The Real Reasons Companies Are So Focused on the Short Term
Anne Marie Knott

https://hbr.org/2017/12/the-real-reasons-companies-are-so-focused-on-the-short-term


Quite thought provoking.

We have a slight change for our April Driving Org Growth class at Kellogg because of a conflict with Easter Sunday. We will begin the class on Monday, April 2, 2018 and end on Thursday at 4:00PM.

As this will be my last posting this year, I would like to wish all of you the best for the New Year!!

This has been a remarkable year for the markets.  The S&P and the Dow indexes are up 18% and 19%, respectively.  But this run-up isn’t based on solid business foundations.  Quarterly profits have only increased 5% since 2012, but investors’ valuations of those profits (as measured by earnings per share) has increased 59% over the same period. What’s behind the disconnect?  Some argue that profits are stagnant because of short-termism—that decades of focusing on current profits over long-run innovativeness has resulted, now, in companies that are hollowed out. 

Indeed, a study by Rachelle Sampson and Yuan Shi found that company short-termism is negatively correlated with innovativeness, measured as RQ (“research quotient,” a measure of the return on R&D investments). Investors punish companies with a short-term orientation by applying higher discount rates to them, which increases the cost of capital for those companies. In contrast, companies with a long-term orientation are rewarded with a lower cost of capital, which allows them to afford more innovation—a virtuous cycle. 

Most attempts to combat short-termism are flawed because they focus on changing CEO behavior through some combination of pleading and incentives. While well-intentioned, these efforts fail to recognize that CEO behavior is largely circumscribed by firm structure.  In particular, there are three widespread, interrelated structural trends that have fostered short-termism and reduced corporate innovativeness: increased hiring of outside CEOs (particularly from the late 1980s through the 2008 recession); the decentralization of R&D (over a similar time frame); and a focus on the “development” side of R&D rather than the “research” side. Below, I’ll expand further on these trends and explain how reversing them would reduce short-termism and revive growth.
Instead of hiring outside CEOs, hire insiders—or at least CEOs with domain expertise.
One trend that has contributed to short-termism and lower innovativeness is the increased prevalence of outside CEOs.  From 1970 to 2004, the percentage of CEOs hired from outside the firm increased from 12% to 39%. 

While outside CEOs are valued because they bring new perspective, my colleague, Trey Cummings, and I believe they impose a hidden cost to innovation at firms whose growth derives from R&D (roughly 49% of firms).  We came to this conclusion through interviews with CTOs across a range of industries, which we conducted as part of an NSF study to identify factors explaining differences in firms’ RQ.
A recurring theme in those interviews was bemoaning major changes in R&D strategy that occurred as a consequence of new, often outside, leadership.  In these stories, firms shifted from an orientation of “R&D as a driver of growth” to “R&D as an expense.”  What was reported to happen as a consequence of this shift was a steady decline in firms’ R&D intensity (R&D/Sales) and a corresponding decline in firms’ R&D capability. In other words, the new leader’s disinvestment cut meat as well as fat.
While the identity of the interviewed firms is confidential, it is easy to find similar examples from publicly available accounts in other firms. Consider GE during Jack Welch’s tenure, Trimble Navigation under Steve Berglund, or IBM under Lou Gerstner. In all three cases, our analysis shows, there was a decline in R&D investment followed by a decline in the returns on that investment (RQ). 

We also know some details about how R&D strategy changed in these cases:  GE shifted to strategy of divesting businesses in which they were neither number one or two in their markets (televisions, semi-conductors, and aerospace) and expanding into businesses that didn’t rely on R&D (NBC, GE capital); Trimble shifted from a strategy of developing its own technology to one of acquiring other firms for their technology; and IBM shifted to a strategy of reducing R&D while patenting the stock of existing innovation (increasing patents almost 500%).  The shift in patenting policy was not to protect innovations, but rather to license them and/or to use them as chips to gain access to other firms’ technology. 

Why do these shifts occur? We believe, and now have correlative evidence, that it’s because outside CEOs are less likely to possess the technological domain expertise necessary to drive growth from R&D. When CEOs lack this expertise, they are more likely to manage R&D “by the numbers,” despite the fact that those numbers are more elusive than those for capital and advertising.  Indeed, we found that companies with outside CEOs have lower innovativeness as measured by RQ, and that those effects become more pronounced the more R&D intensive the company is and the more technologically different it is from the CEO’s prior company. 

