doomed.

People are both rational and emotional beings. And for most of them, strategy work is layered on top of a full burden of day-to-day activities (with lots of pressure to get them accomplished). If you do not break through the clutter of the day-to-day and create enthusiasm for the plan at both a rational and emotional level, the strategy will lose the battle for attention against the day-to-day. Implementation will suffer.

Studies show that strategies typically fail due to weak implementation. Strategy retreats can help “rally the troops” around the strategy in a manner which increases the enthusiasm for the plan. This improves the level of commitment in the people and increases the likelihood of successful implementation.

Here are some suggestions about how to make the best use of a strategic retreat.

1) Don’t Try to Use Strategy Retreats to Create Strategy
As it turns out, strategy creation is a complex, time consuming process. Great strategies cannot be created over a weekend once a year. Besides, not everyone is great at strategy creation. It takes a different kind of thinking to be great at strategy creation. Therefore, trying to create strategy at a strategic retreat is a waste of time. Don’t even try.

Instead of trying to get people to “create” strategy, try to get them to “react” to strategy. As I’ve mentioned in a prior blog, most people are better at reacting to ideas than creating them. Therefore, use the retreat to deal with reactions. Find out:

a) Where the rational and emotional resistance lies among those required to implement it.
b) How the strategy can be improved.

By incorporating this feedback into the plan, you give the people a sense of having participated in creating the plan without actually having a creation session. This minimizes implementation resistance and increases emotional commitment in a very efficient manner. And efficiency is important if all you have is a weekend at your disposal.

Pep rallies don’t create strategies. Follow their lead.

2) Use Strategy Retreats to Break Through the Daily Clutter
It is difficult to get enthusiastic implementation from people who do not fully understand or comprehend what it is they are being asked to implement. Lack of comprehension can be one of the biggest enemies of implementation. Therefore, use the retreat to maximize comprehension and understanding of the strategy.

It often takes time for all the rationale and all of the nuances of a strategy to sink in. It cannot be done in little “sound bites.” Back at the office, where all the daily pressures take place (the “tyranny of the immediate”), about all the time the strategy can get is little sound bites—spoken when the audience is only half-listening. The real benefit of the retreat is that it pushes away the tyranny of the immediate, so that the ears have the time and the attention levels necessary to fully comprehend and embrace the strategy.

Use that time to fully explain why the strategy is so critical to future viability and success. Explain how the environment is forcing a need to change and why this is the best change to take. Explain the dire consequences of the status quo. Show how its importance truly eclipses the day to day. Show why this strategy is worth becoming a priority in their life. Make them BELIEVE in the rightness of the strategy, both rationally and emotionally.

This is more than just lecturing. Make it come alive through demonstrations and role playing. If you let them play the part of the competition who seeks to destroy the company, they will quickly see the vulnerability of not embracing the right strategy. Show them interviews with disgruntled customers. Let them experience the competitor’s products first-hand. Appeal to all the senses—seeing, hearing, touching, experiencing.

Keep the daily pressures as far away as possible. Ban electronic devices. Prevent digressions into daily problems. Don’t let them communicate with the office. That way you have the full attention of all the senses. Then you can make the strategy truly come alive and become something more than just a clever slogan. It is then something real which can be understood, believed and embraced.

3) Use Strategy Retreats to Break Down Silos
Not only does strategy implementation require people, it requires people to cooperate. Cooperation relies on three elements:

a) A willingness for people to set aside personal agendas for the greater good.
b) A willingness to trust others and work together.
c) An understanding of how your role fits within the larger picture—what you are responsible for and how that interacts with what others are responsible for.

Strategy is not a “corporate” thing. It is an “everybody” thing. If people don’t understand how they fit into the implementation plan (and make it a priority), they cannot fulfill their part of making the implementation a success. It has to get very personal at all levels.

Strategic retreats are a good time to break down those individual silos and improve cross-departmental cooperation. After all, this may be one of the rare times when these executives get to interact with each other in a neutral environment where daily pressures don’t get in the way. It is a time to build bonds of trust.

It is a time to show how all the pieces fit together…a time to for people to see how they fit into the plan and what they need to do. Never let a strategy retreat end without people seeing how their role fits into the strategy implementation. You may never get a better opportunity.

