By: Chris Bradley, Martin Hirt, Sven Smit
26-MINUTE AUDIO / 3,400 WORDS (10 PAGES)
Have you experienced strategy meetings that promise a breakout growth that rarely materializes? Do you feel that the social dynamics in the strategy room might have reduced breakthrough ideas to safe bets? And even when strategies succeed, the results are often just modest. What happened?
Based on in-depth empirical research on thousands of companies, McKinsey Partners Chris Bradley, Martin Hirt, and Sven Smit provide a data-driven “outside view” to overcome social dynamics and create effective strategies. This book offers ten performance levers that dramatically increase your chances to outperform competitors and create breakout growth.
TOP 20 INSIGHTS
Survey shows that 70% of executives say they don’t like the strategy process, and 70% of board members don't trust the results.
Strategy is challenging because it deals with low-frequency, high-uncertainty problems that are prone to cognitive biases. These biases typically reinforce favorable narratives. A study found that 80% of executives believe that their product stands out against the competition, while only 8% of the customers agreed.
The economic profit graph of companies follows a power law with a long flat middle and tails that rise and fall at exponential rates. Companies in the top quintile capture nearly 90% of all economic profits. Their average economic profit is $1.4 billion a year as compared to a mere $47 million for companies in the middle.
This Power Curve is growing steeper with time. The companies in the top quintile collectively made $684 billion in economic profit from 2010 to 2014, while the bottom quintile made a collective loss of $321 billion. From 2000 to 2004, the corresponding figures were much lower at $186 billion and $61 billion respectively.
Companies compete not only in their industries and their market segments. As far as capital is concerned, they also compete against every other player in the world. Companies that started in the top quintile in 2004 garnered nearly 50 cents of every new dollar invested. Moving up the Power Curve is therefore imperative.
Nearly 50% of a company’s position in the Power Curve is determined by its industry. It’s much better to be an average company in a great industry than to be a great company in an average industry. For example, the median pharmaceutical or technology company would be in the top 10% of food product companies.
Success is defined as moving up the Power Curve. Companies that jump from the middle to the top quintile gain an average increase of $640 million in annual economic profit. This requires big moves that outperform competitors.
A recent survey found that CEO’s attribute only 50% of target-setting decisions to facts and analytics. The remaining 50% is due to the dynamics in the strategy-making process.
The Power Curve is sticky. The general odds of a company moving from the middle to the top quintile over ten years is just 8%. 78% of firms in the middle quintiles, 59% of those in the top quintile, and 43% of firms in the bottom quintile remained at the same position ten years later.
Among 101 companies that moved up a quintile, two-thirds of the time it was due to just one business unit creating the breakout. Correctly identifying that business unit and feeding it the resources it needs for breakout growth can determine your organization’s progress on the Power Curve.
The probabilities for individual companies moving up the power curve can vary from 0 to 80%. Ten performance levers grouped into endowments, trends, and moves can predict the probability of success. Roughly, endowments determine 30%, trends 25%, and moves 45% of the probability of moving up the curve. This provides an outside view to analyze the quality of strategy.
Of the 117 organizations that moved up a quintile, 85 moved with their industry. If an organization faces an unfavorable trend, then there are two difficult options ahead: transform the industry to change its growth prospects and gain competitive advantage or shift industries. Neither option is easy, and the social dimensions make it much harder.
Big moves can help an organization get ahead of trends and shift odds in its favor. However, these need to be big enough in comparison to the rest of the industry to move up the Power Curve. The impact of big moves compounds. Each additional move nearly doubles the odds of moving up the Power Curve.
Four of the five big moves are asymmetrical one-sided bets. They increase the odds of going up the Power Curve and decrease the odds of sliding down.
M&A’s improve chances of moving up the Power Curve. This means executing at least one M&A per year that amounts to 30% of market cap in ten years with no deal being more than 30% of market cap. M&A requires skills that are built over time and practice. Infrequent and large moves affect value creation.
Reallocating at least 50% of capital expenditure across industries, operating segments, business units, customer groups, and geographies over ten years can create breakout growth. This necessarily means deallocating resources from other segments.
