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.

1 comment:

  1. Gerald Nanninga,
    Great post. It is not knowing where to go; but also if you have the talent to stay where you want to go. Honestly, this post is a treasure for it requires the strategist and business to figure out not only their current capabilities, but also the different talent requirements if they if they end up where they want to go.