Investile Dysfunction

Disaggregating Revenue Into Its Components

I've spent the last bit going through an old issue of the McKinsey Quarterly hence my second post on an article from them.  This article is titled "The Granularity of Growth" and is authored by Mehrdad Baghai, Sven Smit and S. Patrick Viguerie and is in their issue #2 in 2007.

Unlike my prior post on the McKinsey M&A article which contradicted itself, this one has an underlying premise/approach which is sound and actually quite useful.  Unfortunately, the results are completely unbelievable and 100% contrary to our own very similar research.

First, let's discuss the portion that makes some sense - the methodology.  Revenue is disaggregated into its three components: revenue from market growth in segments in which it competes, revenue gained through M&A and the revenue gained/lost through market share gain or loss which is effectively organic growth.  So breaking up revenue into its components makes total and complete sense.  Companies spend a ton of effort understanding expenses but the revenue side is often not as carefully studied or broken down.  Their methodology is fairly sound, but I'd recommend breaking up the organic component into revenue attrition (customers who leave or who are asked to leave the franchise) and organic revenue growth (for example, revenue from new customers to the organization or gained through deepening relationships with existing customers).

I actually utilize this method in my recent article in Business Finance Magazine entitled "The Care and Feeding of Plus-Sized Portfolios." (To see a .pdf of the article as it appeared in the magazine, click the following link to download the article.  Download business_finance_magazine_article_anand_sanwal_corporate_portfolio_management.pdf)

With a sound methodology in place, the authors disaggregate revenue to deliver their findings as follows:

• "A company's growth is largely driven by market growth in the industry segments where it competes and by the revenues it gains through mergers & acquisitions"
• "These two elements explain nearly 80% of the growth differences among the companies we studied."
• "Whether a company gains or loses market share - the third element of corporate growth - explains only 20% of the difference."

They conclude that "executives ought to complement the traditional focus on execution and market share with more attention to where a company is - and should be - competing."  They in the sentences prior also comment that "although good execution is essential for defending market share in fiercely contested markets and thus for capitalizing on the corporate portfolio's full-market-growth potential, it is usually not the key differentiator between companies that are growing quickly and those that are growing too slowly."

Here is where I disagree quite vehemently.  First and foremost, the hint that execution maybe less important strikes is a half-baked idea.  Also, from an analytical, data-driven perspective, we've completed a similar study which found that companies that control attrition and grow organically (both functions of resource allocation and the management of the corporate portfolio) actually outperform their peers on a shareholder returns basis.  Our findings reveal that not all dollars of top line growth are created equal and that in fact, the market favors a dollar of organic growth more than one from M&A.  Part of the discount for M&A revenue maybe that it is risky.  Look at the history of M&A deals and it is obvious they are inherently and highly uncertain.

What about the market growth piece you might ask?  As I speak about in the aforementiond article, "Market growth in the near term is really not under an organization's control. If you happen to be in an industry growing at double-digit rates, good for you. Conversely, if you are in an industry that is growing at a slow rate or even shrinking, too bad. The short of it in either case is that there is not much you can do in the immediate term to juice market growth."

The short of it is that portfolio repositioning strategies are sexy as is M&A, but both are uncertain, costly and time-consuming.  To deliver better returns, the component of growth most under an organization's control is what should be optimized and that is organic growth.  Furthermore, the organic growth can come from a variety of sources including from existing customers as well as the creation of new services & products through innovation.  It is likely that these are more controllable and hence the value per unit of risk that is possible is higher.  Companies like AmEx and P&G have realized this and continue to be rewarded by the market for this.

Execution matters the most and drives the most important lever of revenue growth - organic.  M&A is a miserable way to grow revenue and portfolio positioning, while important takes time and is not something that can be changed quickly.  Additionally, positioning your portfolio in higher growth segments also means you will compete with others head on who've also realized the growth in this segment.

Schizophrenic short-termism - Judging an M&A deal's goodness in 2 days

Short-term thinking, albeit terrible, seems to be rampant.  And I love when I see examples of this because it is (1) amusing and (2) contrary to everything corporate portfolio management is about.  So I came across this gem by McKinsey which is deserving of an award for not only its short-term outlook, but its ability to actually contradict itself.

