We hear this all the time.

Rather than an ever-more-precise inside view, strategy needs an outside view where data about the thousands of other experiences by other executives and their companies in other strategy rooms are brought into your own strategy room to shape the discussions. 

The data shows that many companies are simply not bold enough, their strategies are not designed for big moves. All too often the result is incremental improvements that have companies playing along with the rest of their industries.

Strategy is precisely the wrong problem for human brains and the right problem for playing games, especially when the inside view goes unchecked.

The inside view creates a veritable petri dish that can grow all sorts of dysfunction…and soon get us to the hockey stick: The graphs that show revenue and profit heading straight for the sky a few years out.

“The strategy process is a ritual dance before you get to what really matters: the annual operating budget”

Playing the inside game:

The inside view often prevails in strategy rooms because they are tightly sealed. A lot of data and information comes into the room but typically it is focused on your own company and a handful of key competitors and your own industry.

People’s egos, careers, bonuses, status in the organization, resources they get to fund the growth of their business all depend to a large extent on how convincingly they present their strategies and the prospects of their business.

Strategies can also be constrained because they are being developed bottom up as each business unit projects how it will perform over the coming years, those plans are rolled up into the company-wide strategy are rarely calibrated against outside data to see how similar growth plans historically fared at similar businesses in similar situations.

A survey of 159 chief strategy officers showed that more than 70% of executives surveyed say they don’t’ like their strategy process and 70% of board members don’t trust the results

People are prone to many well-documented unconscious cognitive biases – overconfidence, anchoring, loss aversion, confirmation bias, attribution error. These biases exist to help us filter information for decision-making.

Strategy processes are also prone to survivor biases. We only see what happened, not what didn’t happen. We all read the case studies about great companies that succeeded with explanations rationalized after the fact for why they did so. Our experiences are shaped by learning from survivors and our strategy rooms are fraught with biases related to not having failed big-time.

Adding social dynamics into the mix

As soon as you introduce people into strategy, you get biases. When you introduce other people – where the approver is different from the doer – you get agency problems.  Agency problems are fuelled by incongruences between management and other stakeholders such as:

• Sandbagging – “I can’t risk being the one division that misses budget.” – The reality is the individual will often have a different attitude to risk than their overall enterprise.

• The short game – “Someone else will be running this division in 3 years anyway” – The motivations of the executive are not aligned to those of the owners.

• My way or your problem – “If I don’t get the resources I ask for, there’s my excuse for not delivering” – The line executive has inside knowledge and the CEO and board have little choice but to accept their version of the truth.

• I am my numbers – “I’m just going to work hard enough to hit my targets, not a lot more.” – One supervisor can’t directly observe the quality of efforts. Were those poor results a noble failure? Were those great results just dumb luck?

People have different motivations and asymmetric information. Presenting in front of your superiors and peers is a matter of pride, your track record is a matter of ego. Your team wants protection.

Charles Munger and Warren Buffet used to say “95% of behavior is driving by personal or collective incentives.” They later corrected themselves “The 95% is wrong, it’s more like 99% percent.”

The data shows that companies that rapidly reallocate capital to new growth business outperform those who take a steady state approach.

Yet the social side of strategy suggest companies still tend to take a peanut butter approach – spreading a thin layer of resources smoothly across the whole enterprise even when it’s clear that opportunities are great in some areas than in others.

Strategy processes often generate a high-level commitment to making a change, but too often the processes don’t surface and deal with other prior commitments that immunize companies against change.

As one CEO put it “If you want a big idea done, you have to pursue it to the last detail. Just because the group said “yes” doesn’t mean it’s going to happen.”

At its heart business strategy is all about beating the market, defying the power of perfect markets to push economic surplus back to zero.

Using economic profit as a yard stick for success

Economic profit – the total profit after the cost of capital is subtracted – measures the success of that defiance by showing what is left on the table after the forces of competition have played out. Businesses also pursue other objectives such as delivering inventions, securing employments, making social contributions, and building communities. But if good strategy succeeds in taming market forces, residual economic profit will grow making it easier to accomplish the other objectives.

