Tuesday, November 27, 2012

Anticipation and Creation

By almost any measure you can think of, free-market economies are superior to the highly planned economies of socialism/communism.  Free market economies create more total wealth and do a better job of raising the general standard of living for the whole society.

Yet, for many years, I have been advocating strategic planning for businesses.  This begs the question:

If the economy in total is better off with free markets versus planned markets, then why do I believe that individual companies are better off having strategic planning?

This question is becoming more relevant based on the most recent book by Nasssim Nicholas Taleb, called “Antifragile.”  You may recall Taleb’s earlier book, “The Black Swan,” which caused quite a stir.

In Antifragile, Taleb takes a dim view of strategic planners.  His claim is that strategic planners do more harm to businesses than good in their attempt to gain control by way of rooting out the risk of randomness.  Taleb believes that the unintended consequences of these acts are to add delay, complication and inflexibility to the very business they are trying to improve.  As a result, instead of saving the business, the planning increases the risk of failure. 

This is a valid concern.  I have seen examples where this type of result has occurred.  For example, in the name of reducing risk by sharing knowledge and expertise, large shared services organizations are built.  These shared services organizations, if structured improperly, can add delay, complication and inflexibility to a business.  In two instances I am personally aware of, these negative results were so severe that the shared service organizations were dismantled.

So we cannot just dismiss the argument posed in this book.  We need an answer to the question.

One of the main reasons why a free economy is superior to a planned economy is due to the concept Joseph Schumpeter referred to as creative destruction.  The general idea of creative destruction is that great improvements to the economy do not come from proactively tweaking the status quo.  Instead, they come from allowing the status quo to die and be replaced by something far superior.  Only by freely allowing marketplace churn—letting old business models be destroyed by new business models—does the market make great leaps forward.

And the beauty is that, when left free of excessive planning, the market will do this creative destruction all by itself.  It is when we try to interfere and protect the status quo that we hinder the ability of the marketplace to make great strides. 

In a macro sense, allowing creative destruction has much merit.  But business leaders live in a micro world.  Their primary role is not the health of the total economy, but the health of their business.  Freely allowing their business to be destroyed in the name of Creative Destruction will not win them any praise from their stakeholders (shareholders, lenders, employees, etc.).  No, these stakeholders want the business leaders to cause their businesses to survive and thrive regardless of what is happening in the macro economy.

I believe that the best way to do this is via planning (we’ll discuss how to do this further below).

In his excellent book “Good Strategy/Bad Strategy,” Richard Rumelt makes the case that most of what is practiced today in the name of strategy is truly awful.  Worse than just poor execution of good processes, Rumelt believes that much of what is called strategy today is not strategy at all.  It is just terrible actions which hurt businesses. 

I suppose Rumelt would agree with many of the points made by Taleb.  In the name of strategy, a lot of negative activity is taking place.  But that is no reason to abandon strategic planning.

That would be like saying that just because some doctors conduct malpractice, we should abandon the science of medicine.  Or, because some reporters distort the facts, we should ban all news organizations.    

No, the proper response would be to eliminate the bad practices and promote good, healthy planning which works in concert with creative destruction rather than against it.
My first rule of strategy is this:  “ALL strategic initiatives eventually fail.”  My second rule of strategy is this:  “You are not an exception to rule #1.  YOUR strategic initiative will eventually fail.”

The primary reason why strategic initiatives eventually fail has a lot to do with the forces of creative destruction.  The environment in which you conduct business keeps changing.  What was the best thing to do in one environment is usually not be the best thing to do in a different environment. As the environment changes, your original strategic initiative becomes less relevant.  If you do not change, eventually your strategic initiative becomes irrelevant and you die—destroyed by creative destruction.

But here is where my rule #3 comes in: “Just because strategic initiatives die does not mean that your company has to die.  As long as you continually abandon failed strategic initiatives and replace them with relevant initiatives, the company will outlast any individual strategic initiative.”

The idea here is that good strategic planning is not primarily about trying to preserve the status quo or reduce the risk within the status quo.  It is about preparing yourself to prosper in a world where the status quo changes.

Hence, two of the most important words in good strategic planning are ANTICIPATION and CREATION.

Yes, the environment is changing.  But the change is rarely random.  There is logic behind the change.  The impact of an aging population can be roughly predicted.  The impact of business life cycles can be roughly predicted.  Advances in technology can be roughly predicted (like Moore’s Law).  As a result, the future environment should not be a complete surprise.  It can be ANTICIPATED.  And if something can be anticipated, then it can be prepared for.  And that is a key role for good strategy—to help companies better anticipate the changing environment in which they must prosper (and find ways to best exploit what is anticipated).