Note the solution is not to avoid outside CEOs. There are many reasons companies benefit from hiring an outsider, such as to effect change.  Moreover, not all outside CEOs lack domain expertise (e.g., CEOs from rival firms); conversely not all inside CEOs have it (CEOs promoted from finance).  Rather, the solution is to ensure that companies whose growth derives from R&D hire CEOs with technological domain expertise.
Instead of decentralizing R&D, recentralize it. 

One of the changes we learned outside CEOs make is decentralizing R&D.  Decentralizing is a natural consequence of managing by numbers because it shifts R&D investment decisions to divisions, where R&D investment can be more readily linked to outcomes.  The problem with giving division managers control of R&D, is that their compensation is typically based on division profits (which they largely control), rather than on the company’s market value (over which they have little control). 

The distinction between current profits and market value is important because market value takes into account future profits, so in principle it captures the long-run returns to R&D.  In contrast, current profits penalize R&D, because accounting rules require R&D to be expensed.  This means all R&D is subtracted from operating income in the year it’s expended, while the payoffs to R&D don’t occur until future periods. Thus the further out the fruits of R&D, the less likely operating divisions are to conduct it. 

My research indicates that companies in which R&D is decentralized have 40 to 65% lower RQ than companies with centralized R&D.  This means they generate less revenue, profit and market value per dollar of R&D.  Perhaps more problematically, a study by Nick Argyres and Brian Silverman found that decentralized R&D produces innovations that have a smaller and narrower impact on subsequent innovation.   

Instead of over-focusing on “development,” shift the portfolio back toward “research.”
The logic underlying the push for decentralization and greater relevance of R&D is that R&D directed by divisions will be more responsive to what the customer wants. While responding to the customer sounds completely unobjectionable, its vulnerability is best captured in the Steve Jobs quote, “A lot of times, people don’t know what they want until you show it to them.” 

When R&D is directed by divisions, the company fails to invest in the early stage technologies that open up new opportunity. Again, this occurs because division manager compensation is tied to division profits. So in addition to causing R&D to disproportionately favor development rather than research, it also causes R&D to be parochial to the funding division.  This is because there is little incentive to conduct R&D that benefits multiple divisions. 

A real-world illustration of this parochialism comes from the “Organization 2005” initiative at Procter and Gamble (P&G).  The initiative decentralized R&D in an effort to make the big company “feel small” (e.g., to provide greater managerial control and break bureaucratic inertia), as well as to more closely fit the needs of customers.
The result was a dramatic shift at P&G from 90% centralized control of R&D in the 1990s to 90% decentralized control of R&D by 2008. In the words of then-R&D chief Bruce Brown, making business-unit heads responsible for developing new items inadvertently slowed innovation by more closely tying research spending to immediate profit concerns.  Relatedly it led to smaller, more incremental innovation.  While the number of innovations doubled, the revenue per innovation decreased 50%.
One reason revenue per innovation decreased is that early stage research dwindled.  Prior to the decentralization, P&G was known for creating entirely new product categories: first synthetic detergent (Dreft in 1933), first fluoride toothpaste (Crest 1955), and more recently: Febreeze odor fresheners (1998), Swiffer (1999) and Crest Whitestrips (2001). Following the decentralization, and the shift away from research, P&G failed to introduce a single blockbuster. 

This is not a surprise.  In a study with my colleague, Carl Vieregger, we found that across the five most common configurations of R&D allocation, the configuration with the highest RQ allocates twice as much of its total R&D investment to basic and applied research than does the average company. 

While a long horizon is necessary for innovation and growth of companies (as well as the economy), a call to resist the forces of short-termism is unlikely to yield results.  This is because short-termism is now built into company structure, due to the rise in outside CEOs, a trend toward decentralized R&D, and a move away from basic research.  Each of these trends on its own is associated with lower RQ.  Moreover the trends are interrelated: Outside CEOs tend to decentralize R&D, and decentralization tends to decrease basic research. 

But fortunately, these trends can be reversed.  Boards in firms whose growth derives from R&D can begin taking domain expertise into account when hiring CEOs. Further, firms can begin recentralizing R&D, and increasing the levels of basic and applied research.  Prudently applying these prescriptions should increase a company’s RQ, and accordingly its revenues, profits, and market value from R&D.  This will generate fundamental growth of firms, rather than merely growth in their valuations.

The Fallacy of The Next Big Thing

https://medium.com/@kumarmehta_16246/the-fallacy-of-the-next-big-thing-2db25e969f58

I thought this was pretty interesting.

Just want to announce that our next Org Growth class at Kellogg is scheduled for April 2 to the 6th. In case you were unaware, the class was extended for a full day which enabled us to add two additional, critical discussions-- how to most effectively build the new Capability Platform from acquisitions to alliances AND a more in depth discussion on on decision biases that are critical to understand in any process or endeavor. The ratings are through the roof for the program.

