THE STRATEGY PARADOX
Most strategies are built on specific beliefs about the future. Unfortunately, the future is deeply unpredictable.
The Strategy Paradox: strategies with the greatest possibility of success also have the greatest possibility of failure.
The best-performing firms often have more in common with humiliated bankrupts than with companies that have managed merely to survive.
Call it an “emotional paradox”: two very different dispositions — loving and hating — can have far more in common with each other than a seemingly intermediate state.
A new principle I call Requisite Uncertainty and a new management tool I call Strategic Flexibility provide a way for managers to implement the kinds of strategies that can deliver outstanding results while minimizing exposure to the vagaries of fate.
Accepting the strategy paradox forces us to accept mediocrity, giving up a chance at greatness as the price of our continued corporate existence.
A successful strategy allows an organization to create and capture value. To create value, a firm must connect with customers. For a firm to capture value, its strategy must be resistant to imitation by competitors. Satisfying customers in ways competitors cannot copy requires significant commitment to a particular strategy, that is, strategic commitments, to unique assets or to particular capabilities.
The most successful strategies are those based on commitments made today that are best aligned with tomorrow’s circumstances.
The strategy paradox is a consequence of the need to commit to a strategy despite the deep uncertainty surrounding which strategy to commit to. Call this strategic uncertainty.
The strategy paradox rests on two premises: commitments cannot be adapted should predictions prove incorrect; and predictions are never reliably or verifiably correct.
Adaptability is far less useful than we might like. Specifically, adaptability is viable only when the pace of organizational change matches the pace of environmental change. When the environment changes either faster or slower than the organization, adaptability is no longer sufficient.
As a result, adaptability cannot expect to resolve or even mitigate the strategy paradox.
The first half of the paradox is commitment: companies cannot adapt their commitments should they turn out to be the wrong ones.
Predictions in the form of point estimates betray a fundamental misunderstanding of what the future actually is. The future is a range of possible outcomes, not a specific set of circumstances that will inevitably come to pass.
The strategy paradox is a consequence of the conflict between commitment and strategic uncertainty. The answer to the paradox lies in separating the management of each, charging some with the responsibility of delivering on the commitments the organization has already made, and others with the task of mitigating risk and providing exposure to promising opportunities.
Senior management, because it is responsible for longer time horizons, should therefore focus its efforts on managing strategic uncertainty. Those lower down in the hierarchy, because they are responsible for shorter time horizons, should focus on delivering on the commitments already in place. This new organizing principle is called Requisite Uncertainty, because each level of the hierarchy is defined by its relationship to managing strategic uncertainty.
Only by shifting the emphasis at the top of the hierarchy from making and executing strategy to managing strategic uncertainty can corporations hope to mitigate strategic risk while simultaneously creating strategic opportunities.
Set of constraints defined by the corporate office. Resource constraints limit the time horizon a division can consider and the investment level it can support. Structural constraints restrict the operating scope of a division and enforce specific size parameters. And strategic constraints ensure that relentless attention is paid to particular customer groups and that the risk profile of a division remains within well-under-stood boundaries (typically enforcing a floor, not a ceiling).
J & J is pioneering a new role for the corporate office, giving structure and repeatability to the insights and intuition that have traditionally been the preserve of a “heroic” CEO. The resulting framework, called Strategic Flexibility, has four phases:
- Anticipate: build scenarios of the future
- Formulate: create an optimal strategy for each of those futures
- Accumulate: determine what strategic options are required
- Operate: manage the portfolio of options
In the context of Strategic Flexibility, scenarios are transformed from an adjunct to strategic planning into its foundation, for scenarios serve to define the key strategic uncertainties that a company faces (the Anticipate phase). Strategy development is no longer a determination of what commitments to make and is instead a process for identifying which risks a company will accept, hedge, or avoid (the Formulate phase). The Accumulate and Operate phases rely on the principles of Requisite Uncertainty, and make it possible for concrete investment decisions and ongoing strategic action at every level of the hierarchy to reflect the appropriate emphasis on commitment and uncertainty. The result is an integrated approach to creating greater value at lower risk. That is about as close as we can hope to come to getting something for nothing.
Requisite Uncertainty provides the foundation for separating the management of uncertainty from the management of commitment.
This is only the first step. The rest of the answer lies in a new toolkit, Strategic Flexibility, which provides a step-by-step process for each level to address the uncertainties it faces and to deliver on its commitments.
CHAPTER TWO
Success demands commitments to hard-to-copy, hard-to-reverse configurations of resources and capabilities that are aligned with the competitive conditions of a market.
Sony built and implemented its Betamax and MiniDisc strategies the way one is supposed to … and failed.
The point is that at the time Sony had to make its choices there was no way to tell definitively which road was the right road, and there was nothing Sony could have done to determine more accurately how to proceed. The existing tools of strategic planning demand either prediction, which ignores uncertainty, or adaptability, which accepts it, because they have no meaningful mechanisms for managing uncertainty.
The problem is that the next war is always different from the last one, and it is almost never possible to tell just what those differences will be.
Understanding the past is very different from predicting the future.
Sony’s strategies for Betamax and MiniDisc had all the elements of success, but neither succeeded. The cause of these failures was, simply put, bad luck: the strategic choices Sony made were perfectly reasonable; they just turned out to be wrong. The problem is that Sony focused too much on strategic success and not enough on strategic uncertainty.
CHAPTER THREE
The most profitable strategies are “extreme” strategies that commit companies to positions of either product differentiation or cost leadership. These extreme positions expose firms to a greater likelihood of bankruptcy by increasing the strategic risk they face. Consequently, the strategies likeliest to succeed are also likeliest to fail. That is the strategy paradox.
Among Michael Porter’s many contributions to management thinking, in my view the most substantial and seminal is that all strategies can be thought of in terms of their position along a continuum between product differentiation and cost leadership.
Treacy and Wiersema, in their 1995 book The Discipline of Market Leaders, identified three generic strategy types: operational excellence, product leadership, and customer intimacy. Going back to 1978, Miles and Snow proposed defender, prospector, and analyzer categories. James March, in a 1991 paper, suggested a dichotomy between exploitation and exploration strategies.
