Chapter 29. Strategy for the 21st Century: Portfolio Is Back

Maurice Saias and Olivier Tabatoni

Mechanistic strategic approaches are gone. Since the first oil crisis, turbulence has become the rule, leading to a drastic questioning of both our ways of thinking and our managerial practices. Most managers expect that sooner or later their own organization will experience some kind of discontinuous change. In these uncertain times, businesses that take nothing for granted will have an edge. It is time to reexamine how we anticipate and prepare for the future, given that the strategic toolboxes, which were developed in the 1960s and 1970s, are almost totally obsolete.

Nowadays, it is very hard to be a credible strategist, and the quest for the right moves is a waste of time and energy. Does this mean that strategy has become irrelevant for business? That the 21st century will be so erratic that pure opportunism is the only possible strategic behavior? Definitely not, but our perspectives on strategy must change. Instead of considering just strategic maneuvering, we must now take into account strategic mindsets—competition dealing as much with the approach to strategy as its content. For the winning organizations committed to creating their own future, the challenge is open.

In this chapter, we develop three points: What is strategy today? What kinds of discontinuities do corporations face? What are possible strategic responses?

What Is Strategy Today?

The debates about the nature of strategy have never been so intense. Questions being raised include:

• Is strategy about anticipating, forecasting, and reacting, or is it about creating, influencing, and shaping?
• Is it about positioning in an industry or redrawing industrial boundaries?
• Is strategy about sustaining a competitive advantage or creating next advantages?
• Are we talking about limits to value and market creation or capabilities?
• Is it luck that differentiates the winners from the losers, Darwinism that determines the survivors, or is it purpose?

We can clarify these debates by clustering the characteristics of strategy into six broad categories.

Change

During the 30 glorious years when changes were less frequent, doing consistently better was sufficient, and mechanistic models were effective; the capacity to take small or big steps made the difference in the race toward increased market share and profit. Incremental models were more than adequate. However, since the first oil shock, we have witnessed a permanent reallocation of the best cards. Turbulence, which replaced linearity, has been replaced by discontinuities. We have entered a world in which forecasting and planning are pure divination. This has made strategic planning an oxymoron. In a world in which constant change is the only thing that is predictable, the ability to question what is being done and the nature and reasons for past and present success, as well as a readiness to change the rules of the game, are indispensable strategic ingredients.

Creativity

To become and stay a leader in today's fast-paced world requires a great deal of creativity. Destabilizing an entrenched competitor requires more than following the leader. For example, Toyota confronted the best car manufacturers of the West by challenging widely accepted production processes and traditional ways of managing assets. Komatsu used the new possibilities offered by fast transportation and delivery to shake up the competitive advantages of Caterpillar. The key is to systematically challenge established and accepted rules of success.

To change the game and refuse to imitate are good signs of creativity. To choose a direction and to stick with it demands imagination.

Choices

To say that resources are limited and that strategy means making choices is trivial. Strategy is associated with resource allocation and is therefore a political process. But, the conditions around these choices are new. First, speed and complexity have increased dramatically; second, costs are extremely high. Each decision is risky and costly. In this sense, strategy resembles gambling at a casino: Nobody knows which table to play at, given that the games change constantly. Furthermore, chips are astronomically expensive and returning to a table after having refused to play or having left is seldom possible. To watch is to not take part, and not participating means rejecting the possibility to win.

Courage

The more creative and surprising a strategy is, the higher its potential reward. However, as the reward increases, the risk increases. Therefore, decision makers must have courage. Indeed, unlike a few years ago when economic growth and a permissive environment eradicated mistakes, a strategic mistake today is likely to lead to a financial disaster.

Many CEOs, concerned with how they will fare in the business history books, find risk-taking less than appealing. However, success breeds failure. Strategy involves having the courage to challenge what we are and what we have been, to go against broadly accepted thinking and widely spread practices.

