A Fresh Approach to Business Strategies

McKinsey consultants calculate the probability that specific strategies will achieve big success.
David McCannFebruary 22, 2018
A Fresh Approach to Business Strategies

Most executives have read plenty of business books, seeking insights on how to achieve breakthrough success. Typically, these volumes contain designed-to-inspire case studies, best practices, and anecdotes.

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A remarkable new book by three McKinsey consultants, “Strategy Beyond the Hockey Stick” (Wiley, 2018), is very different. It relies on deep and broad empirical research on 2,393 large, non-financial companies that were in business throughout a 14-year period, 2001 through 2014.

The resulting data, including performance information together with analyses of the strategies the companies used, supports the mathematical probability that any particular strategy, or set of strategies, will send performance soaring, plunging, or neither. The authors — Chris Bradley, Martin Hirt, and Sven Smit — call the probabilities they calculate “the odds of strategy.”

The chief takeaway from the book, Bradley told CFO in an interview, is this: To beat the odds of strategy, you have to unlock “big moves.” And in order to do that, you have to confront “the social side of strategy.”

The social side of strategy is the chief culprit hindering companies from making the big moves that will enable them to achieve their vision, the authors say.

The social side has many elements. For one, executives are as prone as anyone else to classic cognitive biases like the halo effect, anchoring, and loss aversion. They’re also reluctant to deny resources to loyal colleagues or friends. Overall, they tend to allocate resources with a “spread-the-peanut-butter” approach to avoid alienating anyone, including leaders of business units that may actually merit reduced resources.

Importantly, executives’ chief goal when introducing multi-year business plans is not, typically, identifying the true path to successful execution of the plan, according to the authors. Rather, it’s winning a robust first-year budget for the initiative, which actually counts far more toward executives’ reputation and remuneration than does the plan’s ultimate success or failure.

“Most managers will try to secure resources for the coming year while deferring accountability for the returns on these investments as far as possible into the future — maybe even long enough that people will have forgotten about the original commitments, or that they themselves will have moved on to the next position,” the authors write.

One outcome of that dynamic is the “hockey stick,” a diagram of a new business plan’s future results that shows skyrocketing success after an initial dip in performance. While some hockey sticks do reach full fruition, the vast majority don’t. Still, they’re ubiquitous in business. “Truly, if there ever was one, the hockey stick is the icon of the strategy process,” the authors of the informative and entertaining book disapprovingly state.

The Inside View

When formulating strategies, the authors note, executives generally don’t pay enough attention to the fact that other companies are formulating their own strategies. This tendency is part of what the book calls “the inside view.” (And it’s not just competitors they should be worried about. The authors stress the obvious but frequently overlooked truth that companies compete for capital from investors and lenders against the entire universe of companies, not just those in their industry.)

“The inside view often prevails in strategy rooms because they are tightly sealed,” the authors say. “What comes into the room is basically what the participants bring in with them. There is generally a great deal of relevant experience, carried in the brains and memories of a few executives. A lot of information comes into the room too, but it is typically focused on your own company, a handful of your key competitors, and your own industry. A lot of information stays outside the room. The air gets stuffy and recycled.”

That’s what provided the impetus for the McKinsey consultants to tap their firm’s extensive database on companies for their deep research. They sought to develop a tool to show why companies must bring to bear an “outside view” — comparing the results of their strategies with those of the universe of companies — in order to position themselves for making big moves.

The Measuring Stick

To quantify the effectiveness of business strategies, the authors first had to choose a measurement yardstick. They picked “economic profit,” defined as net operating profit after subtracting the costs of capital.

“We like economic profit because it captures the two things that are important about strategy: a company’s spread — the gap between cost of capital and return on invested capital — and its scalability,” Bradley says.

He acknowledges that there’s debate around the significance of that measure, as larger companies have a built-in advantage just because of their size. For instance, Walmart’s average annual ROIC from 2010 through 2014 was about 14%, which was “not spectacularly above the average” of 9.9%, Bradley notes. “So what made Walmart so special? It was the ability to sustain that spread while employing $150 billion of capital.”

Starbucks, on the other hand, invested far less capital than Walmart, which helped drive the coffee giant’s average annual ROIC to a level three times that of Walmart. “So people ask me, does that mean Starbucks was more strategically successful than Walmart?” says Bradley. “And I say, they were both very, very strategically successful. It’s just that one had a model that was more about scalability, and the other had a model that was more about returns.”

From 2010 through 2014, the average company in the data set reported $920 million in annual operating profit, which it earned by investing $9.3 billion of capital. Investors and lenders required a return of 8.0% for use of their funds, as measured by weighted average cost of capital. That left $180 million in economic profit.

The Power Curve

The authors divided the 2,393 companies in the data set into five quintiles based on volume of economic profit. Plotting them on a graph yielded what the book calls a “Power Curve,” with the tails rising and falling at exponential rates and a long flatline stretching across the middle three quintiles.

Back-testing the strategies the companies used across a 14-year period against changes in their economic profit levels shined a bright light on what companies must do to dramatically improve their performance.