The labels are different, but the central elements of a cost leadership (Porter), operational excellence (Treacy and Wiersema), exploitation (March), or defender (Miles and Snow) strategy are cost, efficiency, reliability, and execution.
Product differentiation (Porter), product leadership/customer intimacy (Treacy and Wiersema), exploration (March), and prospector/analyzer (Miles and Snow) are all outwardly focused, with an emphasis on innovation, discovery, customers, or differences in product features or performance levels.
Choosing a strategy can therefore be thought of in terms of choosing a position on the production possibility frontier.
Becoming stuck in the middle is often a manifestation of a firm’s unwillingness to make choices about how to compete.
Strategies based on commitments are by definition very difficult to copy quickly.
Good strategies are not necessarily fragile, but they are intricate, with many interdependent, tightly linked components.
The notion of commitment in strategy also finds expression in the concept of “Big Hairy Audacious Goals.”
BHAGs are explicit, nowhere-to-hide, psychological commitments to specific outcomes.
The observation that firms pursuing pure strategies enjoy higher average performance is necessarily based on the returns of only those firms that were not driven into bankruptcy. (You cannot observe the returns of a bankrupt company.)
In the finance arena, it is generally accepted that higher returns come at the price of higher risk. Higher returns imply higher risk, but not the other way around.
The extreme strategies that increase the probability of success also increase one’s probability of failure.
A recent study has examined precisely this, finding that operating companies pursuing higher-returning pure strategies suffer from a materially higher probability of bankruptcy compared to firms pursuing lower-performing hybrid strategies.
Pure firms enjoy a feast-or-famine existence, profiting mightily when customer tastes favor their strategies, and starving — often to death — when market preferences shift. Pure firms are exposed to strategic uncertainty far more than are hybrid firms.
Higher returns mean higher mortality. That is the essence of the strategy paradox.
Strategy often has this character. It begins with a choice, is followed by commitment, and the outcome is decided for good or ill in large part through luck.
Strategic uncertainty would simply not exist if companies could choose the right strategy and stay there (a stable environment), shape the environment to their strategies (a controllable environment), or prepare themselves for a future they see coming (a predictable environment).
CHAPTER FOUR
One possible response to strategic uncertainty is adaptability: changing one’s strategy in accordance with the shifting demands of the market.
Change that proceeds either faster or slower than the organization can respond creates insurmountable problems. In addition, fast and slow changes impinge on an organization simultaneously, and a company cannot adapt at different rates at the same time.
The dark side of commitment lies in the very real possibility of committing to the wrong things: creating products with the wrong characteristics or organizations with the wrong capabilities.
In his seminal 1970 work Future Shock, Alvin Toffler concluded that tens, if not hundreds, of millions of people were about to be overwhelmed by change.
Concepts such as “logical incrementalism,” “sense and respond,” “emergent strategy,” and “improvisation” all hold out the promise of enabling organizations to shift their strategic footing as circumstances require.
Organizational change is only a valid response to environmental change when the pace of change is the same for both.
No matter how adaptable one might be, there is always something out there one cannot adapt to.
Typically, an inability to adapt is defined as “inertia.” This results when the relevant environment changes faster than can the organization.
There is a second type of fast change, one that has a much longer gestation period, even though it can seem extraordinarily abrupt.
In business environments, this kind of “long fuse/big explosion” change often takes the form of “new-market disruption,” a particular type of disruptive innovation.
In new-market disruptions, two different business models develop largely independently of each other. They focus on different customers with different needs, employ different technologies to serve those needs, and build different revenue models and cost structures in order to secure the profits necessary for survival and growth. Essentially, two different industries evolve separately. These industries collide when the improvements in technology and process performance that characterize every industry happen to allow one of these sectors to serve the customers of the other.
Fast change, then, cannot be addressed through adaptability. It is simply too … fast. In addition to rapid changes in the environment, there are also very slow changes that often prove impossible to adapt to. The final collapse might be sudden, but the change itself was slow, incremental, and visible from the start.
A second mechanism of slow change is found once again in disruptive innovation.
The second type of disruption is “low-end disruption,” and this plays out quite differently. Low-end disruptors find their foothold in the least attractive segments of an established industry.
Adapting to environmental change can be a highly effective response. Like most managerial responses, however, it is most effective under specific circumstances.
The mechanisms of fast change create shifts that no company can hope to adapt to. Exogenous shocks in the form of rapid and extensive deregulation have repeatedly created insurmountable challenges for many otherwise well-run organizations. New-market disruption, a mechanism of fast change, can brew for a long time, and often at a pace that is far slower than the pace of change within either of the industries involved.
The mechanisms of slow change can take the form of secular shifts in the underlying structure of the economy, as befell the large industrial corporation. A second mechanism of slow change, low-end disruption, is similarly obvious in its short-run specifics and equally insidious in its long-run implications.
Finally, for any change a company chooses to adapt to, there will likely be additional environmental shocks or shifts that proceed either faster or slower.
Well-run companies seem best able to adapt to changes precipitated by other, largely similar organizations.
Competitors can certainly undermine your strategy, but competitive moves can often be parried by sufficiently adroit companies.
Adaptation has its benefits and its place. We overestimate its applicability at our peril. Thanks to the pervasiveness of both slow and fast change, even the most highly adaptable organizations will require something more, and very different, if they are to cope with the demands of an unpredictable environment.
CHAPTER FIVE
Forecasting is a cornerstone of traditional strategic planning processes, and might be seen as a way to compensate for any limits to organizational adaptability. Unfortunately, it is impossible to forecast as accurately as is required for strategic planning or as is necessary to substitute for adaptability.
Planning of any type is future-oriented, and thinking about the future can only be done in terms of forecasts, predictions, assumptions, extrapolations, and so on.
Dan Gilbert asserts that thinking about the future is a uniquely human trait.
Nassim Taleb distinguishes between “prophesying” and “forecasting.”
The ability to forecast accurately is central to effective planning strategies. If the forecasts turn out to be wrong, the real costs and opportunity costs … can be considerable.
Industry foresight gives a company the potential to get to the future first and stake out a leadership position … The trick is to see the future before it arrives.
