56: Shrinking is not a growth strategy

You can tell when a company is struggling. It announces a material round of layoffs, out of nowhere, without any major shock impacting the business. Someone just realised that they were running the company with 10% more staff than needed. Alternatively, a company is to “divest underperforming assets” to concentrate their footprint. In both cases shrinking rarely leads to something better.

My fellow compatriot, and Politecnico di Torino alumni, Vilfredo Pareto identified the Pareto distribution and the 80/20 rule, or Pareto Principle[1]: in any given situation, a large proportion of the results are typically driven by a small proportion of the contributors. This applies to many aspects of a business and, at any given time, you will likely have a Pareto distribution of your customers, risks or business units performance[2].

During crises, real or fabricated, it’s tempting to apply the 80/20 rule and "simplify" the portfolio, cutting underperforming markets, resources, or teams while focusing on the high performers. However, this often represents wishful thinking of "growing by shrinking." While there can be exceptions, these are rare, because reducing positions, staff, capabilities, or divesting core assets leads to a weaker, not a stronger, business.

Downsizing is for sure not a motivator for staff and, at times of high stress or uncertainty, motivation and creativity, critical for growth, are jeopardised. Customers start to doubt the ‘market leadership’ of that business and future innovation will never happen because R&D and investments in innovation are canned. With fewer resources, maintaining market share becomes a challenge, leaving the door open for competitors to exploit weaknesses and accelerate decline.

A particularly dangerous example of this short-term mindset is cutting costs in organic R&D, sales efforts, or investments during a period of market creation. This effectively hands the business of the future to more patient competitors. While reductions can sometimes be necessary, for survival or efficiency, they are only short-term fixes, not pathways to growth. Sustainable growth strategies focus on expanding capabilities, entering new markets, enhancing products, and investing in innovation. Growth is about adding not subtracting.

The Boston Consulting Group (BCG) simplified this dilemma in their famous 2x2 matrix[3] which often works very well: it is better to be in a growing market with a strong position (star) than in a declining market with a weak position (dog). But the simplification, especially with ‘cash cows’ and ‘questions marks’, might lead to wrong conclusions and divestments of assets with intrinsic strong value just because they happen to be at a moment in time at the bottom of a list.

Shrinking to grow is rarely a winning strategy because, in order to grow, at a later time, those assets, positions, customers, markets would have been handy, but are now in the hands of a competitor. Having multiple positions creates additionally a more diversified portfolio from a risk perspective (not my idea, Markowitz got a Nobel prize on this) but also optionality for the future.

The real issue lies in identifying why certain markets or business units are underperforming (scale, offerings, costs, regulations?) and deal with the issue. Markets struggling due to extrinsic factors will often self-correct. If every player in an industry is losing money, the strongest competitor will outlast the others, ultimately benefiting from customer shifts.

A clear red flag is to observe assets being disposed that attract buyers who do not have any synergy, or even experience, with the asset they are investing in. They know something that the seller doesn’t know; they are probably getting a good deal!

If a branch does not deliver fruits you might need to cut it off, but be careful, because when you cut it, you might fall with it.

[1] Pareto got a degree at the Regio Istituto Tecnico in Turin, later Politecnico di Torino. Check out his brilliant career Vilfredo Pareto - Wikipedia.

[2] You might observe that around 80% of your total revenue might be generated by only 20% of the businesses in your portfolio or your customers. This helps in identifying the high-performing customers that drive most of your income. Similarly, 20% of your activities will be responsible for 80% of the risks or issues within your portfolio.

[3]The BCG Matrix divides business units into four categories based on their market growth rate and relative market share: Stars: High Growth, High Market Share: These are business units or products that have a high market share in a rapidly growing market. They require significant investment to sustain their growth and maintain their position. If managed well, they can eventually become cash cows. Cash Cows are in Low Growth, High Market Share: These are established products or business units with a high market share in a slow-growing market. They should generate significant cash flow and require minimal investment. Excess cash can be re-invested in other businesses/markets. Question Marks have High Growth, Low Market Share: These are business units or products with a low market share in a high-growth market. They have potential but require substantial investment to increase market share. The future of question marks is uncertain, and they can either become stars or be divested. Finally, Dogs have Low Growth, Low Market Share: These are products or business units with a low market share in a slow-growing market. They generate minimal cash flow and are often candidates for divestment or discontinuation.