Scenario Planning

Even in the midst of the recent financial crisis, you probably also noticed that the price of oil has dropped.  In fact, it's had a record-setting drop (read article here).  It was just in July that oil peaked at $147/barrel.  Now it's trading around $60-70/barrel.  I'm sure you've noticed the benefit if you're a U.S. driver, as the gasoline pump price has dropped from over $4/gallon to under $3/gallon.

A lot of people simply breathed a sigh of relief.  "Well, that's one problem I can now forget about" an executive recently said to me.  I was disappointed to hear him say that.  Because how does he know oil won't go back up to $150?  Or drop to $25?  Regardless, doesn't it have implications on how competitors in your business behave?  On who wins and who loses?  Things certainly haven't "returned to normal."  The signs are all around us that there have been substantial changes in how companies manufacture, procure IT services and finance their business.  Just because the price of oil went from $25 to $150 to $65 dollars doesn't mean things are "back to normal."

Scenario planning is really important to developing competitive strategy.  Most people spend a lot of energy to achieve high precision understanding their historical sales, customers, technology comparisons, price comparisons and share.  But they put very little energy on creating potential scenarios about the future.  When they do look forward, the tendency is to seek the same sort of precision.  As a result, too few scenarios are developed and they end up being based on data people feel are "highly predictable."  The scenarios that are important are the ones where unlikely events and outcomes occur.  They create opportunities for changes in competitive position.

Scenario planning should start with "big themes."   Once you explore that theme, however, the objective is not to develop your "best guess."  Instead, the objective is to cast a wide net and explore, in detail, what the world will look like given that scenario.  How would thing change given the expectation?  How will that help, or hurt your ocmpetitiveness.  Who will be the big winner?  The big loser?  Create a robust description of that scenario – what are the implications – not the likelihood of it happening.

Over the last year the price of energy was one such big theme which interested a lot of people.  But most people only explored one scenario – what if oil prices went to $200 or $250?  Interesting, but not sufficient.  Yes, that scenario is well worth investigating in great detail.  But, it's also important to investigate other options – like oil at $150, or $100 or $65 or $35.  All of those have different implications.  What's important in scenario planning is to investigate them all.  To understand how each would impact competition and individual competitors.  So your SWOT (Strengths, Weaknesses, Opportunities and Threats) analysis can be done for the future – not just for today

The other value from scenarios is identifying and understanding the triggers.  By exploring the scenarios you start to understand what would make each of the outcomes more likely.  Not so you can develop a probability distribution – which will lead you to the "average" or "most likely" outcome – and thus the least likely to make any difference and therefore the least interesting.  You don't want to use scenarios to become a forecaster – because odds are you won't be very good at it.  You want to recognize the implications of these scenarios, and then figure out how you can use that scenario to improve your competitive position.  To upend competitors who did not do the scenario planning and thus aren't prepared.  Then you can start tracking key variables, key metrics, in order to recognize when you need to prepare for one of the various outcomes.  And if you've done a good job with your scenarios, be the competitor best prepared to take advantage of the changed circumstance to improve your position

The only way you can be prepared is to have considered the scenarios, and developed some plans should that scenario happen.  To be a long-term winner it's not enough just to be good in the current environment, you have to be prepared to succeed no matter what the environment.  By developing scenarios, you can be prepared to take advantage of market shifts – and if your competitor isn't, you can gain market share and improve your returns. 

We all are subject to letting current events drive our views of the future.  Then we try to "stand back" and look at a long term trend and develop some sort of "average" point of view.  But neither of these really help when markets shift.  What's needed is a set of scenarios – such as oil at $25 or 50 or $100 or $150 or $250 or $300.  Understanding how you can grow sales and profits in each makes you prepared, and greatly improves your long-term chances of growth.  It's the only way to prepare for market shifts, and worth a lot more during turbulent changes, like we're seeing now, than the deepest analysis of what you've done the last year, 3 years or 5 years.

Deadly stalls

The business press, whether print or on-line, is full of stories about lay-offsMotorola (chart here) to cut another 3,000 jobs in its flailing handset business (article here).  American Express (chart here) to cut 7,000 jobs (article here).  Over the last few weeks, other announcements included 3,200 job cuts at Goldman Sachs (chart here), 5,000 at Whirlpool (chart here) and 1,000 at Yahoo! (chart here). 

Given the regularity with which leaders have implemented layoffs since the 1980s, investors have come to expect these actions.  Many see it as the necessary action of tough managers making sure their costs don't unnecessarily balloon.  And political officials, as well as investors and employees, have started thinking that layoffs don't necessarily have much negative long-term meaning.  People assume these are just short-term actions to save a quarterly P&L by a highly bonused CEO.  The jobs will eventually come back.

Guess again.