Henry Mintzberg, in his book The Rise and Fall of Strategic Planning, reviews research on the accuracy of forecasts used as the basis of strategy formulation. He concludes that even the proponents of strategic planning cannot escape the fact that “long range forecasting (two years or longer) is notoriously inaccurate”.
“Monkeys at typewriters”: if enough monkeys hammered away at typewriters for long enough, one of them would come up with the Iliad. Similarly, with so many prognosticators predicting so many different outcomes, it is all but inevitable that someone will come up with a run of accurate predictions.
When it comes to forecasters, it is not enough that someone get it right; we need to be able to say who will get it right before they perform their feat of sooth-saying. Without being able to specify in advance who can see the future — that is, unless one can predict who will be the best predictor — post hoc claims of accuracy, the definition of a track record, are meaningless.
When viewed from the perspective of today, there is a probability of any given event occurring at any given point in the future. Summing across all events, all time horizons, and all probabilities, we can conceptualize a probability distribution function (PDF) for the future. This can be thought of as a “possibility space” of all events and their associated likelihoods for all time. If a given event happens or does not, its probability of happening collapses to 1 or 0.
More complex still, the probability of some events is contingent upon other preceding events.
There is no specific future out there waiting to be discovered as time’s arrow carries us toward it. Instead, there is a constantly shifting mass of probabilities, with events dropping in and out of the possibility space while new events enter.
Demonstrably accurate predictions of what the future actually is simply do not exist.
Two facts put predicting accurately and usefully enough of the variables relevant to strategy-making permanently beyond our reach: randomness and free will.
In A New Kind of Science, Stephen Wolfram identifies three mechanisms of randomness. The first two are relevant for now:
- Randomness injected into an otherwise orderly system from its external environment. Call these “exogenous shocks.”
- Randomness in initial conditions. A system might be orderly but highly sensitive to its starting position. If the starting position — the initial conditions — is anything less than orderly, a process of amplification transforms those inputs into random output. This is the domain of chaos theory.
Sensitivity to initial conditions is something chaos theorists study. Often captured in the metaphor of the “butterfly effect,” the basic idea is that the flapping of a butterfly’s wings in Brazil could cause a tornado in Texas.
The inescapable conclusion, then, is that randomness — the lack of order or pattern — is a necessary component of every system we might want to understand and control. We are doomed to either draw our boundaries too narrowly, leaving ourselves open to an injection of randomness from the environment, or to underspecify the initial conditions that determine the ultimate outcome. Frequently, we are victims of both. Either way, it is uncertainty, not predictability, that best characterizes our future.
Wolfram’s third mechanism is internally generated randomness, which he discovered through experiments in computational complexity. Wolfram found that simple systems can create random outcomes that are resistant to perturbations in initial conditions but nevertheless exhibit no pattern.
Clearly, it is not our rational faculty that determines our behavior; apparently, it is not our moral faculty either. The result is that human behavior is deeply, and irretrievably, unpredictable. And since business systems are populated by people, the systems themselves are subject to Wolfram’s “internally generated” unpredictability — sometimes because we choose to be unpredictable for rational reasons, and sometimes because we simply cannot help ourselves.
The tension between the need to make commitments and our general inability to predict the future has been identified and explored by other researchers.
It is only in high-commitment/high-uncertainty contexts that a form of strategy “dilemma” emerges as a result of a pincer between a need to commit despite an inability to predict. The implication is that few organizations need worry: most organizations can either predict (when commitment is valuable and uncertainty is low) or adapt (when uncertainty is high and commitment not necessary), while only the unlucky ones must deal with the contradictions of committing despite uncertainty.
The strategies with the greatest probability of success necessarily imply the greatest probability of failure. For some organizations, understanding this reality (even if only implicitly) results in a middle-ground, hybrid strategy that trades profitability for survival. For other companies, failing or refusing to accept this fact results in a strategy built on bravado and bluff.
The solution to the strategy paradox explained in subsequent chapters embraces uncertainty, putting what we do not know at the center of every decision every person in an organization makes.
CHAPTER SIX
Strategic uncertainty — which is different from operational or financial uncertainty — increases as one attempts to plan over longer time horizons.
Structural problems require structural solutions. The strategy paradox is a structural problem.
If strategic uncertainty is the question, time is the answer. The longer the time horizon over which a strategy must play out, the greater the range of possible outcomes that must be considered and the less certain one can be of the probabilities associated with any given result.
The board of directors and CEO of an organization should not be concerned primarily with the short-term performance of the organization, but instead occupy themselves with creating strategic options for the organization’s operating divisions.
Most organizations seek to grow, and there are essentially two ways to achieve this end: do more of what is being done (increasing scale), or do new things (increasing scope).
The notion that companies should organize around what matters most has been explored extensively by Jay Galbraith. Galbraith explains that there are essentially five dimensions of corporate structure: function, product, market, geographic region and process.
Structure matters because it is a formal expression of a firm’s strategic priorities.
Structure, as discussed so far, has been defined largely in terms of lateral differentiation: separating functions, regions, markets, products, or processes from one another. But within these divisions there exists in almost every organization of any size a vertical dimension of differentiation as well. This is hierarchy.
The tension between differentiation and integration was explored most famously by Paul Lawrence and Jay Lorsch in Organization and Environment.
One of the hallmarks of progress in management has been the gradual development of circumstance-based theories.
With “contingency theory,” Lawrence and Lorsch gave birth to what has become the current orthodoxy: that there is not a single best way to do anything, and that good theory must describe the circumstances under which particular tools or methods are useful.
Is time a “universal constant” of hierarchical structures? And if so, what does this mean for the management of strategic uncertainty?
The most undeservedly ignored management researcher of the modern era is Elliott Jaques. Level skipping is a severe pathology in any hierarchy, for if the hierarchy is to have any substantive meaning it must serve as a decision-making chain of command.
Jaques hypothesized that time is the most important characteristic of any job. Any experienced manager, whatever his or her job, takes the great importance of time for granted. Building on this premise, Jaques developed the idea that jobs could be defined in terms of time horizons.
Jaques identified temporally defined strata of decision making at two, five, ten, and twenty years, for a total of seven levels of hierarchy, no matter how complex the organization. Although known by several different names over the years, the generally accepted term for Jaques’s theory has become “requisite organization,” or RO.