Why I would even argue that unusual Black Swans (events which have never before occurred) can be anticipated.  Sure, we won’t know the exact nature of the next potential disaster, be it a tsunami, earthquake, nuclear meltdown, housing crisis or whatever.  But bad, unusual things cycle through on a fairly regular basis.  And the best strategic response to negative black swans often doesn’t vary much.  There are only so many ways a black swan can impact the environment, no matter what it is.  Through the anticipative act of scenario planning, one can have a set of pre-planned responses which will work for almost any black swan.

However, even stronger than anticipation is CREATION.  Creative destruction occurs when a company reinvents the rules in a way which renders the status quo obsolete.  Those who are early masters of the new status quo typically gain disproportionate benefits.  Creative destruction has to be created by someone.  It may as well be you.  After all, isn’t it better to destroy someone else’s status quo than to have someone else destroy your status quo?

As Peter Drucker put it, “The best way to predict the future is to create the future.”  Therefore, good strategic planning looks at ways to reinvent business models—to create the next cycle of creative destruction.  In essence, the planning process is not used to preserve the status quo, but to become a leader in controlling how the status quo will be destroyed.

This is somewhat similar to the Blue Ocean approach to strategy.  The idea is to use planning to look for new, uncontested spots in the marketplace.  In other words, instead of trying to win in the highly competitive red ocean of the status quo, create your own new status quo (the blue ocean).

Strategic planning as a source for anticipation and creation might even be an approach that both Rumelt and Taleb would find acceptable.

Even though highly planned economies tend to be inferior to a more free-market economy, that doesn’t mean that planning is a worthless activity for individual companies.  Planning is worthwhile for individual companies, because it provides a means for them to survive the forces of creative destruction—either through anticipation or creation.   However, not all processes labeled “planning” focus on anticipation and creation.  Some focus on trying to preserve the status quo.   In a world where all strategic initiatives eventually fail, that second approach is not a recipe for long-term success.

The best planning looks forwards, not backwards.  As hockey great Wayne Gretzky put it, skate to where the puck is going to be, not to where it has been.  Anticipation drove his actions.  You should be driven by the same thing.

Tuesday, November 20, 2012

Strategic Planning Analogy #477: Waiting for Avocados

There’s a story about the early days of the Chipotle Mexican Grill restaurants.  They had a winning formula which looked poised for rapid growth.  McDonald’s invested in the company in the 1990’s, because they could see the huge growth potential as well.

But there was this little green mush getting in the way, called guacamole.  As the story was told, guacamole was only a minor item on the menu, but a significant roadblock to rapid growth.  The key ingredient in guacamole is avocado.  Avocados are not a particularly widely grown crop.  The acreage devoted to avocado trees in the US at the time was very small.  If Chipotle Mexican Grill was going to hit their growth targets, there would have to be a lot more avocado orchards than currently existed.

But there were three problems.  First, you cannot just plant an avocado pit into the ground and get a tree full of avocados.  Avocado trees grown from seed tend to be barren of fruit.  To get the tree to grow avocados, you need to graft branches of fruit-bearing trees onto the seedling.  That takes a lot of time and effort.

Second, even after the tree is sprouted and grafted, it can take from 5 to 12 years before the tree starts to bear fruit.  So even if Chipotle got an immediate increase in avocado orchards, it would be many, many years before it would impact their ability to make guacamole.

Third, farmers needed to be convinced that demand for avocados would skyrocket before they would make such a commitment to increasing the crop.  Why should they believe that this small restaurant chain of a few dozen outlets (primarily in Colorado) would have enough growth to absorb all of the extra avocado output?  If Chipotle doesn’t follow through on its growth plans, they’d be stuck with crops they couldn’t sell at a profit.  And for the first 5 to 12 years, the farmers wouldn’t have anything to sell from those trees to anybody.

Eventually the folks at Chipotle convinced farmers to increase the output of avocados.  And now, about a dozen years later, Chipotle is selling a lot of guacamole in their more than 1,300 restaurants.  Chipotle claims that on an average day they go through 97,000 pounds of avocados (or about 44,000 kg).  That’s over 17,000 tons of avocados in a year.

Even little things can become big things if you grow large enough.

