5 Things I Learned About the Science of Strategy From "Profit Beyond the Hockey Stick"

Five Things is a series of thoughts on the art and science of finance, analytics, and corporate development, with occasional forays into leadership, communication, and other topics for the well-rounded, professional

I recently read the book Strategy Beyond the Hockey Stick by McKinsey consultants and authors Sven Smit, Martin Hirt and Chris Bradley. I’ve got to admit that the title really grabbed me. Here in Minnesota we take our hockey sticks very seriously. As a finance and M&A professional I have had many occasions to review (and even prepare) “hockey stick” plans for various projects, acquisitions, and investments, and many a time I have looked at a 5-year-old plan that hasn’t quite lived up hockey-stick aspirations. You know the one:

But the beauty of this book for me is not so much in lamenting the foibles of management teams creating “hockey stick” strategies that often don't pan out, but in the scientific horsepower that was put to bear on the strategy process by the authors and their team of analysts to drive insights into what strategies actually work over the long term.

So here are the 5 things I gleaned from the science behind Strategy Beyond the Hockey Stick:

1.   The crazy things we do in the strategic planning process are based on the way our brains work

The authors make the point that the strategy process is exactly the kind of problem our brains are least adapted to handle. The problems involve long time frames, a large amount of uncertainty, and are encountered at low frequency.

As such, behavioral economics takes over, and we see things like refusing to acknowledge that our competitors are just as smart as we are (halo effect), relying on data that confirms our position while ignoring data that refutes our position (confirmation bias), and allocating capital based on “we’ve done it before, we will do it again” rather than the real merits of the project (champion bias).

Then throw incentives and group dynamics into the mix and behavior becomes even more psychologically interesting - sandbagging, short time horizons, and other dysfunction.

Much has been written about how the prudent investor can succeed by fighting against these bias and effects (most notably Warren Buffet's advice - "be fearful when others are greedy, be greedy when others are fearful"). In setting our strategy, can fighting against the way our brains are wired reap outsized benefits?

2. We can predict the odds of success or failure of firms over a medium-term time horizon based on a select set of attributes

I’ve always loved the great, classic “case study” books like Built to Last and Good to Great – all searching for the common characteristics of “great” companies. But, the math nerd in me was always searching for something more in terms of analytical framework that uses harder data to draw harder inferences on which companies will likely achieve this greatness.

I think the authors and their team have made great strides here in creating a model based on objective data, isolating just 10 variables that predict which companies will be able to escape mediocrity and significantly outperform their peers.

3. Happiness is choosing the right yardstick

In building this predictive model, the authors did not take the task of choosing the definition of success (the “yardstick”) lightly. From my perspective, they nailed it by choosing economic profit. Economic profit is basically earnings minus a charge for the use of capital – it is unreported, unaudited, rarely used, a “dinosaur metric from the 90’s,” and absolutely the best way to measure a firm’s return to shareholders in my opinion.

When plotting firms against one another, the team found some really interesting dynamics. Of the 2,000+ largest non-financial firms, the average annual Net Operating Profit was about $900 million, but after paying capital charges the average Economic Profit was $180 million, made up of:

·     Bottom-quintile (20%) companies on average losing about $700 million per year in economic profit

·     The middle three quintiles making, on average, only about $50 million per year

·     The top quintile exhibiting the slippery side of the exponential curve, driving an average of over $1 billion in annual economic profit and representing 90% of the entire economic profit earned by this group of companies.  

The authors rightly define a successful strategy as one that moves a company or keeps a company in that very lucrative top quintile over the long term. See this article for a deeper dive into the dynamics of this "power curve of economic profit."

4. A firm can achieve success by being in the right place at the right time

We live in an uncertain world, so there is no one strategy or group of strategies that will guarantee success, but the authors found 10 variables that maximize the odds of enjoying the fruits of first-quintile success.

Of the 10, the first 5 have to do with your past and your present - the 3 “endowment” variables of company size, debt level, and past investment in R&D and the 2 “trends” variables of industry trend and geographic trend. 

All of these variables are, at best, modestly controllable by a company's management team, but have strong predictive power.  Correctly reading trends and making moves into the right industry and geography at the right time are bold, often hailed, sometimes disastrous, and always risky.

BUT. . .

5. A firm can achieve success by taking action and making “big moves”

The rest of the variables in this magic formula lie well within the power of the organization. These are made of the 5 “big moves” that can drive up the probability of reaching first-quintile nirvana if done forcefully and in concert with one another (the more moves, the better):

1. Programmatic M&A and Divestiture defined as doing one or more deals per year that cumulatively amount to only a portion of beginning market capitalization (thus avoiding the much-vilified “bet the company” deals).  

2. Resource Allocation and De-Allocation – meaning that the company is obviously making hard choices and shifting more than 50% of capital expenditures across business units.

3. Strong Capital Programs that magnify and accelerate growth, by having a capex/sales ratio higher than the industry average.

4. Productivity Improvements that deliver significantly more improvement than your industry group.

5. Differentiation as measured by a significant advantage in gross margin over the competition.

My takeaway is this: let’s move away from the strategic plans that largely say “we will grow incrementally because we will try harder, work smarter, and ride out momentum better than our competitors” with “we will do these specific things, that will be hard to do, to pull these proven levers to give us the best chance of driving significant economic value for our owners.”

In Conclusion

Strategy Beyond the Hockey Stick is an important work that explores the art and science behind the ever present, highly visible, resource intensive strategy processes that exist in most large companies. The authors and their firm have done an excellent job of moving this “soft science” into a more analytical light and providing real actions for companies to improve their effectiveness and focus (see this Forbes article or this McKinsey article for a better discussion on the practical advice contained in the last chapter). Of course, there is more to be done: more data to review, new variables to consider, new techniques to apply. I'm looking forward to the next generation/s of this type of analysis.

I will say that I would have liked to see a bit more detail on the methodology used to gather data, interpret data, and build the model – maybe I will need to wait for Strategy Beyond the Hockey Stick – Math Nerd edition.

What are your thoughts? What other science should we consider applying to the art of strategy? How can we best apply this science?

Until next time. . .

[Insert closing catch phrase here] Work hard, work smart, and keep in touch!

With 20+ years of experience helping firms make strategically and financially sound decisions that drive profitable growth, Joe Krekelberg has held finance, corporate development, and actuarial leadership positions at Fortune 500 companies. He is located in the greater Minneapolis-St. Paul area and can be reached at [email protected].