Strategic Planning Analogy #510: Overcoming the Spread

THE STORY
Awhile back I was trying to help my mother liquidate some of her assets. One of the things she had was a collection of old coins. I went to a dealer in coins to find out what they were worth.

I was shocked by the spread between the wholesale price (the price the dealer pays to acquire my mother’s coins) and the retail price (the price the dealer charges when he resells the coins). I felt like I was being cheated.

It looked to me like collectable hobbies were a big rip-off. You are stuck buying at retail (high) and reselling at wholesale (low). Even if your collection appreciates in value, you may never see any of that gain because it gets lost in the spread between buying high (retail) and selling low (wholesale).

If you advocated dealing in the stock market in that same way (buy high, sell low), you’d be seen as crazy. But collectable hobbyists do it all the time. I guess that’s why it’s called a hobby instead of a business.

THE ANALOGY
In the business world, there are essentially three ways to make money. One is to be like a collectable hobbyist. You trade in assets (like coins) which you hope will appreciate in value, so that you can resell them at a profit. We’ll call that the “Appreciation” strategy. The appreciation strategy includes a lot of the business approaches used by those who do a lot of M&A activity, private equity funds, and stock traders.

The second way to make money is by being like that coin dealer. You make money by helping people using the Appreciation strategy make their transactions. Your profits come from the spread between retail and wholesale. We’ll call this the “Mediator” strategy. It is the approach used by brokers, agents, investment bankers and retailers, among others.

The third way is to make money by adding a new element of value that wasn’t there before. We’ll call this the “Creator” strategy. The value can be created by taking raw materials to make a new product (i.e., manufacturing) or by taking raw ideas and processes to make a new service (which is like a form of intangible manufacturing).

Just as I saw collectable hobbies as a rip-off, I see similar flaws in strategies primarily focused on the Appreciation or Mediator approaches. As we will see in this blog, the Creator strategy approach has inherent advantages over the other two approaches, because it tends to avoid the problems I saw in collectable hobbies.

THE PRINCIPLE
The principle here is that the approach you take for gaining profits makes a difference, and the creator approach tends to have the most solid foundation for success.

1) Problems With the Appreciation Strategy

As we saw with the coin collecting, there is a big spread that needs to be overcome in order to profit from any appreciation. This same problem applies to all who operate under more of an appreciation approach. If you are a private equity fund acquiring assets or a business doing a lot of M&A, you are familiar with this problem, although you may call it something else.

There is something called an “acquisition premium” when you buy companies or businesses. It is the price you pay over the current ongoing value of the business as is. This is most easy to see when a publicly traded company is acquired. The acquirer always pays a lot more than what the company had been previously trading for. Supposedly, the public trading price on the stock market is a fair assessment of the value of that business pre-acquisition. So the premium means that you are paying a lot more than the market thinks it was worth.

The fact that one has to pay a premium over the trading price is like the spread at the coin dealer. You acquired the company high, sometimes as much as 30% or more over the pre-acquisition valuation. And often, the company is resold via an IPO, where the price is intentionally set relatively low, to appeal to the initial buyers of the IPO stock, who want to achieve a quick appreciation on their investment.

As a result, a whole lot of appreciation has to occur in order to cover that spread and make money. That can be hard to come by in this slow-growing economic environment. This is compounded by the fact that those attempting to acquire are finding more savvy sellers who are demanding a larger premium (just ask Michael Dell in his attempt to take Dell private). So the gap may be getting larger while the opportunities and tricks available to get an appreciation over the gap are getting more difficult. This is why many private equity funds are having difficulty finding ways to effectively invest all that money.

A second problem for those using the Appreciation strategy approach is that they tend to have less control over their strategy than those using the other approaches. Commodity prices can fluctuate rapidly. As we saw in the great recession, prices on mortgage devices can plummet quite quickly. And the strategy only works if you can find another set of buyers to pay you more than when you first bought the asset, which is not guaranteed. With less under one’s direct control, the harder it is to make sure the Appreciation strategy succeeds.

