Win­ning in the new age of strat­egy

When cap­i­tal is both plen­ti­ful and cheap, many of the un­spo­ken as­sump­tions about what drives business success must be chal­lenged and a new play­book de­vel­oped. Some companies are suc­cess­fully adapt­ing to the new era, and these are some of the changes they

Finweek English Edition - - ON THE MONEY MANAGEMENT - By Joachim Brei­den­thal, Michael Mank­ins, Karen Har­ris and David Hard­ing

fmostor of the past 50 years, business lead­ers viewed fi­nan­cial cap­i­tal as their most pre­cious re­source. To­day, fi­nan­cial cap­i­tal is no longer a scarce re­source – it is abun­dant and cheap. Bain & Com­pany’s Macro Trends Group es­ti­mates that global fi­nan­cial cap­i­tal has more than tripled over the past three decades and now stands at roughly 10 times global GDP. As cap­i­tal has grown more plen­ti­ful, its price has plum­meted. For many large companies, the af­ter-tax cost of bor­row­ing is close to the rate of in­fla­tion, mean­ing that real bor­row­ing costs hover near zero.

Any rea­son­ably prof­itable large en­ter­prise can read­ily ob­tain the cap­i­tal it needs to buy new equip­ment, fund new prod­uct de­vel­op­ment, en­ter new mar­kets, and even ac­quire new busi­nesses. Lead­er­ship teams still need to man­age their money care­fully, but the skil­ful al­lo­ca­tion of fi­nan­cial cap­i­tal is no longer a source of sus­tained com­pet­i­tive ad­van­tage.

Strat­egy in the new age of cap­i­tal su­per­abun­dance de­mands a dif­fer­ent ap­proach from the tra­di­tional mod­els an­chored in long-term plan­ning and con­tin­ual im­prove­ment.

Companies should move away from mak­ing a few big bets over the course of many years and start mak­ing nu­mer­ous small and var­ied in­vest­ments, know­ing that not all will pan out.

They must learn to quickly spot – and get out of – los­ing ven­tures, while ag­gres­sively sup­port­ing the win­ners. This is the path taken by firms in­no­vat­ing in rapidly evolv­ing mar­kets, but in an era of cheap cap­i­tal, it will be­come the dom­i­nant model across the business econ­omy.

Companies that prac­tice this strat­egy will have the edge so long as cap­i­tal re­mains su­per­abun­dant – and ac­cord­ing to our anal­y­sis, that could be the case for the next 20 years or more.

A world awash in money

Many of to­day’s business lead­ers cut their teeth in a period of rel­a­tive cap­i­tal scarcity and high bor­row­ing costs. In the early 1980s, double-digit fed­eral-funds rates pre­vailed, and cor­po­rate debt and eq­uity se­cu­ri­ties traded at high pre­mi­ums.

Our re­search sug­gests that for most large public companies, the weighted aver­age cost of cap­i­tal, or WACC, ex­ceeded 10% for most of the 1980s and 1990s.

But the world changed fol­low­ing the fi­nan­cial col­lapse in late 2008. Cen­tral bank in­ter­ven­tions pushed in­ter­est rates in many coun­tries to his­toric lows, where they re­main nearly a decade later. Many ex­ec­u­tives be­lieve the cur­rent in­ter­est rate en­vi­ron­ment is tem­po­rary and that more-fa­mil­iar cap­i­tal mar­ket con­di­tions will re­assert them­selves soon. Our re­search leads to the op­po­site con­clu­sion.

Bain’s Macro Trends Group found that global fi­nan­cial as­sets grew at an in­creas­ingly rapid pace from $220tr in 1990 (about 6.5 times global GDP) to $600tr in 2010 (9.5 times global GDP). We project that by 2020 the num­ber will have ex­panded to about $900tr (mea­sured in 2010 prices and ex­change rates), or more than 10 times pro­jected global GDP.

We see two fac­tors prin­ci­pally ac­count­ing for the con­tin­u­ing trend:

Grow­ing fi­nan­cial mar­kets in emerg­ing economies:

Although prospects for growth in ad­vanced economies are rel­a­tively weak, the fi­nan­cial mar­kets in China, In­dia, and other emerg­ing economies have only started to de­velop. These na­tions will ac­count for more than 40% of the in­crease in global fi­nan­cial as­sets from 2010 to 2020. Data sug­gests that emerg­ing economies will con­tinue fu­el­ing growth in fi­nan­cial cap­i­tal well be­yond 2020.

An ex­pand­ing num­ber of “peak savers”:

The pop­u­la­tion of 45- to 59-year-olds is crit­i­cal in de­ter­min­ing the level of sav­ings (ver­sus con­sump­tion) in the global econ­omy. Peo­ple in this age bracket have moved past their prime spend­ing years and make a higher con­tri­bu­tion to sav­ings and cap­i­tal for­ma­tion than any other age group. These “peak savers” will rep­re­sent a large and grow­ing per­cent­age of the global pop­u­la­tion un­til 2040, when their num­bers will slowly be­gin to de­cline.