Coherence

Choices must be consistent not only among, but also with, the processes in use and with those that will be adopted or modified. We are not concerned here with coherence in time, but with consistency between strategy and the systems and processes that lead to action. The following two examples illustrate this point:

• A medium-sized successful enterprise has crafted a vision stating its intent to become the innovative leader in its industry. All the necessary ingredients are in place: communication, vision, objectives, and lines of conduct. The short-term actions are well designed, packaged, and interrelated. However, the first person to try something dramatically innovative failed and was subsequently fired. In that instant, the vision of becoming an innovative leader lost its backing.
• Another corporation had to change from selling products to providing systems and solutions. Top management realized that in order to succeed, the different business units needed to cooperate. However, they refused to change the reward system entirely, which was based on individual business-unit performance. Team effort across business units was not taken into account and resulted in the multiplication of conflicts, a lack of cooperation, and customer dissatisfaction.

This coherence imperative is difficult to achieve, because it is risky to modify systems and processes that represent the administrative core of the corporation too frequently.

Capacity to Deal with Complexity

Strategists have long used simple models and paradigms to spread their approaches across their organizations. They have relied upon reduction mindsets to make choices look clear and unambiguous. For example, a company might compete either on cost, quality, size, speed, or flexibility. Unfortunately, these simple binary options have become irrelevant under the pressure of more complex demands. Financial markets demand increasing quarterly results over the long term: They record quarterly profits while asking for social and societal responsibility. Corporations must be big, fast, and flexible; centralized and decentralized; global and local; combative and consensual.

Strategy, then, is the art of carving a path in this paradoxical world; however, the culture and education of most western leaders has prepared them to think in alternative terms and to search for the "right" answer. Thus, confronting increasing ambiguity and complexity is not an easy management task.

Where Are the Major Discontinuities?

In this perpetually changing world, where are the major sources of discontinuity, which, beyond technological or political revolutions, represent the highest stakes? About 10 have a systematic impact on most businesses. For simplicity's sake, we present each one separately, but it is their interrelationships that make them so complex and difficult to grasp.

Globalization

Although globalization has its advocates and opponents, it is a reality. The question then becomes, How long will the reasons that incite corporations to globalize last? Some reasons to globalize include the following:

• The explosion of fixed cost that unavoidably lead to the quest for higher volume.
• The search for growth through geographic expansion, especially when domestic markets seem to be maturing.
• The fall of regulatory and legal barriers; faster, better transportation and communication facilities, which have accelerated the worldwide harmonization of tastes and lifestyles.
• The search for balance between political and economic risks.
• The spread of financial and human resources across the world with an overly underutilized potential of highly qualified labor force.
• The global customer base.
• The globalization of suppliers.
• The globally competitive environment that leads to the necessity to develop retaliatory capabilities.

Deregulation and Privatization

Deregulation and privatization are taking place all over the world, even in the most hostile political environments. A few widely publicized counterexamples, such as the incoherent deregulation of power generation in California or the situation of railroad transportation in the United Kingdom, cannot conceal the benefits of deregulation and privatization, especially for consumers. Deregulation and privatization have been used to correct decisions made for ideological reasons rather than economic or managerial ones. Moreover, they have become a source of government funding in difficult times.

Volatility

"Volatility in the 21st Century," a special issue of Business Week, contributed to the popularization of this concept. In summary, it looks as if linearity has disappeared and economic cycles will be shorter, with much higher peaks and deeper troughs. Rigid assets no longer meet the flexibility imperative; likewise for unyielding human assets and mindsets.

Convergence

The impact of convergence is more visible in the high-tech arenas, such as information, communication, entertainment industries, leisure, and consumer electronics converging. However, it does stretch to the more traditional industries, such as the automotive industry, which is converging in the areas of mechanical technology, electronics, software, and new intelligent materials. Financial services are impacted by convergence; banking, insurance, mass retail distributors, the automotive industry, and large industrial conglomerates, as well as telecom operators converge and compete.

Industrial Frontiers

As a consequence of convergence, industrial borders blur or disappear entirely. It becomes harder to identify competitors as companies get involved in new domains with drastically different approaches and unorthodox business methods. By doing so, they multiply the possible migration paths, and the nature of competition is modified. Competition deals as much with migration paths as it does with endgames themselves. A second type of border is disappearing. The frontiers between suppliers, customers, and competitors are being replaced by alliances and partnerships, which is accelerating the development of what is referred to as co-opetition.