Our understanding of lateral structure — that is, the dimensions around which departments in an organization should be created — is quite well-developed.
Whereas the basis of lateral divisions is highly contingent and evolving, Jaques’s work suggests strongly that the time basis of hierarchical divisions is much more stable. As initially suggested by Chandler, and intuitively understood by most practicing managers, the more senior levels of the hierarchy are defined by the longer time horizons over which their decisions play out.
RO gives a formal, theory-based expression to these intuitions based on careful and extensive empirical testing.
Why longer time horizons imply greater complexity and why the nature of that complexity is a sound basis for establishing hierarchical strata.
Many uncertainties can compromise an organization’s performance, but not all of them are strategic. Strategic uncertainty is a bone fide class of uncertainty that must be addressed with a particular set of tools. Only if an uncertainty has implications for the basic elements of how a company creates and captures value is it strategic.
And so we are left with one of life’s little ironies: the longer your time horizon, the greater your range of choices for action, but the less certain you can be of what precisely to do.
At the same time, operational and financial uncertainties are subject to greater swings in the short term, and they are not open to nearly such significant variation in the long term as are strategic uncertainties.
Managing operational and financial uncertainty is everyone’s job, and much of the risk-management field is dedicated to developing the tools and processes required to do this effectively. Managing strategic uncertainty, however, is not everyone’s job. Strategic uncertainty increases monotonically as time horizons are extended.
Corporate-level investments should reflect this unpredictability: tentative, easy-to-reverse explorations of new markets, technologies, and business models are the kinds of bets corporate managers should place.
The intent is not to decide how to succeed, but to ensure that some element of the corporation is positioned to succeed regardless of what the future holds.
The idea that a company must cope with today’s pressures while positioning itself to capitalize on tomorrow’s opportunities is not a recent insight.
Corporate executives should concern themselves with the operating success of today’s businesses while also allocating resources to businesses that are small today but have the potential to become tomorrow’s growth engines.
As described by Galbraith, the operating division is the product, customer, process, or region around which the organization is built.
It turns out that the skills required to operate in multiple time horizons simultaneously are in terribly short supply; at best, 5 percent of the population is able to clear this cognitive hurdle. Building a model of management that requires such skills as a matter of course is optimistic enough, never mind a model that requires essentially every manager at every level to have that kind of intellectual and emotional capacity. Such an approach does not resolve the strategy paradox — it replicates it.
By the lights of Requisite Uncertainty, product-design groups deal with material operating uncertainty, but no strategic uncertainty, over a time horizon of eight years. Operating divisions implement specific strategies, but with an eye to key contingencies and uncertainties that pose material risk or present genuine opportunity. Corporate management takes the relevant long view for each of its divisions and considers how best to reconfigure divisional assets to ensure continued growth and profitability.
Under Requisite Uncertainty, a well-functioning hierarchy is differentiated by the degree of strategic uncertainty addressed at each level and integrated through a cascading series of strategic commitments as those uncertainties are resolved.
There is a forty-year tradition in management research, known as the “resource allocation process” model, that has laid bare how decisions tend to crystallize in larger companies. The notion of the CEO and the senior management team working out the strategy, then issuing marching orders to the rest of the company, is a realistic archetype for very few firms. Rather, the corporate office has tended to set specific targets for growth or profitability or other measures of success, known collectively as the corporate context. Functional management recognizes gaps in the organization’s ability to meet those targets. Perhaps quality is too low, or production capacity is insufficient, or critical capabilities are needed. Having identified the problem, functional managers then define the types of investment required to solve it and meet the demands of the corporate context. Divisional managers work the middle ground, giving impetus to specific projects that they feel will best meet the targets set at the corporate level.
Requisite Uncertainty provides an explicit principle upon which to base the management of both sides of the strategy coin: commitment and uncertainty.
There is a general consensus that directors do not and cannot know as much as management about the company, the industry, or the relevant strategic challenges. Nevertheless, most informed observers feel that either the CEO should “make better use” of the board, or the board should be actively involved in strategic planning.
Open and frank discussions between the board and management about what to commit to do not suspend the strategy paradox.
The challenge posed by the strategy paradox is not an agency problem, because the strategy paradox is not a consequence of either criminality or decision-making bias. Resolving the strategy paradox means wrestling more effectively with the inescapable reality of an unpredictable and potentially radically changing future.
Under Requisite Uncertainty, the board grapples with the longest time horizon of all: the “going concern” assumption behind every healthy corporation.
Whether the corporation serves first shareholders, stakeholders, or itself, it must still manage strategic uncertainty. However, the resources devoted to the management of strategic uncertainty will depend on which theory motivates the board’s decisions . Shareholders are typically highly diversified and highly liquid, and so need relatively less assistance managing risk than do, say, employees who are perforce much less diversified and less liquid. A corporation seeking first its own survival will manage strategic uncertainty to the extent required to persist, but because strategic change can often require significant asset reallocation, likely not as aggressively as prescribed by stakeholder theory, which places a higher value on the preferences of employees, communities, and other affected parties.
By responding to strategic uncertainty with one or (more likely) a combination of the above (seeking, accepting, avoiding, or managing), the board determines the company’s overall exposure to strategic risks and opportunities. It is then management’s role to create the exposure that the board has deemed appropriate.
The ability of the CEO to have a positive impact on short-term operating results is surely quite limited. We often either credit or blame CEOs for short-term results, but this often makes no more sense than the praise or pillory received by politicians who have the good luck or misfortune to take office just as an expansion or recession hits.
Hierarchies should be structured around time, with higher levels focused on longer time horizons. Strategic uncertainty increases with time. Therefore, the higher the hierarchical level, the greater should be the emphasis on the management of uncertainty. Consequently, the board’s role is to determine the corporation’s overall exposure to strategic uncertainty. Senior management must then develop mechanisms for hedging the relevant strategic risks and ensuring that the relevant strategic opportunities remain viable. Operating division management must commit to a specific strategy but work to avoid catastrophic outcomes should key assumptions prove invalid. Functional management is charged with delivering short-term results.
CHAPTER SEVEN
In the telecommunications space, critical uncertainties remained salient and unresolved through much of the 1990s, particularly with respect to the relative merits of the phone companies’ and cable companies’ technological infrastructures.
