Capital Punishment

Posted on Nov 8, 2012 | 6 Comments

Here is this month’s piece from Brand Velocity, an Atlanta-based consulting firm that is putting Peter Drucker’s ideas into practice at major corporations.

 

One of Peter Drucker’s most enduring concepts is the critical need for companies to define a “theory of the business”—basic assumptions about mission, markets, technology and core competencies.

The trouble is that even a good theory doesn’t last forever. “What underlies the malaise of so many large and powerful companies,” Drucker noted in his seminal 1994 Harvard Business Review article on the topic, “is that their theory of the business no longer works.”

It is with this in mind that my BV colleagues and I have been issuing a firm warning: A fundamental assumption that corporate executives have relied on for over 40 years is about to change radically.

Since the mid-1970s, companies have built strategies, invested money and shaped their operating models based on a stable or declining cost of capital. And it has worked. More than 65% of the gain in value of the S&P 500 since 1982 has been driven by the declining cost of capital—not inflation, not increased profits.

But suddenly, a broad range of global factors are poised to drive up the cost of capital significantly:

  • Savings rates in developed economies are far less than the demand for replacement and growth capital.
  • Savings rates in the developing world, which have supported much of the need for cheap capital, are declining while the demand for capital in these countries is rising rapidly.
  • Governments in the developed world have massively increased their debt, with little or no real growth in GDP to support it.

In short, both debt and equity costs of capital are likely to rise soon as companies compete with each other for growth and replacement capital, as well as with governments that must refinance their deficit spending.

Yet few companies have adjusted their “theory of the business” to address this new operating environment. The old paradigm of aggressively investing low-cost capital in assets or acquisitions to quickly grow earnings is likely to deliver increasingly disappointing—or even negative—results.

Indeed, companies must shift their focus from income-statement-based strategies to investment-return strategies. Return of capital, calculated correctly, will be the critical driver of value going forward.

In addition, companies must:

  • Target investments in high-capital-return business units.
  • Strategically redeploy new and replacement capital into areas important to customers and future innovation.
  • Explicitly align risks to the key drivers of value and growth.
  • Invest early in known and needed asset restructurings and upgrades.

Once again, Drucker got it right when he wrote that successful executives “accept that a theory’s obsolescence is a degenerative and, indeed, life-threatening disease. And they know and accept the surgeon’s time tested principal, the oldest principal of effective decision making: A degenerative disease will not be cured by procrastination. It requires decisive action.”

What actions will you take in this new world?

—Wally Buran

6 Comments

  1. Rohn
    November 9, 2012

    Yeah i agree, Ducker got it right.
    It would be nice if you could share something more about Investing early in known and needed asset restructurings and upgrades. What all aspects should i consider before doing it. Looking for more updates from you on this matter, thanks

    Reply
    • Wally Buran
      November 14, 2012

      Hi Rohn,

      THanks for your reply. We have been doing a lot of thinking about how management paradigms will need to change as we enter a rising cost of capital environment. Two things stand out particularly. 1) Management focus must shift from maximizing the income statement at the expense of the balance sheet, to a return on capital optimization optimizing income statement and balance sheet considerations. 2) Future capital investments will be more costly and create higher return on capital challenges than investments earlier in known, required capabilities driven by the theory of the business. The key issue is to identify where and how the theory of the business will or likely will need to change in the future, where and how Drucker’s innovation framework should focus efforts within the business, and what capabilities will be needed to support renewing the theory of the business. This then allows companies to target investments on the critical future capabilities needed, which certainly may include current capabilities that need enhancement. This allows capital investment early in known, market and customer relevant capabilities despite future uncertainty.

      For example, Lockheed back in the 1980′s invested in composite technologies even though there was no current application in their existing aircraft because their theory of the business showed them that future aircraft (the Advanced Tactical Fighter which they eventually won to contract to develop) would require heavy use of composite technologies. They created product applications for composites in their existing aircraft even though they lost profit doing it, and invested in composite design tools, engineers and production assets in order to learn and win future contracts. While this was easier during a declining cost of capital environment, it will be critical for companies to pursue this thinking in a rising cost of capital environment if they want to win in both the competitive markets and the capital markets.

      One side note, companies must also develop and implement true measures of shareholder value internally to guide business decisions. The current focus on financial reporting measures as a measure of shareholder value is wrong and leads to maximizing accounting profit at the expense of real shareholder value. All the accounting measures (ROA,ROE, EBITDA/PE Multiple, EVA, RONA, etc) all correlate at less than 40% with actual changes in shareholder value. There are better measures that adjust for accounting distortions without major systems changes that do measure real shareholder value at above 70% correlations with actual stock price changes. In a rising cost of capital, these better measures with be critical for companies to make better investment decisions.

      I hope this helps.

      Wally

      Reply
  2. Rohn
    November 9, 2012

    Yeah i agree, Drucker got it right.
    It would be nice if you could share something more about Investing early in known and needed asset restructurings and upgrades. What all aspects should i consider before doing it. Looking for more updates from you on this matter, thanks

    Reply
  3. Maverick18
    November 9, 2012

    Where this has been going is that invesment in people is displacing investment in hard capital as the invest and grow model. If you cannont productively invest in people, your business is not “invest and grow,” it is “manage for cash.”

    Reply
  4. william P
    November 13, 2012

    Wally,Great thoughts and right on as Leaders of companies need to be prepared for the cost of capital issue.

    Reply
  5. Kent Gregoire
    November 13, 2012

    Wally, you and your colleagues are wise to issue a firm warning and thank you for doing so. Maybe I’m just one of those people that continually looks into the future (as if I had a crystal ball – lol) to understand what we need to do today to adapt to changes taking place…and I too have been suggesting that what worked isn’t going to keep working.

    I have been one of those guys that have bucked the trend by consistently focusing on return of capital as a critical driver over income-statement-based strategies. Why? I believe that the best investment we can make is in our people — and increasing their capacity to perform provides an extraordinary return on capital.

    Today I spend much of my time helping sales organizations adapt to today’s buyer (Buyer 2.0). Just three years ago people thought we were crazy and wondered how did we make such stuff up. Guess people today are not laughing.

    So again, thank you for taking the bold step of speaking up about sticking onto ‘theory of the business’ may lead us into what I consider to be troubled waters. Change is great…now we just need to understand what is being asked of us and adapt to it. Fun…

    Reply

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