strategy and tactics

This website has consistently attacked the folly of two dangerous and linked cults - the Cult of the Chief Executive and the Cult of Shareholder Value. The intellectual foundation of this double disaster is simple.

The corporate economy exists to enrich its owners. The correct route to that end is to appoint an able chief executive and gird him with all the powers required to direct the corporation in ways that will create capital gains for the shareholders.

The process of creating wealth will simultaneously bring immense rewards to the CEO and his key subordinates. Being an all-round genius, the CEO, incentivised by the wealth carrot, will perform as brilliantly as expected, and the share price will dutifully respond. This formula can be usefully described as the Welch Effect. At General Electric, hero manager Jack Welch presided over 20 years of sustained outperformance that enormously enriched the boss and satisfied the more modest desires of the investors.

THE IMMELT PARADOX

Not any more. The Immelt Paradox has taken charge. Jeff Immelt is the anointed successor of Welch. He took over in late 2001 and has delivered solid results by following the GE tradition of proactive succession.

Like Welch two decades before, Immelt has moved the management in new directions, stressing growth and creativity. Earnings per share have risen by 22% since 2001. But the Welch Effect has failed to kick in. The share price has fallen by 14.9% over the same period. What has gone wrong?

It’s tempting, of course, to make Immelt bear the blame. The widely received view that the new man has moved in the right direction at the right time in the right way may simply be wrong. But this issue, while interesting, is irrelevant. For Immelt is not alone. The 17 April issue of Business Week lists 16 other blue-chip companies whose share prices have under-performed despite earnings growth which in 14 cases has been notably better than at GE - topped by a whopping 173.1% achievement by Intel.

The microprocessor maestro’s shares also left GE’s performance well behind - Intel’s stock dropped by 29.9%. Here, too, a new management strategy and tactics have been hailed. But the Immelt Paradox also applies to Microsoft - and Cisco, Coca-Cola, Disney, Du Pont, IBM, JP Morgan Chase, Oracle, Pfizer and Wal-Mart. The paradox is a pestilence to which all these blue-chip, large capital companies have fallen victim.

The Double Cults don’t work now because they never did - the premises were false. Have a look at them again, and decide whether they are true or not.

1. The corporate economy exists to enrich its owners.

False: other parties are more significant - above all, the customers. No customers, no business.

2. The correct route to that end is to appoint an able chief executive and gird him with all the powers required to direct the corporation.

False: the CEO in a large and complex corporation should be a primus inter pares, a first among equals. The strength of the entire management team, and of its relationship with customers and workforce, is what matters for success.

3. The CEO directs the management in ways that will create capital gains for shareholders.

False: many applauded business strategies, notably mergers and acquisitions, destroy far more wealth than they create.

4. Their success at creating wealth will at the same time bring appropriate rewards to the CEO and his key subordinates.

False: the rewards, while immense, bear little relation to the actual achievements.

5. Finally, far from being incentivised by the wealth carrot, or from being an all-round genius, the CEO cannot in any event affect the share price - because the latter is moved by forces beyond any control by management.

TRUE!

This truth fully explains the Immelt Paradox. As Business Week points out, in a brilliant study, investors have simply gone off ‘large cap’ companies. The returns on the S&P 100stock index have fallen to 2.3% annually with dividends, 0.19% with dividends excluded.

Other investments have far excelled this weak performance. Had you invested in large-cap US stocks five years ago, $10,000 would have grown only to $11,058 - relative peanuts.

In commodities, the same nest-egg would now be worth $15,150; in energy, $17,537; in small-cap US stocks, $19,997; in boring old gold, $21,400. On top of the pile are emergent markets, where the $10,000 would again have more than doubled - to $21,500. Obviously, there’s an element of self-fulfilling prophecy here. If investors turn against a class of assets, that will inevitably lower the valuation as the holders buy less and sell more.

However, there are economic realities behind the investor turn-off. Goldman Sachs reckons that the S&P 100 saw their earnings fall from the 2000 peak by 53% to the trough in 2002.

Enlarge the numbers to 500 stocks, and you get a fall from $50 to $17.50. Move up to the 600 indexed stocks with smaller capitalisation, though, and you get a three-year run of hefty rises: 20%, 15% and 28%.

History confirms the unavoidable conclusion that smaller firms have something that large ones almost invariably lose. Part of the explanation is arithmetical. The larger the numbers grow, the harder it becomes to maintain the same slope of rise. BW quotes the famous economist Herb Stein, who once wryly observed that ‘if something cannot go on forever, it will stop’.

RASH PROMISE

I recall that when IBM once undertook to grow in step with the IT industry, it was very rashly promising to add the equivalent of three whole Digital Equipments - that being the next largest competitor. Not surprisingly, IBM failed abysmally. But management becomes as great a limit to growth as size - and the two problems are plainly linked, as GE’s Jack Welch once noted: ‘For a large organisation to be effective, it must be simple.’ That won’t happen unless its people ‘have self-confidence and intellectual self-assurance’.