Economic profit captures the 2 parameters driving share price performance – return on invested capital and growth. As many commercial enterprises are not listed on public markets, economic profit is a more universally applicable measure.

Once you plot all economic profits in an ordered line you find they demonstrate a power law – the tails of the curve rise and fall at exponential rates with long flatlands in the middle. 

Inside views gives us a detailed look at how we compare with last year, our immediate competitors and expectations for next year. When we zoom out and look at the landscape of profitability – at all major companies in all industries and geographies – we get an important new perspective. Good strategy shouldn’t focus narrowly on last year or next or competitors. The goal of strategy needs to be to move to the right on the Power Curve.

Some feels it’s unfair to be compared against companies in other industries and other nations but that’s the comparison that capital makes. It flows to the best opportunities no matter the industry or geography. Your main competitor is the Darwinian force of the market that squeezes your profitability; your main measure of whether you are winning is the extent to which you avoid the squeeze.

In a recent survey CEOs attributed 50% of decisions on target-setting and strategy to facts and analytics and the other half they attributed to the strategy process and dynamics in the strategy room.

Forecasting

When it comes to forecasting several silent killers can creep into our strategy room. Some of the most popular ones include:

• A lack of proper baseline – Forecasts are often building on things we believe we know. Another evergreen problem with baselines is planning for market-share gains.

• Errors about performance attribution – Often performance is mistaken for capability. A realistic perspective on corporate performance also tends to be obfuscated by stretch goals. In setting these, leaders often put hope over facts and managers with exceptional track records seem especially prone to willing their way to performance by setting unrealistically high-performance bars, at times with negative effects on the morale of their team.

• The ways we deal with uncertainty – At some level is it easy for the CEO to deal with uncertainty by playing a portfolio game – knowing that not every bet has to pay off for the total play to work. The problem is that what is a portfolio game on the corporate level becomes a matter of al-in commitment for an individual business unit leader.

Here are some of our favorite ways that people deal with uncertainty in the strategy room:

• Ignoring uncertainty – many presentations start with an analyst-based projection of the market. From then on you get single-point estimates for the plan.

• Treating uncertainty as an afterthought – usually a slide about risks on page 149 of a 150 page strategy deck.

• Pretending to deal with uncertainty – One scenario is used picked as base case and that’s the last thing you hear about uncertainty.

While the calculator loses reputation by wrongly calculating risk; the manager loses reputation by giving up resources. These all lay the foundations for setting the wrong ambition levels and consequently flawed strategies.

A recent study of a large sample of big companies showed that over 90% of budgets on a business unit level are statistically explained by the previous years’ budget levels.

“Strategy plays out in a world of probabilities not certainties, but the odds are knowable.”

The odds of individual business units moving up and down the power curve are roughly the same as for companies. When companies make a big move up the curve it’s mostly because one or at most two of their businesses make a hockey stick improvement.

• If you underperform on both growth and ROIC improvement, you have virtually no chance of getting off the ground.

• High growth with below median ROIC improvement gives you a small chance of an upside but doesn’t do much to reduce downside risk

• A performance only strategy that focused on improving ROIC but does not deliver above median growth is playing it safe.

• The magic happens when both growth and ROIC improvements work in concert. It is this increasing returns to scale dynamic that seems to matter. Assets built around common, sharable intellectual property, those with network or platform effects and those with higher fixed costs enabling massive economics of scale tend to have increasing returns to scale.

The push for certainty

In strategy rooms here often seems to be a push towards certainty – not odds. The work usually begins by entertaining lots of ideas, testing them to winnow them down, clear hypotheses are tested and refined with the idea of reducing uncertainty. Forcing us to think in terms of probabilities works against the desire for certainty, a consensus lets us all leave the room united on the plan and ready to execute.

How to find the real hockey stick

“You can shift the odds of strategy by capitalizing on your endowment, riding the right trends, and most importantly making a few big moves.”

Many ideas about strategy provide a lens for looking at history and understanding why something failed or succeeded, but what really matters is having a way of peering into the future, not the past. Knowing the number for yesterday’s lottery winner doesn’t help much.

