Strategy in the media

Citation

Henry, C. (2009), "Strategy in the media", Strategy & Leadership, Vol. 37 No. 1. https://doi.org/10.1108/sl.2009.26137aae.003

Strategy in the media

Article Type: CEO advisory From: Strategy & Leadership, Volume 37, Issue 1

Craig HenryStrategy & Leadership’s intrepid media explorer, collected these sightings of strategic management in the news. A marketing and strategy consultant based in Carlisle, Pennsylvania, he welcomes your contributions and suggestions (Craighenry@aol.com).

Analytics and the financial crisis

There is clearly some evidence that the current financial crisis was created – at least in part – by poor use of analytical approaches and techniques. If we’re going to avoid similar crises in the future, we have to learn from our mistakes.

What’s the evidence that the problem was somewhat analytical in origin? Let me count the ways:

• •

  Banks and mortgage companies use analytics to make automated or semi-automated decisions about mortgage loans. Various industry experts have told me that many firms continued to make subprime loans even though a close analysis of the data would have suggested that charge off rates were climbing for such loans. The companies simply didn’t monitor their analytical models closely enough.

• •

  Saul Hansell in a New York Times blog argues that Wall Street quants “lied to their computers” in their analytical models. He states that they included more years of history in their trading models for mortgage-backed securities than was warranted in order to make them look less risky. Quoting Gregg Berman of RiskMetrics, Hansell also states that traders knowingly traded mortgage-backed securities even when the risk of the securities being traded wasn’t accurately assessed by available metrics.

• •

  There seems to have been a general problem in financial analytics with the transparency and explicitness of assumptions behind quantitative models. Many mortgage-oriented models were implicitly based on the assumption that housing prices would continue to rise. Credit default models were based on the assumption of continued liquidity in credit markets. Neither, of course, have turned out to be valid assumptions for the current period.

• •

  I’ve heard several suggestions that some of the hedge funds that are having difficulty now used me-too trading and valuation models. The quant analysts involved either moved from one fund to another – taking their models and assumptions with them – or they reverse-engineered the models based on what they could learn through their social networks.

• •

  It’s also clear that risk analytics are not what they should be. AIG almost fell because of its inability to price and predict credit defaults; Moody’s, S&P, and Fitch were clearly unable to assess the risk of mortgage-backed securities and attach accurate credit ratings to them. The 1987 stock market crash was caused in part by a similar inability to assess the risk of portfolio insurance …

Going forward, however, financial services organizations need to radically change their analytical focus. They need to incorporate “model management” – the systematic capturing and monitoring of analytical models – into their businesses. They need to be much more explicit and transparent about the assumptions behind models. They – and their regulators – need to be skeptical about the ability to model and manage risk in extraordinary circumstances. And financial firm executives need to learn much more about the models that are running their businesses.

Tom Davenport, “Is this an analytics-driven financial crisis?,” 25 September 2008, The Next Big Thing, http://discussionleader.hbsp.com/davenport/2008/09/is_this_an_analyticsdriven_fin.html

Is Apple repeating past mistakes?

Watching Google and Apple carve out space in the mobile business, one can hardly avoid thinking that history is repeating itself. In the 1970s and ’80s, Apple created the first great personal computers. But because Apple closed its platform, it was IBM, Dell, HP, and especially Microsoft that reaped the benefits of Apple’s innovations. The Mac’s operating system ran only on Mac computers; Windows ran on lots of lots of different companies’ hardware. This made non-Apple computers both cheaper than Apple’s machines – competition between hardware manufacturers pushed down prices – and more useful, as third-party developers flocked to write must-have programs for Windows. Apple seems to be following a similar restrictive strategy with the iPhone. Already, some developers have threatened to move to Android; Sokirynsky says he’s building an Android version of Podcaster. Hasn’t Steve Jobs learned anything in the last 30 years?

Well, maybe he has – and maybe he’s betting that these days, “openness” is overrated. For one thing, an open platform is much more technically complex than a closed one. Your Windows computer crashes more often than your Mac computer because – among many other reasons – Windows has to accommodate a wider variety of hardware. Dell’s machines use different hard drives and graphics cards and memory chips than Gateway’s, and they’re both different from Lenovo’s. The Mac OS, meanwhile, has to work on just a small range of Apple’s rigorously tested internal components – which is part of the reason it can run so smoothly. And why is your PC glutted with viruses and spyware? The same openness that makes a platform attractive to legitimate developers makes it a target for illegitimate ones.