Most layoffs indicate a serious problem with the company.  Long gone are the days when layoffs meant people went home for a major plant retooling.  Now, layoffs are a permanent end of the job.  For the employer and the employee.  Layoffs indicate the company is facing a market problem for which it has no fix.  Without a fix, management is laying off people because the revenues are not intended to come back.  Thus, the company is sliding into the Swamp – or possibly the Whirlpool – from which it is unlikely to ever again be a good place to work, a good place to supply as a vendor or a good place to invest for higher future cash flow.  Layoffs are one of the clearest indicators of a company implementing Defend & Extend Management attempting to protect an outdated Success Formula.  Future actions are likely to be asset sales, outsourcing functions, reduced marketing, advertising &  R&D, changes in accounting to accelerate write-offs in hopes of boosting future profits — and overall weak performance.

Layoffs are closely connected with growth stalls.  Growth stalls happen when year over year there are 2 successive quarters of lower revenues and/or profits, or 2 consecutive declines in revenues and/or profits.  And, as I detail in my book, when this happens, 55% of companies will have future growth of -2% or worse.  38% will have no growth, bouncing between -2% and +2%.  Only 7% will ever again consistently grow at 2% or more.  That's right, only 7%. 

When you hear about these layoffs, don't be fooled.  These aren't clever managers with a keen eye for how to keep companies growing.  Layoffs are the clearest indicator of a company in trouble.  It's growth is stalled, and management has no plan to regain that growth.  So it is retrenching.  And when retrenching, it will consume its cash in poorly designed programs to Defend & Extend its outdated Success Formula leaving nothing for investors, employees or suppliers.  The world becomes an ugly place for people working in companies unable to sustain growth.  People try to find foxholes, and stay near them, to avoid being the next laid off as conditions continue deteriorating.  Just look at what's happened to employment and cash flow at GM, Ford and Chrysler the last 40 years.  Ever since Japanese competitors stalled their growth, "there's been no joy in Mudville."

Given how many companies are now pushing layoffs, and how many more are projecting them, this has to be very, very concerning for Americans.  Clearly, many financial institutions, manufacturers, IT services and technology companies appear unlikely to survive.  Meanwhile, we see wave after wave of new employees being brought on in companies located in China, India, South America and Eastern Europe.  For every job lost in Detroit, Tata Motors is adding 2 in India.  For every technologist out of work in silicon valley, Lenovo adds 2 in China.  For every IT services person laid off at HP's EDS subsidiary, Infosys adds 2 in Bangalore.  It's no wonder these companies don't regain growth, they are losing to competitors who are more effective at meeting customer needs.  There really is no evidence these companies will start growing again – as long as they use layoffs and other D&E (Defend & Extend) actions to try propping up an old Success Formula.

Sure, times are tough.  But why die a long, lingering death?  Instead of layoffs, why not put these people to work in White Space projects designed to turn around the organization?  Instead of trying to save their way to prosperity – an oxymoron – why not take action?  In most of these companies, lack of scenario planning and competitor focus leaves them unprepared to rapidly adjust to these market changes.  But worse, Lock-in and an unwillingness to Disrupt means management simply finds it easier to lay off people than even try doing new things.  And that is unfortunate, because the historical record tells us that these companies will inevitably find themselves minimized in the market – and eventually gone.  Just think about Polaroid, Montgomery Wards, Brach's Candy company, DEC, Wang, Lanier, Allegheny Coal, Bear Sterns and Lehman Brothers.

Hunting for growth

Wal-Mart (see chart here) has not been doing badly the last couple of quarters.  Of course, it hasn't done great either.  And if we look back the last 8 years – well there's not been much to get excited about.  Wal-Mart Locked-in on its low price Success Formula 40 years ago and hasn't swayed since.  Today as incomes go down and fear is huge about jobs and investments people are looking for low prices so they are returning to Wal-Mart.  But those sales aren't coming easily, because Target, Kohls and other retailers are battling to get recognized for value while simultaneously offering benefits consumers demonstrated they enjoyed before economy went kaput.  It's not at all clear that the small uptick in sales at Wal-Mart is anything more than a short-term blip in a very flat environment for Wal-Mart.

It's unclear that there's much growth.  This week Wal-Mart admitted it was finding fewer opportunities to open new stores as saturation of its low-price approach appears imminent in the USA (read article here).  Instead of opening new stores capital expenditures are going to decline by 1/3, and dollars are being shifted to store remodeling rather than new store opening.  This implies a far more defensive tactic set, reacting to inroads made by competitors, rather than an understanding of how to regain the growth Wal-Mart had in the previous decades.

So now Wal-Mart is saying it will turn investments toward emerging markets (read article here).  Sure.  Wal-Mart wrote off huge investments and exited failed efforts in Germany and France, It's efforts to expand in Canada and the U.K. have been marginal.  In Japan it only avoided a huge write-off and failure by making an acquisition.  And its China project has gone nowhere, despite much opening hoopla 5 years ago.  So why should we expect them to do better with a second attack into China, possibly going into India and Mexico? 

