www.strategydynamics.com

This has become particularly prevalent since the fashion for privatising utilities – water, gas, power, rail – but was already an issue in commercial asset-intensive industries, such as steel and oil. Management can always defer capital and current spend with long-term payback because the short-term damage will be insignificant – for a while. Then, the accumulated under-spend finally breaks out in frequent, big problems. Bear in mind that in many of the industries affected, very little can be done about market-facing strategy – folk don’t generally want a lot more sewage services or power supplies. For these companies, strategic management is dominated by choices on management and investment of capital intensive assets.

It’s not as simple, though, as spend v. not-spend – there are many choices and trade-offs. Should we up the maintenance rate on deteriorating assets or fix them well when they break down, should we replace the most unreliable assets or refurbish them, etc?

Here’s a section from chapter 6 of Strategic Management Dynamics explaining the issues, and here is a simulation exercise to try the challenge for yourself. It’s a zip file with a slide and model – run the slide show. You will need our mystrategy software for this – the free Reader will do fine.

I must thank my friend Bob Thurlby of Serco PLC who does a lot of practical work on strategy in asset intensive businesses for the opportunity to develop these insights.

Click for more on strategy dynamics.

Cyclicality afflicts many industries, not just basic materials like steel, paper-pulp and chemicals, but other sectors including shipping, insurance and office space. They suffer far worse cyclicality in price-levels and profitability than can be explained by variability in the markets they serve – why?

How these industries behave

What these industries have in common is that capacity increases come in large lumps and take a long time from any decision to raise capacity and that increase coming on-stream. So, any growth in demand leads to tightening supply and rising prices and profitability. Many firms respond by announcing new capacity, and during the delay while shortages persist, prices and profits sky-rocket, leading to still more plans for new capacity. Eventually, that capacity all comes on-stream, grossly exceeding demand levels, and prices collapse for as long as it takes for demand to grow to match – often many years.

A further mechanism is that during the up-turn, investors take some time to be persuaded that higher prices and profits are real, adding a still further delay and exaggerating the boom and bust still further.

How to manage strategy in cyclical industries

Dealing with these circumstances was certainly documented as long ago as 1996, though experienced executives in many of the industries affected by cyclicality had long known intuitively what to do:

• first, do not spend money on building new capacity when demand exceeds supply and prices and profits are strongest – every else will be doing the same
• instead, take all the excess margin and build up cash reserves
• when excess capacity comes on-stream and prices and profits collapse, competitors will be in trouble, and you can use the capital war-chest to buy fire-sale assets or entire companies
• take the opportunity to shut down inefficient capacity, either amongst what you had before or acquired, to shorten the time when supply exceeds demand
• if underlying demand looks healthy, invest in new capacity before prices and profitability recover, so that it will come on-stream in time to take most of the share of any increased demand.

[BEWARE - as with all strategy principles, this one should be checked carefully to make sure it's right for you under the circumstances you face.]

The Economist article implies that many of the big firms in basic industries ignored these principles, bet the farm on demand growth going on for ever, and made matters worse by borrowing heavily – resulting in still greater excess capacity than would otherwise have been the case. Were they really not aware of age-old wisdom, had never read this or other articles on the issue, or did they just hope that gravity had been abolished?

The interesting extension of this story is that the naive strategy of ‘build-capacity-when-demand-is-exploding’ seems to have infected many, many industries that would not normally have been susceptible to the problems in 2005-07, just as it did between 97-99.

We are still waiting to hear where the consultants were who should have been advising caution .. and did the strategy academics have anything to say on the subject? If you were a consultant or strategy professor who urged caution, or a business who received that advice, do let us know.

This is a big step forward from the much-abused, misused and dangerous focus on ‘core competences‘ – the idea that some unique and super-powerful capability will deliver sustainable competitive advantage. [I even came across one quoted company who re-titled the entire strategic planning system in the firm as their 'core competence process']. Here’s an extract from my chapter 10 showing one example of why it doesn’t work …

 “Practising managers commonly look for core competences, but it should by now be clear that firm performance depends on accumulating and maintaining a complete system of mutually-supportive resources. If any of these is inadequate in scale or quality, the performance of the entire system will suffer – the firm must be capable in all resource-building and maintenance activities. Attempts to identify a single capability that will provide sustained advantage are doomed to failure, as the following quote from the Economist (July 4th, 1998) illustrates for Honda.
‘… by 1990, Honda was in thrall to its engineers – a priesthood … untroubled by the dismal business of marketing and accounting … It hardly seemed to matter that customers were not buying Honda’s flights of engineering fancy … Things were already going wrong [due to lack of] attention to what the customer wanted and producing it at reasonable cost. … it was taking twice as long to get a new Honda into production as Toyota.’Â
This brief comment is remarkable for indicating the supposedly non-core capabilities that were in poor shape – design capability to create cars that people wanted, product-development capability to get them into production quickly, production engineering capability to achieve low unit-cost, marketing capability to build the customer-base, and accounting and control capability to translate revenues into cash. The solution to Honda’s troubles involved reducing the focus on technology for its own sake, turning attention instead to market research and product-design, and moving policy control from the engineering function to the marketing and production departments. ” – interesting to note that Honda was in this mess in 1990, exactly the year that their core competence in engine technology featured in an HBR article! Of course Honda has come a long way since then, and the HBR article never actually said that you didn’t need to be basically capable in all other functions.

