If you had to vote on the most relevant strategic risk news in the media in the past few years, what would it be? Most people will point to items such as computer virus infection, SOX, pension funds' unfunded liabilities, or soaring energy prices. I vote for an issue highlighted on 16 December 2005 in USA Today's Money section. It was titled: 'Optimism puts rose-coloured tint in glasses of top execs'. It summed up several recent surveys of hundred of thousands of employees and executives and reported the conclusion that executives are inherently more optimistic than anyone else in their organisations.
It makes sense. As one interviewee in that piece said: 'who wants to follow a pessimist?' But the consequences can be frightening. I call it the only true strategic risk.
When Mattel, the leading toy manufacturer, acquired The Learning Company in 1999, it paid $3.5bn, or 4.5 times annual sales. It turned out The Learning Company had several problems, from declining growth and questionable profitability, to aging brands. Its own acquisitions in 1994-1996 were ranked among the 10 worst in the US.
Despite a surprising loss of $105m in the third quarter of 1999, Jill Barad, Mattel's CEO, held to an optimistic forecast of synergies and aggressive revenue growth for the company. Barad told Wall Street that next quarter's earning would be good. Instead, the company lost $184m, due mostly to problems at The Learning Company. The first quarter of 2000 brought an additional $171m loss. Barad was forced to resign and The Learning Company was sold to Gore Technology for future earn-out, and no upfront cash. Mattel wrote off $430m.
This is not a unique story. Disastrous acquisitions abound, from Quaker Oats acquiring Snapple to Daimler Benz acquiring Chrysler. The issue is not bad decisions, which are known only in perfect hindsight. The issue is rose-coloured glasses, over-optimistic leaders who turn a blind eye to reality, and admit no problems and no mistakes. The risk involved is strategic risk in its purest form, since the leaders are sticking by their strategy, refusing to see that it does not work.
Throughout the ordeal of The Learning Company, Barad continued to make statements to the analysts along the lines of 'we continue to be confident in our strategy'. Similar statements have been made since 2005 by Rick Wagoner of General Motors, as his company accumulated billions of dollars in loss and its market share kept shrinking. Quite often, this kind of optimism indicates loss of contact with reality, not true leadership. The question should be not, who wants to follow a pessimist, but who wants to follow a blind leader?
Substantial is not strategic
This is the one and true strategic risk. Over the years, the term has encompassed every risk which is substantial. But substantial risks are not necessarily strategic, since many of them have no relation to the company's strategy.
A product failure might bring a company down (think Viox), a bad deal might bankrupt a company (think Enron), but that does not mean the company's overall strategy was wrong. Michael Porter of the Harvard Business School defines strategy as a unique set of activities that positions the company in a different competitive space to its competitors. Strategic risks therefore must be related to this difference, not to the results of some natural or man-made disaster.
Executives believe their strategy is right. They believe their strategy is right even when it is wrong. That is a strategic risk: a strategy going awry, but the ones responsible for it keep pushing it forward, ignoring signs of its misalignment with reality.
So what can be done?
Executives' rose coloured glasses take many forms. They believe their company is healthier than their own employees believe (a Booz Hamilton survey). They believe decisions at their organisations are made fast, while their employees think otherwise (a Sirota survey). They even believe their tenure in their job will be longer than it actually is on average (an ExecuNet survey). Undoubtedly, these qualities help them rise to the top, convincing others by their vision and passion. But when optimism runs amok, who is there to give them a reality check when it is needed?
If you think it is the task of the board of directors to bring over-optimistic CEOs back to earth, you are right. The chance of it happening, though, is lower than the chance Britney Spears will stay married to Kevin Federline until 2010. Boards are often passive, uninformed, and clubby. A 2006 Fortune Magazine forum for directors, called Fortune Boardroom Forum, listed four major sponsors: McKinsey, Gap International, Herman Miller, and ... Johnnie Walker. I couldn't think of a more appropriate description of the value of boards.
Until governance is meaningfully reformed in western companies, what about using external experts? Can the McKinseys and Booz Hamiltons of the world bring reality into corporate C Suites? Philip Tetlock, a professor at UC Berkeley, collected 82,361 forecasts of future events by experts and non experts in a study documented in his book, Expert Political Judgment: How good is it? How can we know? (Princeton University Press, 2005). His conclusion is that experts are no better than laymen. Moreover, the more famous the experts, the worse their performance. Their only differentiator from mere humans: was that they could give many more reasons for their predictions (which did not make them any better).
