Are Investors Bad for Business?

Uh-oh, he's at it again. 'He' being Clayton Christensen, the Harvard Business School professor who invented disruption in the business context.

Truth to tell, he's never stopped being at it, he's just evolved. But now he is taking on the holiest of holies, the concept of shareholder primacy, the cult that became a state religion within the confines of management theory. The belief system that launched a thousand acquisitions, enshrined scale as an unquestioned deity and sanctified competitiveness as a watchword of the faith.

But how could Christensen, one of the high priests in the management temple, turn on his acolytes?

This is, not surprisingly, about numbers, their uses and meanings. It's about returns on invested capital and assets. Bedrock principles familiar to anyone who slept through Econ 1. But the question, the challenge really, homes in on whose capital and what assets. And it gets to really big issues about who is doing what - and for whom.

This brings to mind that old jibe about the relationship of academia to what passes for the real world: it works well in practice, but will it ever work in theory?

Managers and executives say they are constantly looking at impact and returns. That they have skin in the game and want compensation to be performance-based. And they say that because they know they are expected to say it. But, as the following article explains, that is not how they really manage. They manage for the short term because they have come to understand that there is a rarely, if ever, a long term. At least one in which they figure or in which they have a stake.

This state of affairs has emerged as a result of a broader global failure of belief in the future. Which is why so many companies are sitting on piles of cash so vast that mythical dragons guarding heaps of gold would be diverted. Sums measured in the tens of billions. All of which, we are led to believe, is best left to garner interest in the 3 percent range rather than be put at risk in hopes of greater, but less certain returns.

Which brings us back to the fundamental premise: investors are essential to business but have infected it with their own querulous cautions, borne of the fear that these are the good old days and we shall not see their like again, unless, of course, we are required to do so - as that famous tag line once said - the old-fashioned way, by earning it. JL

Steve Denning comments in Forbes:

Is the organization going to be an instrument of society or simply a short-term money-making machine for its managers and shareholders?
1997: The Innovator’s Dilemma
Christensen became the most influential business thinker in the world with his 1997 book, The Innovator’s Dilemma. It described the slow but inexorable process of disruption that occurs when a new technology peels off low-value customers and markets.
The frightening thing about it was that “good management” was no defense. Based on the principles of traditional management, it made perfect sense for managers to welcome the intrusions of a disrupter, because business returns improved by losing low value customers and markets, until suddenly there was no business left. The fatal disease affected every sector. It spared no one.
2003: The Innovator’s Solution?
In 2003, Clayton Christensen, in a book co-authored with Michael Raynor, The Innovator’s Solution, proposed a “solution” to the innovator’s dilemma, essentially by embracing the disrupting technology, and competing with the disruptor, head-to-head. To avoid the tendency of businesses to crush disruptive new ideas, the book proposed protecting the disruptive new business from hostile anti-innovation forces by creating an independent business unit. There, the innovation could thrive without having to fight off the interferences and intrusions and anti-innovation attitudes of the existing culture.
The problem? “Separate organizations don’t work—or at least not for long,” as analyst David Garvin noted in HBR. Even if the innovative independent business unit is successful, the firm often folds the subsidiary into the mainstream of the organization and the culture in due course crushes it to death, as happened with the PC division of IBM IBM +0.33%. The “innovator’s solution” isn’t a “solution” to the innovator’s dilemma. It doesn’t neutralize the forces hostile to innovation; it merely postpones the task of finding a solution to a later date. Companies continued to be disrupted in significant numbers.
2011: It’s the metrics?
In 2011 at the Gartner Gartner Symposium ITExpo, Christensen’s described the evolution in his thinking. He began putting forward both a new diagnosis and a new solution. The problem of disruption, he said, was essentially one of decision-making driven by the wrong metrics. Disruption was being “driven by the pursuit of profit. That’s the causal mechanism for these things…There is a pernicious methodology for calculating the internal rate of return on an investment. It causes you to focus on smaller and smaller wins… There’s another one: the rate of return on net assets causes you to reduce the denominator—assets—because the fewer the assets, the higher the rate of return on net assets–RONA.”
“The fundamental thinking,” he concluded, “drives decisions that are just plain wrong.” In November 2012 he developed this thinking further and sketched some preliminary ideas as “seeds for discussion.”
2014:  The Capitalists Dilemma resolved?
Now the June 2014 HBR article declares victory. “We’re happy to report that we think we’ve figured out why managers are sitting on their hands, afraid to pursue what they see as risky innovations [i.e. market-creating innovations]. We believe that such investments, viewed properly, would offer the surest path to profitable economic and job growth….”
The HBR article “is an attempt to form a theory from the ground up, by looking at company experience.” It’s an interesting experiment. The authors assembled the best and brightest—the Harvard Business School alumni—and set out to put together a comprehensive solution to the problem. The article constitutes is interesting sociological study of the way a diverse group of people in business think about these issues.
Business performance are measured by ROA and ROIC?
“In our view,” the article says, “the crux of the problem is that investments in different types of innovation affect economies (and companies) in very different ways—but are evaluated using the same (flawed) metrics… A big part of the answer lies in an unexamined economic assumption. The assumption—which has risen almost to the level of a religion—is that corporate performance should be focused on, and measured by, how efficiently capital is used. This belief has an extraordinary impact on how both investors and managers assess opportunities. And it’s at the root of what we call the capitalist’s dilemma… Because they were taught to believe that the efficiency of capital was a virtue, financiers began measuring profitability not as dollars, yen, or yuan, but as ratios like RONA (return on net assets), ROIC (return on invested capital), and IRR (internal rate of return).”
But is this actually true? Do the rates of return on assets or on invested capital ever figure  prominently, or even at all, in quarterly presentations to investors? How often do analysts refer to them?
Frankly I can’t recall that happening. Ever.
All the attention of management and investors in these quarterly reviews is on short-term profits, not the ROA or even the ROIC. That’s because the rates of return on assets or on invested capital are lagging indicators: they don’t tell us much about what is happening in the most recent quarter, which is the focus of analysts’ attention. And the IRR doesn’t tell us anything about overall corporate performance. These ratios are simply not part of the discussion. But the ROA and ROIC should be.
In fact, as Deloitte’s Shift Index has shown, the rates of return on assets and on invested capital of US firms have been on steady decline for over four decades and are now only one-quarter of what they are in 1965.