When an organization’s capital expenditure to sales ratio crosses 1.7 times the industry median for ten years, it creates breakout growth. Successful capital expenditure requires managing a pipeline of low-risk near-term options, medium-risk medium-term options, and some high-risk long-term options. This is the only big move that can increase the odds going down the curve as well.
Strategic issues do not lend themselves to instant decision-making. It’s best to trim the annual strategy process and have regular monthly strategy conversations around an active list of issues.
Use the analysis of endowments, trends, and moves to calibrate strategic decisions against the Power Curve. This will bring the focus to moves that can realistically get the company ahead of the competition.
Have conversations on growth and improvement plans to get bold ideas before discussing risks. Knowing the growth prospects, improvement, and risks for each initiative allows decision makers to prioritize strategic incentives based on a risk-return assessment. Incentives and performance targets must be adjusted to reflect risk.
Strategies tend to focus on incremental improvements and not on big moves. Breakthrough ideas are reduced into safe bets, and resources are spread thin across all verticals irrespective of growth potential. Why does this happen?
THE SOCIAL SIDE OF STRATEGY
Social dimensions — including individual bias and group dynamics — can overpower the best of strategic intent. A key reason for this is the fact that strategy rooms are excessively focused on the “insider view” - data about your organization, key competitors, and your own industry. The “insider view” creates distortions in strategic planning. The picture presented is mostly overly optimistic. Ultimately, the presentation shows a Hockey Stick Curve with an initial dip and a subsequent exponential breakout. This is used to bargain for resources or create sandbags to make sure targets are achieved. Either way, the predicted growth rarely materializes.
Social games are played because of people’s egos, status, and the resources they get; and careers depend on how they present their growth strategy. Strategy is challenging because it deals with low-frequency, high-uncertainty problems that are prone to cognitive biases. Further, there are agency problems that arise due to misalignment between management and other stakeholders. Some of them are:
Sandbagging: Individual managers create excessively safe plans that they are sure to achieve.
Short-Termism: The tendency to milk gains in the short run which may have long term consequences.
My Way or Your Problem: Managers may use not getting the resources they demanded as an excuse not to deliver.
The Numbers Game: Managers may spend their time optimizing for the metrics by which they are evaluated, ignoring other equally important factors.
Incentive mismatch: While CEO’s optimize for the overall success of the organization, managers tend to look out for their business units and their employees. Managers also know that they have to over-project to get the resources they actually need.
The social side of strategy ultimately leads to the “Peanut Butter Approach”, where resources are evenly spread across all units, even though some have far greater growth opportunities. What is needed is an “outside view” - data from thousands of organizations to objectively benchmark strategy.
THE POWER CURVE
Economic Profit — the total profit after subtracting the cost of capital — is a good indicator to measure by how much a company has beaten the market. When the authors graphed the economic profit of 2,393 of the largest non-financial companies between 2010 to 2014 from highest to lowest, they found that these companies follow a power law with a long flat line in the middle and tails that rise and fall at exponential rates.
This is divided into three regions: the bottom of the curve is represented by the first quintile of companies, the middle of the curve covers the second, third, and fourth quintiles, while the top of the curve covers the top quintile in economic profit. The average profit in the top of the curve is 30 times more than the middle of the curve. As the vast majority of the profits are in the top quintile, the goal of strategy must be to escape the broad middle and move into the top.
SHIFT TO THE OUTSIDE VIEW
The Power Curve brings a fundamental shift in strategic thinking. The comparison is with companies across the world for capital and economic profit. Success is now defined as moving up the Power Curve. Companies that jump from the middle to the top quintile gain an average increase of $640 million in annual economic profit.
KNOW YOUR ODDS
The Power Curve is sticky. The odds of a company moving from the middle to the top quintile over ten years is just 8% percent. 78% of firms in the middle quintiles, 59% of those in the top quintile, and 43% of firms in the bottom quintile remained at the same position ten years later. Among 101 companies that moved up a quintile, two-thirds of the time it was due to just one business unit creating the breakout. Correctly identifying that business unit and feeding it the resources it needs for breakout growth can determine your organization’s progress on the Power Curve. Bringing probabilities to the table can lead to a more realistic evaluation of risks and better decision-making.
