Understanding the Real Drivers of Corporate Success

Trends Magazine

The goal of every senior manager is to lead a company that outperforms its peers.  Similarly, every investor wants to buy shares in a business that will perform better than its competition.  This quest for the secrets of high performance explains the enduring popularity of such classic business best sellers as In Search of Excellence and Built to Last.

In the 1982 book In Search of Excellence,¹ McKinsey consultants Tom Peters and Robert H. Waterman, Jr. presented the eight attributes of what they called America's "best-run companies."  Those eight characteristics are as follows:

 

1. A bias for action
2. Close to the customer
3. Autonomy and entrepreneurship
4. Productivity through people
5. Hands-on, value-driven
6. Stick to the knitting, (focus on the core business)
7. Simple form, lean staff
8. Simultaneous "loose / tight" properties

In Built to Last,^2,3 Jim Collins and Jerry Porras analyzed the results of a six-year research project at the Stanford University Graduate School of Business and compared 18 "truly exceptional and long-lasting companies" to close competitors that outperformed the market but were not nearly as successful.  What set those 18 "built to last" firms apart, according to Collins and Porras, were as follows:

 

1. Clock building, not time telling (creating a lasting company rather than being guided by a single idea or leader)
2. More than profits (focusing on core ideologies)
3. Preserve the core/stimulate progress
4. Big hairy audacious goals
5. Cult-like cultures
6. Try a lot of stuff and keep what works
7. Home grown management
8. Good enough never is

However, while those books were widely influential, several of the companies the authors based their formulas upon have not fared as well. 

In fact, according to Beyond Performance:  How Great Organizations Build Ultimate Competitive Advantage,⁴ a 2011 book by McKinsey consultants Scott Keller and Colin Price, "It's revealing to look at what has become of the ‘excellent' companies lauded in the pages of In Search of Excellence and Built to Last:  By 2006—well before the recent financial crisis—20 percent no longer existed, 46 percent were struggling, and only 33 percent remained high performers."

With all that in mind, it's clear that the effectiveness of any formula for business success can only be judged after a couple of decades have passed.  Too often, the shared principles of winning companies are credited for those firms' past success, but there is no guarantee that those principles will lead to success in the future.

Despite that shortcoming, however, a new team of McKinsey consultants has created yet another approach to distilling the ingredients of corporate success into a simple formula for picking winners in any industry.  Instead of a list of attributes, however, the new approach offers broad conclusions about how the best companies achieve superior performance.

Chris Bradley, Angus Dawson, and Sven Smit presented their findings in a recent McKinsey Quarterly article called "The Strategic Yardstick You Can't Afford to Ignore."⁵  As they explained, they conducted a large-scale analysis of economic profit for nearly 3,000 large non-financial companies in McKinsey's proprietary corporate-performance database.  As a result, they were able to "distill generalizable lessons about what it takes to win consistently."

Bradley and his colleagues evaluated the effectiveness of corporate strategies by assessing the resulting economic profit (EP).  EP is a measure of net operating profit minus the cost of capital.

Based on their analysis of economic profit, they came to eight conclusions:

The first conclusion is that not all companies are created equally.  When the 3,000 companies in the study were divided into five groups, or quintiles, by economic profit based on 2011 revenues, the 60 percent of companies in the middle three quintiles were found to create slightly more than $29 billion in EP.  That's about $17 million each, which is only 10 percent of the total EP.

By contrast, the companies in the top quintile generated $677 billion.  That means that each firm in the top quintile created about 70 times more economic profit than firms in the middle created.  Meanwhile, in the bottom quintile, companies destroyed almost $411 billion in EP.

The second conclusion is that size matters.  The companies that create the most economic profit, as well as the firms that destroy the most, are those that generate the largest revenues.

However, there are actually four parts of economic profit: 

 

1. Revenues
2. Margins
3. Asset turns
4. The tangible-capital ratio (TCR)

There's no need to define revenues and margins.  Asset turns refers to the ability to generate revenue from a certain volume of assets.  TCR is the ratio of physical to total capital.

Bradley and his colleagues discovered that every company has what they call a "fingerprint" that suggests its value-creation formula based on these four drivers.

Companies in the top quintile enjoy high margins.  Those in the bottom quintile suffer from low asset turns.  Surprisingly, the top companies have the worst TCR, while the bottom companies have the best TCR.

The third conclusion is that wealth stays at the top.  Over time, market performance tends to regress to the mean.  Bradley's team divided companies into cohorts based on the performance of companies in 1997. 

The first cohort represented the top quintile; the second cohort the middle three quintiles; and the third cohort the bottom quintile.  Then they tracked the cohorts' performance until 2001 to see how long the differences between them endured.

When the cohorts' performance was measured by the valuation multiple—enterprise value divided by earnings—the cohorts quickly converged so that the wide differences that existed in 1997 completely disappeared in 2001.  When they were measured by returns on invested capital (ROIC), the cohorts converged so that about half the differences vanished. 

In both cases, it's clear that the companies earning the highest economic profit were quickly imitated by competitors, which caused them to lose all or some of their competitive advantage, while the low EP performers caught up.

However, when a third measure—economic profit—was used, there was hardly any change in the results over time.  The best-performing companies continued to outshine the weakest performers.

The explanation for this phenomenon leads to the fourth conclusion:  Companies with the most economic profit attract the most capital.  Even as returns on invested capital converge across all the quintiles over time, the firms in the top quintile stay ahead by attracting more investment than the companies in the lower quintiles do.  During the study period 1997-2001, the top-quintile firms were able to invest 2.6 times more fresh capital than the companies in the bottom quintiles invested over the following decade.