Those two highly desirable qualities have been dented by GE’s poor share performance. That’s a noxious outcome of the Cult of Shareholder Value. Managers look at the share price, which they can’t control, but don’t judge themselves by the factors that are within their competence.

Communication is one. But in large companies, how many people know what the business is trying to achieve? And have they any idea whether current policies offer the best promise of reaching the competitive objectives?

The Sema consultancy once listed ‘key competitive factors’ which translated into five powerful, non-financial questions:

1. Are we achieving superior customer relationships?

2. Do we know what we are really good at, and how to obtain the utmost mileage from that excellence?

3. Are we sharing the rewards among those who created the achievement?

4. Can we respond flexibly to political, economic, sociological and technological change?

5. Do we make expert use of external ‘expert partners’? Note how well these five factors fit the truths that emerge from the wreck of the Double Cults – the necessity to make the customers and their service the core of business strategy and measurement; the downward delegation of powers to staff, coupled with the upward flow of information from the sharp ends of the organisation; the necessity of creating new wealth for the business, with the rewards for shareholders and staff flowing from that success - and not from financial manipulation; the effective relationship with outside partners (including the customers).

These features fit the profiles of smaller companies far more readily than those of corpocratic giants. The ‘self-confidence and intellectual self-assurance’ lauded by Jack Welch may well help to keep an organisation simple; but there’s a chicken-and-egg problem here.

What if the complexity of the outfit damages the confidence and assurance, or makes it harder to give people the freedom of action required? Anyway, isn’t the notion of simplicity a romantic fiction if 250 units are stuck together under the same corporate roof?

That’s the total for the subsidiaries which Tyco – once the would-be ‘new GE’ - will have to dismantle before possible de-conglomeration (the opposite strategy) can be completed. Most of those Tyco units, no doubt, are bigger than any of the companies I’ve been visiting for a second survey of innovation commissioned by the East of England Development Association. Just as I found in the first round a couple of years ago, these companies are tightly focussed on the necessities of their markets and technologies - both present and future.

POSITIVE AMBITIONS

This doesn’t mean a lack of ambition. On the contrary, the six studies all revealed plans to expand the size and range of the businesses that would result in sweeping and important change. The change is both the midwife of progress and its result. The management structure and processes derive from the needs of the firm - one of those interviewed actually manages very well without any managers at all. The ownership structures are diverse, ranging from a substantial public company to a three-man partnership. But I couldn’t unearth any important connection between the ownership and the ability of the company to pursue and progress its own destiny.

Big-time managers and their advisers have, of course, spotted the advantages of small time management and have tried to replicate them. I have often made the case for having flat organisations which keep their central establishments small, bureaucracy minimal, and staff focussed on the new - placing a premium on new ideas and constantly seeking to match or surpass the best standards in all significant activities. To quote Sema again, that last phrase is covered by six elements: people, processes, money, information, technology and time. The divisions between the six, however, are meaningless. The business won’t succeed over time unless all the elements are in place.

What does this mean for the Sorry Sixteen – those famous blue-chips whose shares have languished despite their strong earnings? If GE’s Immelt is any example, the leaders of these corporations still haven’t got the message. He complained in the latest annual report that ‘We earn significantly more income and generate substantially more cash than we did when the stock traded at an all-time high’. What doesn’t seem to have occurred to him is that the anomaly lay in the previous high, not the present low.

Immelt’s strategy for dealing with the latter, baleful situation is to talk about ‘his disappointment and frustration’ over the share price at every opportunity and in every forum - at ‘employee town halls’, talks with investors, even student groups. He has put his money where his mouth is by buying more GE stock himself and converting a $6 million cash bonus into performance shares linked to the growth of cash flow and performance relative to the 500 stocks indexed by S&P. He would be less disappointed and frustrated if he realised how irrelevant all this effort is.

EQUITY VALUE

In the days before the Cult of Shareholder Value, I seldom if ever encountered a chief executive who didn’t believe that his shares were undervalued - ignoring, just like Immelt, the fact that equity is only worth what the market says. That’s the definition of its value. It is true that ‘value investors’, of whom the greatest is Warren Buffett, operate on the basis of ‘intrinsic value’, judging the current price of the equity by its likely performance against the going rate for government bonds. But that’s an artificial construct, which doesn’t give the investor any guarantees.

Coca-Cola, one of Buffett’s prime selections, is one of the Sorry Sixteen, with a 12.9% fall in the share price over the past five years despite a 37.3% gain in earnings, Disney, another pet, has recorded a rise, but of only 4.1% against a 24.2% advance in earnings. And Buffett has only recently invested in Wal-Mart, whose share dipped slightly, even though earnings shot up by 83.5%.

Not surprisingly, Buffett has recently switched his investment strategy to buying four market indexes, only one of which is based on the US. The truth of the matter is that the Double Cultists have been worshipping false gods. They may come again, rising from the dead. But the gods will still be false.