That’s why we emphasize the use of deep, testable data on broad characteristics, drawn from large samples. It focuses on probability and is calibrated from the top down so provides a bulwark against social distortions. The result  is a way to calibrate your strategy in a probabilistic world.

The 10 variables that make a difference

We’ve grouped these 10 levers for ease of use into 3 categories: endowment, trends and moves. With these, you will be able to understand much better your real chances of success ahead of time when you can still do something about your strategy and its execution. Your endowment is what you start with. Trends are the winds that you are sailing, pushing you along, moves are what you do. They’re like the primary colours of strategy, now we just have to mix them appropriately.

Endowment

• Size of your company –To have a significant advantage on this variable you need to be in the top quintile for total revenue, which means exceeding $7.5 billion in revenue. That figure has doubled in the last 10 years

• Debt level –The key here is to have a debt to equity ratio that puts you in the top 40% for your industry

• Past investment in research & development (R&D) – You need to be in the top half of your industry in your ratio of R&D to sales to benefit from a significant improvement in chances of moving up the power curve. This offers a 15% difference in your chances of making it into the top quintile of the Power Curve.

Trends

• Industry trends – The single most important of all 10 levers. The metric used is average growth in economic profit across all companies in the industry

• Geographic trends – The key here is to be in markets that are among the top 40% for nominal GDP growth. You calculate your corporate-wide GDP based on the % of revenue received from each geographic market

Moves

• Programmatic M&A activity – A steady stream of deals costing no more than 30% of your market capital adding up over 10 years to at least 30% of your market capital

• Dynamic allocation of resources – Feed the units that could break out and produce a major move up the Power Curve, starve those unlikely to surge. The threshold here is reallocating at least 50% of capital expenditure among business units over a decade

• Strong capital expenditure – Typically this means spending 1.7 times the industry median

• Strength of productivity program – Everybody is trying to reduce costs. Research found that the bar is an improvement rate that’s at least in the top 30% of your industry

• Improvements in differentiation – To make business model innovation and pricing advantages improve your chances of moving up the power curve, you need to make it into the top 30% in your industry in terms of gross margin. This measure captures whether a company has been able to develop a sustainable cost advantage or charge premium prices due to product differentiation and innovation

Do other variables matter? Talent, leadership, culture and the deeper details of execution? There is incomplete empirical research to suggest that they would. No matter the quality of the talent base, if the strategy does not pass the thresholds of the 10 levers, it will be hard for talent to compensate for the weakness in endowment, trends or moves.

When battling the effects of the social side of strategy is you now have a benchmark for the quality of a strategy independent from subjective judgements in the strategy room and an external reference point to help calibrate the likelihood of success and a tool to change the conversation with your team.

Trends Explained:

We see trends all the time and are comfortable talking about them – what’s happening in the economy, new technology innovations, what’s happening in our industry, new styles of apparel, but ask yourself: how often do we underestimate the importance of trends, the context in which we operate, because we are accustomed to believing that we are in control. How often do we see trends but do not act fast enough upon them?

Almost every strategy pays at least some credence to trends but often companies don’t build the capabilities or lay out the specific actions to capitalize on the trends. They rarely translate trends into practical investable pockets and decisively shift resources to capture the opportunities.

Getting ahead of trends is easily the single most important strategic choice you have to make. It’s crucial to both identify all the relevant trends and to act on them in the right timeframe.

If you find yourself facing a disruption of the scale Kodak did with digital photography you have 2 options;

• Transform your industry e.g. through consolidation to change its fundamental performance prospects

• Decide to leave your industry to establish a new foothold in a less threatened space.

Neither is easy.

If you can’t rewrite the rules of your industry, you might have to reposition your portfolio toward new growth businesses. Strong re-allocators move more than 50% of their capital base over a 10-year period.

One crucial piece is to shake free of the notion that that status quo is baseline. Just keeping up is hard these days. Although geography doesn’t matter as much as industry, it still matters.

Even beyond the specific insights you get by understanding the relative ranking and prospects for various industries and geographies, looking at trends starts to change the dialogue in the strategy room.