As the Shift Index 2013 points out, “ROA provides a useful framework for understanding how the longer-term forces of the Big Shift are affecting firm performance. At the highest level, assets are growing faster than income. Economy-wide, companies require more assets to generate an equivalent amount of income now than back in 1965.”
If firms and investors had been paying attention to the ROA or the ROIC, firms and the economy wouldn’t be in the extended and fundamental slump that they are in: i.e. “the Great Stagnation” as Tyler Cowen has called it.
“Investors and managers alike,” the HBR article says, “were taught to maximize the revenue and profit per dollar of capital deployed.” That may have been what they were taught, but that’s not what they do, or even say they do. They have consistently ignored the ROA and ROIC. The focus, as the discussion of the Harvard alumni shows, is instead relentlessly focused on the absolute amount of short-term profits, not the relative return on assets or invested capital.
Firms don’t use ROA at all
The problem isn’t excessive use of the ROA, says the Shift Index. It’s failure of companies to use it all. Instead, the focus is all on the short-term profits.

“It’s a vicious cycle. Executives are increasingly reluctant to develop and communicate long-term strategic direction given the perception, and often a reality, of greater market uncertainty. In the absence of vision and guidance from company leaders, financial analysts and investors are left with little more than near-term financial results to judge a company’s potential. But as the investment community shifts focus to short-term financial metrics, executives also focus more on these same metrics. This type of self-reinforcing, short-term thinking leads to reactive behavior from management. Companies tend to hedge their bets by deploying resources in multiple areas with the hope that at least one bet will prove fruitful. These types of management practices do not differentiate among short-term events, and they have the tendency to spread resources too thinly. The result is sub-optimal performance on all fronts and failure to achieve longer-term goals or chart a course for long-term viability.”

Pursuit of profits vs pursuit of ROA
Is it possible that the article confuses two related, but quite different, things: “pursuit of short-term profit” and “pursuit of efficient use of capital (as measured by ROA)”? Pursuit of the efficient use of capital may or may not increase profits in the short-term, although it does tend to assure profits in the long-term.
The real disease afflicting business would appear to be the pursuit of short-term profits, not the pursuit of efficient use of capital (as measured by ROA. In fact, as Deloitte’s Shift Index 2013 points out, the ROA is a relatively good measure of corporate performance and should be used more widely.