TEN LEVERS THAT MATTER
While the general odds of moving up the Power Curve is 8%, the probabilities for individual companies can vary between 0% and 80%. Using data from 2,393 companies from 127 industry sectors over 15 years, the authors have identified ten performance levers that can predict the quality of a company’s strategy. These variables have been grouped into endowments, trends, and moves.
Endowments are where the organization is today; trends are current environmental factors that might assist or hinder growth; moves are actions by the organization. Roughly, endowments determine 30%, trends 25%, and moves 45% of the probability of moving up the curve. Endowments, trends, and moves provide a true outside view by giving an objective benchmark to analyze the quality of strategy beyond subjective opinions.
Endowments are based on history and determine the starting point for an organization. Below are aspects to consider:
Starting Revenue: The larger the organization, the better the chances to move up the Power Curve. To become a significant advantage, the organization must be in the top quintile in total revenue.
Debt Level: The lesser the debt, the greater the chances of moving up the Power Curve. To have an advantage, the debt-to-equity ratio must be in the top 40% of that industry.
Past Investment in R&D: To gain a significant improvement in the Power Curve, the ratio of R&D to Sales must be in the top 50% of that industry.
Success in riding trends means accurately understanding shifts in the industry, channeling resources towards opportunities, and doing it faster than competitors. This requires analytics ranging from broad industry macro-trends to granular data about growth prospects. Two major trends are:
Industry Trends: Of the 117 organizations that moved up a quintile, 85 moved with their industry. If an organization faces an unfavorable trend, then there are two difficult options ahead: 1) transform the industry to change its growth prospects and gain competitive advantage, or 2) shift industries. Neither option is easy and the social dimensions make it much harder.
Geographic Trends: Exposure to high-growth geographies can propel organizational growth. Organizations headquartered in developing countries not only benefited from stronger growth in these markets but also performed better in developed markets.
FOUR STAGES OF DISRUPTION
Identifying new trends may be difficult as they begin in a slow, quiet, and unimpressive manner that does not catch the attention of industry leaders. Avoiding being disrupted requires foresight and a willingness to navigate the four stages of a disruptive trend:
Stage 1: Detectable
There are only faint signals and barely any impact on the core business. Further, it is difficult to figure which trends to ignore and which to respond to. Diagnosing shifts accurately requires challenging governing beliefs about value creation in the industry. Changing mindsets is difficult, and status quo arguments will appear more sensible.
Stage 2: Change takes Hold
The technological and economic dimensions of the trend are clear but there is still no impact on earnings. Companies must nurture initiatives to gain a foothold in the new space. These ventures must have autonomy from core business even if there is a conflict of interest. However, this is difficult because there are existing revenue channels to protect and boards and investors to answer to. The long term threat doesn't seem as painful as the immediate difficulty.
Stage 3: Inevitable Transformation
The new model is proven to be superior and has gained acceptance among early adopters. To gain acceleration at this stage, companies must single-mindedly shift resources from the old to the new model. This is the hardest stage to navigate. As revenues suffer, the tendency to become conservative and focus on the core legacy business increases. Boards may be unwilling to accept reduced performance to achieve long-term goals. Where there is a lack of in-house capabilities, acquisitions must be explored.
Step 4: The New Normal
The industry has fundamentally changed. Incumbents will find their earnings dwindle. Some might adapt and survive, but many will go through waves of restructuring and consolidation. Sometimes an exit may be the best way to preserve value.
FIVE BIG MOVES
Big moves can help an organization get ahead of trends and shift odds in its favor. However, these need to be big enough in comparison to the rest of the industry to move up the Power Curve. Three big moves boost the odds of moving up the Power Curve from 8% to 47%.
The most effective style is executing at least one M&A per year that amounts to 30% of market cap in ten years with no deal being more than 30% of market cap. M&A requires skills that are built over time and practice. Infrequent, large moves affect value creation.