The Wal-Mart Success Formula worked in the USA and drove incredible growth, but it is unclear that shoppers in developing countries get much benefit from a strategy largely based on buying goods from low-cost underdeveloped countries and importing them to the USA for mass-market buyers in low-cost penny-pinching store environments.  What's the benefit to Wal-Mart's approach in Mexico or India?  In India and China customers must pay high duties on imported goods, and low-cost retail exchanges already exist across the country for domestic products.  Additionally, lacking a robust infrastructure (meaning a big car and good roadway to carry home mass quantities of stuff bought in large containers) it's unclear that Wal-Mart's approach is even viable.  If you have to carry goods home on a bicycle, why would you want to go to a big central store?  Isn't buying regularly what you need better?  Wal-Mart has made no case that it's Success Formula is at all viable outside the USA, and especially in emerging countries

Compare the Wal-Mart approach to Google (see chart here).   In the last year Google has moved beyond mere search into other high-growth businesses such as mobile telephones.  And today Google announced it is going to legally offer books and other copyrighted material to customers in some ways unique – but competing with Amazon's e-book (Kindle) business (read article here).  Google keeps entering new high-growth markets with new demands from new customers.  And in each market Google enters with new products intended to be better than what's out there today.

Wal-Mart keeps trying to find a way to Defend & Extend its old, tired Success Formula.  Wal-Mart is huge, but its growth has slowed.  Competitors have entered all around it, and every year they are chipping away at Wal-Mart by offering different solutions to customers.  The competitors are getting better and better at matching the old Wal-Mart advantages, while offering their own new advantages.  And we can see Wal-Mart is now being defensive in its histiorical markets while naive in trying to export its old Success Formula to markets that don't show any need for it.  Wal-Mart is mired in the Swamp, struggling to fight off competitors while its growth is disappearing and its returns are under attack.  On the other hand, Google keeps throwing itself back into the Rapids of growth in new businesses that offer new revenues and increased profits.  And it enters those markets with new solutions that have the opportunity of changing competition.  Google doesn't have to have everything work right for it to find growth through its White Space projects and continue expanding its value for customers, suppliers, employees and investors. 

It’s never too late

Yesterday I talked about how Lock-in to an old Success Formula kept Sun Microsystems from undertaking Disruptions in the 1990s that would have helped the company keep from floundering.  One could get the point that with this weak economy, the die has been cast and there’s little we can do.  "Oh Contrare little one".

Let’s look at Apple (see chart here) – the company Sun passed up to focus on its core server business in the 1990s.  Today Apple announced profits are up 26% this year – despite the soft economy (read article here).  We all know about the iPod, iTunes, iTouch and now iPhone.  Apple has demonstrated that it is willing to bring out new products in new markets without regard for "market conditions", and as a result drive new revenues and profits.  It would be easy to delay new investments and new launches in this economy to drive up profits, but the company CEO maintains commitment to internal Disruptions and ongoing White Space to drive growth – especially while competitors are retrenching.

Another recent example is Coach (see chart here) the maker of high-end luggage, leather goods and fashion accesories.  Most high-end goods are seeing sales plummet.  But Coach used its scenarios about the future to invest in its 103 factory outlets and many discount outlets.  Instead of running to the high end and doing more of the same, while cutting costs, Coach has put new products into the market and offered new discount programs – in addition to its growth of outlets beyond the traditional Coach stores (read article about Coach here.)

Any company can take action at any time to grow.  All it takes are plans based on future scenarios, rather than based on just doing "more of the same."  Being obsessive about competitors allows for launching new products before anyone else, and gaining share.  And using Disruptions to create White Space for successful new business development.  This can happen at any time – not just when times are good.  In fact, when times are bad (like now) it can be the very best time to focus on growth.  When competitors are trying to retrench it creates the opportunity to change how customers view you, and grow.  This might well be the best time ever to not only Disrupt your own thinking – but Disrupt competitors by changing your Success Formula and doing what’s not expected!

Disrupt when times are good

With the economy soft, and sales harder to come by, more companies are thinking about what changes they can make to be more competitive.  But what we’re seeing now is the emergence of competitors that Disrupted when times were good, and the decline of those who chose to Defend & Extend old Success Formulas in order to maximize profits back then.

Let’s take a look at Sun Microsystems (see chart here.)   Trading today at $5.25/share, Sun was a darling of the internet boom – peaking at about $250/share in 2000.  But $5.25/share (adjusted for splits) is about what Sun was worth in the mid-1990s.  At that time Sun was a big winner as internet usage exploded and the telecom companies – as well as industry participants from tech to manufacturers – could not get enough Unix servers.  Everyone was predicting that the need for servers was never going to decline, and Sun was "#1 with a rocket", to use an old radio term for a big hit song.