Let’s remember, too, that if keeping a platform closed was Steve Jobs’ greatest blunder, it was also a part of his greatest success. The iPod is a closed platform: The device runs Apple’s software, it connects to iTunes on your computer, and its music store sells songs that will work only on Apple’s devices. In 2004, Microsoft tried to take on the iPod with a more open music strategy called PlaysForSure. (OK, relatively more open; PlaysForSure, like songs sold on iTunes, included a copy-protection scheme.) Microsoft set out to certify and license music players made by lots of different manufacturers, an attempt to fight Apple’s music business the same way it had taken on Apple’s computer business. But this time Microsoft failed – the iPod-iTunes link simply worked better than the tangle of PlaysForSure devices. Eventually Microsoft went Apple’s way – it ditched PlaysForSure in favor of the Zune, for which it designs both the hardware and software.

Farhad Manjoo, “The cell phone wars: Apple’s iPhone is closed. Google’s G1 is open. Which is better?,” Slate, 25 September 2008 http://www.slate.com/id/2200914

High-value outsourcing gains momentum

On the top floor of a seven-story building in this dusty aspiring metropolis, Copal Partners churns out equity, fixed income and trading research for big name analysts and banks. It is a long way from the well-cooled corridors of Wall Street, and quarters are tight; business is up about 40 percent this year alone.

“This is one bulge-bracket bank,” said Joel Perlman, president of Copal, pointing toward a team behind an opaque glass wall. “And this,” he said, motioning across a narrow corridor “is another.”

The banks edit and add to what they get from Copal, a research provider, then repackage the information under their own names as research reports, pitch books and trading recommendations.

Wall Street’s losses are fast becoming India’s gain. After outsourcing much of their back-office work to India, banks are now exporting data-intensive jobs from higher up the food chain to cities that cost less than New York, London and Hong Kong, either at their own offices or to third parties.

Bank executives call this shift “knowledge process outsourcing,” “off-shoring” or “high-value outsourcing.” It is affecting just about everyone, including Goldman Sachs, Morgan Stanley, JPMorgan, Credit Suisse and Citibank – to name a few.

The jobs most affected so far are those with grueling hours, traditionally done by fresh-faced business school graduates – research associates and junior bankers on deal-making teams – paid in the low to mid six figures.

Cost-cutting in New York and London has already been brutal thus far this year, and there is more to come in the next few months. New York City financial firms expect to hand out some $18 billion less in pay and benefits this year than 2007, the largest one-year drop ever. Over all, United States banks will cut 200,000 employees by 2009, the banking consultancy Celent said in April.

The work these bankers were doing is not necessarily going away, though. Instead, jobs are popping up in places like India and Eastern Europe, often where healthier local markets exist.

“Cost-cutting in New York, but a boom in India,” The New York Times, 12 August 2008.

The downside of the “strategy revolution”

I called Walter Kiechel, the former managing editor of Fortune magazine and former editorial director of Harvard Business Publishing. For the past several years, he’s been researching and writing a book – due out next spring on the history of corporate strategy stretching back to the 1960s.

As Kiechel argued, businesses made plans before the 60s, but there was no concept of corporate strategy in the sense that we have it today – as a comprehensive framework that looks at costs, competition, and customers. The birth of that framework–what Kiechel calls “the strategy revolution” – brought about changes that turbocharged business over the last few decades, but that have also contributed to the chaos over the past few weeks.

For instance, in the early 60s, the strategy revolutionaries changed the way we see debt. “Early proponents of strategy like Bruce Henderson, who founded the Boston Consulting Group in 1963, just wrote flat-out, ‘Use more leverage than your competitors or get out of business,’” Kiechel explained. At the time, that was groundbreaking. “We forget today that back in those days, in the 50s and 60s, companies were still not using a lot of debt. A lot of times their management had grown up during the Great Depression and they were very frightened of [debt].”