“ROA is not a perfect measure, but it is the most effective, broadly available financial measure to assess company performance. It captures the fundamentals of business performance in a holistic way, looking at both income statement performance and the assets required to run a business. Commonly used metrics such as return on equity or returns to shareholders are vulnerable to financial engineering, especially through debt leverage, which can obscure the fundamentals of a business. ROA also is less vulnerable to the kind of short-term gaming that can occur on income statements since many assets, such as property, plant, and equipment, and intangibles, involve long-term asset decisions that are more difficult to tamper with in the short term.”

The Shift Index gives the example of Circuit City, which in 2002 took a number of decisions to increase profits, including selling off its most profitable division in home appliances, discontinuing sales commissions, aggressive expansion of stores, and replacing experienced, higher-paid workers with more junior staff. Profits increased in the short term but customer satisfaction declined sharply. If Circuit City had been paying attention to ROA, it would have noticed that ROA decreasing from 3.7 percent to –0.02 percent from 1997 to 2003 as the decisions were implemented, and it might not have gone bankrupt.
The root cause: pursuit of short-term profits
If the heart of the problem of the capitalist’s dilemma is not the use of the ROA, ROIC and IRR, but rather the notion that the purpose of a firm is the pursuit of short-term profits, maybe we need to get back to the fundamental insight of Peter Drucker in 1973: “The only valid purpose of a firm is to create a customer.”
Drucker’s perspective was that the goal of a firm isn’t fundamentally about creating profits or maximizing shareholder value. Profits and shareholder value are the results of adding value to customers, not the goal. Even Jack Welch has come to see that maximizing shareholder value is “the dumbest idea in the world.”

If Drucker was right, then the problems of short-term focus are not simply matters of using the wrong metrics. They are problems of having the wrong understanding about the purpose of a firm. As I will show in a second part to this article, it’s possible to use the very metrics that the article criticizes to get the right answer on what the HBR article rightly sees as key: market-creating innovations.
The way to sustainable economic growth
Drucker’s insight is even more important today, as a result of epochal shift of power in the marketplace from seller to buyer, the customer is now in charge. We now live, as Roger Martin has pointed out in his path-breaking book, Fixing the Game, in the age of customer capitalism. Making money and corporate survival now depend not merely on pushing products at customers but rather on delighting them so that they want to keep on buying. To prosper, firms must have knowledge workers who are continuously innovating and delivering a steady supply of new value to customers and delivering it sooner.
Focusing everyone in the organization on delivering additional value to customers is what gives a firm resilience. As a result, as Ranjay Gulati explains in his book, Reorganize for Resilience (2010), the firm’s goal has to become one of serving customers: i.e. a shift from inside-out perspective (“You take what we make”) to an outside-in perspective (“We seek to understand your problems and will surprise you by solving them”). The purpose of a firm is to serve its clients and its bottom line become: are the customers delighted? This can be measured by a combination of the Net Promoter Score, which measures whether customers are delighted by what the firm is doing and the use of ROA.
As Deloitte’s Shift Index 2013 points out,

“Absolute profits, however, matter little—at a minimum, profits should be considered relative to total revenue to get a sense of whether profits are rising faster or slower than revenue. But even that analysis overlooks a critical component of business activity: the assets required to run a business. Ultimately, companies need to earn a healthy return on those assets in order to stay in business. ROA captures how well a company used its assets to create value. Thus, ROA is a more effective measure of fundamental business performance.”

Firms need to be evaluating future investments strategically in terms of how they will affect their capacity to go on delighting their customers for a sustained period in the future.
The right level of discussion
This is not just a technical wrangle about what’s the right metric to apply. It’s a discussion about what we value as a society. Is the organization going to be an instrument of society or simply a short-term money-making machine for its managers and shareholders?
As Richard Straub and Julia Kirby point out in a recent HBR article, “Drucker’s early insistence that the corporation is a social institution, which can harness the capacity and potential of its people only when it respects them, becomes increasingly valid every year as more of the work of the global economy becomes knowledge work… The job of managers in his organization, he says, is to eliminate obstacles and provide tools to their teams – the people on whose knowledge and collaborative energy the company depends.”