The time to rethink three widely believed, but outdated management ideas is long overdue.
1. Some industries are structurally unattractive, and destined to generate poor returns
When I started my business career in the late 1970s, Michael Porter had just published “How Competitive Forces Shape Strategy,” still considered one of the pillars of modern business strategy. Porter established “Five Forces”—essentially the underlying market and competitive characteristics of a given industry—to explain why some companies are inherently more profitable than others.
Porter advised managers to seek out businesses with strong bargaining power over buyers and suppliers, low threats of entry from similar or substitute products, and sustainable barriers that inhibit competition. It’s hard to argue against such a prescription; after all, who wouldn’t want to operate in such a favorable environment? In essence, Porter’s Five Forces framework gave credence to the notion that there are inherently “good” and “bad” industries, more or less conducive to attractive financial results.
Following this logic, airlines are often considered to be a bad industry, given the intense price competition, high structural costs and fickle customers that have bedeviled this sector for years. In the first three decades following deregulation, the U.S. airline industry as a whole largely failed to earn its cost of capital, and every major legacy carrier went bankrupt — at least once. Who in their right mind would want to enter such a doomed business? As Richard Branson once quipped, “the easiest way to become a millionaire is to start out as a billionaire and go into the airline business.”
But if the financial performance of companies in structurally challenged industries is destined to suffer, how can one explain that Southwest Airlines’ market cap since 1980 has grown more than four times faster than the S&P 500 and more than 90 times faster than the airline sector as a whole?
If a company’s choice is either to enter a poorly performing industry, playing by the same rules as incumbent market leaders, or to stay out of the business entirely, Michael Porter’s and Richard Branson’s cautionary advice is well taken. But there is a third choice, and that is to recognize that a hidebound industry may be missing an attractive opportunity to address poorly served customers by playing by a very different set of rules.
Southwest Airlines initially focused on passengers who neither valued, nor were willing to pay for the broad range of in-flight amenities traditionally offered by legacy airlines. Southwest built its entire business model around delivering efficient and friendly one-class service that attracted new passengers who found its reliable, frequent, low-price flights highly appealing.
A similar pattern is now playing out in many other industries, where enlightened strategy trumps industry structure in creating opportunities in growth-challenged industries such as general merchandise (Costco), mattresses (Casper), men’s grooming products (Dollar Shave Club) and entertainment (Netflix).
Companies who exploit opportunities to attack sources of widespread customer dissatisfaction and/or high costs are repeatedly proving that there’s no such thing as a bad industry, except of course if you’re an incumbent mired in an outdated business model.
2. The objective of management is to maximize shareholder value.
Perhaps no management principle is preached more dogmatically than that the objective of management should be to maximize shareholder value (MSV).
Proponents of the MSV dogma note that of all the stakeholders in a public corporation, only outside shareholders face the risk of receiving no return on their contributions to the firm, and therefore only they are entitled to profits if and when they materialize. To avoid conflicts between principals and their agents, MSV advocates suggest that firms offer stock-based compensation incentives, making both the principals (shareholders) and their agents (management) share a common goal of maximizing shareholder value.
The theory is fine, but in practice the MSV dogma has led too many executives to seek short-term gains in quarterly earnings per share (EPS) and stock prices with actions that compromise long-term growth and value creation. This is a serious problem and it’s been getting worse.
For example, in a survey conducted by the National Bureau of Economic Research, 80 percent of CFO’s reported that they would cut R&D spending if they felt their company might miss a quarterly earnings forecast. Moreover, over the years 2006-2015, the 459 companies in the S&P 500 index publicly listed over this entire period expended nearly $4 trillion on stock buybacks, representing 54 percent of net income, raising legitimate concerns as to whether too many large enterprises have been under-investing in innovation and corporate capabilities to sustain long-term profitable growth. Allocating corporate capital to buy back shares unquestionably increases a company’s short-term EPS – that’s just math — but there is growing evidence to suggest that excessive stock buybacks undermine long-term growth and value creation.
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