Some issues can be resolved quickly.  Others take more time.  Avocados are an issue which takes years to adjust.  If you want a lot of avocados in 10 years, you have to start planning for them right now.  Even though avocados were a minor part of the entire menu, they became a major concern when plotting restaurant growth.

A similar situation can happen in many other businesses.  Small items can make a mess out of carefully crafted long-range plans because they cannot be adjusted fast enough to accommodate the plan.  This is particularly true if one ignores the slow changing issue until the last minute.

Therefore, when planning the big picture, you also need to look at the small picture.  You need to find those little “avocados” that can destroy the big picture if you did not start adjusting them soon enough.

The principle here is that a large strategy can only move as fast as its slowest component.  Therefore, if you want to move quickly, you need to find where the slowest components are and find ways to speed them up. 

Not Just Avocados
This applies to a lot more than just avocados.  The US version of the Mars candy bar was originally designed with hazel nuts.  However, Mars was not proactive in getting a grip on the small, slow-adjusting hazelnut market.  As a result, the supply and pricing of hazelnuts was erratic.   It was destroying the elaborate growth plans for the US version of the Mars Bar.  As a result, after introducing the candy bar to the market, Mars changed the formula from hazelnuts to almonds.  The almond market was larger, more stable and could more quickly adjust to the growth requirements of the Mars Bar.   

Of course, using almonds made the Mars Bar less distinctive in the market place and probably made the strategy less successful than originally planned.  But at least it kept the brand alive (at least until 2002).

Another story was less successful.  Back in the 1970s General Mills came out with a cereal called Buc Wheats.  It was sort of like corm flakes except made from buckwheat.  Like avocados and hazelnuts, the buckwheat supply was small and slow adjusting.  General Mills never fully got control in the supply of this ingredient.  As a result, even though the cereal was in high demand, they ceased production.  All because they didn’t do like Chipotle and put early effort behind shoring up the weak link in the strategy.

Not Just Food
This principle also applies to non-food issues.  Many industries, like mining and pharmaceuticals have very long lead times before an investment becomes productive.  I worked with a mining company who understood the long lead times and had already done the hard, slow work to find and secure a replacement site for a mine.  That way, they were prepared for when the current mine was no longer viable and could continue operations uninterrupted.  Had they waited until the first mine was nearly depleted before looking for a replacement, there is a good chance they would have spent years without any mining output (like waiting for avocado trees to reach fruit-bearing years). 

Lately, there has been a large movement in both the mining and pharmaceutical industries to shift strategies more towards acquisitions.  But that’s what you have to do when your efforts to build a pipeline of new products fails and you still want to grow.  You have to buy someone else’s pipeline.  And when you have to buy the pipeline, a big chunk of the profits from that growth are given to the person you bought the pipeline from.

A great example of a company who really understands this principle is Amazon.com.  In the early days of e-commerce there were a lot of companies that wanted to become a huge player in this space.  Nearly all of them quickly disappeared.  Amazon.com is one of the few left standing from those days and it is standing strong.

Why?  Amazon understood that to become a massively successful e-commerce firm for the long haul, it would need a lot of capabilities that are time consuming or expensive to develop.  There were a number of “avocados” they had to deal with, like search capabilities, recommendation engines, one-step check-outs, big-data algorithms, efficient distribution centers, and so on.  Amazon worked very hard in the beginning to master these skills, knowing they would pay long-term dividends. 

With an avocado tree, you don’t get any fruit for many years, but once you reach fruit-bearing years, you get a big crop every year.  Similarly, Amazon did not produce any meaningful profits for a long time because they were putting all the money into growing their avocado trees.  Now those trees are bearing fruit year after year after year.  Not only is Amazon benefitting from those plantings, but they are becoming an outsourcer of choice for other ecommerce firms who did not prepare in advance to plant their own avocado tree infrastructure.

And Amazon hasn’t stopped.  Recent profits were depressed because of the massive spending Amazon was doing to expand internationally.  But Amazon knows that a half-hearted effort will fail.  It needs to really invest big into slow returning infrastructure.  Otherwise it won’t have enough avocados (infrastructure) to handle the growth plan.

And Amazon did not wait until the demise of analog media to work on its replacement.  It made the early investment in Kindle so that it was ready and strong with a replacement when the current stream of profits dry up.

Lessons Learned
So what can we learn from all of this?