Media companies had long worked with a “blockbuster” economic model.
More recently, the traditional opportunities for economies of scale and scope in large media companies have been called into question thanks to new digitally based forms of distribution and consumption. Specifically, these changes create the possibility for a shift from blockbusters to “long-tail” businesses.
In July 2002, Vivendi Universal (Vivendi), then one of France’s twenty largest companies and the second-largest media conglomerate in the world, came within ten days of filing for bankruptcy. Under severe pressure from his board, Jean-Marie Messier, the forty-four-year-old chairman and chief executive, resigned and was replaced by Jean-René Fourtou, the sixty-two-year-old semiretired vice chairman of Aventis, a pharmaceutical giant.
Traditional media companies created value in essentially one of two ways. First, by leveraging a successful property in one medium in other media: a successful movie becomes the foundation for TV shows, soundtrack sales, Broadway shows, books, and so on. Second, leveraging a successful property in a given medium to make other content in that same medium more successful: control over scheduling and programming allows media companies to generate exposure for otherwise overlooked content that can compete with alternative offerings but cannot find an audience without an initial major “draw.”
Messier wanted VU to be in the vanguard with AOL/TW, while other media groups just did not “get it.” Disney, Sony, and Viacom in particular were relying on content-only models and would be left behind.
Messier admits that he pushed the company a “little” too far and a “little” too fast.
Messier attributes his inability to create a new-age media empire largely to speculators and unjustified pressure from creditors.
Success, rather like tomorrow, was always just a deal away. Edgar Bronfman, Jr., had a different take: “We were ahead of our time, way ahead. And that’s the same as being wrong.”
The convergence of technology, media, and telecommunications that so inspired Messier was both a once-in-a-lifetime opportunity and a potentially mortal threat to an Old Economy telco.
Many incumbent telecoms firms responded with significant commitments that almost universally failed to live up to expectations. In the United Kingdom, France, and German, mainstream telecoms companies ended up paying enormous fees for “third-generation” wireless licenses, believing that the additional bandwidth would prove its worth by enabling advanced services via wireless access to the Internet.
Enthusiasm for all things converged did not stop at the forty-ninth parallel. Beginning in the mid-1990s, Canada’s largest telecoms company, BCE Inc., found itself grappling with profound questions of corporate scope as it considered investments in wireless telephony, media, e-commerce, computer and network systems integration, and more. The company’s response to these challenges was not only a break with its own past, but a step forward — albeit an inadvertent one — in the evolution of corporate strategy.
The company’s first wave of diversification began over a century later, when in 1983 CEO Jean de Grandpré restructured the company, creating “Bell Canada Enterprises” (BCE).
It is important to note that in both cases — wireless and IT consulting services — BCE was no better or worse at finding integration opportunities than its competitors. Its advantage was that by structuring its investments as partial equity stakes and then managing those investments appropriately, BCE was able to gain a window on an emerging market and position itself to act as the relevant uncertainties were resolved. The company mitigated the risk of commitment without forgoing a nascent opportunity through inaction. These examples illustrate a way of reconciling the need to act when considerable uncertainty surrounds what to do.
In more general terms, BCE provides a groundbreaking example of the application of “real options” to corporate strategy. Its investments conferred the right, but not the obligation, to invest further in order to pursue a particular growth strategy. This created valuable flexibility — strategic flexibility — in the face of an uncertain future.
BCE’s solution was to create a window onto these opportunities yet avoid acquisition premiums by taking only partial equity stakes. In other words, other telcos “bought the stock,” whereas BCE “bought the option.”
Finally, a big part of why a real options-based corporate strategy can be so powerful for companies in situations similar to BCE’s is that none of the individual organizations in BCE’s portfolio could have adapted in real time to the uncertainties each faced, and for all the reasons explored in Chapter 3. Wireline/wireless integration is an example of “slow change.”
Messier’s mistake was pursuing nothing but commitments. Monty’s mistake was not understanding the power of the options-based strategy he had stumbled into and sticking with it as he continued to plumb the uncertainties of his industry.
Microsoft might have been confused about which bet to make, but that was perfectly reasonable. In the face of that confusion, it created a series of options, each designed to deal with the demands of different possible market outcomes. Each option would be exercised only as it became clear that additional commitment was justified by commensurately lower risk.
In the middle 1990s, just as Microsoft might have been tempted to declare victory in the OS and applications world, new threats and opportunities emerged. As at Vivendi and BCE, the rise of the Internet and World Wide Web and the convergence of technology, media, and telecommunications promised to undermine the source of Microsoft’s historical success.
Microsoft responded by leaping on its horse and galloping off in all directions. Between 1994 and 2005, the company made more than 200 acquisitions or investments in other companies across just about every segment of the telecommunications, media, and technology sector.
Any firm attempting to manage strategic uncertainty using the kinds of real options described above will find itself with a diversified portfolio of operating companies. BCE and Microsoft ended up with not only a highly heterogeneous group of businesses but also wide variety in the level of control they enjoyed.
It would be a mistake, though, to conclude that diversification destroys value. The critical distinction is between the average level of performance for the firm as a whole and the marginal performance of each additional line of business into which a firm enters. If diversification efforts lower the performance of the firm overall, but the performance of each new business venture is still above the firm’s average cost of capital, then diversification will create value.
diversification should sometimes be understood dynamically: a firm can transform itself from an unrelated to a related diversifier without altering its portfolio. In fact, Microsoft and BCE diversified as they did hoping that such changes would occur. It is unlikely that Microsoft acquired part of a cable company because it wanted to be in the cable television business. A more reasonable assumption is that the company is hoping that material synergies between cable technology and some or all of online services, consumer devices, and software will emerge, giving Microsoft the opportunity to exercise the option that its initial investment has created. Similarly, BCE did not get into the IT consulting business because synergies existed. Instead, BCE was hoping that technological and market shifts would create the opportunity to leverage key resources or vertically integrate at some point in the future.
Could a company delay its diversification initiatives until the nature of the synergies to be captured had become clear? Perhaps, but there is no free lunch.
Acquisitions with significant and generally acknowledged strategic value tend to leave very little value for the acquirer.