The offending item was in an article entitled "Maintaining discipline in M&A" by Richard Hobbs, Hannu Suonio and Vincenzo Tortorici.  The authors reviewed 1000 global deals valued at more than $500 million that occurred between 1997 and 2006.  They contend, "By examining stock price movements shortly before and after each deal was announced, we were able to assess how financial markets view its worth.  While such "announcement effects" are by no means a perfect measure, academic research has shown them to be a good indicator of long-term value creation.*"

So the asterisk at the end of this quote was interesting enough that I went and read the footnote where they explain as follows, "To determine the value created, we compared share prices two days before and after each deal was announced, adjusting for general stock market movements during this period.  This analysis of short-term price movements reduces the impact that factors other than the deal might have on price movements.  But because the market's initial response to a deal can be wrong or affected by factors other than its value - factors such as bid speculation before the deal, signaling, and tax and market liquidity sisues - announcement effects cannot be used to judge an individual deal's ultimate success."

Now let's review.  First, McKinsey wants us to believe that a review 2 days prior and post of the deal can indicate the deal's value creation capability.  Two days?  Why not just pick the first hour of trading after the deal is announced to decide this?  The market will tell you what they thought of the deal.  And of course, if it is your deal, you want the market to be positive about its prospects.  But how 2 days of stock price performance is any indication of long-term value creation seems like a bit of a stretch. 

More interesting in this article are the underlined and bolded words from above.  In the text of the article, it says these thse "announcement effects" are good indicators of long-term value creation.  And then in the footnote, it says these announcement effects cannot be used to judge an individual deal's ultimate success.  At this point, I'm lost.  Is McKinsey arguing with itself or proving its own point wrong?  For those who have the physical copy of The McKinsey Quarterly (2007, No 2), look on page 96 and you'll see the above mentioned words on the same page right after one another. 

My advice when writing an article: 

1. Don't take a short-term view (2 days is just too short - try for at least a week)
2. Don't contradict yourself (esp on the same page)

What is Project Portfolio Management? Attempt number 1

I've heard the term Project Portfolio Management (PPM) for some time and in the beginning I naively thought it was synonymous with corporate portfolio management with an IT twist, e.g. a cousin of corporate portfolio management which was just not as expansive in its use.  But recently, when I've been speaking at conferences, it's become pretty apparent that PPM and corporate portfolio management are definitely not the same.  As a result, I thought I should try to understand what the two really are and see how similar or dissimilar they are.  So instead of putting together my own definition of PPM, I'm looking for definitions of PPM as given by various 'experts' and will then compare & contrast them with corporate portfolio management.  This entry is caveated with "attempt number 1" because a quick search of the web revealed that there is a far from standardized definition of PPM (I suspect that might be a problem) so I'm going to use various definitions I find and do the comparison with each over time.

In attempt #1, I'm going to use a definition I found on Webopedia which describes itself as "The #1 online encyclopedia dedicated to computer technology".  Webopedia's entry on project portfolio management defines it as follows, "PPM, short for project portfolio management, refers to a software package that enables corporate and business users to organize a series of projects into a single portfolio that will provide reports based on the various project objectives, costs, resources, risks and other pertinent associations. Project portfolio management software allows the user, usually management or executives within the company, to review the portfolio which will assist in making key financial and business decisions for the projects."

Ok this one should be easy as this definition of PPM has little to do with corporate portfolio management.  Most obviously, corporate portfolio management is a strategic discipline and not a software.  While software might enable corporate portfolio management (MS Excel will work fine for most to be honest), it is not a key element by any stretch.  Instead, corporate portfolio management is a marriage of modern portfolio theory (investment valuation, prioritization, optimization, etc) and organizational behavior (using data instead of decibels to make decisions and making sure silos are broken down and incentives aligned to do what the investment prioritization and optimization might indicate are the right things to do).  At the heart of corporate portfolio management is good, credible data which is arrived at in a consistent and driver-based manner.  And it is this realistic data about investments that make up the organization's portfolio.

The Webopeda definition of PPM basically is about a glorified reporting tool.  You have a software that aggregates information about investments (with little regard it seems for how that data is arrived at).  And then presumably, this definition would have you believe that executives would review the portfolio (aka a list of projects) to make decisions.  By this definition, project portfolio management is less about managing a portfolio than displaying the "portfolio" with cool reporting bells & whistles.  Sizzle over the steak. 