The use of leverage as a strategic tool allowed companies to prosper greatly in the decades since, but some took it too far – including those hit the hardest by this month’s meltdown(s). As Kiechel pointed out, some Wall Street investment banks took on as much as 35 times as much debt as the value of their underlying assets. “That would never have happened,” he continued, “If people hadn’t taken a new attitude toward debt.”

http://conversationstarter.hbsp.com/2008/10/a_financial_crisis_fifty_years.html

Shareholder value and executive compensation

During the stock market boom of the 1980s and 1990s the argument that “maximising shareholder value” results in superior economic performance dominated corporate governance debates. Economists argued companies should disgorge their “free cash flow” to create value for shareholders, rather than horde cash or invest in productive capacity that was insufficiently profitable.

Traditionally companies distributed cash to shareholders through dividends. Increasingly, however, the payouts of US companies have taken the form of stock repurchases – total repurchases surpassed total dividends in 1997. Over the past five years, stock buy-backs have increased at a remarkable rate. Combined, the 500 companies in the S&P 500 index in January 2008 repurchased $120 bn in 2003 and $597 bn in 2007; in 2007 repurchases represented 90 per cent of their net income, while dividends were another 39 per cent.

These buy-backs are a measure of the grip that shareholder value ideology has on corporate America. Economists argue that among all stakeholders, only shareholders are risk-bearing “residual claimants”. The returns they get depend on what is left over after other stakeholders have been paid for their contributions according to guaranteed contractual claims. However, it is not true that all stakeholders receive guaranteed returns. Workers, for example, supply their skills with an expectation of long-term rewards such as promotion, but without these being contractually guaranteed. Governments often subsidize businesses without guaranteed returns to taxpayers. The shareholder-value perspective provides a simplistic answer to a complex problem: how to reward stakeholders so that their contributions raise living standards and provide economic gains that can be shared equitably.

Cash dividends are fundamentally different from stock repurchases. Dividends provide a return to those who hold stock, and hence maintain a commitment to the company. Yet executives have become enamored by stock repurchases. Their abundant stock options give them an incentive to do buy-backs to boost stock prices even if this undermines long-term value.

The adverse impact of these decisions goes beyond the unseemly explosion in executive pay. The crisis in the US financial sector offers one example. Having spent billions on stock repurchases, some of the oldest Wall Street banks find that the subprime crisis has left them in need of cash to stay afloat.

William Lazonick, “Everyone is paying price for share buy-backs,” Financial Times, 25 September 2008.

Proactive strategy and ecosystems

Hammered by relentless technological change, many companies take a reactive stance: They focus solely on keeping up, protecting their existing markets, and improving their performance. But a few companies take a proactive stance by executing shaping strategies:

They use technology changes to create new business ecosystems that benefit themselves and other participants. Take Google’s AdSense: It has reinvented the advertising business by enabling advertisers, content providers, and potential customers to connect with one another quickly, easily, and cheaply.

To succeed, a shaping strategy needs a critical mass of participants, say Hagel, Brown, and Davison. Shapers can attract them by:

• •

  Convincingly articulating opportunities available to participants.

• •

  Defining standards and practices that make participation easy and affordable.

• •

  Demonstrating they have the conviction and resources for success and won’t compete against participants.

Well-executed shaping strategies mobilize masses of players to learn from and share risk with one another creating a profitable future for all.

Develop a shaping platform

A shaping platform is a set of standards and practices that organize and support participants’ activities making it easy and inexpensive for participants to develop and deliver their own products or services.

Example:

Google’s AdSense has protocols governing how ads are submitted, priced, presented, and paid for. It allows even small advertisers and Web sites to invest minimal time and effort, with little oversight from Google, and still generate value for one another. This platform’s scalability makes specialization by participants economically attractive.

John Hagel III, John Seely Brown and Lang Davison, “Shaping strategy in a world of constant disruption,” Harvard Business Review, October 2008.

Lessons learned from business failure

Here are six lessons that, had they been learned a decade ago, would have kept us from being in our current mess:

1. 1.

   It doesn’t work to let dealmakers make all their money up front. Whether it’s lenders hawking mortgages, bankers pushing bonds, or salespeople closing contracts before the end of the quarter, dealmakers have to have responsibility for the health of those decisions years down the road. Where possible, the individuals who make the deals should also have their compensation depend on the long-term performance of those deals.

2. 2.