The crucial insight isn’t always about mega trends or mega disruptions either. One of the biggest challenges to acting on trends is the daily grind of serving your customers and responding to their needs in a timely manner. Success over the long term might simply be the accumulation of accurately understanding trends within your industry, making sure you have the flexibility to adapt and channel your resources to the best opportunities accordingly and doing so faster than your competition.

The need for privileged insights

These come from moving from high-level trends all the way down to investable pockets – specific and addressable business opportunities.

This can require investing in proprietary data. You can also collide macro and micro insights to identify which trends are real and which are just hype or fads.

“Companies rarely die from moving too fast, they frequently die from moving too slowly.” – Reed Hastings, CEO of Netflix

“Everybody likes change, except for the change part”

– Alan Kay, personal computer pioneer

The 4 stages of a disruptive trend

• Signals amid the noise – Gaining sharper insights and escaping the myopia of this first stage required incumbents to challenge their own story and disrupt long standing and sometimes implicit beliefs about how to make money in a given industry

• Change takes hold – Bolder action becomes a necessity and executives must commit to nurturing potentially dilutive and small next-horizon businesses in a pipeline of initiatives. Managing such a portfolio requires high tolerance for ambiguity and requires executives to adapt to shifting conditions both inside and outside the company even as the aspiration to deliver favorable outcomes to shareholders remains constant. The difficulty is the tendence to protect the core because of short-term financial incentives and emotional ties that inhibit a shift to the periphery

• The inevitable transformation – This is often the hardest stage for incumbents to navigate. As company performance starts to suffer, tightening up budgets, established companies naturally tend to cut back on peripheral activities and focus on the core. Under the influence of the social side of strategy the reflex to conserve resource kicks in just when you most need to aggressively reallocate and invest. Even when the course is reasonably clear getting the team moving in a new direction can be hard. When incumbents lack the in=house capability to build new businesses, they must look to acquire them instead. Here the challenge is to time acquisitions somewhere between where the business model is proven and where valuations become too high.

• Adapting to the new normal – Disruption has reached a point where companies have no choice but to accept reality. In some cases the incumbent’s capabilities are so highly tied to the old business model that rebirth through restructuring is unlikely to work, and an exit is the best way to preserve value. In many companies the challenge is to adapt and structurally realign cost bases to the new reality of profit pools and accept the new normal likely includes far fewer rivers of gold.

Five big moves make all the difference in shifting your odds. Big moves sound scary but they are the safest best. They are best done by purposefully making a series of smaller steps over time.

Programmatic M&A and divestitures

The myth that 75% of all mergers fail was based on a statistic related to “announcement day effect” that failed to capture the reality of corporate value creation (not to mention that many smaller deals don’t get announced but cumulatively matter a lot).

Repetition of M&A helps you get past the curse of introspection, strengthens the capabilities of your business. M&A and post-merger programs are not innate talents, they are mastery acquired by doing them over and over again.

Active resource re-allocation

Re-allocation Is not just limited to capex across segments. Re-allocation within segments is important too and so is re-allocation of operating expense. Inertia matters a lot, and so do our organizational silos. We often don’t look at all our resources in their proper context and see how they can be shared or moved.

Strong capital programs

Successful capital programs manage a pipeline: making sure you aren’t just investing in options that you know are “in the money” – making sure you’re investing in some riskier medium terms options for the company and even longer-term even-higher-risk options.

There must be real discipline and robust investment processes. If a project doesn’t generate returns at least equal to the cost of capital, it’s actually destroying value for shareholders. This is one of the reasons why we use economic profit – after capital charges have been deducted – as our measure of financial performance for observing the Power Curve.

Distinctive productivity improvement

Being able to force the entire organization into consistently driving productivity and capturing bottom-line impact are real differentiators.

All too often the hard work on productivity is giving away in pricing or lost when other parts of the organization absorb the gins. The German sausage effect – you squeeze on one end and the fat sloshes to the other end.

Structuring and launching an effective, sustained productivity program is not easy but in the age of machine learning and artificial intelligence, new tools to accelerate such programs are becoming mainstream.