With the definition from Webopedia, it seems that Project Portfolio Management and Corporate Portfolio Management have little in common.  Actually, one of the 7.5 Deadly Sins of Corporate Portfolio Management that I talk about in my book (Optimizing Corporate Portfolio Management: Aligning Investment Proposals with Organizational Strategy) is "Let me install this software and then I'll have an optimized portfolio."  Seems like the definition of PPM that Webopedia is advocating is that sin in a nutshell.

Well, with attempt #1, I'm genuinely underwhelmed by PPM.  It's a marketing ploy it seems by software and consulting companies to sell more stuff, but it has little to do with and little ultimate benefit when it comes to managing a portfolio.  Installing software when you don't understand the basic discipline and strategy behind portfolio management does you little good. 

I will keep looking for new definitions of Project Portfolio Management and see how they compare with Corporate Portfolio Management.  I'm hoping that there is some real portfolio management going on within the world of PPM and not just software sales chicanery and that there is some synergy or relation with corporate portfolio management.  If any of you has seen a good definition of PPM that you can share, please do let me know.  I'm hoping there is something more substantive to PPM than just the hype. 

Design - The latest flavor of the moment for driving corporate outperformance

What drives corporate outperformance?  Those who've read my blog before know: 

1. It cannot be boiled down to a single factor.  That would indicate that outperformance is a science which can be made into an equation to the effect that "add this and watch your company magically outperform."  This type of thinking is small-minded and ineffective and and although people (aka supposed management gurus, luminaries and the media) make a lot of money selling this type of alchemy, it doesn't work.  It definitely makes for good stories, however, and stories sell.
2. Optimizing resource allocation is the key to outperformance.  Unfortunately, for those looking for an elixir, this is not what you want to hear as fixing this takes time.  But ultimately, companies that make better bets (which is what optimizing resource allocation is about) win.  This is the power of corporate portfolio management.  But it's a multi-faceted discipline - not a one trick pony.

That said, the experts will have you believe corporate outperformance can be driven by a single measure.  In the last year, I've read about how a company's talent strategy, corporate social responsibility efforts, corporate governance, innovation, and IT strategy amongst others drive outperformance usually as measured by total shareholder return (TSR) or PE valuation premium or some similar metric.

The latest entrant into the pick a metric to determine company performance is DESIGN.  With Apple being the darling of the Street and consumers alike and with the "elegant, simple" website design of another high-flyer Google, everyone is clamoring to determine what drives the success of such companies and anoint the next great corporate hope.  And design is the new anointee and holds the championship belt (for now).

And so in line with this, Fast Company's October 2007 issue is dedicated to their "Masters of Design".  While I usually like the magazine, they fell prone to the oversimplification manifesto from the beginning and did some overly effusive articles on a variety of "design-masters".  And they pointed to the benefits of design right from the start with their letter from the editor, Robert Safian.  Safian mentions a study by The Design Council (warning flag #1) that found that a portfolio of 63 design-driven British companies beat the broader FTSE 100 (warning flag #2) over a period of 13 years (warning flag #3).

Warning flag #1 - As I've said before, you need to look at the source of any such study.  The Design Council performed this analysis.  What are the odds of them coming out and saying that companies focused on design underperformed?  I'll give you 10 seconds.............Ok the answer is - ZERO.

Warning flag #2 - The FTSE 100 is amongst the largest companies so it is important to understand if the 63 companies are of a similar scale.  If small emerging companies in the early part of their growth curve are compared with older more established companies, the performance comparison is not 'apples to apples' and hence not fair.

Warning flag #3 - A period of 13 years?  Quite a random time period.  I wonder on what basis this period was selected.   

What I am not saying is that design is unimportant.  Obviously, it is.  But attributing outperformance to just one metric, whether it be design or any of the many hundreds that have been suggested in the past and which will surely be suggested in the future, is foolhardy.  Nevertheless, enjoy the flavor until the next one comes along. I'd presume there will be another rage within a few months.  Any bets on what it will be?

Decibel-driven decisions and Chinese toys

So there has been quite a furor over the Chinese toy / lead paint issue in the press recently.  Legislators are calling for laws to help with this effort.  "Sen. Mark Pryor, D-Ark., has spoken about the need for increased inspection of imported nonfood products. On Wednesday, Pryor will discuss legislation he plans to introduce that will "rebuild" the CPSC so that it can "meet the challenges of today's economy posed by emerging technologies and counterfeit and dangerous imports," according to a statement from his office." (source: MarketWatch by Dow Jones).

