January 2020
Chronic Illnesses Kill Organizations Too
24/Jan/20 12:33
In most of our work on Strategic Risk we examine the effects of uncertainty in a complex adaptive system world and try to understand how and why catastrophic, existential threats to businesses develop and what lessons boards of directors and executive teams can learn from these dynamics. Yet there is another class of threat to a business which can be as serious in its effect and may also eventually lead to its demise – serial underperformance.
Analogous to a chronic rather than an acute illness, businesses (or other forms of non-profit organizations) that fail to achieve health year after year, sometimes for decades, also carry a heavy price for their failure. Moreover, their long-term enfeeblement inevitably reduces organizational resilience and eliminates many options for adapting in the face of external crises. The weak die first.
This point was highlighted to us recently by the commentary of Terry Smith, iconoclastic banker, stockbroker, author* and CEO at Fundsmith. Commenting on fashions in investing Smith notes that serial underperformers will almost never represent better value, even if the stock price appears to represent a “value investment” opportunity. He cites Charlie Munger of Berkshire Hathaway:
“Over the long term, it’s hard for a stock to earn a much better return that the business which underlies it earns. If the business earns six percent on capital over forty years and you hold it for that forty years, you’re not going to make much different than a six percent return - even if you originally buy it at a huge discount. Conversely, if a business earns eighteen percent on capital over twenty or thirty years, even if you pay an expensive looking price, you’ll end up with one hell of a result.’ Our emphasis added.
Mr Munger is not offering a theory or an opinion — what he is saying is a mathematical certainty.“
To put this another way, the cost of serial failure is severe and will inevitably end up as an existential threat to an organization. That is why it represents a Strategic Risk.
Now, no doubt some readers are already objecting that they cannot be held accountable for events four decades in the future. Leaving aside the point that, at least in the UK, directors have a statutory duty to ensure the long term success of the enterprise (so perhaps that four-decade outcome is your accountability after all), serial underperformance does not require that kind of timescale to produce serious adverse effects.
Consider a firm making 2% ROCE. Over 5 years the cumulative return, with full reinvestment, is approximately 10.5%. For a firm making 5% ROCE, the comparable cumulative return is 27.6%, i.e. more than two and a half times better. A five year timespan is quite feasible as a time threshold for an existential threat. If the second company has been effectively anticipating and assessing such a potential threat, it has had five years in which to prepare for adaptation and mitigation (assuming it has been monitoring indicators of the potential event). It has also had more resources to dedicate to such a task.
When we examine the cases of corporate failure to identify the root causes and repeating patterns that have led to them, we frequently observe a chain of causality that has stretched back over time, five, ten or even twenty years. These are mostly directly attributable to failures of anticipation, risk blindness arising from reliance on faulty strategic assumptions, failures of assessment that added to blindness through the false comfort of subjective risk probabilities, and failures of action to monitor and mitigate the effects of emerging threats. When serial underperformance is added to this deadly mix, the result – the demise of the corporation – becomes almost inevitable.
When did your board last seriously seek to anticipate threats to the health of the enterprise (and how to adapt to them) over even a five year period?
* Accounting for Growth, Random House, London
Analogous to a chronic rather than an acute illness, businesses (or other forms of non-profit organizations) that fail to achieve health year after year, sometimes for decades, also carry a heavy price for their failure. Moreover, their long-term enfeeblement inevitably reduces organizational resilience and eliminates many options for adapting in the face of external crises. The weak die first.
This point was highlighted to us recently by the commentary of Terry Smith, iconoclastic banker, stockbroker, author* and CEO at Fundsmith. Commenting on fashions in investing Smith notes that serial underperformers will almost never represent better value, even if the stock price appears to represent a “value investment” opportunity. He cites Charlie Munger of Berkshire Hathaway:
“Over the long term, it’s hard for a stock to earn a much better return that the business which underlies it earns. If the business earns six percent on capital over forty years and you hold it for that forty years, you’re not going to make much different than a six percent return - even if you originally buy it at a huge discount. Conversely, if a business earns eighteen percent on capital over twenty or thirty years, even if you pay an expensive looking price, you’ll end up with one hell of a result.’ Our emphasis added.
Mr Munger is not offering a theory or an opinion — what he is saying is a mathematical certainty.“
To put this another way, the cost of serial failure is severe and will inevitably end up as an existential threat to an organization. That is why it represents a Strategic Risk.