  1. Make sure you understand what is needed to make your growth plan succeed (from yourself and from your supply chain).
  2. Put special effort around those issues which require more time and attention in order to not derail your growth plan.
  3. Don’t wait until a need arises before trying to resolve it.  Anticipate what you need and prepare in advance to be sure it is already established when needed.
  4. Be willing to invest in slow-returning areas if they help build long-term enduing strength.   

Most strategies involve growth.  And growth both requires and causes change to the status quo. If you do not anticipate and prepare for the type of change needed to make your growth strategy a success, your strategy will most likely fail.  Since that preparation can take a lot of time and effort, start working on it early in the process.  Otherwise, you may not be prepared in time.  Then, your well-crafted strategy will become a worthless piece of paper.

I guess what I’m asking for is “Patient Greed”—an understanding that you might become a lot wealthier in the long run if you are patient enough to invest early in the right slow-returning activities.  Unfortunately, greed and patience rarely seem to go together.  Greedy people rarely want to wait for the avocados to grow.  But if you are able to put these two qualities together, you will gain a competitive advantage.

Tuesday, November 13, 2012

Strategic Planning Analogy #476: Passion for What

Back in the late 1990s, I went to a seminar at the annual Consumer Electronics Show in Las Vegas.  There was a panel of experts talking about the future of connected consumer homes.

Most of the “panel of experts” were the geekiest of geeks, the nerdiest of nerds.  They each seemed to live in homes with about a half dozen satellite dishes on them and about four different sets of connectivity wires running through their houses.  They had all sorts of bizarre homemade networking devices trying to connect all their computers.  And they were predicting that eventually all consumers would have homes as geeky as theirs.

The audience was almost as geeky as the panel and were nodding their heads in approval.  That is, until the last panel member began to speak.

The last member was not geeky or nerdy.  He was a consumer marketer.  He had done consumer research and found that the average person would not put up with all of that geeky stuff.  The audience started to boo him walked out in disapproval.

Well, here we are, about 15 years later.  None of the geeky predictions came to pass and the marketer was right. 

The members of the so-called “panel of experts” were extremists in their enthusiasm for consumer electronics and technology.  It was their passion.   They knew all the jargon.  They were willing to devote all their spare time to learning the obscure technology behind it.  They could build their own computers and program them to do specialized tasks.

In other words, they were not normal.

These people mistakenly believed that eventually everyone else would have the same level of passion as they did for all this geeky stuff.  In other words, they felt that eventually, their odd behavior would become normal.  It did not.

As it turns out, the panel member who best understood the future of the connected home had no passion for the subject.  His expertise was in listening to the customer, who was saying something entirely different.

I’ve been around a lot of companies who are looking for passionate employees.  I’ve seen a lot of job advertisements looking to hire people with passion for the products the company was selling.  The rationale is that employees who are passionate about the product are better employees.

But is that really true?

That panel of experts was so passionate for their business that the members were blind to the fact that they were outliers in society.  They were so abnormal that they couldn’t understand normal people.  And normal people are the customers.  As a result, they completely missed the mark on helping businesses in the industry prepare for the future.

Instead, it was the one panel member who was not biased by personal passion (the marketer), who could accurately hear the customer and give sound advice.

This excessive passion can be particularly messy for strategic planners.  If they are too passionate for the business they are in, they can become biased extremists who are blind to the realities of normal people.  As a result, their strategic recommendations can be way off the mark and hurt the companies they work for. 

The principle here is that it is often better to hire people who have passion for their individual job skill than passion for the business where they apply that skill.  In other words, if you are in the green energy business, it is better to hire an accountant who is passionate about accounting than one who is passionate about green energy. 

There are many reasons why I believe this:

1. Improper Bias
In the story, we saw that the people with excessive passion had a biased and distorted view of the world.  Their extremism blinded them to what normal people are like.  They rejected consumer research (the facts), because it did not line up with their distorted, passionate viewpoint.  As a result, they became useless in helping companies address the needs of normal people.

I’ve seen this occur in multiple companies, where passionate extremist employees would promote all sorts of crazy ideas and bad strategies based on the notion that they found it appealing to their own passions.  Their rational was, “I would like that, so everyone else should like it, too.”

Unfortunately, the ultra-passionate segment of most businesses is quite small.  There are not enough of them to support these ideas.  Just because abnormally passionate people like something does not mean that normal people would also like it. 

And when you fill a company with passionate extremists, they start thinking that they are closer to normal than they really are, because all of their co-workers share the same biased extreme.  This leads to bad forecasts, bad strategies, and bad results.