Standards

Battles for standards have always existed; however, globalization presents a new dimension. Standards give considerable commercial power to those companies who have successfully imposed theirs on the industry, as is exemplified in the use of VHS for JVC, Windows for Microsoft, and GSM for UMTS. The role of alliances, partnerships, co-opetition, and complementors is crucial for the adoption and expansion of standards. Real coalitions develop and fight for their common standards. The battles that follow often overshadow the fight for profit among the members of the coalition at least until one set of standards prevails.

Disintermediation

The distance between producers and end users is becoming shorter and shorter. The cascade of distributors can be reduced to one step through new ways of getting in touch with the user. Charles Schwab, Dell or Gateway, and Amazon have challenged the traditional distribution value chain. The overflow of information to the user does not guarantee the quality of his or her decision. In order to help him or her, a new intermediary has emerged: the expert. The expert's role is to check the quality and the price and to make recommendations, thus helping potential customers find their way into the jungle of direct offers. Disintermediation influences the cost and the assets structure. In the medium and long run, it changes the business model.

Ecosensitivity

Today, ecology is perceived as a set of rules and regulations imposed on business. The pressures are initiated by various groups whose objectives are not always clear. In the future, ecosensitivity could be a major creator of new activities.

Demography

The following numbers reveal expected demographic trends. Between 2000 and 2050, the world population will grow from 6 billion to 9 billion. In the developed world, population will stabilize at about 1 billion. Life expectancy, with a few exceptions, has increased dramatically; since 1975, adding .25 per year in the developed world. Fifty percent of girls born in 2000 will live to be 100 years old. Within the next 30 years or so in the United States, WASPs will no longer be the majority, while the population of Hispanics will grow rapidly. The United States could then become the largest bilingual country in the Western world. Demographic trends impact upon markets as well as upon political, economic, and financial decisions.

Financial Markets

The growing power of financial markets has not stopped since the early 1960s. Beginning in the United States, followed by the United Kingdom, and then extending to most of Western Europe and the rest of the world, the last bastions of the so-called patient capitalism have fallen one by one. Value creation for shareholders has become the unavoidable leitmotiv. Currently, the markets react as much to the financial results, EVA, and other measurements of a corporation's economic profit as they do to their growth. Investors have been tempted by the pursuit of fantastic growth at the expense of profitability, but it did not last long. The two imperatives are again balanced in the investors' minds.

What Kinds of Strategic Responses?

In most cases, revolutionary strategic decisions are made while one's "back is against the wall." Usually, fundamental changes of direction and in-depth questioning of current business practices take place in desperate situations and/or with the arrival of a new leader.

This pattern begs the questions, Is the only possible route to strategic decision making apparent in discontinuous times? Is strategic revolution the only possibility? Does evolution mean rehearsing the past? If we go beyond semantic fighting or clan-like quarrels, revolution and evolution are complementary, as shown by the strategic behavior of winners around the world. These winners demonstrated their ability to successfully manage two strategic dilemmas and to handle diversity well.

The Profitable Growth Dilemma

Corporations are expected to deliver profitable growth. First, profit is evaluated through EVA, which is the difference between the return on capital employed (ROCE) and the weighted average cost of capital (WACC). This difference (ROCE–WACC) must be positive. Second, growth can take many forms. Usually, growth is generated internally (organic) or externally through mergers and acquisitions.

External Growth

Recently, markets began reacting negatively to external growth. A few years ago, these negative reactions developed several months or years after the actual operation. Today they appear immediately, almost as soon as the announcement of the merger or the acquisition is made. Financial analysts have come to realize that the outcome of mergers and acquisitions seldom meets expectations. The synergies that have been promised rarely materialize, and when they do they take the form of rationalization and restructuring, which are nothing more than cost-cutting exercises. And diminishing returns apply to cost cutting. Returns increase momentarily, but they plunge rapidly because of efficiency losses due to internal conflicts, cultural shock, undesired departures of good people, and so on. The time spent by top management to solve integration issues is not devoted to the future development of the new entity. Introduced as an offensive and a source of fantastic opportunities, most mergers and acquisitions turn defensive and troublesome. The grandiose vision translates into a succession of retrenchments and restructurings, and frequently the market capitalization of the new entity falls below the level of each of the components before the operation.