Differentiation improvement

Differentiation expressed in the comparison between the average gross margin of companies and that of their industry is a way of summarizing how much customers’ value a company’s products and services relative to its competitors.

This is where management objectives, incentives and long-term interest of shareholders often collide.

Big moves make for good strategy

Understanding the role of big moves in your strategy is more than just what they are and how they work in isolation, it’s also how they work together.

Big moves are really valuable, they’re non-liner, they must be relative to your industry, and they compound. They are asymmetric – the upside possibility far outweighs the downside risk. Programmatic M&A for example not only increases your odds of moving up the curve but simultaneously decreases your risk of sliding down. Big moves are also cumulative, they are not silver bullets. Companies that successfully deliver on their big moves make them part of their day-to-day mantra. It’s constancy of purpose that makes moves turn into big moves.

Eight shifts to unlock strategy

• From annual planning to strategy as a journey

Trying to solve your big strategic questions and lock down an agreed plan at the same time can be near impossible. The world doesn’t unfold in nice, neat, annual increments. Things change all the time in your business and in the markets around you. Discuss key strategic questions and performance every week or month at minimum complementing traditional annual strategic planning processes; start maintaining a live list of the most strategic issues, your big moves, and a pipeline of initiatives for executing them; track your portfolio of initiatives through different stage-gates and monitor a rolling 12-month plan that you can update as needed.

• From getting to “Yes” to debating real alternatives

Frame strategy around hard-to-reverse choices, calibrate aspirations against an outside view; compare real alternative plans with different risk and investment profiles; track assumptions over time and build contingencies int your plans so you can evolve your choices as you learn more; use de-biasing techniques to ensure quality decision making. 

• From peanut butter to picking your 1 in 10s

It is nearly impossible to make big moves if resources are peanut-buttered across all business and operations. Adjust your incentives so the team support the resource re-allocation; pick where to compete on a granular level, even by vote; allocate resources from a portfolio-level view and skew towards opportunity; play to win – allocate enough resources to outcompete others in key areas.

• From approving budgets to making big moves

We need a shift to end the situation where strategy is little more than the opening act to the budget. Instead of forcing decisions on targets and making uncertain promises, focus the strategy dialogue on big moves, on your best ideas for how to beat the market, then just let the outcomes follow. Build a momentum case rather than a base case. Do a tear down of past results to see what came from trends and what came from moves; check the plan is big enough to fill the gap between the momentum line and the aspiration; benchmark the big moves relative to the competition to test that they are big enough to move the needle; separate the discussion on moves from the discussion on budget. One should follow the other.

• From budget inertia to liquid resources

To mobilize resources and budgets there needs to be a certain level of resource liquidity. This is the currency of strategy. Start freeing up resources as much as a year before your strategy will need to deploy them; move to 80% based budgeting to unlock a kitty of contestable resources; charge managers an opportunity cost for their resources so they have an incentive to free them up.

• From sandbagging to open risk portfolios

The fundamental ideas is to move away from the current dynamic of sandbagging the budget and hockey stick the strategy to a situation where risks and investments are managed on an aggregate level. Move from hockey sticks everywhere to one corporate-level view, based on a series of big moves; force separate conversations for improvements, growth and risk; make risk vs growth decision at portfolio level not within business units; tailor approaches on no-regret moves, big bets and real options; adjust incentives and measure to reflect the risk people are taking.

• From you are your numbers to holistic perspective of performance

Unless there is a sense of shared ownership for the fortunes of the company, you will have a hard time getting the full commitment of your team to the big moves required to mobilize your business. Encourage noble failures and focus on quality of effort; reflect higher or lower probabilities of success in your incentive structure; use team incentives over longer time-horizons in riskier contexts.

• From long range planning to forcing the first step

After identifying your big moves, you must break them down into proximate goals, realistically achievable within a meaningful timeframe (say 6 – 12 months)

Strategy remains hard work and good strategy takes a lot of creativity. Executing strategies requires determined and resilient leadership. Only then do companies have the chance of moving up the Power Curve.