So, if external help is scarce, what about internal processes? The distinction between financial and operational risks and strategic risk is that the former have clear and systematic corporate practices to identify and mitigate or correct them. They have a locus of responsibility and accountability (typically CFOs and operational managers). True strategic risk is an orphan. Presumably, everyone at the top is responsible for identifying signs that the company's strategy is going to fail. In reality, executive teams are reluctant to confront the boss. In an article called 'Why Dream Teams Fail', Fortune's Geoffrey Colvin places hiding from the real issues as one important reason. Corporate cultures abhor confrontation and cultivate politeness.
Strategic Early Warning systems
If the use of expensive consultants or board politics to look for strategic risks is basically worthless, and internal mechanisms are non-existent, maybe it is time executives tried a different approach. This approach, called Strategic Early Warning (SEW) is not a panacea. For example, it cannot overcome a CEO who hides the truth from analysts and his own people (as one energy company discovered). But, for all its shortcomings, this approach is much cheaper than consultants, and more effective than boards.
The principle behind early warning systems is simple: you have to identify threats early enough to prepare an adequate response. This is not crisis management. This is not business continuity practices. This is early detection of specific weak signals so that management can take proactive actions. The value of an SEW is in early detection of trouble, as well as early identification of opportunities.
SEW relies on three processes: identification of risks, monitoring of risk evolution, and proactive management action. There are two categories of risks and opportunities: risks to the company's differentiation and opportunities to strengthen differentiation. This is not the differentiation that marketing talks about. It does not involve image or advertising. It is the strategy of doing things differently or doing different things that identifies the company as having, or not having, a distinct strategy. Risk is identified as any external development that erodes this difference. Opportunity is defined as any change in an industry's dynamics that allows for even stronger difference in activities.
Mechanism
The SEW relies on a core team of managers with the ability to identify early signals of change, and a systematic process of executive immersion. Team members' job descriptions are less important than their ability to tolerate ambiguity, and seniority matters less than deep clarity on strategy. Analytical ability and communication abilities, while important, take a back seat to synthesis ability: the ability to process large number of seemingly unrelated tactical pieces of data and see a strategic picture.
The SEW team reports to the executive committee. It is important that the team leader has a thick skin. Many of the team's alerts will be ignored by management. The essence of a SEW is not to identify issues that management already has on its agenda, but small- scale events that management has not yet focused on but which may turn out to be critical.
What is on the management agenda is not what SEW looks at. This distinction, so simple and so straightforward, can be a real problem in a corporate culture where management attention is everything, as this example shows.
In the early part of the 21st century, Interstate Bakery Corporation (IBC), which was producing such famous US brands as Wonder bread, Twinkies and Hostess, identified problems with the company's sales of its major brands and deteriorating profitability due to stiffer competition from fresh bakes. A new CEO, brought in in 2002, focused on cost cutting, which was his expertise. The strategy was to increase shelf life of IBC's various products by adding a water-binding enzyme to Wonder bread, and a particular gum to the cakes. This promised savings on deliveries, the possibility of closing plants, and improved availability of products. But IBC's strategic risk had nothing to do with cost. It had everything to do with diet change. The American consumer shifted emphasis to multigrain, low carb, low sugar bakes and away from the white flour, high fat products of traditional IBC brands. IBC completely ignored the shift. It filed for bankruptcy in 2004, the year it at last came round to introducing a multigrain bread of its own.
Core lessons
Creating SEWs in several US and European companies, I came to the following conclusions
- The value of SEW is not in being right, but in putting issues in front of management that no one else cares to, or dares to, put.
- The major impediment to the effectiveness of SEW is understanding what is the essence of the strategy - the difference - that one needs to defend.
- Every SEW system must get top executives to 'see' the future, even if that future is one top management does not believe can happen.
- SEW's best chance of success is when management looks on it as personal insurance. If a company is willing to pay a few million dollars for D&O insurance, the argument for an SEW is unequivocal.
In the words of Tim Koogle, the legendary former CEO of Yahoo, management must ask itself every so often: "Are we still doing the right things?"
SEW is one way to answer that honestly.
- Ben Gilad, the author of Early Warning (AMACOM, 2003), is a former associate professor of strategy at Rutgers School of Management in New Jersey, and president of The Academy of Competitive Intelligence, www.bengilad.com