The com­bi­na­tion of these fac­tors leads us to con­clude that up to 2030 (at least), mar­kets will con­tinue to grap­ple with cap­i­tal su­per­abun­dance. Too much cap­i­tal will be chas­ing too few good in­vest­ment ideas for many years.

The new rules of strat­egy

When cap­i­tal is both plen­ti­ful and cheap, many of the un­spo­ken as­sump­tions about what drives business success must be chal­lenged and a new play­book

de­vel­oped. A few companies are al­ready in­cor­po­rat­ing cap­i­tal su­per­abun­dance into the way they think about strat­egy and or­gan­i­sa­tion. The changes they are mak­ing – and de­riv­ing ben­e­fits from – ac­cord with three new rules:

1. Reduce hur­dle rates

Vir­tu­ally ev­ery large com­pany sets ex­plicit or im­plicit hur­dle rates on new cap­i­tal in­vest­ments. A hur­dle rate is the min­i­mal pro­jected rate of re­turn that a planned in­vest­ment must yield. Exceed this rate and the in­vest­ment is a “go”; fall short and it will be scut­tled. For too many companies, how­ever, hur­dle rates re­main high rel­a­tive to ac­tual cap­i­tal costs. Re­search con­ducted in 2013 by the US Fed­eral Re­serve found that companies are ex­tremely re­luc­tant to change hur­dle rates even when in­ter­est rates fluc­tu­ate dra­mat­i­cally.

Too many in­vest­ment op­por­tu­ni­ties are be­ing re­jected, cash is build­ing up on cor­po­rate bal­ance sheets, and more and more companies are choos­ing to buy back com­mon stock rather than pur­sue in­vest­ments in pro­duc­tiv­ity and growth. Reuters stud­ied 3 297 pub­licly traded US non-fi­nan­cial companies in 2016 and found that 60% bought back shares be­tween 2010 and 2015.

And for companies with stock re­pur­chase plans, spend­ing on buy­backs and div­i­dends ex­ceeded not just in­vest­ments in re­search and de­vel­op­ment but also to­tal cap­i­tal spend­ing.

In the new era, lead­ers should have a strong bias to­wards rein­vest­ing earn­ings in new prod­ucts, tech­nolo­gies, and busi­nesses. It is the only way for the companies that have bought back shares to grow into their new mul­ti­ples and for all companies to fuel in­no­va­tion and ac­cel­er­ate prof­itable growth.

With ex­pected eq­uity re­turns in the sin­gle dig­its, it shouldn’t be dif­fi­cult for man­age­ment to iden­tify strate­gic in­vest­ments with the po­ten­tial to gen­er­ate more at­trac­tive re­turns for in­vestors. To qual­ify, op­por­tu­ni­ties need only be ca­pa­ble of gen­er­at­ing a re­turn on eq­uity higher than shareholders’ cost of eq­uity cap­i­tal, which we es­ti­mate is a mere 8% for most large companies.

2. Fo­cus on growth

A lin­ger­ing ar­ti­fact from the age of cap­i­tal scarcity is a bias to­wards tweak­ing the per­for­mance of ex­ist­ing op­er­a­tions, rather than try­ing to build new busi­nesses and ca­pa­bil­i­ties.

When cap­i­tal was ex­pen­sive, in­vest­ments to im­prove prof­itabil­ity trumped in­vest­ments to in­crease growth. Ac­cord­ingly, over the past sev­eral decades, most companies have fo­cused on removing waste and in­creas­ing ef­fi­ciency. At the same time, how­ever, the rate of in­no­va­tion has de­clined, ac­cord­ing to re­search con­ducted by the OECD, and since 2010, top-line growth has been flat (or neg­a­tive) for nearly one-third of the non­fi­nan­cial companies in the S&P 500. Success in the new era de­mands that lead­ers fo­cus as much (or more) on iden­ti­fy­ing new growth op­por­tu­ni­ties as on op­ti­mis­ing the cur­rent business – be­cause when cap­i­tal costs are as low as they are to­day, the pay­off from in­creas­ing growth is much higher than what can be gained by im­prov­ing prof­itabil­ity. In ad­di­tion to set­ting up for­mal struc­tures that en­cour­age new business ideas, companies can adopt in­for­mal pro­cesses to re­ward con­tin­u­ous ex­pan­sion. 3M is the clas­sic ex­am­ple. For years it has per­mit­ted its 8 000-plus re­searchers to de­vote 15% of their time to projects that re­quire no for­mal ap­proval from su­per­vi­sors. The com­pany also pur­sues tra­di­tional prod­uct de­vel­op­ment ef­forts in which business man­agers and re­searchers work to­gether to cre­ate new of­fer­ings and im­prove ex­ist­ing ones. This mul­ti­pronged in­no­va­tion process has en­abled 3M to gen­er­ate count­less new prod­ucts – from in­dus­trial ad­he­sives to Post-it notes – and con­sis­tent top-line growth, year af­ter year. Mak­ing con­tin­ual ex­pan­sion part of a com­pany’s DNA is not easy, and companies have tra­di­tion­ally suf­fered from los­ing fo­cus and over­di­ver­si­fy­ing. But that is not an ar­gu­ment for duck­ing the chal­lenge. In­vest­ment in real growth has al­ways been risky, and ex­ec­u­tives must learn to ac­cept and even em­brace fail­ure. This im­plies the need for new per­for­mance ap­praisal pro­cesses and an ef­fort by se­nior man­agers to con­sider how their or­gan­i­sa­tions are gain­ing knowl­edge by ex­plor­ing new av­enues of growth – whether those pan out or not.

