Chris Bradley, Martin Hirt, and Sven Smit, Authors, Strategy Beyond the Hockey Stick: People, Probabilities, and Big Moves to Beat the Odds
Only 1-in-12 companies manage to rise from the middle of the pack to the top. Here’s how to become one of them
Several times a year, top management teams enter the strategy room with lofty goals and the best of intentions: They hope to learn from each other how different parts of their business are faring, and to mount a decisive, coordinated response to changing market conditions.
Then reality intrudes. The strategy room is crowded with egos and competing agendas. Jobs—even careers—are on the line, so caution reigns. The budget process intervenes, too. You may be discussing a five-year strategy, but everyone knows that what really matters is the first-year budget. So most managers try to secure resources for the coming year while deferring accountability for results as far as possible into the future. Former chief executive of a major Las Vegas casino operator once told us, “I wish I met once, just once, a guy who would walk up to me and say: ‘Man, things are not well down here, and, to tell you the truth, I can’t tell which way is up. But we are on it, rolling up our sleeves to turn this sucker around.’”
One outcome of these dynamics is the hockey stick projection, confidently showing future success after the all-too-familiar dip based on the first year’s investment. Yet, more often than not, this projection fails to materialize, leading to a new hockey-stick strategy being proposed the following year.
We set out to reset the strategy process and tame the social dynamics. How? With data.We examined publicly available information on dozens of variables for the world’s 2,393 largest corporations between 2010 and 2014,and found the levers that explain more than 80 percent of the up-drift and down-drift in corporate performance. Our goal was to develop an objective, external benchmark that will enable CEOs to assess a strategy’s odds of success before they leave the strategy room, much less start to execute the plan.
THE ODDS OF STRATEGY
The starting point for developing such a benchmark is embracing the fact that business strategy, at its heart, is about beating the market. Economic profit—the total profit after the cost of capital is subtracted—measures a company’s success at this by showing what is left after the forces of competition have played out.
Plotting the average economic profit for each company demonstrates a power law—the tails of the curve rise and fall at exponential rates, with long flatlands in the middle.
The power curve reveals a number of important insights:
Market forces are pretty efficient. For companies in the middle, the market takes a heavy toll. These firms delivered economic profits averaging just $47 million a year.
The curve is extremely steep at the bookends. Companies in the top quintile capture nearly 90 percent of the economic profit created. At the other end of the curve, the undersea canyon of losses is deep—though not quite as deep as the mountain is high.
The curve is getting steeper. Back in 2000-04, companies in the top quintile captured a collective $186 billion in economic profit. Fast forward a decade and the top quintile earned $684 billion. A similar pattern emerges at the bottom. Since investors seek out companies that offer market-beating returns, capital tends to flow to the top, no matter the geographic or industry boundaries.
Size isn’t everything, but it isn’t nothing, either. Economic profit reflects the strength of a strategy based not only on the power of its economic formula but also on how scalable that formula is. Compare Wal-Mart, with a moderate 12 percent return on capital but a whopping $136 billion of invested capital, with Starbucks, which has a huge 50 percent return on capital but is limited by being in a much less scalable category. They both generated enormous value, but the difference in economic profit is substantial: $5.3 billion for Wal-Mart versus $1.1 billion for Starbucks.
Industry matters, a lot. Our analysis shows that about 50 percent of your position on the curve is driven by your industry—highlighting just how critical the “where to play” choice is in strategy. Industry performance also follows a Power Curve, with the same hanging tail and high leading peak. The role of industry in a company’s performance is so substantial that you’d rather be an average company in a great industry than a great company in an average industry.
Mobility is possible—but rare. Here is a number that’s worth mulling: the odds of a company moving from the middle quintiles of the Power Curve to the top over a 10-year period are 8 percent. That means just 1-in-12 companies make such a leap.
THE POWER OF BIG MOVES
Sohow can you improve the odds that your company will be among the 8 percent? We identified 10 performance levers and, importantly, how strongly you have to pull them to make a real difference in your strategy’s success. These levers fall into three categories: endowment, trends, and moves. Your endowment is what you start with, and the variables that matter most are your revenue (size), debt level (leverage), and past investment in R&D (innovation). Trends, in both your industry and geography, are the winds that are pushing you along, hitting you in the face, or buffeting you from the side. In analyzing the odds of moving on the Power Curve, we found that endowment determines about 30 percent and trends another 25 percent.