Every company is continually looking for the next big thing. I can’t count the number of times I have heard executives say something along the lines of “I want to know what’s going to be the next iPhone before it becomes the next iPhone.” Corporations are looking for someone to tell them what trends and products are going to be the big hits. Once they know what the next big thing is (ideally, before everyone else knows about it), they can invest early, create a dominant presence, and reap the rewards. Simple.
Unfortunately, it does not work that way. While my research on innovation has revealed some distinct factors necessary to create breakthrough offerings, it also highlighted some of the misconceptions and fallacies that impede corporations as they try to become more innovative. One of the prime misconceptions in the corporate world today is that companies must continually quest for the next big thing. 

There are three problems with looking for the next big thing. They are, in order, (1) next, (2) big, and (3) thing.
NextRarely do innovations and trends take the world by surprise. One of the consistent themes in the history of innovation is the concept of slow burn, or a slow evolution. Most industry trends are visible and provide clues about the next breakthrough. …Most innovations in history have had a slow evolution process. Things move slowly, but not because they have to; rather, it is because people often don’t see the value in what is being developed and don’t adopt the innovations…..In the technology industry, where I spent the majority of my career, the trends have always been clear. They were the PC, the Internet, mobile devices, the smartphone, and the cloud. Today the trends include AI, machine learning, and other developments. The innovators were the ones who rode these trends to create fantastic products that customers embraced. They created business models that produced gravity-defying profits, and ecosystems that built a generation of entry barriers. Microsoft did not create the first computer operating system. Google did not create the first search engine. Facebook did not create the first social platform. Apple did not create the first portable music player or the first smartphone. None of these trends were a secret; they were available to everyone to build societal value. None of these companies were first to market; instead they did it better or engaged their users in better ways..BigThe second fallacy of the continual search for the next big thing is “big.” Looking at the history of innovations, rarely does something become big right from the start, and rarely does the innovator know that what they are developing is going to change the world. Few world-changing innovations started with a view to change the world. Few billion-dollar businesses started with a view to earn a billion dollars. The one thing they had in common was that they altered customer experience through a unique approach and, in the process, created an immense amount of value for their users.As we know now, Google became big — very big. The “big” happened not by executing a plan to build a world-changing company but by providing a big improvement to the experience of users — a large experience delta, the difference between the current experience and the new one. The business model (based on advertising revenues) that created over half a trillion dollars of market value was not part of a grand plan, but as the company increased its value to society, society figured out a way to reward the company…..…In looking for the next billion-dollar opportunity, corporations spend countless hours doing strategic planning and modeling how their new initiatives will generate massive financial returns... .l. These plans rarely focus on customer experiences, because these are nebulous, or on products that inspire customers on a small scale, because although these small changes might add up to enormous changes for society as a whole, they don’t visibly move the corporate needle…..Worse yet, inspiring ideas and innovations that could be breakthroughs often get shoved aside (like the first digital camera developed at Kodak) because they don’t fit with the existing business model or have a billion-dollar plan…...So keep in mind that the big opportunity you are chasing may actually appear as something quite small. The key is to learn to recognize the opportunities that alter experiences and to understand and articulate how these customer experiences are transformed. Once you can do this, even at a small scale, the chances are high you’ll find the right opportunities that will evolve into the big game changers we are all looking for.ThingThe third flaw in the relentless search for the next big thing is the “thing.” My research has shown that there are two main problems with this. The first is that an innovation is often not a physical thing — a product. The second misleading aspect of “thing” is that the value of the innovation is often not in the thing that is being developed; the real value is in how an invention is supported — something I call the “thing behind the thing.” Let me explain both of these misconceptions.The thing is not a thing..…..companies have always enjoyed unparalleled success not by selling things but by providing value in other ways. Innovation can come in many forms, and even if you are a product company, it would be wise not to think about innovation as solely the creation of new products.
The thing behind the thingThe second issue with focusing on the thing is that the invention we think of as being the innovation is often not the main creation — it is something else. Sometimes, the key to the success of an innovation is an entire system of supporting developments. These supporting developments are the thing behind the thing, essential elements without which there wouldn’t be an innovation. For example, everybody thinks of the wheel as one of the greatest inventions of all time, enabling the first information and commerce highway in history. When you study the invention of the wheel, you learn that creating the wheel was the easy part; the hard part was connecting it to a stable platform. The true innovation was in the development of the axle, and it was the combination of the wheel and the axle that allowed the wheel to have a transformative effect on society. The axle was the thing behind the thing…..How to think about innovation in light of the next-big-thing fallacy…..Given the fallacies about the next big thing, your company should take a new approach when thinking about innovation. To start with, you need to have a deep-seated understanding of the trends in your business and of new developments that are being worked on within your own organization, other companies in your sector, and other sectors.. .…You will also need to experiment more and increase the number of new bets you make. Your rate of success will increase once you have a culture of innovation — when launching new offerings to customers is part of your company’s DNA. Not all the new bets will have breakthrough success, but if you get in the habit of launching offerings geared toward transforming customer experiences, the rate of innovation will increase.Finally, don’t think about new product introduction as the only way to innovate. Think about all the other forces that can make your product more successful. Think of the things behind the thing. Think of ancillary benefits that can provide insanely high customer value and make an existing product irresistible. .