   Risks may correlate more than you think. In other words, a single problem can take you down if it’s severe enough.Long Term Capital Management thought it had diversified its risks in the 1990s but found its whole portfolio turning sour simultaneously and collapsed in 1998. Having missed that lesson, this time around companies such as Merrill Lynch and WaMu built huge portfolios of mortgage-related securities that relied on historical data suggesting that housing markets were localized – in other words, the market in Denver was independent of the market in Sacramento, which was independent of the market in Pittsburgh. In fact, the credit crunch has clobbered all markets and all classes of lenders.

3. 3.

   In a crisis, liquidity can disappear overnight.LTCM thought that, in the event of problems, it could always unwind its positions in orderly fashion. In fact, all buyers disappeared. The same thing happened to Merrill, WaMu and others. The market got so scared so fast that nobody would buy their debt portfolios at almost any price. While Bank of America might have bought Merrill at a bargain for $50B, they also acquired $64B of toxic debt that will eventually mushroom the true cost of the acquisition.

4. 4.

   It’s incredibly dangerous to buy a business unless you understand it in excruciating detail.

5. 5.

   Whenever anyone says they’ve managed to do away with risk, head for the hills.LTCM said its portfolio was impervious to risk. AIG and others said the same thing about the securities that were built based on subprime mortgages. We’ve no doubt that yet others will be saying the same as they argue for ways to take advantage of others’ mistakes as the current crisis unfolds.

6. 6.

   Perhaps the greatest lesson of all is that bad strategies can happen to great companies and smart people, even those acting on seemingly thorough analysis and the best of intentions. The humility that comes with this lesson should cause the smartest companies and managers to instill process and cultural mechanisms that absorb these lessons and avoid such mistakes in the future …

The next generation of great leaders will be the ones who absorb these lessons. Everyone else is doomed to repeat the same mistakes.

Paul B. Carroll and Chunka Mui, Billion-Dollar Lessons: What You Can Learn from the Most Inexcusable Business Failures of the Last 25 Years (Portfolio Hardcover, 2008).

How to market now

The spillover from the subprime mortgage crisis is weakening both consumer confidence and the consumer spending – much of it on credit – that has been buoying the US economy.

Companies should bear eight factors in mind when making their marketing plans for 2008 and 2009:

1. 1.

   Research the customer. Instead of cutting the market research budget, you need to know more than ever how consumers are redefining value and responding to the recession. Price elasticity curves are changing. Consumers take more time searching for durable goods and negotiate harder at the point of sale.

2. 2.

   Focus on family values. When economic hard times loom, we tend to retreat to our village. Look for cozy hearth-and-home family scenes in advertising to replace images of extreme sports, adventure and rugged individualism. Zany humor and appeals on the basis of fear are out.

3. 3.

   Maintain marketing spending. This is not the time to cut advertising. It is well documented that brands that increase advertising during a recession, when competitors are cutting back, can improve market share and return on investment at lower cost than during good economic times. Uncertain consumers need the reassurance of known brands – and more consumers at home watching television can deliver higher than expected audiences at lower cost-per-thousand impressions.

4. 4.

   Adjust product portfolios. Marketers must reforecast demand for each item in their product lines as consumers trade down to models that stress good value, such as cars with fewer options. Tough times favor multi-purpose goods over specialized products and weaker items in product lines should be pruned.

5. 5.

   Support distributors. In uncertain times, no one wants to tie up working capital in excess inventories. Early-buy allowances, extended financing and generous return policies motivate distributors to stock your full product line.

6. 6.

   Adjust pricing tactics. Customers will be shopping around for the best deals. You do not necessarily have to cut list prices but you may need to offer more temporary price promotions, reduce thresholds for quantity discounts, extend credit to long-standing customers and price smaller pack sizes more aggressively.

7. 7.

   Stress market share. In all but a few technology categories where growth prospects are strong, companies are in a battle for market share and, in some cases, survival.

8. 8.

   Emphasize core values. Although most companies are making employees redundant, chief executives can cement the loyalty of those who remain by assuring employees that the company has survived difficult times before, maintaining quality rather than cutting corners and servicing existing customers rather than trying to be all things to all people.