So … the capability-coherence notion from Cesare Mainardi and colleagues is a welcome call to make sure all necessary capabilities are strong.

 I don’t have time to do a wide-ranging review of their output during 2004-2007 for all possible warnings and advice – though I cannot recall a single such warning - but I did do a quick scan for anything on the subprime crisis. That after all was a crystal-clear case of an originally reasonable strategic opportunity that numerous competitors managed to mess up big time. It was also very evident in the media, due to the widespread concern about policies towards different customer groups. [There's a great little history of the events up to 2006 at BNET - if that doesn't work in your country, Google A short history of subprime by Brenda White in 'Mortgage Banking'.]  

So I had a look …

I find plenty of reports about problems as they arose in particular companies as long ago as mid-2005, but astonishingly I could not find a single article from the top-level management journals describing the strategic crisis that was brewing or what firms in the industry should be doing about it. And this in spite of the fact that regulators were already expressing concern from May 2005. Even when casualties were beginning to pile up during 2006, there were still no considered articles pointing out the nonsense that supposedly sophisticated firms were pursuing.

McKinsey Qtly Aug97 highlighted opportunities in reinventing real-estate transactions, in which subprime lenders stood to do well. In Jun04 they reported “A deterioration in the credit quality of consumer loans, will probably lead to an increased chance of failure among subprime lending institutions as a group“, but did not offer any warning or advice to the banks themselves. In Aug04, it praised “Spanish-language education programs for potential home owners with an array of prime and subprime mortgage products and innovative credit evaluations to increase [loans to] Hispanic borrowers.”  adding “… recent immigrants may not take for granted the relative stability of US financial institutions.“ In Jan06 they offered a pessimistic scenario “Overburdened US consumers giving way” in which “… return-on-equity levels in the subprime-mortgage industry could fall to 5 percent, from 20 percent“. But the killer came in Jun07, when an article entitled Surviving—and Prevailing—in the US Subprime-Mortgage Market actually encouraged further commitment to an already collapsing sector – “Despite recent dramatic downturns and the threat of increased regulation, subprime-mortgage opportunities still abound for players that are willing to wait for an upturn and can stomach the attendant risks.”

Perhaps we shouldn’t be too hard on McKinsey, though – at least they offered a view. strategy+business did not mention the sector at all before 2007. HBR seems not to have noticed the sector either, but at least by April 2008 had caught up, recommending that “If you don’t understand, ask questions“ - a touch late, perhaps? There were just 13 occurrences of the term in the Financial Times during 2004-05, none mentioning the strategic risks, and the Economist didn’t touch on it at all until Dec06, by which time the problems were piling up.

Now there are two reasons this makes me so angry. First, it is the primary responsibility of those directing an organization’s strategy [and of the consulting firms they employ] to ensure that its future is secure. Secondly, we have been here before, and not long ago …

During 1999-2000 I was being rubbished by colleagues for asking if the dot-com boom was in danger of busting. One eminent figure told me “You just don’t get it – the way the world works has just changed.” He even claimed that investors no longer put money into equities because they expected that they [or those they would sell stock on to] would ever get a return – they did it because they were in some kind of philanthropic way excited to be supporting a brave new world.

None of the top strategy journals highlighted the danger then either. Nor did the only significant professional body for strategists – the Strategic Management Society. I am told [though cannot confirm] that the Society’s 2001 conference was originally planned for Paris, but was switched late in the day to San Francisco because the West Coast was ‘where it’s all happening’. I didn’t attend that one, but hear that both the attendance and excitement was rather more muted than hoped for, as the dot-com bust destroyed most of those spectacular cases that were to have featured. If the Strategic Management Society can’t look more than a few months ahead, I guess there’s not so much hope for the rest of us.

Lastly, let’s not forget the real victims of this incompetence, both in 2001 and 2008 - not the bankers, consultants or senior executives themselves, but ordinary folk trying to make a living and save for their retirement.

But perhaps I’m wrong, and authoritative sources were indeed warning of the inflating bubble of 2006-07 and giving sound strategic advice on how to avoid it or prepare for it. If so, please do let me and my readers know.

Anyone experienced similar this time round?