Friday, March 27, 2015

Strategic Planning Analogy #549: Toughest Investments to Make

It’s interesting to watch the debates between developers and preservationists. The developers say that if you invest a bunch of money to develop a wilderness area, you get a lot of measurable benefits:
·       Jobs
·       Economic Growth
·       New Tax Income
·       An Infrastructure that can lead to additional growth

The preservationists have a tougher sell. They say that if you spend a lot of money to preserve the wilderness, you only get what you already have—a wilderness. It’s hard to put a measurable return on an investment which returns nothing new. “What is to be gained by that?”, respond the developers. The only persuasive reply the preservationists have is that without investment in preservation, things (like trees and animals) will go away and possibly become extinct.

It can be tough for humans to mathematically compare the relative merit of using private money to create jobs and boost the economy (which both help humans) versus using public money to preserve a wilderness (which mostly benefits the animals under threat of extinction).

However, I suspect that if you asked the animals under threat of extinction, the decision wouldn’t be tough at all.

A large part of business strategy revolves around investment decisions. The idea is to use strategy to determine where the best investment opportunities lie for a particular company.

Many times, these decisions can get framed to look like the wilderness example. The choice is between investments that:

1.     Create great new development opportunities with great new measurable sources of economic return; or
2.     Don’t really create anything new but just “sort-of” preserve the status quo.

When the decision is framed that way, the capitalist mindset will typically lean quickly towards option #1, the investments with a lot of measurable new benefits. After all, isn’t investing for a big new return better than investing just to stay about the same?

Here’s the problem. Without preservation, there is extinction. And that extinction could be your entire business. And if your core business goes bankrupt, all those other investment opportunities tend to disappear as well.

Therefore, we often need to look at these wilderness decisions from the perspective of the animal under threat of extinction, because we may, in fact, be the one that goes extinct if preservation investments are not made.

The principle here is that incremental growth investments often rely on having a core foundational business for these incremental investments to leverage. It can be called synergies or scale or brand power or industry insights or distribution capabilities or funding cash flows or a host of other things. The point is that without a strong foundation to provide these benefits, there is no strategic benefit to making the incremental growth investment.

If all you bring to the investment is money, then you’d better be able to out-invest the professional investment funds which do this for a living and are competing against you for that same opportunity. Good luck with that. Your money is no better than their money, so you bring no advantage.

On the other hand, strategy is about leveraging current strengths and assets. It’s about more than just bringing money to the table. It’s also about all the skills, knowledge, power and infrastructure you have to leverage. Strategy is the process of assessing all that you have to determining where that bundle of infrastructure can create the greatest advantage. This increases your likelihood of success, because now you bring far more to the investment than just money (which is all the same). You bring all that has made your core business uniquely prepared to excel over others in the new investment.

Therefore, it is critically important to invest a portion of your money into preserving these core attributes, even if those investments do not create any additional returns. Their value is not in adding something new, but preserving something old—avoiding extinction. That’s valuable, because if your competitive advantages go extinct, you are back to having nothing but money (if you are lucky). In reality, you may be left with nothing but debt. Now, none of those investments look good.  

Example #1: Sears
I will illustrate this principle with two examples from retailing, starting with Sears. When Eddie Lampert took over control of Sears, he saw his investment opportunities as being like the wilderness example. On one side, he saw this wonderful new opportunity in bringing Sears into the forefront of internet commerce. There were lots of positive new returns on his spreadsheets by diversifying into internet commerce.

On the other side were investments in preserving the Sears retail store foundation. When he ran those investments through the spreadsheets, Lampert didn’t see any additional returns. Lampert reasoned that it was foolish to invest in a place where there were no new returns when he had other incremental opportunities where there was the potential for large new returns. Therefore, Lampert essentially stopped investing in the foundation and poured the money into internet ventures.

The problem was that by not investing in preserving the Sears core, the core was starting to go extinct. The stores became ugly and undesirable. The merchandising suffered. And worst of all, the image of the brand suffered. Customers were abandoning Sears and all that it stood for.

As the Sears brand suffered, its connection to the internet ventures created a negative influence rather than a positive influence. The connection made people less likely to embrace the internet venture. In addition, when the core deteriorated to the point that it became a major cash flow user rather than a cash flow provider, there was no longer any money to invest in the new venture.

By letting the core approach extinction, Lampert not only destroyed the core, but lost any benefits the core could bring to the success of the internet ventures. Without the synergies, his internet ventures had no advantage in the marketplace. In fact, now they had the disadvantages of being associated with a “loser” brand and being stuck in a place that no longer had any cash flow to fund it. Now, the situation is so dire that manufacturers are reluctant to ship any product to Sears. The end of the entire company may be near.

By contrast, if Lampert had diverted some of that investment money into preservation, he might not have seen a lot of new returns in the core, but the core would have been preserved to the point where it could be an asset to internet venture and given that strategy more of a competitive edge.

Example #2: Target
The technology and equipment necessary to convert from magnetic stripe credit cards to chip-embedded credit cards has been around for years. It has been up and functioning in Europe for years. But retailers and banks in the US failed to make the investments in the chip technology, even though it provided far superior security.

Why? When they ran the numbers through the spreadsheets it didn’t look good. A lot of investment money was required to make the switch, but there really weren’t a lot incremental returns. They didn’t think that converting to chip credit cards would create any meaningful additional sales. No new benefits were seen that would justify the expense. Therefore the investments weren’t made.

What they failed to take into account was that without the investment in chip credit cards, their credit operations were at high risk of being hacked by criminals. Yes, there may not have been any new benefits from the investment, but without the investment, the core was at risk.

Eventually that day of risk came. The hackers started attacking the old style credit cards. Target was probably the retailer which suffered the most from the hacking. Not only did Target immediately suffer huge financial losses, they suffered losses to the brand image. Customers were more fearful of shopping at Target. They were less likely to want to pay any extra money for the privilege of shopping there.

These losses to the strength of the core reduced Target’s longstanding competitive advantages. So now, Target has been faced with abandoning Canada (at great loss) and laying off thousands of employees and struggling to find a new position of strength in the US marketplace. Of course, Target’s current problems were caused by more than just the credit card hacking. But, by not investing in this core, they certainly made the problem worse than it would have been, both in terms of cash flow, management distraction, and image.

Without strong competitive advantages, a company brings nothing to an investment except money. And most of the time, just bringing money is not enough, because others can also bring money plus their own set of competitive advantages. Therefore, it is important to continue to make investments which preserve and strengthen those core competitive advantages, even if the investments themselves create no direct additional return. For without the preservation of these advantages, the entire company is put at risk of extinction.

Investments in preservation can be the toughest investments to make. They are extremely difficult to justify on a stand-alone basis via spreadsheet analysis. Yet, without them, the entire foundation of the business may crumble. You have to continually remind yourself that these investments may not create something new, but they can keep you from extinction—and that is worth a lot.

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