Internal Growth

Internal, or organic, growth can be generated by present or new businesses on current or new markets. Whatever the content,it may be handled in a traditional or innovative manner. Even the so-called mature markets can grow. Innovation can transform even the most mature markets, thanks to new products and services, new processes, new organizational forms, or challenging mindsets. In the 21st century, competing on the basis of mindsets is as important as competing on the basis of products and services. Unfortunately, innovation hardly meets the challenge of EVA. If innovation and external growth do not convince the markets, what can be done to deliver profitable growth?

The Exploitation/Exploration Dilemma

Corporations must manage exploitation and exploration simultaneously. Excellence in exploitation, the first requirement, means a perfect command of the following:

• Competitive advantages: cost, quality, speed, flexibility, and so on;
• Core competencies: finding and protecting them as well as preventing them from becoming core rigidities; and
• Organizational capabilities: innovation, knowledge management, learning, acuity, and multivalence.

When competitive bases are underdeveloped, core competencies undetermined, and organizational capabilities weak, financial results are poor or purely accidental. Under these circumstances, markets lose faith and penalize attempts at exploration. In order to explore new avenues, corporations must first prove their excellence at exploiting their present businesses. This means optimizing current activities as well as extending their domain and broadening their market basis. Then, they will be allowed to explore fundamentally new, high-risk possibilities, which are potential sources of high-profit growth.

In order to reduce the exploration risk, managers often resort to experimentation. They try new products, services, solutions, markets, and rules in one part of the organization. Experimentation appears a more reliable basis for collecting information than market research. They also tend to resort to alliances, joint ventures, and partnerships to share the risk.

The strategic success of a corporation is dependent upon its capacity to capture a disproportionate share of the future value that will be created in the evolution of its industry. At the heart of this challenge rests the capacity to manage all kinds of diversity, not just products, markets, and core competencies. Diversity and portfolio management are again at the forefront, but with very different strategic, financial, and leadership requirements.

The New Management of Diversity

Resource-based approaches that relay a clear vision sustain the search for flexibility, innovation, efficiency, and sharing amongst businesses and markets better than a best-fit approach. Similarly, being present on many markets—the first step toward globalization—and in many businesses helps to systematize experimentation.

A clear corporate vision based on strong core competencies and organizational capabilities and backed by flexibility and continuous innovation, should satisfy shareholders. However, the large discrepancy between strategic common sense and financial outlook results in markets that, at the same time, constrain and help strategic decision-making.

Markets are influenced more by results and the convincing power of CEOs than by the future profitability of different possible strategies. Corporate valuation results from two steps: (1) The capacity to generate future cash flows with the present assets; that is, the outcome of past investments is valued. (2) The cash flow that will be generated by the future investments is valued. This second step is a bet on the amount of future investments and their profitability. To evaluate the expected cash flows the markets take into account the capacity to optimally manage the present assets as well as the clarity of the vision, managerial capabilities, and so on. Analysts also use discount rates to take risk into account. This approach assumes that investment decisions are binary and irreversible. Whereas the approach looks acceptable in a stable environment, it may be entirely inappropriate for discontinuity.