John Quelch, “How to market in a recession”, Marketing KnowHow, 24 September 2008, http://conversationstarter.hbsp.com/2008/10/a_financial_crisis_fifty_years.html

The global benefits of provincial America

Provincial America depends on the initiative of ordinary people to get through the day. America has something like an Education Ministry, but it has little money to dispense. Americans pay for most of their school costs out of local taxes, and levy those taxes on themselves. In small towns, many public agencies, including fire protection and emergency medical assistance, depend almost entirely on volunteers. People who tax themselves, and give their own time and money for services on which communities depend, are not easily cowed by the federal government or by large corporations …

The fact that ordinary people safeguard their rights and have the means to challenge established interests does not exclude the possibility of fraud on a grand scale.

Asian investors were cheated by a conspiracy of the financial industry and the ratings agencies, which sold them ostensibly low-risk securities that turned out to be toxic. Despite this fraud and its attendant humiliation, and despite the deterioration of governance in American markets, Asian investors are putting more rather than less money into America, judging from the decline of Asian currencies against the dollar in the course of the crisis.

One doesn’t see demonstrations by wronged peasants in the small towns of America. There never were peasants – American farmers always were entrepreneurs – and the locals avenge injury by taking over their local governments, which have sufficient authority to make a difference. At the capillary level, school boards, the Parent Teachers’ Association, self-administered religious organizations and volunteer organizations incubate a political class entirely different from anything to be found in Asia. There are tens of thousands of Sarah Palins lurking in the minor leagues of American politics, and they are the guarantors of market probity …

It is true that Asian economies depend on American consumers and an American recession is bad for Asian currencies. But why don’t Asians consume what they produce at home? The trouble is that rich Asians don’t lend to poor Asians in their own countries. Capital markets don’t work in the developing world because it is too easy to steal money. Subprime mortgages in the US have suffered from poor documentation. What kind of documentation does one encounter in countries where everyone from the clerk at the records office to the secretary who hands you a form requires a small bribe? America is litigious to a fault, but its courts are fair and hard to corrupt.

Asians are reluctant to lend money to each other under the circumstances; they would rather lend money in places where a hockey mom can get involved in local politics and, on encountering graft and corruption, run a successful campaign to turn the scoundrels out. You do not need PhDs and MBAs for that. You need ordinary people who care sufficiently about the places in which they live to take control of their own towns and states when required.

Spengler, “Hockey moms and capital markets,” Asia Times, 6 October 2008.

GIGO vindicated again

So where were the quants?

That’s what has been running through my head as I watch some of the oldest and seemingly best-run firms on Wall Street implode because of what turned out to be really bad bets on mortgage securities.

Before I started covering the Internet in 1997, I spent 13 years covering trading and finance. I covered my share of trading disasters from junk bonds, mortgage securities and the financial blank canvas known as derivatives. And I got to know bunch of quantitative analysts (“quants”): mathematicians, computer scientists and economists who were working on Wall Street to develop the art and science of risk management.

They were developing systems that would comb through all of a firm’s positions, analyze everything that might go wrong and estimate how much it might lose on a really bad day.

We’ve had some bad days lately, and it turns out Bear Stearns, Lehman Brothers and maybe some others bet far too much. Their quants didn’t save them. I called some old timers in the risk-management world to see what went wrong. I fully expected them to tell me that the problem was that the alarms were blaring and red lights were flashing on the risk machines and greedy Wall Street bosses ignored the warnings to keep the profits flowing.

Ultimately, the people who ran the firms must take responsibility, but it wasn’t quite that simple.

In fact, most Wall Street computer models radically underestimated the risk of the complex mortgage securities, they said. That is partly because the level of financial distress is “the equivalent of the 100-year flood,” in the words of Leslie Rahl, the president of Capital Market Risk Advisors, a consulting firm.

But she and others say there is more to it: The people who ran the financial firms chose to program their risk-management systems with overly optimistic assumptions and to feed them oversimplified data. This kept them from sounding the alarm early enough.

Top bankers couldn’t simply ignore the computer models, because after the last round of big financial losses, regulators now require them to monitor their risk positions. Indeed, if the models say a firm’s risk has increased, the firm must either reduce its bets or set aside more capital as a cushion in case things go wrong.

In other words, the computer is supposed to monitor the temperature of the party and drain the punch bowl as things get hot. And just as drunken revelers may want to put the thermostat in the freezer, Wall Street executives had lots of incentives to make sure their risk systems didn’t see much risk.