How Coca-Cola, Netflix, and Amazon Learn from Failure
Bill Taylor
NOVEMBER 10, 2017

https://hbr.org/2017/11/how-coca-cola-netflix-and-amazon-learn-from-failure

Thoughts on failure well captured

Why, all of a sudden, are so many successful business leaders urging their companies and colleagues to make more mistakes and embrace more failures? 

In May, right after he became CEO of Coca-Cola Co., James Quincey called upon rank-and-file managers to get beyond the fear of failure that had dogged the company since the “New Coke” fiasco of so many years ago. “If we’re not making mistakes,” he insisted, “we’re not trying hard enough.” 

In June, even as his company was enjoying unparalleled success with its subscribers, Netflix CEO Reed Hastings worried that his fabulously valuable streaming service had too many hit shows and was canceling too few new shows. “Our hit ratio is too high right now,” he told a technology conference. “We have to take more risk…to try more crazy things…we should have a higher cancel rate overall.” 

Even Amazon CEO Jeff Bezos, arguably the most successful entrepreneur in the world, makes the case as directly as he can that his company’s growth and innovation is built on its failures. “If you’re going to take bold bets, they’re going to be experiments,” he explained shortly after Amazon bought Whole Foods. “And if they’re experiments, you don’t know ahead of time if they’re going to work. Experiments are by their very nature prone to failure. But a few big successes compensate for dozens and dozens of things that didn’t work.” 

The message from these CEOs is as easy to understand as it is hard for most of us to put into practice. I can’t tell you how many business leaders I meet, how many organizations I visit, that espouse the virtues of innovation and creativity. Yet so many of these same leaders and organizations live in fear of mistakes, missteps, and disappointments — which is why they have so little innovation and creativity. If you’re not prepared to fail, you’re not prepared to learn. And unless people and organizations manage to keep learning as fast as the world is changing, they’ll never keep growing and evolving. 

So what’s the right way to be wrong? Are there techniques that allow organizations and individuals to embrace the necessary connection between small failures and big successes? Smith College, the all-women’s school in western Massachusetts, has created a program called “Failing Well” to teach its students what all of us could stand to learn. “What we’re trying to teach is that failure is not a bug of learning it’s the feature,” explained Rachel Simmons, who runs the initiative, in a recent New York Times article. Indeed, when students enroll in her program, they receive a Certificate of Failure that declares they are “hereby authorized to screw up, bomb, or fail” at a relationship, a project, a test, or any other initiative that seems hugely important and “still be a totally worthy, utterly excellent human being.” Students who are prepared to handle failure are less fragile and more daring than those who expect perfection and flawless performance. 

That’s a lesson worth applying to business as well. Patrick Doyle, CEO of Domino’s Pizza since 2010, has had one of the most successful seven-year runs of any business leader in any field. But all of his company’s triumphs, he insists, are based on its willingness to face up to the likelihood of mistakes and missteps. In a presentation to other CEOs, Doyle described two great challenges that stand in the way of companies and individuals being more honest about failure. The first challenge, he says, is what he calls “omission bias” — the reality that most people with a new idea choose not to pursue the idea because if they try something and it doesn’t work, the setback might damage their career. The second challenge is to overcome what he calls “loss aversion” — the tendency for people to play not to lose rather than play to win, because for most of us, “The pain of loss is double the pleasure of winning.” 

Creating “the permission to fail is energizing,” Doyle explains, and a necessary condition for success — which is why he titled his presentation, with apologies to the movie Apollo 13, “Failure Is an Option.” And that may be the most important lesson of all. Just ask Reed Hastings, Jeff Bezos, or the new CEO of Coca-Cola: There is no learning without failing, there are no successes without setbacks.