Think about the battery-powered automotive industry.  Many of the companies were filled with employees who loved the idea of electric cars and thought everyone else should love them too.  So they came up with business models that were far too optimistic and now many of these businesses are going bankrupt.

2. The Charitable Cause Phenomenon
Although there are some great charitable organizations out there, I’d have to say that some of the worst-run businesses I’ve ever seen are charitable organizations.  Why?  Usually it is because the people running the business have more passion for the cause than for their individual job. 

They want to be a part of the cause, so they will do whatever job they can get to become a part of it.  That often means doing jobs for which they are not the most qualified.  Yes, passion can make up for some skill inadequacies, but often not enough to make many of them truly productive.  Just because their heart is in the right place doesn’t mean they are best qualified to get their job done.

Organizations need a lot of different skill-sets, from as mundane as janitorial or data entry to as sophisticated as a strategist, CEO, CIO, or COO, etc.  If people do not have lots of skills or passion for their individual task, then that task will not get done well.  If enough tasks don’t get done well, then the entire organization starts to fall apart.

That is why I like people’s primary passion to be around their assigned task, rather than the business.  That way, the people are happily excelling on that which they are assigned to do, because that is their love and passion.

3.  The Stockholm Syndrome
The Stockholm Syndrome is based on studies which show that people captured by terrorists will, over time, tend to become more sympathetic to the views of their captors. If normal people can start feeling more like the radical extremists who captured and tortured them, then I think normal people can start feeling good about the businesses which capture the bulk of their waking hours.

In other words, if you take a great accountant and put him or her into a green energy company, most over time will become more sympathetic to the green energy cause.  It is a natural consequence.

However, I don’t think the opposite is necessarily true.  If I take someone who loves green energy and is only moderately interested in accounting and put them into a green energy company, I don’t think they become a lot more passionate about being an accountant. 

Therefore, hire people who are passionate about their task, and you can train them to care about the business.  This will work out better than hiring people who love the business and then try to get them to love their individual job.

That’s why you commonly hear people in service businesses say that they look for people who love giving service (their job) and then train them in their business.  This works a lot better than finding people intimately in love with the business but have no desire to serve.

Great strategies rely on great insight and great execution.  Great insight and execution often are at odds with people who are excessively passionate about the business they are in.  First, their excessive passion biases them so they cannot see the realities of the normal world.  Therefore, their insights are inaccurately biased and subject to failure.  Second, people who are doing jobs based on their passion for the business rather than a passion for their job are not the best at doing their job, so execution suffers.  A better approach is to fill your business with people who are passionate for the skills of their individual task.  They will execute well on more accurate assessments of reality.

I have been a strategist at many companies where I did not have an excessive passion for the products being sold.  And I was proud of that.  I would tell people that this kept me from becoming too biased based on personal distortions.   I was forced to listen to the customer.  Second, my passion was for doing strategy, so they would get great strategies (and isn’t that what they hired me for in the first place?).

Monday, November 5, 2012

Strategic Planning Analogy #475: Don’t blame the Violin

If you put a violin in my hand and told me to play it, I don’t think you would like the results.  It would sound awful.  After all, I’ve never had a violin lesson in my life.

I could blame the problem on the violin.  I could say that it was a bad violin and that is why the music sounded so poorly.

However, I knew someone who was the first chair violinist for an orchestra.  If you put that same violin in his hands, the music would sound quite different.  In his hands, the music would be wonderful.  So was the problem the violin or the one holding it?

A frequent topic of business strategy is growth.  Often times, the growth strategy involves either acquiring another company or entering another business.  A lot of time and effort goes into determining whether what is a good company to acquire or a good business to enter.  Yet, in spite of all that analysis, a large percentage of growth strategies fail.

We can start blaming the failure on the growth target.  For example, we can say that the acquisition target was bad or the targeted new industry was bad.  However, for every industry where someone fails, someone else succeeds.  So is it really a bad industry?

The problem is similar to the violin.  In the right hands, the violin makes great music, whereas in the wrong hands, the violin produces an irritating screech.   The value of the sound coming from the violin is not primarily due to the quality of the violin.  Instead, the value is created by the quality of the hands playing the violin.

In the same way, the value of owning a particular business or being in a particular industry often has more to do with the quality of the company who is trying to obtain it than the quality of what is trying to be obtained.  So before you start blaming your growth target, take a moment to look at your own hands.  Are those the hands of a virtuoso in this venture or are your hands better skilled for something else? 