Diversification that creates real options on the pursuit of new strategies is referred to as “strategic diversification.” Strategic diversification creates value for shareholders because it positions a firm to pursue new strategic opportunities more effectively and at lower cost than outright acquisition.
This kind of diversification is especially valuable when industry boundaries are shifting due to technological, regulatory , or market uncertainties.
Diversification within strategy types hedges operational risk, while diversification across strategy types hedges strategic risk.
Strategic diversification is unlike vertical integration, unrelated, and related diversification because it is not about creating value directly. Strategic diversification is about the other side of the value equation — uncertainty.
The highest levels of the hierarchy should be focused on managing strategic uncertainty.
Some have suggested that in turbulent environments the appropriate role of senior management is to articulate a “guiding philosophy,” or “strategic intent,” as a way to tell the firm “where to look for opportunities” without overspecifying what those opportunities should be. Such organizations need to be extremely flat, with individual, highly focused units within a diversified corporation seeking out and exploiting evanescent chances to seize fleeting competitive advantage.
Corporate diversification makes sense to shareholders only if it either captures synergies or creates options on synergies that investors cannot replicate.
Definition, if a division is facing strategic uncertainty, then it is the boundaries that define each division that are subject to the kind of unpredictable change to which they cannot adapt.
For a company to take strategic uncertainty seriously, it must avoid making commitments in the face of uncertainty and instead create strategic options that can be exercised or abandoned depending on how those uncertainties are faced. Only in this way can a firm hope to deal effectively with an environment that changes unpredictably.
CHAPTER EIGHT
J & J’s highly decentralized structure had led the various OpCos — for all the right reasons — to focus on the markets and technology platforms that were critical to their individual businesses. As a consequence, when JJDC found technologies that it thought could serve as a foundation for significant growth, there was no way to give these new opportunities an organizational home — short of creating a new OpCo, which was often not an appropriate response.
In order to explore and develop future growth platforms, JJDC needed to invest in ways the OpCos could not, yet if it did invest in initiatives beyond the purview of the OpCos, there was no way to take its discoveries to market. On the other hand, even if JJDC aligned its investments with the strategic priorities of the OpCos, anything that looked interesting should either stay with that OpCo or not be done at all: if the OpCos did not want it, how would JJDC ever hand it back? It was a classic catch-22.
J & J is a paragon of corporate virtue, however you define it.
A big part of the company’s success has been its nearly unique ability to acquire or launch new OpCos in order to pursue specific market opportunities.
JJDC is a specific example of the general phenomenon of “corporate venture capital” (CVC). Most commentators see CVC as serving a growth imperative: a large, established corporation invests in a small start-up either to increase the returns earned in the core business or to create entirely new growth engines.
The limits to adaptation are in part a consequence of the binding nature of resource, structural, and strategic constraints.
J & J wisely avoided Vivendi-like big bets, yet lacked the owner-manager structure of Microsoft, but still hoped to avoid BCE’s fate, precipitated by managing strategic uncertainty without a formal process.
Holveck would first have to understand both the benefits and the drawbacks of the constraints that limited each OpCo’s actions. Second, he would have to figure out how to compensate for those constraints without undermining their effectiveness. Finally, he would need an explicit framework for communicating his objectives throughout the organization and coordinating the action of thousands of people across hundreds of divisions.
What any organization can achieve is in large part a function of three key resources: money, time, and people.
this entire book is about the way in which companies can effectively manage the trade – off between the present and the future.
Rewarding OpCo management for the future impact of current decisions was very difficult; the future, after all, is uncertain.
Resource constraints determined what the OpCos could spend. Structural constraints limited how those resources could be spent.
If resource constraints define how much to spend and structural constraints define how to spend it, strategic constraints define whom to spend it on.
Today’s customers must be served today, and so operating companies are structurally unable to explore technologies that today are able to address only less demanding, less profitable markets even if those technologies might redefine their industry in the future.
The combination of resource, structural, and strategic constraints serves to drive OpCos to riskier strategies than they would have been likely to pursue as stand-alone companies.
Strategic flexibility is very different from run-of-the-mill flexibility or adaptability. “Flexibility” means “change within existing constraints.” Flexibility can be helpful, but strategic uncertainty demands strategic flexibility — the ability to change strategies, which is something made largely impossible by the commitments required for success. Creating the real options required to implement new, different, effective, commitment-based strategies on a tempo defined by competitive markets can be done only in the spaces beyond constraints. Consequently, only the corporate office can devote resources to operating outside of the constraints that bind operating companies’ actions. When referring to the ability of an operating company to change its strategy thanks to real options on alternative strategies, capitals will be used: Strategic Flexibility.
JJDC managing the OpCos ’ strategic uncertainty. The framework that Holveck adopted has four basic components:
- Anticipate. The existence of strategic risk is a function of the unpredictability of the future.
- Formulate. With scenarios in place, it is possible to determine the strategies required to be successful under these different conditions. In other words, there is an optimal strategy for each scenario. Each optimal strategy can then be decomposed into its constituent elements — the technologies, capabilities, or other assets required to implement the strategy. Elements that are common to many of the optimal strategies are known as core elements, while those that are common to only a few optimal strategies or perhaps unique to one optimal strategy are called contingent elements.
- Accumulate. Core elements can be pursued without reservation, for there is no strategic risk associated with them; commitment is entirely appropriate, because there is very little chance of having “guessed wrong”. Combining scenarios with optimal strategies places boundaries on the range of assets and capabilities an organization might need in order to be successful across a range of plausible futures.
- Operate. The accumulate phase results in a portfolio of options covering the contingent elements related to specific optimal strategies described in the formulate phase. These optimal strategies are in turn linked to the scenarios developed in the anticipate phase. The operate phase demands a close monitoring of the environment.
In every industry there is a complex, multiplayer chain of decision makers, distributors, and others who stand between the manufacturer and the end consumer.
JJDC built strategies for addressing specific disease states, not for specific organizational units inside J & J. Taking disease state as the fundamental unit of analysis allowed JJDC to look across J & J’s existing organizational boundaries (e.g., drugs and devices) and to not worry about the necessarily ever-changing organizational structure.