In 1995 Sun held a management retreat for all its managers and higher in Monterey, CA.  Scott McNealy, the chairman and CEO, asked the audience "if you could buy Apple, would you do it?"  The audience reacted with a positive roar!  These managers all saw the benefit of having a low-price workstation line to augment their expensive servers.  Further, Unix was notoriously difficult to use and the hope of bringing a better GUI interface was very appealing.  They saw that if they could help the sales of Macs it would be a great way to slow the Wintel (Microsoft Windows plus Intel microprocessor) PC platform – which was the biggest competitor to Unix.  And Apple had lots of applications in media and the office that eluded the very techie Sun products.  These managers, directors and V.P.s had all thought about an Apple + Sun merger, and they saw the opportunities.

Mr. McNealy looked at the raucous, hopeful crowd and said, "you think you could fix that mess?  With all we have to do to keep up with market growth, you don’t see buying Apple as a major diversion?"  The air was sucked out of the room.  Obviously, Apple was troubled.  But there was real hope for growth in new and unpredictable ways from combining the two companies, their positive brands, their great technologies and their creative roots.  But Mr. McNealy went on to tell the audience that the executive team had thought about the acquisition, and just couldn’t see doing it.  It would be too disruptive.

That management retreat had as its keynote speaker Gary Hamel, author of Competing for the Future.  Mr. Hamel gave a great presentation about how his research showed great companies figured out their core – their core strength – and then reinforced that strength.  The rest of the retreat was spent with the management personnel in various break-out sessions defining the "core" at Sun Microsystems and then identifying how Sun could reinforce that core.

Of course, it only took 5 years for the internet bubble to burst.  The telecoms were some of the first victims, with their value plummeting.  Demand for servers fell off a proverbial cliff.   Meanwhile, Unix servers from IBM and others had increased in performance and capability – giving the once high-flying Sun a competitive kick in the pants.  Worse, the power of Wintel servers had continued to increase, making the price difference between a Unix server and a Wintel server much less acceptable.  IT Department customers were beginning to shift to PC servers in order to lower cost.  And Sun, with its focus on servers, had no desktop product to sell – no competitor to the PC – nor any software products to sell.  The internet market was rapidly shifting toward Cisco and those who sold robust network gear.  Sun was watching its market disappear right out from under it – and happening in weeks.

Now it’s unclear what the future holds for Sun Microsystems (read article here).  Sales have not recovered.  Losses have been mounting.  Sun’s dealing with hundreds of millions of dollars in restructuring costs (again), and some of its businesses are now worth so little that the company is probably going to be forced to write off millions (maybe billions) in goodwill on the books.  If it has to write off too much good will, Sun could end up declaring bankruptcy.

The time for Disruption at Sun was when business was good – in 1995 and 1996.  Had they bought Apple, who knows what combination might have happened.  At the time, Cisco (see chart here) was growing quite handily.  But Cisco built into its ethos the notion that the company would obsolete its own products.  This desire, to never ride too far out the product curve and instead cannibalize their own sales before competitors did, has allowed Cisco to keep growing revenues and profits.  Instead of "focusing on its core" Cisco keeps looking for the competitors (companies and products) that could make Cisco obsolete – and using those competitors to help Cisco drive growth.

Even with Disruptions, many competitors will not survive this recession.  Not because the managers are lazy or sloppy.  But because they will become victims of better competitors who built Success Formulas more aligned with future market needs.  Those who Disrupted in 2005 and 2006, who positioned themselves for globalization and rapid market shifts, will do relatively better in 2009 than those who chose to Defend & Extend what they used to do.  The best time to Disrupt and create White Space is when things are good – because that prepares you to win big when markets shift and times get tough.

Reading ALL the headlines

Ever heard of "confirmation bias"?  It’s a term that refers to how our behavior changes due to Lock-in.  As we develop Lock-in we don’t see all the information around us.  Instead, we start filtering information according to our Lock-ins – focusing on the things related to what we know and mostly ignoring things not related.  As a result we often start missing things that could be really important.  Consider someone who makes hammers (or pheumatic hammers) and nails.  They can easily ignore glues, or super-powerful adhesive tape, when those solutoins might well be a greater long-term profit threat than offshore hammer and nail manufacturers!

Another example.  A recent headline in The Chicago Tribune read "Abbott Absorbed with new Stent Therapy" (read article here).  (See Abbott chart here)  The article talks about how newly engineered dissolvable stents have been working extremely well in trials.  If you aren’t in the health care industry, or being treated for a possible heart attack, or an investor in Abbott, you might well completely ignore the article.  But, that would be a mistake.

Bio-engineering is going to be as important to our future as air travel and computers became.  It was easy for people in 1928 riding horses, or driving a Model A, to think air travel was something exotic and only interesting for people obsessed with flight.  But, we all know that by the end of WWII airplanes had changed the world, and the way we travel.  Likewise, it would have been easy for people with slide rules and adding machines in 1968 to ignore computer discussions when they were mostly about mainframes in air conditioned basements.  Yet, by the 1980s computers were everywhere and businesses that were early adopters figured out how to gain significant advantages.  And that’s the truth about bio-engineering today.  It will make a huge difference in all aspects of our lives.