The principle here has to do with strategic fit.  If the desired company or business is a bad strategic fit for you, it really doesn’t matter how great the desired target is.  In your hands, it will fail.  Therefore, a good strategic process should spend more time focusing on its own hands than on what it wants to put in it.

Wanting to Be in an Industry in The Worst Way
We can see this principle in action by looking at an example.  I have a friend who is looking at getting into the mobile payments industry.  This industry is concerned with figuring out how to transfer payments from the buyer to the seller when items are purchased on a smartphone.  Is this a good industry to get into?

Some facts would indicate that the mobile payments industry could be very lucrative.  Smartphone penetration is high and rapidly getting higher.  Long-term estimates of commerce over mobile phones is astronomical.  Even if you can only charge a miniscule fee for handling the payment transfer, the net revenue potential is huge.  So perhaps this is a great place to be.

But so far, we’ve only looked at the quality of the industry.  Predicting success by only looking at the industry is like trying to predict the value of the sound from a violin by only looking at the violin.  If we want to truly understand how the violin will sound, we also need to look at the hands of the one who wants to play the violin.

So I look at the hands of my friend.  He’s a great businessman with many skills.  However, for this venture, he has only a small pool of capital and a small staff of support.  He has never directly been in the payment transfer business.

I compare this to the hands of other people who would also like to own the mobile payments business:

1)      ISIS, a consortium of some of the largest mobile carries in the world (AT&T, Deutsche Telekon, Verizon, Vodafone) who want to cut out the middle man and do the transfers themselves.

2)      Merchant Customer Exchange, a consortium of some of the largest retailers in the world (Walmart, Target, Best Buy, CVS, etc.) who want to cut out the middle man and do the transfers themselves.

3)      Well capitalized companies willing to devote a lot of time and talent to owing the mobile payment space, like Google Wallet, Square, and PayPal (part of EBAY).

4)      And, of course, we cannot forget the sizable threat from the traditional payment transfer experts (Visa, Mastercard, AMEX).  They have a lot to lose if commerce moves from their stronghold to the mobile space.  They know the business and will fight strongly to keep it.

When I compare the hands of my friend to these hands, it is obvious that he is not the virtuoso in this space.  His hands are not good enough to win against these foes.  It is almost irrelevant how much potential the industry has.  He will never see it, because he will lose.

Now some would say that if an industry is large enough and profitable enough, there is room for smaller players (with lesser hands) to do well.    The problem with that thinking is that it doesn’t take into account the dynamics of an industry.  New, exciting industries eventually mature.  This usually causes the following:

1)      The industry consolidates to only a few survivors (almost none of the little guys survive to maturity).

2)      The profits are not spread equally.  The leaders get a disproportionate share of the profits with the lesser players being lucky if they break even.

3)      The intense competition to get to the top usually results in the profit level of the entire industry to drop.  That is why most mature industries have a return on investment near the cost of capital.

So, for my friend, entering this business would be a big mistake. It doesn’t fit his hands.

Wanting to Buy a Company in the Worst Way
A similar problem occurs in acquisitions.  One could analyze all sorts of acquisition targets.  You might find a company with a great business model, great people, and a great balance sheet.  Is that a great company to acquire?

Well, just as you cannot tell if a violin will sound great by only looking at the violin, you cannot tell if a company should be bought by only looking at the target company.  You also need to look at the company doing the acquiring.

The biggest problem is that thorough due diligence will typically find out what the underlying value of the target company as is would be.  And both sides of the negotiation will know that value.  Great companies will command a premium and weak companies will command a discount.  It is very difficult to steal away a company at a bargain price below market value.

In fact, acquirers typically have to pay a premium to obtain a company, often in the range of 20 to 40% above market value.    

So here’s the dilemma.  For this acquisition to be a great deal, you have to have such good hands that you can make the business perform at levels so superior to the status quo that you can cover the premium plus enough extra to cover your required rate of return.   If your hands aren’t skilled enough to do that, then you will lose, no matter how great a company the acquisition target is.

The irony is that supposedly “bad” companies may be better acquisition targets, because it may be easier to add value to them.  That is why there are firms out there like Cerberus, who specialize in investments in very weak firms.  They do well because they have developed skills in turning around weak companies.  In these specialized hands, they can add value to weak firms.  They are the virtuosos of turnarounds and can make good music even with a weak company.