However, it is your moves—what you do with your endowment and how you respond to trends—that make the biggest difference. Our research found that the following five moves, pursued persistently, can get you where you want to go:
Programmatic M&A. You need a steady stream of deals, each amounting to no more than 30 percent of your market cap but adding up over 10 years to at least 30 percent of your market cap. Corning understood that doing three deals a year means maintaining a steady pipeline of potential targets, conducting due diligence on 20 companies, and submitting about five bids. The result: over a decade, the company moved from the bottom to the top quintile of the Power Curve.
Dynamic reallocation of resources. Winning companies reallocate capital at a healthy clip, feeding the units that could produce a major win while starving those unlikely to surge. The threshold here is reallocating at least 50 percent of capital expenditure among business units over a decade. When Pieter Nota took over Philips’ consumer business in 2010, he launched a massive resource-reallocation initiative. He divested stalling assets, and started tracking resource allocation not just across five business groups but at the level of more than 150 “business market” cells, such as coffee makers in Italy and shavers in China. That turned Philips’ consumer business from the worst- to the best-performing division within five years.
Strong capital expenditure. You meet the bar on this lever if you are among the top 20 percent in your industry in your ratio of capital spending to sales. That typically means spending 1.7 times the industry median. Taiwanese semiconductor manufacturer TSMC pulled this lever when the Internet bubble burst and demand for semiconductors plunged. The company bought mission-critical equipment at the trough and was ready to meet the demand as soon as it came back, laying the foundation for TSMC becoming one of the most successful semiconductor manufacturing pure plays in the world.
Strength of productivity program. This means improving productivity at a rate sufficient to put you at least in the top 30 percent of your industry. Hasbro is a case in point. Following a series of performance shortfalls, the company consolidated business units and locations, invested in automated processing and customer self-service, reduced headcount, and exited some businesses. Sales productivity also rose significantly. Over the decade, Hasbro shed more than a quarter of its workforce yet still grew revenue by 33 percent.
Improvements in differentiation. For business model innovation and pricing advantages to raise your chances of moving up the Power Curve, your gross margin needs to reach the top 30 percent in your industry. German broadcaster ProSiebenSat.1 moved to the top quintile by shifting its model for a new era. Some of ProSieben’s innovations were costly, even cannibalizing existing businesses, but the company decided that experimenting with change was a matter of survival first and profitability second. ProSieben’s gross margin expanded from 16 percent to 53 percent during our research period.
You should be mindful of several dynamics when undertaking major strategic moves. Moves are most effective when done in combination—and the worse your endowment or trends, the more moves you need to make. For companies in the middle quintiles, pulling one or two of the five levers more than doubles their odds of rising to the top, from 8 percent to 17 percent. Three big moves boost these odds to 47 percent.
Our research also shows that big moves can “cancel out” the impact of a poor inheritance. Making strong moves with a poor inheritance is about as valuable as making poor moves with a strong inheritance. Additionally, big moves are non-linear, meaning that just pulling a lever does not help; you need to pull it hard enough to make a difference. And four of the five big moves are asymmetric. In other words, the upside opportunity far outweighs the downside risk.
Finally, making no bold moves is the usually most dangerous strategy of all. You not only risk stagnation but miss out on the additional reward of growth capital, which mostly flows to the winners.
When you know, ahead of time, the chances of your strategy succeeding, and you can see the levers that matter most to your own business, you can make better choices and mitigate the impact of fear, ambition, rivalry, and bias. A good strategy is still hard to shape, but you can at least navigate toward one based onan accurate map.
About the Author
Chris Bradley is a partner in McKinsey’s Sydney Office. Martin Hirt and Sven Smit are Senior Partners in the firm’s Taipei and Amsterdam offices, respectively. This article is adapted from their book, Strategy Beyond the Hockey Stick: People, Probabilities, and Big Moves to Beat the Odds.