Fistly, simple things.  Like we’re more likely to live longer.  But beyond that, injuries will be less onerous.  As we learn how to engineer products that are somewhere between inanimate and living, we are able to come closer to the bionic man/woman.  We’ll be able to repair major injuries in a fraction of the time.  We’ll be able to regrow damaged organs – from skin to livers.  We’ll regrow nerves – making paralyzation a temporary phenomenon and dramatically lowering the impact of strokes.  Injured soldiers will return to the battlefield within days – instead of going home badly hurt.  Senior citizens will regrow damaged or arthritic joints, instead of replacing them with major surgery making it possible for them to work much longerAthletes will be able to increase performance in ways we’ve never before imagined – and the line between "natural" and "performance enhanced" will become impossible to define. 

But think biggerThere is no computer in our bodies, yet we do amazingly complex analytics in record speed.  Even a 2 year old can recognize the difference between a bird and a plane in a fraction of a second.  Ask a computer to do that simple task!  So we can expect a wave of bio-computers to be developed.  Devices that use chemical reactions to process information rather than electrons acting in logic gates.  How will we apply this technology to our lives and work? Cars that drive themselves? Super-secure baby walkers?   Pens that never misspell words?  Foods that never overcook?  Foods that never spoil?  Clothes that change to dissipate or hold-in heat depending on ambient temperature?  Floors that purge themselves of dirt – pushing it to the surface for automatic removal? 

When we are able to make chemicals – even cells – smart, what happens to the world around us?  Do we ever need to go to a dentist if we can have smart toothpaste that eats away tarter and placque, applying flouride, without going into the enamel?  Can we eat anything we want if we take products that absorb poison – or possibly fats – and discharge it through the system?  Do cosmetics become obsolete if we all have skin creams that repair damage and keep skin forever young?  What happens at companies like Procter & Gamble? 

As you go to work and do your job, it’s easy to get focused on the industry in which you compete – and the traditional way that industry worked.  You stop looking sideways at technologies in other fields not related to what you do today.  And that can be a huge mistake. Because it’s often someone that takes a technology you ignored and apply it to your customers’ needs who makes you less valuable.  Microsoft singlehandedly, and without much thought, destroyed the encyclopedia business by giving away what was considered a third-rate product (Encarta – for more on this story read Blown to Bits by Evans & Wurster).  Encyclopedia Britannica never saw it coming as they kept trying to print a better product. 

Spend some time reading ALL the headlines – and keep your eyes open for opportunities that you previously never considered.

Pay attention to long term trends

Traders help markets function.  Because they take short-term positions, sometimes hours, a day or a few days, they are constantly buying and selling.  This means that for the rest of us, investors who want to have returns over months and years, there is always a ready market of buyers and sellers out there allowing us to open, increase, decrease or close a position.  Traders are important to having a constantly available market for most equity stocks.  But, what we know most about traders is that over the long term more than 95% don’t make money.  Despite all the transaction volume, their rates of return don’t come close to the Dow Jones Industrial Average – in fact most of them have negative rates of return.  Only a few make money.

For investors it’s not important what the daily prices are of a stock, but rather what markets the company is in, and whether the markets and the company are profitably growing.  On days like today, which saw the DJIA down triple digits and up triple digits in the same day (read article here), it’s really important we keep in mind that the value of any company in the short term, on any given day, can fluctuate wildly.  But honestly, that’s not important.  What’s important is whether the company can exp[ect to grow over months and years.  Because if it can, it’s value will go up.

Let’s take a look at a couple of companies in the news today.  First there’s Google (see chart here).  Despite the recession, despite the financial sector meltdown and despite the wild volatility of the financial markets, the number of internet ads continued to go up.  Paid clicks actually went up 18% versus a year ago. (read article about Google results here).  Gee, imagine that.  Do you suppose that given the election interest, the market interest during this financial crisis and the desire to learn at low cost more people than ever might be turning to the internet?  Does anyone really think internet use is going to decline – even in this global recession?  Google is positioned with a near-monopoly in internet ad placement (Yahoo! is fast becoming obsolete – and is trying to arrange to use Google technology to save itself see Yahoo! chart here]).  By competing in a high growth market – and constantly keeping White Space alive developing new products in this and other high-growth markets – Google can look out 3, 5, 10 years and be reasonably assured of growing revenues and profits.  And that’s irrespective of the Dow Jones Industrial Average (where Google might well replace GM someday) or whether Microsoft buys the bumbling Yahoo! brand (read about possible acquisition here).