Pep rallies break down own individual concerns and get us thinking about the entire school and the entire football team. It makes us want to do whatever we can to help the TEAM win. That sounds pretty good for businesses, too.

Although strategy retreats are not great places for strategy development, that doesn’t mean they are a waste of time. Strategy retreats are a great place for improving the rational and emotional commitment of people to the strategy. And that goes a long way towards improving strategy implementation. Use them to increase understanding, get feedback and increase cooperation.

Pep rallies are not the only time students think about football. They also go to where the games are played each week. The support follows where the action goes.

The same principle should apply to businesses. The strategy cannot be isolated to a remote location once a year. It needs to come along to where the game is being played every week. Regular interaction is needed so that people are reminded of the strategic implications of their daily decisions. I think that strategists should have an audience with senior management at least once a month in order to keep the commitment to strategic implementation strong all year long.

The retreat should just be one small piece in the larger context of influence.

Monday, September 5, 2011

Is DCF Becoming DOA?

One of the key financial tools available to strategic planning is Discounted Cash Flow (DCF). It is one of the accepted standards for evaluating a business. The basic idea is to take future cash flow expectations for the business and discount them back to today’s value based upon an assumed cost of capital. There are slight variations in how the cash flow is defined (such as the difference between accounting cash flow and the cash flow definition of EVA [Economic Value Added]), but the general principle is rather basic.

It is such an accepted tool in strategy that if you look at the requirements listed when a company is hiring a strategist, expertise in DCF is often demanded. After all, how can one evaluate alternatives if one has no way to put a value on them? And DCF is the standard accepted way to compute those values. Right?

Well, lately I have found that the DCF methodology is becoming less dependable as a valuation tool. In an increasing number of cases, it appears to me that standard DCF calculations are becoming less reliable—perhaps even deceptive—such that they may lead to the wrong conclusions.

In the rest of this blog, I will explain why I feel this way.

For DCF to be a reliable way to evaluate businesses, one has to accept certain assumptions. The three most important are

1) Future cash flows are the primary determinant of business value.
2) Cost of Capital is relatively easy to determine.
3) Cash Flows are relatively easy to determine.

If any of these assumptions are not true, than DCF becomes a less reliable tool. The greater the number of assumptions that are untrue, the less sense it makes to rely on DCF as the primary valuation technique. And in my opinion, all of these assumptions are currently under attack.

Let’s look at the first assumption: Cash flows are the primary determinant of value. This assumption makes the most sense if you plan on holding a business for a long time and manage it for profits. Since, in this case, profits are the manner in which the return on investment is achieved, then linking value to the cash flow thrown off through operations makes sense.

But what if the primary form of return on investment comes from something else? It seems that to an increasing level, most of the value created in a business comes at the point when a business changes hands.

It reminds me of professional sports teams. People pay a large fortune to own one of these sports teams. Yet, on an annual cash flow basis, most of these sports teams lose money. Based on DCF, these sports teams destroy value. The analysis would say that you should not pay much of anything for a sports team and maybe you should even be paid by the current owners to take it over.

Yet people still pay a fortune for these teams. Why? Well, there are a number of reasons, but one of them is the fact that, over time, the resale value for these teams increases. If, after a few years, you want to re-sell the team, one usually can get back far more than what one originally paid for the team.

In this example, all the value comes from the point when the team changes ownership. None of it comes from annual cash flows. Therefore, DCF is not a very reliable to for determining the value of a sports team. At one time, sports teams were a bit of an anomaly in this regard. Now, this is becoming more of the norm in the business space. We talked about this in an earlier blog.

Just look at all the valuations being created for all the digital businesses in the social networking space. Each level of valuation seems based on what happens at the next shift in ownership. Angel investors and early round funds are looking at how the value may rise when late round funders jump in. Late round funders are looking at how the value may rise when the firm goes public. Early IPO investors are looking for that early bump in stock prices which soon follow an IPO. The original entrepreneurs are at looking at what they can make when they can cash out.

