Intelligent Growth: Why Failure Breeds Winners
Companies that consistently grow sales and improve margin across business cycles create much greater shareholder value than those companies that achieve just sales growth or margin expansion alone. Less than 10% of companies have managed this balancing act over the past 13 years, and their senior executives all share one thing in common: they spend as much time thinking about failure as victory.
In late 2009 the Corporate Executive Board's Finance and Strategy Practice began an experiment at the request of our clients. From previous research we knew that the very best cost-cutters sacrifice sales growth for cost excellence (as much as 3.6% sales CAGR); and we knew that uninhibited sales growth could lead to an unwieldy cost base. What we didn't know was whether it was possible to have the best of both worlds and, if so, it was even worth attempting. We started our investigation with a dataset of more than 1,500 of the world's largest corporations. First, we identified companies that had performed above the industry median in both EBITDA margin and sales CAGR between 1995 and 2008. Second, we isolated the companies that had grown margin and sales simultaneously for more than half the test period. This left us with just 143 elite companies. The research team conducted interviews with the finance and strategy teams at these companies to discover the "shareable code"—if any—that other executives could use in their own organizations.
The good news: none of these companies invented the iPad or paid search. While it is clear that breakthrough innovation typified by Apple or Google can pave the way to sustained, outstanding returns, it is important to note that many companies generate consistent patterns of outperformance by excellence in core management disciplines.
The best news: Companies that are able to consistently grow sales and improve margin across multiple business cycles realize a 4.4% compound total shareholder return (TSR) advantage relative to industry returns over pure growth leaders, and a 5.4% compound TSR advantage over pure margin leaders.
These progressive leadership teams target what we have come to call "Intelligent Growth"(IG)—their goal is to engineer patterns of performance that allow them to avoid distracting cycles of over- (or under-) expansion. We refer to this set of behaviors collectively as "cycle discipline".
Cycle discipline is intuitive but difficult to recreate in a large, complex corporation. Less than 10% of the companies we examined exhibited this kind of financial savvy for more than a few consecutive years at a time. Cycle discipline requires executives to take measures in the current economic phase that set the company up for success in the next economic phase. For example, while most companies are doubling down on growth bets in stable growth and peak scenarios, IG executives are focused on financial discipline: keeping the cost of goods sold lower than peers, and strengthening their balance sheets. However, the real TSR advantage accrues at economic turning points—in the peak and trough scenarios. At the peak, Intelligent Growth companies are more likely to divest underperforming assets and less likely to take on large investments. In the trough—like the post-recessionary scenario we are currently in—Intelligent Growth companies are bold, and make bigger growth investments sooner than peers and sustain this behavior into the early years of the recovery.
Why Failure Matters
At first glance, you may suspect that the Intelligent Growth framework provides contradictory guidance: it advocates for "discipline" and "boldness." In fact, though, one cannot responsibly exist without the other. For example, to act boldly as the economy recovers requires the company to act with discipline during the market's peak, divesting underperforming assets (at relatively high prices) and bolstering the balance sheet.
Just as important—maybe more so—is how Intelligent Growth executives combine boldness and discipline at the outset of initial investment decisions. First, they define failure upfront. So, let's assume one of my criteria for making an investment is the cross-sell potential of a product. Before I make that investment I describe the volume of cross-sell that would cause me to raise a white flag and say: "We failed." Not only do I feel more comfortable that I can track that project's progress over time and make corrections if necessary; but I feel emboldened making the decision because I know we'll pull the plug and free up capital for other investments if we fail.
Second, Intelligent Growth executives maintain longer residual control over capital investments (mid-cycle, post completion reviews) because they make a point of closing the "learning loop" in the investment process. In other words, they openly investigate how good they are at picking investments, and why failure occurs. This reduces investment regret and gives decision makers confidence. In this way, good discipline around monitoring investments for failures enables bolder bets.
Below is a summary of the investment management guidance we are providing to senior finance and strategy executives at the moment based on our Intelligent Growth work.
Lessons in Failure from Intelligent Growth Executives
(1) Define what failure looks like for growth investments—specify when and why disinvestment should occur. Then stick to the plan.
(2) Upgrade your growth investment process by shifting analytical resources away from up-front screening toward life-cycle analysis. Create a "learning loop" for management by dedicating staff to mid-cycle and post-completion project evaluations.
In these ways, "discipline" and "boldness" become different sides of the same coin. Finance and the CFO are enablers of great growth plans, playing defensively at the market's peak so that the company can go on the offensive in the post-recession environment.
Intelligent Growth is a central theme of the Corporate Executive Board's 2011 Executive Guidance series. Go to www.exbd.com/2011 to learn more.
Editor's Note: CEB authors of this article were Scott Bohannon, general manager of the finance & strategy practice at the Corporate Executive Board, and Tim Raiswell, a senior research director in the practice.
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