Active Resource Reallocation:
This move requires reallocating capital across industries, operating segments, business units, customer groups, and geographies. Plan ahead by handing out cuts to create space in the budget for reallocation. Dynamic reallocation of shifting over 50% capital expenditure across business units over ten years can create 50% more value.
Strong Capital Programs:
Capital investment becomes a lever when an organization’s capital expenditure to sales ratio crosses 1.7 times the industry median for ten years. Successful capital expenditure requires managing a pipeline of near term low-risk options, medium-risk medium term options and some high-risk long term options. This requires discipline and a tested investment process. Of the five big moves, this is the only one that can increase the odds of going down the power curve as well.
This is favored by managements as it is under their control. To be effective, however, they have to deliver a 25% productivity improvement over the industry median over a ten-year period. This requires extraordinary effort to build an organizational culture that focuses on driving productivity. Sometimes gains in productivity are lost in sales or absorbed by units.
This includes innovations in products, services, and business models. A good metric to measure differentiation is to compare the gross margin of the company with the rest of the industry. Exceeding the industry by 30% over a decade increases the chances of moving up the curve.
Overall, big moves can cancel a poor inheritance and increase the odds of moving up the Power Curve. The move has to be big enough to cross the thresholds mentioned to make an impact on the Power Curve. The impact of big moves compounds - each additional move nearly doubles the odds of moving up the Power Curve. All moves except Capital Expenditure are one-sided bets. They increase the odds of going up the Power Curve and decrease the odds of sliding down.
EIGHT SHIFTS IN THE STRATEGY ROOM
What do these insights mean for you in the strategy room? There are eight key shifts to leverage these insights and address the social side of strategy.
From annual planning to strategy as a journey:
A regular annual strategy cycle is ill-suited to today’s dynamic business environment. Therefore it’s best to trim the annual process and have regular monthly strategy conversations around a live list of issues. Dynamically track the portfolio of initiatives and suitably update strategy.
From getting consensus to debating alternatives:
Strategic discussions must focus on discussing options instead of getting consensus on a plan. It’s important to use the analysis of endowments, trends, and moves to calibrate strategic decisions against the Power Curve. Techniques like pre-mortem where the team assumes that strategy has failed and analyses the possible causes can de-bias decision-making.
From “peanut butter” to picking breakouts:
Identify winning business units and feed them the resources they need. Incentives have to be structured to encourage resource reallocation. Picking breakouts must be applied granularly at every level of the company. Measure reallocation relative to competitors to get an outside view.
From budget approval to big moves:
Building a momentum case that forecasts the future trajectory at current performance levels can give a better baseline to evaluating strategic choices. Perform a “tear-down” of past results to identify what came from moves and what can be put down to trends. Shift the conversations from budget allocations to big moves that each business unit can pull off to move ahead of the competition. Budgets should be tied to these big moves.
From budget inertia to liquid resources:
Resources must be freed months before to invest in new opportunities during budget allocation time. 10-20% of the budget must be freed every year for reallocation. Create a suitable opportunity cost for resources so that managers have the incentive to free them.
From sandbagging to open risk portfolios:
A good way to avoid sandbagging is to hold conversations on growth and improvement plans to get bold ideas before beginning the conversation on risk. A picture of the growth, improvement, and risks for each initiative allows decision makers to prioritize strategic incentives based on a risk-return assessment. Incentives and performance targets must be adjusted to reflect risk.
From a number focus to holistic performance reviews:
Probabilities of success must be a prominent part of strategic discussions and use them in incentives and performance review. This creates a sense of shared ownership. To encourage long term-tasks with uncertain outcomes, incentives can be based on team performance.
From long-range planning to forcing the first step:
Big moves must be broken down into realistic, achievable time-bound goals. To do this, it’s best to create six-month targets with clear operational metrics. It's important to allocate resources and people to back strategic goals.
These eight shifts work together to transform your strategy. Strategy is still part science and part art, but this approach of understanding the odds and focusing on the outside view can help you better overcome the social side of strategy and create breakout growth.