The same thing applies to the rise in the investment funds and activist investors. They seem focused almost exclusively on getting value from ownership churn. Sometimes, they take businesses private in order to take them public again soon after, hoping that this churn will put extra money in their pocket. Or they want to break up a company because they think the ownership change in a break-up unlocks the “true” value. Or they want to put a company up for sale because they think a new owner will value the business more than current owners.

In both the start-up and the active investor cases, there is little desire to own the business and actually get the return out of the annual cash flow. Instead, the desire is to get the money out of the next ownership shift. If that is the case, then the business is no longer run to optimize cash flow, but to optimize resale value.

It’s like all the people who were flipping houses during the housing boom. They didn’t buy the house to live in it. They bought it specifically to resell quickly at a profit. They would make investments in the house based on what would best increase resale potential rather than what would make the most sense if you planned on living there. We spoke of this in an earlier blog.

This same thing is happening more and more in the business world. Cash flow is not the prime source of value. Pleasing the customer seems to be less important than pleasing the next owner. If you listen to startup firms discuss their strategy, it often sounds like the only “customer” they care about is the one they hope will provide the next round of funding.

In at a lot of these “profits from churn” strategies, it often looks like the investors, their lawyers and the investment advisors may get rich, but the company’s ability to create long-term cash flow actually shrinks. Lots of costs related to creating future value are stripped out (like R&D and maintenance). Instead, money is put into superficial things which may dazzle the next owner, but don’t lead to a better business (sort of like “curb appeal” in selling houses has little to do with living in them).

Based on all of this, I think that cash flows are losing some of their linkage to how value is created
(and how businesses are run). This makes DCF a less effective tool.

There is a simple formula in DCF to determine cost of capital. It looks at risk-free rates of return and adds a factor for industry/business/stock market risk. The risk free rates usually are based on government debt rates. However, since the great recession, it seems that governments are setting their debt rates at levels which have nothing to do with the “true” cost of debt for a business. There are other political and social factors at work. Sovereign debt in many parts of Europe is so messed up that it makes its usefulness as a tool in calculating DCF for businesses much more problematic. Even US Treasuries, which were supposed to be the perfect risk free measure, are complicated by the ratings reduction of US debt by S&P.

Japan has been distorting its debt situation for a long time. There is also little trust in how debt and equity work in China (and that’s where a lot of new business valuations are taking place). These policies distort how businesses invest, in ways that have nothing to do with cash flow prospects.

Between all the volatility and uncertainty in the debt and equity space, I think it is getting increasingly more difficult to determine what a true cost of debt and a true cost of equity should be. And with all the pre-planned churn for taking businesses in and out of equity, I’m not as certain as to how to even factor cost of equity and debt into the calculation.

I was thinking about this recently, while listening to some “business experts” on TV discussing some of the implications were of some of the wild valuations of deals recently taking place. Using the rules associated with DCF, the commentators did the math backwards and concluded that, based on the valuations, companies must have an irrational expectation for cost of capital. No, I think it meant that DCF no longer set the rules as much as in the past. The math didn’t apply.

With a lot of the new social businesses going public, like Groupon, Linked In, Facebook, etc., there are wild speculations about what the future may hold. Heck, some of the businesses being looked at have never made a profit, yet are being valued very highly. And for those making a profit, the valuations assume that profits will grow at astronomically high rates for a long time in order to justify the price. There is almost no scientific, rational way to “prove” the validity of these abnormal assumptions, where history seems to have no bearing on the future.

In times like these, people place their investment bets not based on DCF math, but on what they think mob psychology might lead to, even if they don’t think the mob is correct. Supply and demand math takes precedence over DCF math.

Although DCF calculations still have merit, recent circumstances are making DCF less reliable as the sole source for value calculation. One needs to also consider how other factors influence value, like frequent changes in ownership, laws of supply and demand, non-typical government stances on monetary policy, etc. Otherwise, one may miscalculate value and make poor strategic decisions. So, although it’s too soon to say that DCF is DOA (Dead on Arrival), I think one can say that the health of DCF is not as strong as it used to be.

We merely scratched the surface on this topic. For the sake of length, I cut the discussion short. If you would like to continue the discussion, feel free to leave a comment.