And then today, the toy maker, Mattel apologized to China.  As reported on cnnfn.com, "US-based toy giant Mattel issued an extraordinary apology to China on Friday over the recall of Chinese-made toys, taking the blame for design flaws and saying it had recalled more lead-tainted toys than justified."

Thomas A. Debrowski, Mattel's executive vice president for worldwide operations, stated, "Our reputation has been damaged lately by these recalls and Mattel takes full responsibility for these recalls and apologizes personally to you, the Chinese people, and all of our customers who received the toys." 

He specifically acknowledged that "vast majority of those products that were recalled were the result of a design flaw in Mattel's design, not through a manufacturing flaw in China's manufacturers."

This is not a public policy blog so whether we should have more or less scrutiny of Chinese imports is not my concern.  What this situation illustrates is the decibel-driven nature of the decisions being made or proposed.  And whether the government or a company, these types of decibel- or intuition-led decisions occur frequently and can lead to the wrong outcomes or solutions (as maybe the case here).  Ensuring you have the facts and data straight before making unilateral or far-reaching decisions is very important.  This is one of the fundamental precepts of a well-structured corporate portfolio management effort. 

Oh the beauty of short-term thinking - Circuit City style

It is or should be obvious that utilizing the discipline of corporate portfolio management requires patience.  Management guru theories and case studies present nice stories, but reality requires taking a pragmatic, long-term view when it comes to resource allocation.  And if you do this, it will lead to good things.  And despite people knowing the value of long-term thinking/actions (at least intuitively), they fail to do this.  And it is these moments when a company becomes too short-term oriented that make me wonder.

The latest to break the long-term (or even medium-term) mantra is Circuit City.  Yesterday the company posted disappointing second-quater results.  The impact from this was an 18% drop in the stock price and the demolition of almost $325 million in market capitalization.  All in a days work.  And what was the cause of this ugly day?

Well, the company was attempting to turn itself around (not too successful it seems) and in an effort to do this, the company "shuffled store managers, letting highly paid salespeople go, trimming its HQ staff and recasting store procedures."  (source: Wall Street Journal) All this belt tightening presumably was done to make The Street happy. 

The company's CEO, Phil Schoonover, stated, "We introduced major disruptions that caused distraction, which led to execution problems in our domestic business."  The result per the Journal was that "Circuit City not only registered a sales decline and a wider net loss than expected, but it also saw a decline of more than three percentage points in its gross margin to 21."  The aim of the turnaround's belt tightening was at a minimum to help profitability, but it seems that wasn't even accomplished.

Now the market which began punishing them a year or so ago for their underperformance is doing it even more (perhaps justified).  The problem ultimately was that Circuit City became so short-term fix oriented that they took measures which hurt the health of the franchise in the medium- to long-term.  Isn't short-term thinking beautiful?

Inane Benchmarking Part II: ...Delusions Out

So in part one of this post (click here to see it), I talked about the suboptimal and dubious ways people perform benchmarking exercises.  Now let's understand what drives this.  And it comes down to psychology.

Actually, it comes down to a psychological idea known as social comparison theory.  The theory states "that there is a drive within individuals to look to outside images in order to evaluate their own opinions and abilities." (source: wikipedia)  So people use this in their personal lives when they make comparisons of themselves to other people.  It also occurs withing organizations.

And there are two types of social comparisons that go on (note: these definitions in quotes are all sourced from Wikipedia). 

• "Upward social comparison occurs when individuals compare themselves to others who are deemed socially better than us in some way. People intentionally compare themselves with others so that they can make their self views more positive. In this type of comparison, people want to believe themselves to be one of the elite, and make comparisons showing the similarities in themselves and the comparison group.  (Suls, Martin & Wheeler 2002)" 

Example:  "We benchmarked ourselves against other companies and we see that our IT expense as percent of revenue is in line with those who are best-in-class like (insert prominent company name here, e.g., Google, IBM, GE, Procter & Gamble, etc". 

This association with a premiere company makes us feel good.  It allows us to brag and say "We're as great as these great companies, individuals, etc"

• "Downward social comparison acts in the opposite direction. Downward social comparison is a defensive tendency to evaluate oneself with a comparison group whose troubles are more serious than one's own. This tends to occur when threatened people look to others who are less fortunate than themselves. Downward comparison theory emphasizes the positive effects of comparisons, which people tend to make then when they feel happy rather than unhappy. For example, a breast cancer patient may have had a lumpectomy, but sees themselves as better off than another patient who lost their breast (Suls, Martin & Wheeler 2002)."