The fifth conclusion is that it isn't easy to stay at the top.  When the 3,000 companies in the study were re-ranked a decade later, almost half of the companies in the top quintile had slipped from the top rung, and about 12 percent plunged to the bottom. 

About 79 percent of companies in the middle were still in the middle 10 years later.  Only 11 percent made the jump from the middle to the top.  On average, they increased revenues by 21 percent and ROIC by 18 percent.  How did they do it?

This brings us to the sixth conclusion:  Rising companies are lifted by larger trends.  About 90 percent of the 37 companies that went from the middle to the top are members of industries in which the overall EP soared during the decade.  For example, the average EP in the wireless-telecommunications-services industry in 1997 to 2001 ranked 112^th out of 128 industries in the study.  However, a decade later, the industry ranked 10^th, having climbed more than 100 places.  Unsurprisingly, two companies in that industry rose to the top quintile.

Similarly, five companies in the diversified metals and mining industry went from the middle to the top with the help of that industry's momentum, as it improved 96 places in EP.

Not all the improvements were that dramatic, but the 37 companies that rose to the top competed in industries that, on average, moved 39 places higher in EP.  In fact, 75 percent of the improved EP of the 37 companies can be attributed to positive changes in their markets or industries.

What this means is that the best hope for companies mired in the middle quintiles is to ride the wave of a rapidly improving industry.

The seventh conclusion is that it is better for a company to be in a "good" industry, where companies are three times more likely to create above-average economic profit.

When industries are ranked according to EP, the top five are:

 

• Diversified metals and mining
• Wireless telecom services
• Pharmaceuticals
• Integrated oil and gas
• Communications equipment

The bottom five industries in generating economic profit are:

 

• Electric utilities
• Airlines
• Multi-utilities
• Independent power producers and energy traders
• Railroads

Finally, the eighth conclusion is that, on average, 40 percent of a company's economic profit is determined by the industry in which it competes.

There are three layers of a company's EP:

 

1. The market's average EP.
2. The industry effect, which is the difference between the average EP of the company's industry peers and the market average.
3. The company effect, which is the difference between the company's EP and the industry-average EP.

The industry effect averages 52 percent in the middle quintiles.  In the top quintile, it contributes only 33 percent, and in the bottom quintile it accounts for 38 percent.  

Based on this trend, please consider the following forecasts:

First, companies in the upper quintile must be vigilant for signs that their competitive advantage is eroding. 

Businesses at the top are blessed with the unique ability to attract capital.  Even as competitors close the gap on returns on invested capital by imitating their products and services, firms in the top 20 percent are able to get the capital they need to stay ahead of the curve—if they continue to innovate.  Unfortunately, history shows that nearly half of companies will not heed this advice, and they will drop into the middle or bottom quintiles.

Second, companies in the middle quintiles must strive to get to the top. 

It's much easier if your business is in a fast-growing industry that is generating market-beating economic profit.  Failing that, companies in the middle must rethink their strategies, as outlined in an article by Chris Bradley, Angus Dawson, and Antoine Montard in McKinsey Quarterlycalled "Mastering the Building Blocks of Strategy."⁶  As they explain, the five building blocks are as follows:

 

1. Diagnose:  evaluate how the firm currently creates or destroys value.
2. Forecast:  create a vision of how the future may unfold.
3. Search:  explore several possible ways to win in the envisioned future.
4. Choose:  select one of those alternatives as the strategy to embrace.
5. Commit:  design an action plan and allocate the resources to it so it can succeed. 

Third, companies in the bottom quintile must accept the reality that achieving growth with a losing strategy just means they are destroying economic profit on a larger scale.  

For the short term, the best approach is to try to improve ROIC, which usually means improving asset turns.  Ultimately, however, firms at the bottom need to develop a new strategy to generate more economic profit.

Resource List:

 

1. In Search of Excellence: Lessons from America’s Best-Run Companies by Thomas J. Peters and Robert H. Waterman, Jr. is published by HarperCollins Publishers, Inc.  © 2004, 1982 by Thomas J. Peters and Robert H. Waterman, Jr.  All rights reserved.
2. Built to Last: Successful Habits of Visionary Companies by Jim C. Collins and Jerry I. Porras is published by HarperCollins Publishers, Inc.  © 1994, 1997 by Jim C. Collins and Jerry I. Porras.  All rights reserved.
3. A summary of “Built to Last” in digital or CD format is available from AudioTech Inc.  © 1996 by AudioTech Business Book Summaries.  All rights reserved.          
   http://www.audiotech.com/business-summaries/built-to-last-successful-habits-of-visionary-companies
4. Beyond Performance: How Great Organizations Build Ultimate Competitive Advantage by Scott Keller and Colin Price is published by John Wiley & Sons, Inc.  © 2011 by McKinsey & Company.  All rights reserved.
5. McKinsey Quarterly, October 2013, “The Strategic Yardstick You Can’t Afford to Ignore,” by Chris Bradley, Angus Dawson, and Sven Smit.  © 2013 by McKinsey & Company.  All rights reserved.            
   http://www.mckinsey.com/insights/strategy/the_strategic_yardstick_you_cant_afford_to_ignore
6. McKinsey Quarterly, October 2013, “Mastering the Building Blocks of Strategy,” by Chris Bradley, Angus Dawson, and Antoine Montard.  © 2013 by McKinsey & Company.  All rights reserved.     
   http://www.mckinsey.com/insights/strategy/mastering_the_building_blocks_of_strategy