On the other hand, there’s Harley Davidson (see chart here).  Motorcycles use considerably less gasoline than autos, so you would think that people would be buying them this past summer as gasoline hit record high $4.00/gallon plus prices.  Yet, Harley saw it’s sales tumble 15.5% (much worse than the heavyweight cycle overall market drop of 3%) (read article about Harley Davidson’s results here.)  The problem is that Harley is an icon – for folks over 50!  The whole "Rebel Without a Cause" and "Easy Rider" image was part of the 1940s post war rebellion, and then the 1960s anti-war rebellion.  Both not relevant for the vast majority of motorcycle buyers who are under 35 years old!  Additionally, long a company to Defend & Extend its brand, Harley Davidson has raised the average price of its motorcycles to well over $25,000 – a sum greater than most small cars!  Comparably sized, and technologicially superior, motorcycles made by Japanese manufacturers sell for $10,000 and less!  Worse, the really fast growing part of the market is small motorcycles and scooters that can achieve 45 to 90 miles per gallon – compared to the 30 mile per gallon Harley Davidsons – and Harley has no product at all in that high growth segment!  Harley Davidson is a dying technology and a dying brand in an overall growing market.  No wonder the company is selling at multi-year lows (down 50% this year and 67% over 2 years) .  Even though the stock market may be down, Harley Davidson is unlikely to be a good investment even when the market eventually goes back up (if Harley survives that long without bankruptcy!)

Watching the Dow Jones Industrial Average, or the daily stock price of any company, isn’t very helpful.  Daily, prices are controlled by the activity of traders – who come and go incredibly fast and mostly lose money.  What’s important is whether the company is keeping itself in the Rapids of Growth.  Google is doing a great job at this.  Harley Davidson is Locked-in to its old image and thoroughly entrenched in trying to Defend & Extend its Lock-in – completely ignoring for the past decade the more rapid growth in sport bikes, smaller bikes and scooters.  As investors, customers, employees and suppliers what we care about is the ability of management to Disrupt their Lockins and use White Space to stay in the Rapids of growth.

Relative Risk

Are people risk averse?  Or do they like risk?  Would you believe those questions don’t matter, when trying to understand risk?

Today we’re being told that the bankers who ran some of the world’s largest investment banks were taking ridiculous risks – and the decisions to take on those risks is now undoing financial services globally.  Were these bankers all gunslingers – willing to take crazy risks?  Would you believe me if I said they didn’t think they were taking much, if any risk?

Risk is a relative term.  What’s "risky" is really a matter of perception.  Let’s say I drive to work on a local highway every day.  The traffic cruises at 65 miles per hour, but since I’m always late I drive 75.  On a particularly late day I drive 80.  Because I usually drive 75, the relative risk seems small.  But the reality is that at 80 the chances of a minor mishap becoming a disaster are far greater.  Once you are comfortable driving 75, the perception of greater risk is only the marginal difference between 75 and 80 – so it seems small.  Over time, if I choose to keep driving a bit faster, within short order I’ll be driving 100 miles per hour.  This may seem crazy – yet there are many drivers on Germany’s high-speed autobahn highways that drive this fast – and faster!!  To those of us who poke along every day at 65 miles per hour these speed demons of the autobahn seem to be taking a crazy risk – but to them, working up to those high speeds gradually over time, the relative risk now seems quite small.

And this is what happens in our business.  When a bank takes a deposit, it then can loan money.  But should it lend dollar for dollar – deposit compared to loans?  While nonbankers might say "don’t lend more than you borrowed" that seems ridiculously conservative to bankers.  Bankers say that because most loans are repaid, they only need enough deposits to cover the normal ebb-and-flow of the cash demands on the institution.  So they feel comfortable loaning out 2 or 3 dollars for every dollar of deposit.  Of course, the more loans the banker makes and the rarer defaults occur, the more likely the banker will start to give loans that are 4 times the amount on deposit.  Where does this stop?  We know with Lehman Brothers the leverage reached 30 to 1 (read about financial institution leverage and regulatory recommendations here)!!!  It didn’t take many defaults for Lehman to suddenly find itself unable to meet its obligations and disappear.

The bankers at Lehman Brothers learned not to fear what they knew.  Not only that, but they hired immensely smart mathematicians and physicists to try calculating the amount of risk they were taking on with their leverage and their obligations.  Using mathematics far beyond the grasp of all but a fraction of the population, they asked scholars to try calculating the risk in the loan packages they sold, and the credit default swaps.  They continuously studied the risk.  The more they studied the easier it was to take on more risk.  The longer they kept doing what they had always done, and the more knowledgable they became, the less risky they perceived their behavior.  Of course, as we now know, Lehman Brothers took on far more risk than the company, its investors and its regulators could afford. 

The other side of this coin is how we perceive things we don’t know.  Almost none of the buggy manufacturers in the early 1900’s transitioned to making automobiles.  To them automobile manufacturing involved engines, and that was too risky.  By the time buggy manufacturers felt they had to change, it was too late.  When we are brought new opportunities to evaluate we don’t evaluate the real merits of upside and downside.  Instead, we first question if the opportunity falls into our realm of expertise.  If not, we deem it too risky.  Because we don’t know much about it, we choose to think it’s too risky for us.  Yet, the risk might be quite low. 

