HIDDEN FLAWS IN STRATEGY

1. HIDDEN FLAWS IN STRATEGY PRESENTED AT CENTRAL INDIANA RESOURCE FAIR July 17, 2012 John T Thompson Thompson Distribution/First Electric Supply Source: McKinsey & Co.

2. STRATEGY BASICS GROWTH… …WITH COST CONTROL If you are a contractor that can’t afford a buyer, work closely with a supply house to be your complete supply chain. Form an alliance with an engineering firm to perform invoicing and manage payroll until you can afford to hire staff. Retain an outside bookkeeping/accounting service to prepare monthly financials. However, in order to serve your customer, you must be able to perform these services accurately and efficiently. These back office functions are as important as the construction services. Once you have mastered the basics, how do you differentiate your business from competitors? To surpass them and win! I contend that it is exploiting some change in your environment-in technology, consumer tastes, laws, resource prices, or competitive behavior! Giving of time, talent and treasure should be a part of your strategy from inception. • Given your understanding of customer preferences and needs you develop a strategy to beat your competitors through the gate and win! • A place for SWOT and budgeting • Most strategy is developed ad hoc • For most mwbe firms investing in talent is a key priority to be executed within a carefully controlled budget. • People, plant , equipment and systems. • Mergers, acquisitions and divestitures • Strategic alliances can fill the gap • You can eliminate the middleman but not the function…

3. OVERCONFIDENCE • We tend to be overconfident of our own abilities. This is a particular problem for strategies based on assessments of core capabilities. Almost all businesses believe their brands to be of above average value. • In a 1981 survey, 90% of Swedes described themselves as above average drivers.

4. OVERCONFIDENCE • Combined with overoptimism causes us to be overly optimistic. I’m sure that we can sell the inventory so we purchase without a solid exit plan. • Not pessimistic enough-to compensate for this flaw, reduce your worst case estimate by 25-30%. Also instead of using an odd number of scenarios, use an even number to prevent defaulting to the middle.

5. OVERCONFIDENCE • Build more flexibility and options into your strategy to allow the company to scale up or retrench as uncertainties are resolved. Be skeptical of strategies premised on certainty. • Small business owners took too long to retrench as the recession deepened. We cut expenses 6-18 months too late because of our optimism. • Bad decision-don’t return the inventory and pay the 30% restock fee. • Bad strategy-don’t close the newly opened Louisville office because things will improve. • Bad idea-don’t lien the project, we’ll pay you next month. Of course, your lien rights will expire by then.

6. MENTAL ACCOUNTING • Gamblers who lose their winnings, for example, feel that they have not lost anything, though they would have been richer had they stopped while ahead. • Imposing cost caps on a core business while spending freely on a start up. “You got to spend money to make money” is simply not true. • Make sure that all investments are judged on consistent criteria, and be wary of spending that has been reclassified to make it acceptable. • Be particularly skeptical of any investment labeled strategic. • Treat each dollar the same-eg, as a scarce and precious thing.

7. THE STATUS QUO BIAS • Adopt a radical view of all portfolio decisions. View all businesses as “up for sale.” Is the company the natural parent, capable of extracting the most value from a subsidiary? View divestment not as a failure but as a healthy renewal of the corporate portfolio. Sell your idle equipment. • Liquidity can be a savior in tough times-”CASH IS KING”. • Subject status quo options to a risk analysis as rigorous as change options receive. Most strategists are good at identifying the risks of new strategies but less good at seeing the risks of failing to change. Applies to business as well as personal investments –eg, 401k.

8. ANCHORING • Anchoring can be a powerful tool for strategists. In negotiations, naming a high sale price for a business can help secure an attractive outcome for the seller, as the buyer’s offer will be anchored around that figure. • In the insurance industry, changes in interest rates have caused major problems due to anchoring. Imagine an insurance company that in 2007, assuming that high nominal interest rates would prevail for decades, sold guaranteed annuities accordingly. That assumption has had severe financial consequences for such companies and its policyholders. • The banking industry may now be entering a period of much higher credit losses than it experienced prior to 2008. Hopefully they stress tested for severe credit losses.

9. THE SUNK COST EFFECT • Apply the full rigor of investment analysis to incremental investments, looking only at incremental prospective costs and revenues. This is the textbook response to the sunk-cost fallacy, and it is right. Close that branch office if the outlook dims, don’t say we’ve invested 60% of the plan so we should complete…No NoNo. • Be prepared to kill strategic experiments early. In an increasingly uncertain world, companies will often pursue several strategic options. Successfully managing a portfolio of them entails jettisoning the losers. The more quickly you get out, the lower the sunk costs and the easier the exit. • Use “gated funding” for strategic investments, much as pharmaceutical companies do for drug development: release follow-on funding only once strategic experiments have met previously agreed targets.

10. THE HERDING INSTINCT • Yet the best strategies break away from the trend. Some actions may be necessary to match the competition-imagine a bank without ATM’s or a good on-line banking offer. But these are not unique sources of strategic advantage, and finding such sources is what strategy is all about. “Me-too” strategies are often simply bad ones.

11. MISESTIMATING FUTURE HEDONIC STATES • An illustration of our poor ability to judge future hedonic states in the business world is the way we deal with a loss of independence. • As we make more and more money it does not make us any happier.

12. MISESTIMATING FUTURE HEDONICSTATES • People are bad at estimating how much pleasure or pain they will feel if their circumstances change dramatically. People adjust surprisingly quickly, and their level of pleasure (hedonic state) ends up, broadly, where it was before. • In takeovers, adopt a dispassionate and unemotional view. Easier said than done-especially for a management team with years of committed service to an institution and a personal stake in the status quo. Nonexecutives, however, should find it easier to maintain a detached view. • A new buyer replacing your best “bud "doesn't mean a lost of contracts • Keep things in perspective. Don’t overreact to apparently deadly strategic threats or get too excited by good news.

13. FALSE CONSENSUS • Confirmation bias, the tendency to seek out opinions and facts that support our own beliefs and hypotheses • Selective recall, the habit of remembering only facts and experiences that reinforce our assumptions • Biased evaluation, the quick acceptance of evidence that supports our hypotheses, while contradictory evidence is subjected to rigorous evaluation and almost certain rejection; we often, for example, impute hostile motives to critics or question their competence • Groupthink, the pressure to agree with others in team-based cultures • Sarbanes Oxley is in place to eliminate group think in board rooms, in favor of deeper dialogue on important issues.

14. IN SUMMARY • I revisit these flaws when making big dollar decisions. • Overconfidence and overoptimism has cost me significant money. • Which flaw has cost you dearly?