“The inside view gives us a detailed look at how we compare with last year, with our immediate competitors, and with our expectations for next year,” the authors write. “But when we zoom way out and look at the landscape of profitability — at all major companies in all industries and geographies — we get an important new perspective.”

From that point of view, the vast majority of profits are at one end of the curve and improve exponentially as a company gets closer to that end. So, good strategy shouldn’t focus narrowly on last year or on next year or on competitors. The goal of strategy, the authors say, needs to be to move to the right on the Power Curve.

To a large extent, the authors found, strategies pursued by companies in the vast middle ground of the curve essentially did nothing more than allow them to keep pace with their competitors or eke out small, incremental gains. The proportion of companies that were able to leap into the first quintile from outside of it during any 10-year period consistently hovered around 8%.

It’s important to remember, the authors caution, that the probability that a strategy will achieve a certain outcome is just that: a probability, not a guarantee. If four companies pursue a strategy that has a 75% chance of achieving its goals, statistically one of them will fail. That doesn’t mean the strategy was bad, and the company should not be deterred from making that kind of strong bet again.

Of course, in the real world, a big strategic bet that sputters and fails may cost some executives their jobs. But companies might be less reactionary in that scenario if they understand the dynamics of the Power Curve.

“As soon as you start talking about strategy, you’re talking about choices that will play out in a future world,” Bradley tells CFO. “You’re talking about uncertainty. A conversation about strategy that’s devoid of probability is very, very problematic.”

The Big Moves

The authors say the research-based model they created turned out to be 86% accurate in predicting whether a company would wind up in the top, middle, or bottom of the Power Curve at the end of a 10-year period.

They looked at 40 variables and found that 10 of them were key determinants. They further divided those 10 levers into three groups they called “endowment,” “trends,” and “moves.”

Endowment, which accounts for 30% of the probability that a company will move to any particular location on the Power Curve, is “what you start with” at the outset of a strategic plan. The key variables here were found to be the company’s size, debt level, and past investment in R&D.

Trends (25% influence on the odds) include the trend of the company’s industry on the Power Curve (the single most important among the 10 attributes) and its geographic trend (the key there is to do business in countries that are among the top 40% for nominal GDP growth).

“Moves” is where the real action is, accounting for 45% of the Power Curve odds. The authors found the following five particularly big moves that, pursued persistently, can get companies where they want to go.

Programmatic M&A: The idea that most deals fail is a myth, the authors say. It’s really only “bet-the-company” deals, with purchase prices higher than 30% of the acquirer’s market capitalization, that are prone to fail. The book advocates for “a steady stream of deals adding up over 10 years to at least 30% of your market cap.”

Dynamic allocation of resources: “Companies are more likely to succeed when they reallocate capital expenditures at a healthy clip,” the book says. There’s a sort of magic threshold here: A company must reallocate 60% of its capital over 10 years, or 6% per year. Of course, it matters where you reallocate it. Interestingly, though, those numbers “are completely blind to where you move the capital to,” Bradley says. “We only measure whether you move it, and doing so always increases upside and decreases downside.”

Strong capital expenditure: “You meet the bar on this lever if you are in the top 20% in your industry in your ratio of capital spending to sales,” the authors say. “That typically means spending 1.7 times the industry median.”

Strength of productivity program: Every company is trying to reduce costs and improve labor productivity. The authors’ research found that the bar for making a big move is an improvement rate that’s in the top 30% of a company’s industry.

Improvements in differentiation: Being in the top 30% of a company’s industry in terms of gross margin “captures whether a company has been able to either develop a sustainable cost advantage or charge premium prices because of product differentiation and innovation.”

Making one or two of these big moves more than doubles a company’s chances (from 8% to 17%) of rising over a decade from the middle quintiles of economic-profit performance to the top quintile, according to the authors. Making three of the big moves pushes the odds all the way to 47%.

Sixty companies in the data set pulled four or five of the levers, and every one of them moved up the Power Curve over a 10-year period.

Notably, making a big move is not associated with increased risk. It both increases the odds of moving into the top quintile of the Power Curve and decreases the odds of sliding back on the curve. “Not moving is probably the riskiest strategy of all,” the authors write.

Shifts in Approach

“Strategy Beyond the Hockey Stick” concludes by discussing a series of shifts in approach that companies can make to overcome the social side of strategy and increase their ability to make big moves.

One shift, for example, is moving from spreading peanut butter to picking the “1-in-10” strategies that will propel the company to far greater achievement. “In fashion, people understand that the 1 hit out of 10 is what matters,” the authors write. “The same is true in movies, oil exploration, venture capital, and some [other industries]. But most businesses … lack appreciation for probabilities.”

Other key shifts include moving from annual planning to “strategy as a journey” and from “you are your numbers” to a holistic perspective on performance, among others.

Despite all the advice for success offered in the book, the authors allow that “strategy remains hard work, and good strategy takes a lot of creativity.” Therefore, executing strategies requires determined and resilient leadership.

“Only then,” they write, “do companies have a chance to move up the Power Curve.”