Take for example buying Microsoft stock in the early 1990s as PC sales skyrocketed and Microsoft already had a monopoly on operating systems – and was building its monopoly in office software.  The risk was quite small, since all Microsoft needed was for PCs (PCs made by anybody – it didn’t matter) to continue selling.  That was not a high-risk bet.  Yet most investors shied away because they didn’t understand tech stocks – including Warren Buffet who famously bought a mere 100 shares, declaring he didn’t understand the business!  (Just think, if Warren Buffet had bought a large chunk of early Microsoft, he’d be as rich as himself plus Bill Gates today – now that’s a mind-boggler.)

When markets shift, relative risk can be deadlyIf we continue to perceive things we know as low risk, we will "double down" our bets on customers, market segments, technologies and products that have declining value.  If we think that doing what we always did will produce old returns we will do what’s comfortable, even when the market is moving headlong toward new solutions.  Look at U.S. manufacturers of televisions (remember Quasar, Magnavox and Philco?).  Experts in vacuum tubes and other analog technologies, plus the manufacturing expertise for those components, they were all late seeing the shift to solid-state electronics and all ended up out of business.  All that expertise in the old technology simpy wasn’t worth much when the markets shifted – even though the new technology seemed risky while the old technology seemed familiar, and reliable. 

When markets shift, the greatest risk is the "do what we know" scenario.  Although it’s the easiest to approve, and the most comfortable – especially at times of rapid, dynamic change – it is the one scenario guaranteed to have worsening results.  There’s an old myth that the last buggy whip manufacturer will make huge profits.  Guess again.  As buggy whip demand declines everyone loses money until most are gone.  But there isn’t just one remaining player.  The few who remain constantly see prices beaten down by the excess capacity of buggy whip designers, manufacturers and parts suppliers ready to jump in and compete on a moment’s notice.  Trying to be last survivor just leaves you bloody, beaten up and without resources to even feed yourself.

It’s not worth spending a lot of time trying to evaluate risk.  Because rarely (maybe never) in business is there such a thing as "absolute risk" you can measure.  Risk is relative.  What might appear risky could well be merely a perception driven by what you don’t know.  What might appear low risk could be incredibly risky due to market shifts.  So the real question is, are you Disrupting yourself so you are investigating all the possibilities – good and bad?  And are you keeping White Space alive so you are experimenting, testing new ideas?  New products, new technologies, new markets, new distribution systems, new components, new pricing formulas, new business models —- new Success Formulas?  The only way to avoid arguments of risk is to get out there and do it – so you can get a good handle on what works, and what doesn’t, in order to make decisions based on opportunity assessment rather than Lock-in.

Punctuated Equilibrium

We talk a lot about evolving markets.  When we use that phrase, evolving, we think of gradual change.  In reality, evolutionary change is anything but gradual.

Punctuated_equilibriumPeople think of change as happening along the blue line to the left.  A little change every year.  But what really happens is like the red line.  Things go along with not much change for a very long time, then there’s a dramatic change, and then an entirely new "normal" takes hold.  This big change is what’s called a "punctuated equilibrium."

What we’ve recently seen in the financial services industry is a punctuated equilibrium.  For years the banks went along with only minor change.  They kept slowly enhancing the products and services, a little bit each year.  Regulations changed, but only slightly, year to year.  Then suddenly there’s a big change.  Something barely understood by the vast majority of people, credit default swaps tied to subprime mortgage backed securities, became the item that sent the industry careening off its old rails.  That’s because the underlying competitive factors have been changing for years, but the industry did not react to those underlying factors.  Large players continued as if the industry would behave as it had since 1940.  Now, suddently, the fact that everything from asset accumulation to liability management and regulation will change – and change rapidly.

When punctuated equilibrium happens, the old rules no longer apply.  The assumptions which underpinned the old economics, and norms for competition, become irrelevant.  Competition changes how returns will be created and divvied up.  Eventually a new normal comes about – and it is always tied to the environment which spawned the big change.  The winners are those who compete best in the new environment – irrespective of their competitive position in the old environment.  The one thing which is certain is that following the old assumptions is certain to get you into trouble.

I’ve been surprised to listen to "financial experts" on ABC and CNBC advising investors since this financial services punctuated equilibrium hit.  Consistently, the advice has been "don’t sell.  Wait.  Markets always come back.  You only have a paper loss now, if you sell it becomes a real loss.  Just wait.  In fact, keep buying."  And I’m struck as to how tied this advice is to the old equilibrium.  Since the 1940s, it’s been a good thing to simply ride out a downturn.  But folks, we ain’t ever seen anything like this before!!  This isn’t even the Great Depression all over again.  This is an entirely different set of environmental changes.