Example:  "Our benchmarking results show that our IT expense as a percent of our revenue is far lower than most firms and so it is apparent that we are managing this area more rigorously than most other companies"

At the end of the day, whether it is upward or downward social comparison that has been employed, you've made yourself feel better and under the guise of a benchmark you may have convinced someone of this point.  And this point, the delusions have taken effect. 

Remember that often with benchmarking it is "Garbage in...Delusions Out".  I look forward to hearing your thoughts.

Inane Benchmarking Part 1 - Garbage In...

Companies are always benchmarking themselves against others to see what they are good or bad at.  Occasionally or perhaps fairly often, this exercise is an effort to make themselves feel good or find some type of silver lining in their efforts.  And I don't see anything wrong with this.  Why shouldn't you do this?  Everyone wants to feel good, right?  And if someone else is not going to tell you how great your organization is or how great you are, why not go out and do it yourself?  But unfortunately, it's not that easy, right?  You can't just go out and tell your senior management how great you are.  You have to dress it up and this is where benchmarking is critical.  Benchmarking gives you data and data can impress people.  Armed with benchmarking data, you can stake your claims of superiority. 

But how do you get to this point.  Here's how it generally works.  In this fictitious example, let's assume you want to understand how much companies spend on IT expense as a percent of revenue and compares yours against them.  So you reach out to some consultant type generally who has benchmarked tens or hundreds of IT organizations as part of a "exhaustive research study" of some kind.  Or in some cases, you find a research paper of some kind which you use. You then either go in 2 directions:

1.  Aim to apply their framework to your company to see how you stack up (the self-directed approach)

2.  You hire the consultant to benchmark your organization (the be-directed approach)

In the self-directed approach, you don't know exactly how the consultant did his study so you make some assumptions to come up with your number.  This obviously leads to some uncertainty about the validity of your numbers, but you did the best you could with what you had.  If the data makes you look good, great.  If it doesn't, you can explain it away by explaining the uncertainty present of not knowing what the consultant exactly did and fully understanding their methodology. 

And in the be-directed approach, the consultant comes in and because they understand their methodology and how things are measured, they will be able to provide you with an "apples to apples" comparison of your organization versus others.  What they don't reveal is that every organization measures the said metrics (IT expense in this case) so differently that even they're guessing part of the time.  They may say they adjust or normalize for these differences, but these are fancy words for they fudged it.  What many also won't reveal is that they know your organization will likely emerge in the middle of the benchmarked pack.  It won't be the worst and it won't be the best.  If they say you are the best, that will prevent them from selling you additional services to 'fix' your issues and if they say your the worst, they might offend you.  So you're average or maybe slightly above.

And after going down one of these paths, you've concluded the inane and generally useless benchmarking process.  At this point, you have a number for you to compare against the larger data set.  What happens next?  Check out the next posting...

P.S.  I'm sure there are consultants out there who will disagree with my generalizations.  But I've talked to enough consultants 'off the record' to know this is what happens.  If you are not amongst the type doing this, I applaud you 

Corporate Portfolio Management article featured in Business Finance Magazine

An article I'd written entitled "The Care and Feeding of Plus-Sized Portfolios" appears in the September 2007 issue of Business Finance Magazine.  Click here to be taken to online article.  To see a .pdf of the article as it appeared in the magazine, click the following link to download the article.  [Download business_finance_magazine_article_anand_sanwal_corporate_portfolio_management.pdf]  I look forward to hearing your comments & thoughts and hope you enjoy the article.

Jetting back to school

This posted on blog Footnoted.org is a pretty nice example of resource allocation gone awry.  Looks like Edward Mueller, the CEO of Qwest Communications (Q) has received approval to have his wife and stepdaughter use the company jet for their personal use as revealed in the company's amended employment agreement which the company filed late Friday.

Per Footnoted.org, The stepdaughter attends high school in California and Qwest is based in Denver. “The amendment reflects a great appreciation for his family situation as his daughter wraps up her current schooling in California,” Qwest spokesman Bob Toevs told the newspaper. My guru on all things corporate jet-related estimates that this perk could cost Qwest as much as $600K, assuming normal charter rates for the Falcon 2000.

Quite a length to go to demonstrate a "great appreciation for his family situation."  I assume there was little to no discussion around this investment of Qwest resources?  Perhaps the more pressing question is how does his stepdaughter get to the mall?