3. Invest in ex­per­i­ments

When cap­i­tal was scarce, companies at­tempted to pick win­ners. The con­se­quences of get­ting it wrong could be dire for ca­reers as well as for strat­egy. With su­per­abun­dant cap­i­tal, lead­ers have the op­por­tu­nity to take more chances, double down on the in­vest­ments that per­form well, and cut their losses on the rest.

To win in the new era, ex­ec­u­tives need to get over the no­tion that ev­ery in­vest­ment is a long-term com­mit­ment.

Too many in­vest­ment op­por­tu­ni­ties are be­ing re­jected, cash is build­ing up on cor­po­rate bal­ance sheets, and more and more companies are choos­ing to buy back com­mon stock rather than pur­sue in­vest­ments in pro­duc­tiv­ity and growth.

In­stead, ex­ec­u­tives should fo­cus on whether putting money into some­thing could be valu­able as an ex­per­i­ment.

If the ex­per­i­ment goes south, they can (and should) ad­just. Treat­ing in­vest­ments as ex­per­i­ments frees companies to place more bets and al­lows them to move faster than com­peti­tors, par­tic­u­larly in rapidly chang­ing mar­kets.

Take Al­pha­bet, the par­ent com­pany of Google. Since 2005, Al­pha­bet has in­vested in count­less new ven­tures. Some have been highly pub­li­cised, such as YouTube, Nest, Google Glass, Mo­torola phones, Google Fiber and self­driv­ing cars. Oth­ers are less well-known (gro­cery de­liv­ery, photo shar­ing, an on­line car-insurance com­par­i­son ser­vice).

While many of Al­pha­bet’s in­vest­ments have suc­ceeded, a few have not. But rather than stick with those losers, CEO Larry Page and his team have shed them quickly, en­abling the com­pany to move on, test other in­vest­ment ideas, and re­dou­ble its ef­forts in promis­ing new busi­nesses.

In the past three years, Al­pha­bet has closed the smarthome com­pany Re­volv, shut down Google Com­pare (the car insurance site), “paused” Google Fiber, and sold Mo­torola Mo­bil­ity to Len­ovo.

Dur­ing the same period, the com­pany has in­creased its stake in cloud ser­vices and var­i­ous new un­der­tak­ings man­aged by the com­pany’s X lab group – in­clud­ing elec­tronic con­tact lenses and a net­work of strato­spheric balloons in­tended to pro­vide high-speed cel­lu­lar in­ter­net ac­cess in ru­ral areas.

Not ev­ery in­vest­ment will pay off, but the “no­ble ex­per­i­ments” mind­set has al­lowed the com­pany to ex­plore many in­no­va­tive ideas and cre­ate new plat­forms for prof­itable growth.

Al­pha­bet does have more money than most cor­po­ra­tions and is op­er­at­ing in the “new econ­omy”, where ex­cit­ing ideas con­stantly bub­ble up. But there is plenty of scope to ap­ply the same ap­proach in tra­di­tional sectors. Take con­sumer foods and bev­er­ages. Ev­ery March, as­pir­ing en­trepreneurs in the nat­u­ral and or­ganic foods in­dus­try con­verge on Ana­heim, Cal­i­for­nia, for Expo West, a gi­ant trade show. In the past, large food companies stayed away. They knew the success rate of new prod­ucts was low, and they funded in­no­va­tion in­ter­nally, rather than risk ex­pen­sive cap­i­tal on start-ups.

To­day those large companies are flock­ing to Expo West and tak­ing ad­van­tage of low-cost cap­i­tal to form their own in­vest­ment groups that build port­fo­lios of earlystage food companies. (Kel­logg has Eigh­teen94 Cap­i­tal, for ex­am­ple.) When a new prod­uct takes off, they buy out the founders and bring the op­er­a­tion in-house. In ef­fect, su­per­abun­dant cap­i­tal has made “out­sourced in­no­va­tion” pos­si­ble for food gi­ants, al­low­ing them to tap into the dy­nam­ics of the en­tre­pre­neur­ial econ­omy to solve their big­gest strate­gic is­sue: growth. A ver­sion of this ar­ti­cle ap­peared in the March-April 2017 is­sue (p. 66-75) of Har­vard Business Re­view.

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