In reality, the best thing to have done upon recognizing this change would be to sell your equities.  The marketplace is saying that global competition is changing competition.  How money will be obtained, and how it will be doled out, is changing.  Old winners are very likely to not be new winners.  Competitive challenges to countries, as well as industries and companies, means that fortunes are shifting dramatically.  No longer can you consider GM a bellweather for auto stocks – you must consider everyone from Toyota to Tata Motors (today the total equity value of Ford plus GM is 1/10th the value of Toyota).  No longer can you assume that real estate values in North America will go up.  No longer can you assume that China will buy all the U.S. revolving debt.  No longer can you assume that America will be the importer of world goods.  How this economic change will shake out – who will be the winners – is unclear.  And as a result the Dow Jones Industrial Average has dropped 40% in the last year.

To all those television experts, I would say they missed the obviousHow can it be smart to have held onto equities if the value has dropped 40%?  Call it a paper loss versus a real loss – but the reality is that the value is down 40%!  To get back to the original value – to get your money back with no gain at all – will take a return of 5% per year (higher than you could have received on a guaranteed investment for the last 8 years) for over 10 years!  That’s right, at 5% to get your money back will take 10 years!!  Obviously, you would have been smarter to SELL.  And every night this week, as the market fell further, these gurus kept saying "hold onto your investments.  It’s too late to sell.  Just wait."  Give me a break, if the market is dropping day after day, how is it smart to watch your value just go down day after day!  You should quote Will Rogers and say to these investment gurus "it’s not the return on my money I’m worried about, it’s the return of my money"!!

Or read what my favorite economist, Mr. Rosenberg of Merrill Lynch wrote today "There is no indication…that the deterioration in the fundamentals is abating…all the invormation at hand suggests that the risk of being underinvested at the bottom is lower than the risk of being overexposed to equities….in other words, the risk of geing out of the market right now is still substantially less than the risk of continuing to overweight stocks…what matters now is to protect your investments and preserve your capital." (read article here)

The world is full of conventional wisdom.  Conventional wisdom is based on the future being like the past.  But when punctuated equilibrium happens, the future isn’t like the past.  And conventional wisdom is, well, worthless.  What is valuable is searching out the new future, and learning how to compete anew.  Right now it’s worth taking the time to focus on future competitors and figure out how you can take advantage of serious change to better your position.  You can come out on top if you head for the future – but not if you plan for a return to the past.

A place to grow

The news is really bad in the auto business.  For the first time since 1993 the number of cars sold in the USA in a month has declined to below one million.  Sales are down over 25% from the previous year.  And sales are predicted to decline considerably more in 2009.  The value of General Motors (chart here) has declined to what it was in 1950 – when the Dow Jones Industrial Average was about 269 (GM is a component of the DJIA). (Read article here.) In the 1960s, when GM was king of the industrial companies, a popular phrase was "As goes GM, so goes America."  This was based on the notion that GM was a microcosm of the American industrial economy.  Is this still true – does GM portend the future of America?

A lot has changed in the last 40 years.  Most importantly, the globe is no longer dominated by an industrial economy.  Fewer and fewer people are employed in industrial production.  We see it all around us as we realize that there are more people writing computer code than making computers.  We’ve shifted to an information economy.  Companies that ignored this shift, like GM, without finding opportunities to get into the growth economy are now suffering.  GM started down the new road once, in the 1980s, by purchasing EDS and Hughes electronics.  But later GM leadership sold those businesses in order to "focus" on the auto business.  So now it’s only natural to recognize that the most industrial of the industrial companies are at the greatest risk of failure.  No longer is GM a microcosm of any economy – including America.  As GM goes so goes GM – but that doesn’t say anything about the future of America.

Some companies have shifted.  They find new opportunities for growth.  Today, wind energy is getting a big lift due to higher costs for petroleum fuels and increasing restrictions on greenhouse gases from using fossil fuels.  Wind farms already exist offshore European countries, producing over 1,100 megawatts of power.  Now such farms are being built not only on the great prairies of Texas and the American plains, but off the eastern U.S. coastline (read article here.)  While there isn’t much interest for investing in auto manufacturing, there is lots of interest for investing in these wind farms to produce electricity – especially in high-cost electricity locations along the eastern seaboard.

And in the middle of this market we find – General Electric (see chart here).  GE is the only U.S. company that makes wind turbines, and is a leader in promoting the new source of power.  While many people have fixated on GE Financial and its woes, they have ignored the fact that GE is an American leader in many markets seeing rapid growth globally – such as wind power, water production, health care equipment and municipal infrastructure development.  These markets are benefitting from the ecomomic boom in China, India and other developing countries, as well as emerging growth in the USA

Any country’s economy can continue growing if it develops Phoenix companies that keep their eyes on the future and create White Space projects to keep them moving toward growth.  These companies don’t fall into the trap of being "focused" on a single business, and dependent upon growth within that historically defined market.  They constantly look for places to grow, regardless of what the company has previously done, and develop opportunities to learn in those new markets so they can create a new Success Formula maintaining growth.  As long as America has companies that keep repositioning themselves for growth – such as GE, IBM, Cisco Systems, Apple, Google, Genentech, Johnson & Johnson, Baxter, etc. – America can have a great future.