JJDC has come to fill this role by focusing on four activities:
Creating options. When options on new capabilities or technologies are required in order to manage a particular strategic uncertainty that lies beyond the constraints of the OpCos, JJDC takes the lead by making the requisite investments in early-stage companies.
Preserving options. Generalizing from the experience with Scott Labs and EES, JJDC makes it a point to manage its VC-like investment portfolio with an eye not merely to J & J’s eventual benefit but also to the continued viability of the investment companies.
Exercising options. As illustrated by the “internal syndicate” forming around EES’s conscious-sedation technology and the SMG, JJDC plays a key role in providing resources and establishing strategic alignment among otherwise disparate parts of the organization in order to take advantage of the opportunities for scope created by J & J’s diversity. In other words, without spending a dime on acquiring new technologies, J & J’s existing portfolio of capabilities holds within it any number of options on collaborative opportunities.
Abandoning options. Although often overlooked in many discussions of the more limited notion of corporate venture capital, the ability to abandon an option without suffering severe financial losses is critical to creating value by managing strategic uncertainty. JJDC therefore pays very close attention to its connections with the VC community at large in order to be able to spin off its investments on relatively attractive terms. What makes this possible is that JJDC has the discipline to sell off those investments that are financially attractive in their own right, but no longer serve to manage strategic uncertainty for J & J.
CHAPTER NINE
A genuinely flexible strategy has two primary ingredients: scenarios and real options.
To paraphrase Peter Drucker, for an idea to be of any use it must eventually degenerate into hard work.
There are limits to what can happen, no matter the time horizon under consideration. Scenario building is a tool for determining just what those limits are.
In some sense, scenario building has been around for as long as human beings have been able to imagine alternative futures and ask themselves “What if …?” In the context of business planning, however, it has much more recent origins, growing out of military planning during World War Two and translated into the corporate sphere thanks largely to the efforts of the RAND Corporation.
When grappling with strategic uncertainty the key is to avoid, on principle, reductionist point-predictions of the future. Anything that arbitrarily narrows the range of opinions considered will restrict management’s ability to take seriously the full scope of future possibilities.
scenarios provide an efficient way to summarize and synthesize the interaction of all relevant variables into one coherent picture. Different scenarios capture different, and typically extreme, values for the full set of relevant variables, not slight changes “at the margin” for individual variables.
Scenario-based planning is often misused as a step in a forecasting process. Treating scenarios in this way betrays a persistent, inextinguishable, insatiable, and ultimately pathological desire for accurate forecasting.
Scenarios therefore crystallize and preserve a diversity of opinion among management team members.
A set of scenarios consists of a number of individual stories, each carefully crafted and contextually complete, each based on a very different set of assumptions.
A technique often conflated with scenario-based planning, contingency planning, is really very different and has a fundamentally different purpose.
Contingency planning is less useful at the corporate level because it does not foster disagreement over strategy since it does not raise fundamentally strategic questions.
Contingency planning is therefore far more appropriate for functional managers because it allows them to consider those variables to which the organization can actually respond: launch the marketing campaign now or next quarter; implement a price change or not; expand hiring or implement layoffs; and so on.
Within the context of Requisite Uncertainty, the following five-step process has proved useful in building scenarios that a top management team can use as a foundation for building Strategic Flexibility.
- Ask the Right Question. Assessing strategic uncertainty does not mean examining one decision. The challenge is to assess the extent to which the relevant uncertainties can be addressed within the context of the existing strategy, or whether they signal potential challenges or opportunities that require fundamentally different strategic responses.
- Identify the Dimensions of Uncertainty. With a strategic question and a time horizon in mind, the next step is to identify the dimensions of uncertainty that define the relevant possibility space. Often, this is done “bottom up,” by clustering individual variables into dimensions. It can also be done “top down,” decomposing overall strategic uncertainty into specific dimensions.
- Determine the Limits of Uncertainty. Perhaps the most intellectually challenging element of scenario building is finding the appropriate boundary conditions on each individual dimension of uncertainty. It is critical at this stage not to look for “consensus” forecasts; seek instead divergent opinions. For each dimension of uncertainty, one must attend to many conflicting voices when considering the range of possible future states. The objective is to go beyond the general consensus but stop short of the merely imaginable. Somewhere between “entirely feasible” and “ludicrous” lies each organization’s possibility space.
- Determine the Final Scenario Set. A scenario lies at the intersection of the extreme values of the dimensions of uncertainty. It is possible to identify all such intersections using a “truth table.”
- Determine the Relative Probabilities. Assessing the probability that the future an organization ultimately faces will most closely resemble a particular scenario is perhaps one of the most contentious issues in the scenario-based planning field. Ultimately, the purpose of building scenarios is to guide investments in real options on alternative strategies, and the value of those options is tied directly to the likelihood of a given option being exercised. Consequently, probabilities must be assigned to each scenario.
Requisite Uncertainty differentiates the levels of the hierarchy in terms of their relative emphasis on managing uncertainty and delivering on commitments.
It falls to the corporate level to create strategic flexibility by assembling a portfolio of real options on assets and capabilities that allows the operating divisions to change their strategies in ways they could not if left to their own devices. Individual operating divisions are left to implement a specific strategy but must still face up to material uncertainties that could derail their plans. They must therefore focus on hedging the strategy they have through careful contingency planning and, where possible, avoiding unacceptable risks. Finally, functional managers are responsible for learning how best to achieve the targets that have been set for them within the parameters set for them.
Strategy can then be decomposed into its constituent elements, where each element is a particular resource or capability. Those elements required across all scenarios are considered core, while those that are valuable only under one scenario are considered contingent.
By committing to the core elements and taking options on the contingent ones, the corporate office can create the ability to implement the most appropriate strategy regardless of which anticipated future ultimately materializes.
Microsoft’s corporate strategy appears to be based on core commitments to the personal computer operating system and an array of complementary contingent assets in mobile phones, consumer electronics, telecommunications, and entertainment.
Once the current strategy’s risk has been hedged , there is , of course , still uncertainty to be managed , but not strategic uncertainty .
Requisite Uncertainty prescribes that functional managers focus on learning how to make a strategy work, rather than hedging the downside of the strategy (the divisional leadership’s job) or creating bone fide strategic options (the corporate office’s job).