2) The Problems With the Mediator Strategy

Mediators, like my coin dealer, also have problems. The largest problem has to do with market disruptions and disintermediation. In the past, agents, brokers and the like held special power because they were about the only way to connect buyers and sellers (the power of mediation). Now, thanks to disruptive digital business models, buyers and sellers can approach each other directly. Instead of going to the coin dealer, I could have sold those coins directly to consumers on Ebay and kept some of the spread for myself.

Travel sites have eliminated most of the need for travel agents. Why use an expensive stock broker when you can trade directly online? And in the retail space, there are so many digital ways for consumers to beat the spread, that retail stores are at risk of being showrooms for digital competitors. The ability to go direct makes many Mediators superfluous.

And even those Mediators who are keeping their positions are finding out that the spread between wholesale and retail is shrinking. The digital explosion is making knowledge available to everyone. This eliminates friction, makes markets flat, and reduces the power of the Mediator (who used to thrive by having special information other did not). As a result, the Mediator adds less value to transactions, thereby cutting the commission they can demand.

3) The Benefits of the Creator Strategy

The Creator approach avoids many of these problems. First, instead of getting caught in the trap of buying high and selling low, Creators are more likely to buy low and sell high. Why? Creators buy raw materials and sell finished products. Raw materials tend to cost a lot less than finished products. And buying the services of an engineer can be a whole lot cheaper than selling the cool stuff dreamed up by that engineer.

The Creator strategy, by its very nature, is converting lower cost inputs into higher value outputs. This conversion creates real economic value. You are not trying to take a relatively similar object and artificially create a spread between two transactions for that same object as is done in the other strategies. No, you have two different sets of objects—raw inputs and finished outputs—and the difference between the two causes a natural bump in value.

This Creator bump is easier to protect and is more in your control than the type of spread attempted when working as an Appreciator or Mediator. This gives the Creator strategy approach many advantages.

The Warren Buffett Way

These are not necessarily new ideas. This is essentially the philosophy behind Warren Buffett and his approach at Berkshire Hathaway. Warren Buffett has tried to steer clear of the problems in typical Appreciator of Mediator approaches. For example, instead of doing a lot of rapid buy and sell, Buffett holds for the long term. That way, he has fewer spreads to cover (less buy high, sell low). Instead, he tries to get the value out of the long-term output of what the company creates.

Second, Warren Buffett prefers to invest primarily in businesses where clear and simple creation is going on. Businesses based on fancy financial trade maneuvering or businesses where the path to value creation are more vague (like social media) tend to be shunned.

This approach has worked quite well for him. So maybe a more creator-based strategy is better for you.

Implications

The implication is that the more real value you can create through asset conversion, the better off you tend to be. Even if you are doing acquisitions or acting as an intermediary, there is room to become more of a creator and less reliant on merely trying to beat a spread. As an intermediary, you can be the disrupter of your industry and create the leading substitute for the status quo. As an acquirer, you can become more like Berkshire Hathaway.

And, as a manufacturer or service provider, you can best break out of the commodity mode by creatively adding more and more value into your conversion from input to output. That differential advantage through superior conversion (in speed, cost, quality or innovation) provides more room to find a profit.

SUMMARY
Businesses attempt to make their profit in one of three ways: by Asset Appreciation, Transaction Mediating, or Value Creation through Asset Conversion. The first two approaches tend to be more problematic, because they tend to rely on more of a buy high, sell low methodology. The third approach is more solid, because it creates more value in a more controlled manner.

FINAL THOUGHTS
We covered a lot of economic territory in a very small blog. There are lots of nuances here that we did not address. But the basic idea of trying to create natural value bumps by converting cheaper inputs into more valuable outputs is a key place to focus one’s strategic energy.

Anticipation and Creation

THE QUESTION
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.

 

ANSWER #1:  SURVIVING CREATIVE DESTRUCTION
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).

 

ANSWER #2:  NOT ALL PLANNING IS GOOD PLANNING
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.

 

 
ANSWER #3:  GOOD PLANNING IS NOT ABOUT PRESERVATION
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.

 

SUMMARY
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.

 

FINAL THOUGHTS
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.