Discontinuity supposes the possibility to postpone a decision in order to experiment and collect information; strategic flexibility increases value. Furthermore, when volatility increases (i.e., investments and potential cash flows increase), so does the value of flexibility. With higher volatility, the ability to postpone a decision will prevent large, unprofitable investments in case of downturn, while providing much higher returns if a peak materializes. These conclusions are drawn from the financial option model developed by Black-Scholes and Merton for the financial markets. Researchers have attempted to extend that model from the financial to the physical world without much success, except in the case of natural resources. Today, most strategy consultants, academics, and financial experts are developing models that would be relevant for real options; therefore, increasing the probability of possible extensions from the field of finance to the industrial field in the near future. The strategic implications would be amazing: Financial markets would improve the quality of strategic decision making by providing the tools and thinking that are missing today. Instead of minimizing the risk among investments showing the same expected results, much riskier projects could be selected. Increased corporate value results from blockbuster investments instead of from the optimization of more clearly defined projects.

The key issue in valuing a flexible investment is to know how much time is available before an irreversible decision must be made. This period of time is called maturity of flexibility. If the maturity is nil, then the project is irreversible. Good strategies try to increase that maturity in order to accumulate knowledge.

At this stage, the strategic relevance of learning capabilities and speed becomes obvious. Indeed, if too much time is necessary to reach the final decision, competitors will move in and reap the benefits of the project, including the anticipated cash flows. To prevent that from happening, corporations send signals to convince their competitors that they are irreversibly committed; they try to develop projects that are hard to imitate; they work to lower competitive pressures by looking for strategic alliances, fighting for standards, and buying out competitors with similar projects.

At the appropriate time, managers must also make sure that they have enough financial resources to transform the exploratory adventure into a successful exploitation. Two kinds of risk endanger the corporation with insufficient financial resources:

• Rushing to a final decision, thus losing flexibility; and
• Inadequate resources, leading to abandonment of the project and possibly jeopardizing the corporation's future.

There is a delicate balance to be found with the financial markets. Corporations need the support of the market to mobilize the resources that will help them move from a successful exploitation to an adventurous exploration. But, they also need the markets to find the necessary resources to move from what looks like an exploration with high potential to its exploitation. This complex process requires an exchange of information between the corporation and the financial markets. Top management may not be in a position to fully communicate to the market the highly sensitive, strategic information. On the other hand, the markets may have a hard time grasping the complexity of the exploration activities, especially if the activity is risky and its business model innovative.

In short, the typical role of financial markets is to fund exploitation and not exploration. Therefore, exploration must be financed through internally generated funds. This implies the following:

• Sophisticated management of cash cycles, which in turn means
  • The coexistence of several well-balanced cash cycles connected to a portfolio of strategically well-related businesses (the sharing); and
  • A sound profitability of the core business along with an exploration activity designed as a portfolio of real options. A high profitability makes the liquidation of the corporation less optimal
• Evaluation of financial performance must not rely solely on profit, since it does not take into account exploration activities. Indeed, the most profitable activities are privileged, even if they do not generate enough cash to support the exploration. It is essential to favor high cash-generating activities that help fund exploration and are a large part of the future value created. The cash flow return on investment (CFROI) takes into account the free cash flows, what is left after financing the development of the present activities; the cash value added (CVA) measures the residual cash, what is left after financing development and remunerating capital employed. Boeing, General Dynamics, and EADS use these criteria to make their strategic choices. These companies must balance exploitation businesses with the exploration of long-cycle, cash-consuming activities.
• A new type of corporate communication with the financial analysts. Today, the financial world demands that unused cash is returned to the shareholders as dividends or share buybacks. It is compulsory to convince the analysts that part of that unused cash must be retained in order to be invested in extremely uncertain activities. The only chance to be credible and backed by the shareholders is to build a capital of trust and confidence based on past and present performance of exploitation and past record as an explorer.

Organizations must be able and willing to accept new ventures and to use resources needed to feed exploration activities, whether human, financial, or otherwise. Because these conditions are seldom met, it is difficult for the incumbent exploitation leaders to be simultaneously good explorers.

Conclusion

The bottom line for executives in a world of constant and rapid change, and of increasing ambiguity and complexity, is a dynamic of the courage, creativity, and flexibility to balance the enhanced risks with the greater rewards if their corporation is to embody the paradoxes of being big yet fast, centralized yet decentralized, global and local, combative and consensual. The awareness and willingness to reinvent the rules will be at the heart of the strategic approaches by successful decision makers.