CHAPTER TEN
Unless managers are willing to structure their investments in a manner that reflects the uncertainty revealed in the scenario-building phase, the company is not actively managing strategic uncertainty.
Committing to extreme strategies offers the promise of great reward but brings with it significant risk. Settling on a middle-of-the-road, or robust, strategy mitigates risk but at the cost of being able to generate significant returns. Only by creating options on the contingent elements needed to implement the strategy that is optimized for the future that ultimately emerges can a company reach the “efficient frontier” of strategic investment.
Joint ventures Joint ventures (JVs) are created when two or more organizations create a new company, each partner typically investing a mix of cash and other resources. JVs have long been a topic of intense research interest, and they are an especially popular structure for investing in international expansion and research and development. The benefits of joint venturing are access to critical resources — capital, knowledge, market access, and so on — that a firm could not afford to acquire on its own. A joint venture allows the partners to assemble just those bits of their organizations that are complementary into a new entity without one party having to acquire the other.
Partial ownership A third way to create options on contingent strategic elements, one that addresses directly both the desire to conserve capital and the need for control, is a partial equity stake.
Acquisition, joint venture, or partial equity stake are all reasonable ways to create options. Which mechanism is most appropriate for a given set of circumstances will depend on which one enables a firm to create the desired option value. Investments can have option value when they give an investor access to potentially valuable resources or capabilities. They actually have option value when the structure of the deal enables the investing firm to Operate its portfolio (phase 4 of Strategic Flexibility), which consists of an ability to preserve and exercise or abandon options as appropriate (stages 2 – 4 of managing a portfolio of real options).
The challenge of how best to reconfigure an organization’s resources and capabilities has been tackled by a number of leading researchers. Concepts such as “modular corporate forms,” “patching,” “the Velcro organization,” and “strategic integration” are part of a growing and diverse body of knowledge offering relevant insight.
Patching, then, offers a way to think about bottom-up resource reconfigurations in the pursuit of new opportunities.
Patching is fully consistent with the view that it falls to division-level management to choose the appropriate commitments from the menu of options created by the corporate office.
The successful and ongoing creation and management of a portfolio of real options worked best with a powerful CEO who was relatively insulated from capital market pressures.
When exercising an option falls within the constraints of an existing division, exercising options can indeed be the sole prerogative of division management. When the magnitude of the change required goes beyond the constraints of any existing division, determining when and how to exercise a given option tends to rely much more on an activist corporate office and even heroic CEO. And when divisional assent is crucial to success, either due to corporate culture or the need for industry expertise and insight, then a capacity for collaboration between corporate and divisional management is crucial to determining when and how to exercise the relevant option.
The sunk-cost effect is the well-documented propensity of managers to assess the potential of a given project favorably, and hence continue to invest in it, if they have already made investments in it. As the expression goes, “in for a penny, in for a pound.” In the context of investing in strategic options, if the initial investment required to create the option serves in reality to commit a company to subsequent investment, then the option is not an option at all.
The machinery of financial option valuation, including the widely promulgated Black-Scholes model, consists of different ways of estimating the probabilities of different future stock price values and the implications of those collective probabilities on the value of an option at different specific future prices.
The purpose of real options, in the context of Strategic Flexibility, is to reduce strategic risk and increase exposure to strategic opportunity. These are outcomes that cannot be measured ex ante, and for which suitable proxies in the financial markets simply do not exist.
No valuation technique, no matter how sophisticated, will replace human judgment. Management must determine what kind of Strategic Flexibility can be created at what cost, while the board must determine what kind of Strategic Flexibility is worth having at that price.
The future never gets here. That is why Strategic Flexibility is illustrated as a loop.
Strategic planning built on Requisite Uncertainty and Strategic Flexibility is no longer driven by the calendar.
The four phases of managing a portfolio of real options are: create, preserve, exercise, and abandon.
Real options are valuable in the management of strategic uncertainty. Consequently, determining what real options are worth is a profoundly intuitive assessment based on the risk/return profile that the board and top management feel is appropriate for the company.
CHAPTER ELEVEN
Resolving the strategy paradox requires an organization to pursue both “deliberate” and “emergent” strategy formulation simultaneously.
Subsequent researchers have qualified this debate, suggesting that the alleged dichotomy between deliberate and emergent approaches to strategy is a false one. Instead, each approach is appropriate under different circumstances: a deliberate approach makes sense when the future is clear (or clear enough), while an emergent approach is superior when dealing with material uncertainties.
The willingness to stake one’s success on the ability to make commitments today that will not pay off until years into the future is either evidence of a high tolerance for risk or the height of arrogance. The Ancients teach the only defense against hubris is humility: the recognition that, whatever our strengths, the realm of what we cannot foresee or control far exceeds our grasp.
Traditional strategic planning is not blind to uncertainty, but it treats it as an afterthought: commit first and ask questions later. The prescriptions of industry analysis, core competence theory, and disruptive innovation are all tremendously powerful, but they should come after an assessment of critical uncertainties, not before.
APPENDIX A
Firm diversification that is resource based is related diversification. Because the related diversification required to overcome this sort of market failure increases the operating scope of the firm, related diversifiers are said to capture scope economies.
The research into strategic diversifiers was motivated by an implication of established corporate contingency theory. Specifically, if each “pure” diversification strategy (unrelated, vertically integrated, related) requires a particular administrative system to be most successful (competitive, constraining, and cooperative, respectively), then a portfolio that mixes diversification strategies will have to mix administrative structures. This promises to be difficult for two reasons. First, the defining characteristics of each administrative archetype are mutually exclusive. Second, if a strategic diversifier were to employ a group structure to separate the unrelated from the related or vertically integrated divisions in order to implement the appropriate administrative structure on each group of similarly connected divisions, this would impose additional costs on the corporation without creating any additional benefits. Consequently, strategic diversifiers should suffer a performance penalty.
Strategic diversifiers enjoy operating performance that is equal to that of pure diversifiers, but their Tobin’s q-values are higher, implying that investors expect hybrids to perform better than pure diversifiers in the future.
Strategic diversification can be summarized in much the same way as the three other established diversification profiles. Strategic diversification compensates for failures in the risk markets and creates option economies. A strategic diversifier must have a dynamic administrative structure.