What to Focus On
Therefore, strategists need to focus on the hands of their own company.  What instruments can they play well?  Which instruments will they play poorly?  What instruments could they learn to play well?

After this type of analysis, a couple of strategic results could occur:

1)      Build on a strength.  Great musicians practice all the time to enhance their skills.  Similarly, once a company determines its strategic path, it needs to continually enhance the skills needed to pull it off.  GE has been great for many decades in running diverse portfolios, because it knew that diverse portfolios succeed best when in the hands of great generalist managers.  So GE worked diligently to build a virtuoso group of generalist managers.

2)      Shore Up a Weakness.  If there is a strategic path you want to take, but don’t have the right hands for it, develop that skill before embarking down that path.  There is a reason why firms like Google devote so much effort into getting the best technical talent available.  They realize that to win in the spaces where they want to go requires virtuoso technical talent.  Without it, the strategy will fail, so they make sure that they have it.

When embarking on a path to growth, don’t just focus on the growth target.  Instead, a majority of your focus should be on yourself.  It is only in understanding yourself that you will know where you can add value.  If you can add value, you can make even mediocre targets desirable.  And if you cannot add value, then you will not succeed in even the best looking area of growth.  So make sure you have a strategy for strengthening/creating skills at value creation as part of your overall strategy.

There are several instruments which I can play much better than a violin.  Those are the instruments which I should place in my hands.

Thursday, November 1, 2012

Strategic Planning Analogy #474: Weighing Money

Back in the 19th century, the US was primarily a rural nation.  In those days, if you wanted to purchase something, you didn’t have all the malls with all the stores nearby like we have today.  Instead, if you needed something, you got out your Sears or Montgomery Ward paper catalog and ordered what you needed by mail.  Then, a few weeks later, the mailman would deliver to you what you ordered.

Not only weren’t there many stores back then, there weren’t many ways to pay for the things you bought.  No credit cards or PayPal existed.  Only the very rich had checking accounts.  As a result, almost everything was paid for in advance with cash—usually with coins.

This caused a problem for Sears and Montgomery Ward.  Thousands upon thousands of orders would come to them by mail—each of them in envelopes filled with coins.  Trying to figure out if the right amount of coins were in the envelope to match the cost of the order was a logistical and financial nightmare.

Sears eventually came up with a way to simplify the process.  In fact, they eliminated the process.  Instead of counting the money, they weighed the money.  As it turns out, Sears discovered three things:

1)      The vast majority of people are honest about putting in the right amount of coins;

2)      You can get a reasonable (but not exact) estimate of the value of a pile of coins by weighing them; and

3)      Weighing coins is a lot faster, easier and cheaper than counting them.

By switching from counting to weighing, Sears could process the orders faster with a lot fewer employees.   The big shortages of money would still be caught.  And whatever little shortages that slipped through were small and infrequent.  The money saved from not counting more than made up for any losses from shortages in payment.

So everybody won.  The consumers got their orders processed faster and Sears made the process more profitable.

Sears could have spent a lot of time and money to perfect the system of counting all those coins.  And I’m sure they could have made significant improvements to the money counting process.  But I’m also sure that those improvements would never have been as cost efficient as abandoning the process altogether to switch to weighing money.

At first, it seems counter-intuitive to say that profitability goes up when you stop accurately checking to see if you were properly paid.  How could a company like Sears stop counting its payments?

Well, as it turns out, the top line on the income statement is not the most important line.  The long-term prospects for the bottom line are far more important.  If a little less accuracy on the top line can create far more money on the bottom line, then we should be happy with that. (and, by the way, Sears eventually knew the exact total of all coinage coming in—even if they couldn’t tell which order the coins came from).

I bring this up because a lot of businesses are focused on increasing accuracy all over the place.  Using a host of processes like Six Sigma or Lean, a great deal of time and effort is used to gather tons of data to figure out how to do things better or faster or cheaper or with fewer defects all over the company. 

These practices may improve the individual areas being studied.  But, like Sears, perhaps even more improvement to the consolidated bottom line would have occurred if the study had not occurred and the process was entirely eliminated.

Precision and improved performance is not always the right answer for every process. Sometimes, the bigger picture is better served when some processes stay a little looser or are eliminated altogether.  The secret is in knowing when to apply these tools and when not to.

The principle here has to do with the difference between efficiency and effectiveness.  Efficiency is about focusing on making a process operate as well as possible (speed, cost, accuracy, etc.).  Effectiveness is about focusing on doing those things most critical to long-term success (pleasing customers, gaining competitive advantage, improving long-term cash flow, etc.).

