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
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.