Saul Hansell “How Wall Street lied to its computers,” The New York Times, 18 September 2008.

Economists tackle innovation

Pessimism about America’s future is growing. People worry about the long-term impact of the housing crisis, global competition, and expensive energy. And the policy solutions offered by Republicans and Democrats – mainly tax cuts and government spending programs – seem insufficient.

Yet beneath the gloom, economists and business leaders across the political spectrum are slowly coming to an agreement: Innovation is the best – and maybe the only – way the US can get out of its economic hole. New products, services, and ways of doing business can create enough growth to enable Americans to prosper over the long run.

Certainly the Presidential candidates are taking the idea seriously. John McCain has proposed a $300 million prize for the person or company that creates a better battery technology to power cars. Barack Obama has called for spending $150 billion over the next 10 years on clean-energy technologies. The hoped-for outcome: more jobs, more competitive trade, less dependence on foreign oil.

But here’s the conundrum: If money alone were enough to guarantee successful innovation, the US would be in much better shape than it is today. Since 2000, the nation’s public and private sectors have poured almost $5 trillion into research and development and higher education, the key contributors to innovation. Nevertheless, employment in most technologically advanced industries has stagnated or even fallen. The number of domestic jobs in the computer and electronics sector continues to plunge while pharmaceutical and biotech companies lay off as many workers as they hire. And even the industry category that includes Google – Internet publishing and Web search portals – has added only 15,000 jobs since 2003.

The new field of innovation economics addresses this gap between spending and results. Economists are increasingly studying what drives successful innovation to learn how companies can get more bang from the bucks spent on R&D and higher education. At the same time, they’re collecting new data on American R&D initiatives to understand what’s working in the US and what’s not. And most important, economists are making concrete proposals about how to turn smart ideas into jobs and growth.

“Can America invent its way back?,” Business Week, 11 September 2008.

A coming water shock?

Is water the new oil? The answer is yes, according to a number of economists, business leaders, scientists and geopolitical strategists, who argue that it’s time to stop taking for granted the substance that covers 70% of the planet and makes up a similar proportion of the human body. Just as the late 20th century saw an oil shock, the early 21st century may feature a water shock, where scarcity leads to a sharp price hike on a resource that has always been plentiful and cheap. Such a scenario could have an even bigger impact than peak oil, transforming markets, governments and ecosystems alike.

The basic story: 97% of the world’s water is salty. Human use of the remaining 3% has boomed, the result of industrialization and the need to produce more food to feed a growing, wealthier population.

In 1900, global water consumption totaled approximately 770 cubic kilometers, according to a 2007 report by Zurich-based consultancy Sustainable Asset Management. Today, the figure is 3,840 cubic kilometers. It is projected to grow to over 5,000 by 2025. That’s well under the 9,000-12,000 cubic kilometers of annual rainfall that winds up in places humans can access. But pollution, waste and inefficient delivery take a big bite out of that figure, as does climate change, with its attendant droughts and early snowmelts. The consequences, including water rationing in California and the occasional drying up of portions of the Yellow River in China, are increasingly visible. By 2030, estimates the Organization for Economic Cooperation and Development, more than half the human population will live in areas where the water supply is stressed.

Thus far, the issue – and its impact on economies, populations and businesses – has drawn little attention. A 2007 survey sponsored by the Marsh Center for Risk Insights reported that while 40% of Fortune 1000 companies believed the impact of a water shortage would be severe to catastrophic, only 17% said they had prepared for such an eventuality. “A lot of companies haven’t begun to think of this as a major issue,” says Howard Kunreuther, co-director of Wharton’s Risk Management and Decision Processes Center and a former advisor to the Marsh Center. The same goes for the general public, he adds: People have always tended to consider water “a free good. It pours out of your sink, you take long showers, you get a bill every three months and you pay it and don’t think about it.”

Are we doomed to a thirsty future? Not necessarily. But plain old water is fast on its way to becoming “blue gold,” a commodity to be sought out, fought over, trundled from country to country and possibly sold to the highest bidder – a situation that represents a threat and an opportunity all at once.

“Ebb without flow: water may be the new oil in a thirsty global economy,” Knowledge@Wharton, 1 October 2008, http://knowledge.wharton.upenn.edu/article.cfm?articleid=2059