Now, no doubt some readers are already objecting that they cannot be held accountable for events four decades in the future. Leaving aside the point that, at least in the UK, directors have a statutory duty to ensure the long term success of the enterprise (so perhaps that four-decade outcome is your accountability after all), serial underperformance does not require that kind of timescale to produce serious adverse effects.
Consider a firm making 2% ROCE. Over 5 years the cumulative return, with full reinvestment, is approximately 10.5%. For a firm making 5% ROCE, the comparable cumulative return is 27.6%, i.e. more than two and a half times better. A five year timespan is quite feasible as a time threshold for an existential threat. If the second company has been effectively anticipating and assessing such a potential threat, it has had five years in which to prepare for adaptation and mitigation (assuming it has been monitoring indicators of the potential event). It has also had more resources to dedicate to such a task.
When we examine the cases of corporate failure to identify the root causes and repeating patterns that have led to them, we frequently observe a chain of causality that has stretched back over time, five, ten or even twenty years. These are mostly directly attributable to failures of anticipation, risk blindness arising from reliance on faulty strategic assumptions, failures of assessment that added to blindness through the false comfort of subjective risk probabilities, and failures of action to monitor and mitigate the effects of emerging threats. When serial underperformance is added to this deadly mix, the result – the demise of the corporation – becomes almost inevitable.
When did your board last seriously seek to anticipate threats to the health of the enterprise (and how to adapt to them) over even a five year period?
* Accounting for Growth, Random House, London
Comments
Reduce Overload by Seeking High Value Information
02/Jan/20 12:01
At Britten Coyne Partners, we provide clients with advice, education, and forecasting offerings to help them better anticipate, accurately assess, and adapt in time to emerging threats to their strategy and survival.
One of the points we stress is the importance of reducing overload by searching for high value information, and using it to update prior beliefs (e.g., estimates, forecasts, models). But what constitutes high value information?
We focus on two types.
The first is "high likelihood indicators." In the face of an uncertain future, we often have a mix of probabilistic beliefs about different scenarios or outcomes that could develop in the future. High likelihood indicators are valuable because their presence (or absence) is much more likely to be observed in the case of one scenario or outcome compared to the others. Put differently, high likelihood indicators reduce our uncertainty about the future.
The second type of high value information is anything that triggers the feeling of surprise, which is usually evidence that is at odds with what our mental model of a system or situation would lead us to expect. Surprise is valuable because it increases our uncertainty about the accuracy of our mental models, and signals that we need to improve them.
Unfortunately, the feeling of surprise, and its ability to focus our attention on high value information, is very often fleeting. As Daniel Kahneman has noted, our “System 1” brain automatically seeks to make new sensory inputs cohere with our existing beliefs. This often happens very quickly; we find ourselves remembering feeling surprised, but forgetting what it was that triggered it.
For that reason, leveraging surprise requires us to call on “System 2”, our conscious deliberative brain. In our experience, the best way to do this is to write down the information that triggered the feeling of surprise, so that we can later consider its implications.
One of the points we stress is the importance of reducing overload by searching for high value information, and using it to update prior beliefs (e.g., estimates, forecasts, models). But what constitutes high value information?
We focus on two types.
The first is "high likelihood indicators." In the face of an uncertain future, we often have a mix of probabilistic beliefs about different scenarios or outcomes that could develop in the future. High likelihood indicators are valuable because their presence (or absence) is much more likely to be observed in the case of one scenario or outcome compared to the others. Put differently, high likelihood indicators reduce our uncertainty about the future.
The second type of high value information is anything that triggers the feeling of surprise, which is usually evidence that is at odds with what our mental model of a system or situation would lead us to expect. Surprise is valuable because it increases our uncertainty about the accuracy of our mental models, and signals that we need to improve them.
Unfortunately, the feeling of surprise, and its ability to focus our attention on high value information, is very often fleeting. As Daniel Kahneman has noted, our “System 1” brain automatically seeks to make new sensory inputs cohere with our existing beliefs. This often happens very quickly; we find ourselves remembering feeling surprised, but forgetting what it was that triggered it.
For that reason, leveraging surprise requires us to call on “System 2”, our conscious deliberative brain. In our experience, the best way to do this is to write down the information that triggered the feeling of surprise, so that we can later consider its implications.