The Folly of Putting Efficiency Ahead of Effectiveness
The difference between a focus on efficiency or accuracy can be great.  For example, I could create the most efficient process for sending messages in Morse Code, but that would never be a more effective way of communication when compared to smartphones and the internet.  If the end goal is communication, I should abandon the Mosrse Code and adopt smartphones and the internet.

Focusing on perfecting Morse Code while ignoring smartphones may seem silly, but companies do things almost as silly all the time. 

Most companies never really have an adequate answer to what I call “The Most Important Question,” which is:  What is it about your business strategy which would cause customers to naturally prefer you over the alternatives?  In other words, they have never figured out what will make the company uniquely effective in the marketplace. 

Instead, they do pretty much what everyone else in the field is doing.  They offer essentially the same solution in the same way.  Then the hope is that they can eke out a small advantage by doing the whole thing just a little bit better. So, they use tools like six sigma and lean in an attempt to make everything they do a little more efficient than the competition.

The problem with this approach is that:

1)      Perfecting the status quo does you no good when the status quo becomes obsolete (like when smartphones and other communication tools made Morse Code obsolete).  Being the best obsolete alternative is not much to brag about.

2)      The competition rarely stands still.  They are also trying to become more efficient.  As a result, it is difficult to get a meaningful long term advantage in doing what everyone else does just a little better.  Think of the battle between Fuji and Kodak to become the best at producing photographic film.  They alternated having small temporary advantages until digital technology made both of them obsolete (see more here).

3)      If you don’t start first with understanding what is most critical for effectiveness, you have no way to prioritize what efficiencies to work on.  In addition, you don’t know which approach is best to improve them (is it by reducing costs, reducing defects, saving time or something else?).  As a result, you can end up working on the wrong projects (like improving money counting instead of moving to a less accurate process of money weighing).

The irony is that putting efficiency first is not the most efficient way to improve your long-term prospects.  It wastes a lot of effort on doing things that do not meaningfully improve the really important things, such as winning in the marketplace.

The Benefits of Putting Effectiveness First  
True, lasting efficiency only comes when effectiveness is given top priority.  Effectiveness focuses on finding a way to win.  That “way to win” involves understanding the underlying problem you are trying to solve (your solution) and differentiating attributes where you will excel in order to be the best at that solution.

For example, Wal-Mart’s solution is to improve the lives of lower income people by making the things of life more affordable.  The differentiating attributes they focus on are lowest cost and lowest price.  Wal-Mart doesn’t waste a lot of effort perfecting service or luxury, because that focus won’t improve their ability to win with their strategy.  Instead, they place all of that efficiency and perfection emphasis in areas which lower costs and lower prices.  And Wal-Mart didn’t stop at just trying to perfect the status quo discount store.  When they discovered that supercenters were a more effective way to solve their problem, they quickly made the switch.

The key to strategy execution is knowing which trade-offs to make.  It is virtually impossible to be the best at everything.  If you try to simultaneously be best at low prices, high quality, speed, service and innovation, you will probably end up being inferior to someone on all of these attributes.   No, if you want to be meaningfully superior, you have to focus on only a couple of attributes.  You trade off (do less) in the areas less important to your effectiveness so that you can afford to trade on (do more) in the areas critical to your effectiveness.  

Starting with effectiveness lets you know where to prioritize you efficiency efforts.  And it lets you know which aspect of efficiency (speed, price, etc.) to focus on.  And, most importantly, it lets you know where not to direct your efficiency efforts.  And, finally, it keeps an eye open for non-status quo approaches which are more effective at solving the underlying problem.  This provides an effective way to win year after year after year.

If you focus too hard on trying to be perfectly efficient at everything you do:

1)      You can end up never winning superiority at any attribute relative to competition (because your efforts are dissipated over too many conflicting areas); and/or

2)      You end up perfecting the obsolete.

However, if the primary focus is first on being effective at owning a solution, you will know how to make the right trade-offs, so that you can become perfectly efficient in the places necessary for you to win in the marketplace.

Tools like Six Sigma and Lean should not be looked at as substitutes for strategy (or as being your strategy).  No, they are merely tools.  Tools in the wrong hands can be dangerous.  Tools in the right hands can produce great things.  If you want those tools to do great things, you need to first understand your effectiveness strategy.  This provides the context for knowing where and how to apply those tools.