Cathedrals and iPhones

Today I happened to hear a song that I really like: "Cathedrals" by the Handsome Family. Aside from being a great piece of gothic country, it has an interesting theme: a skewed view of progress over time. After talking about the cathedral in Cologne, Germany, they sing about a fiberglass cathedral in Wisconsin Dells, Wisconsin, where "kids race go-karts 'round the moat". They go on to talk of trying to find love by the ice machine at their motel, but the comparative study of cathedrals is what always gets me.

Are we moving forward, or are we not? Are we just substituting cheap plastic crap for hand-crafted stonework? Aside from cathedrals, where we seem to have peaked some centuries ago, I am a believer in progress. We see stuff getting better, faster, and cheaper, especially in the tech arena.

That's why Steve Jobs' recent defense of the iPhone 4 was so disappointing. He said that the rumors of poor performance are just that, because, in truth, the data show that the iPhone 4 only drops 1 percent more calls than the iPhone 3. Because it's only a little bit worse, people should just get off his back! Imagine saying, "our plastic cathedral is only 1 percent more tacky than the previous version, and it's no more tacky than everyone else's plastic cathedral." While he was at it, Jobs said that the problem's not unique to the iPhone 4, naming his major competitors as just as bad, and claimed that the data says that the issue has been blown "so out of proportion". Hmmm... not great PR or competitive strategy, and not very aspirational.

Steve Jobs, historically, has not set the bar so low for himself. Hopefully, he'll return to form and Apple will go back to giving us better, faster, cheaper products, like we have come to expect.

Why Do We Organize: Focal Bias

The fundamental question of organization theory, which is strategic management without worrying about performance, is why do people organize? One possible reason is that organizations can be better at making decisions than people are because organizations can know more and process information better (inside joke: without reifying the group mind) than individuals can.

When people make decisions, they are trapped by what they know or can easily find out. They tend to latch onto the first solution they come across. And they tend to think that whatever issue they are focusing on is critically important. Every maintenance worker knows that what the organization really needs is a riding power sweeper.

That last tendency is "focal bias," a cognitive bias that gives outsized importance to a particular detail of a problem because they are focusing on that detail. The classic example is to, say, ask New Englanders in February how much happier they'd be living in Los Angeles, where it's a balmy 72 and sunny. In effect, when focused on a detail, like the weather in LA, people confuse how much nicer the weather is with the answer to the question they've been asked, how much happier they'd be. If the weather is much nicer, then it follows (focal bias suggests) that they'd be much happier. In fact, studies show that weather has almost no impact on average happiness.

In other words (and you knew there had to be some math in here somewhere), if Y is happiness and X is weather, focusing people on the weather leads them to assume that Y = X, so that improving the weather leads directly to improved happiness. In fact, the formula for happiness is probably more like: Y = b1A + b2B + b3C ... + .01X + b25Y + b26Z + e. Happiness results from a host of factors, with weather having such a small impact that it gets lost in the noise.

A nice illustration of focal bias can be found here at the Volokh Conspiracy, where Professor Volokh uses focal bias to make his point.

How does organizing help overcome focal bias? In theory, problems are broken up within organizations so that different people focus on different aspects. To act on their solutions, they have to go to a third party (top management, ultimately) for access to scarce resources. Presumably, that forces them to make their best case for why their portion of the problem matters most. Of course, top managers have their own biases, and studies have shown that CEOs who came up from marketing prefer marketing solutions, while CEOs who came up from Finance prefer financial solutions, etc.

The Un-Greenspan: Bernanke is Unusually Uncertain

Ben Bernanke caught the literary attention of global financial markets last week when he said that the economic outlook is "unusually uncertain". (See, for example, Bloomberg's report on the metals markets:"Gold Declines as Bernanke Cites `Unusually Uncertain' Outlook for Economy"; http://www.bloomberg.com/news/2010-07-21/gold-declines-as-bernanke-cites-unusually-uncertain-outlook-for-economy.html). He went on to say that the Fed does not anticipate a double dip in the economy, which is good to hear. Of course, the sound of a phrase is important to its ultimate success as a catch-phrase, and 'unusually uncertain' has a nice rhythm to it - the same rhythm, arguably, as Greenspan's famous 'irrational exuberance'. Neither man is likely to win a poetry slam, but Bernanke's phrase is likely to meet with some success in the land of economic lore. Bernanke's phrase is a little more user-friendly than Greenspan's, in keeping with the general sense that Bernanke wants to increase transparency somewhat. This is a welcome change from "The Oracle" and his obfuscatory prose, at a time when businesses badly need clear information about the economy.

A search on Google (which is not really yet a verb, imho) indicates that there are 409,000 results for 'unusually uncertain', though Google does not yet anticipate the phrase as you type it in (neither does Bing or Yahoo, for that matter).

If you trade options, you are trading volatility, and Bernanke's assessment tells us that volatility should be high. Interestingly, the VIX (the volatility index on the S&P 500) is trading around 22 today, well off of its highs above 40 from early in the summer. It's above pre-crisis (i.e., pre-2008) levels, but around pre-collapse of the world (i.e., Q4-2009) levels. Perhaps the markets are ahead of the story.

The concern for businesses these days, of course, is that demand will taper off, and this may well underlie the reluctance to hire that's been so frustrating for job seekers. There are really two ways to deal with uncertainty, which is generally defined as a lack of information about the future. One is to go get more information. Managers, however, can't just go back to school or read up on the latest forecasts - if the Fed is unusually uncertain, there's not much hope for the rest of us. The second is to stay flexible, by doing things such as shortening the tenor of contracts, building cash, and coping with demand by paying overtime instead of hiring.

The trouble with uncertainty, if you look at the VIX as a proxy, is that, over the last 5 years at least, it has spiked very quickly and dropped slowly. Hopefully, the positive signs will pick up, we can remove the 'unusually' from our uncertainty, and firms will feel confident enough to hire.

How Harvard Business School Ruined American Business

How did Harvard Business School ruin American business? Basically, it's a story of two post-war trends. First, a belief in planning -- the more massive the better -- as the answer to every problem. Second, the decision of the large foundations -- Ford, Carnegie and Rockefeller -- to pour money into management education so long as it looked "social scientific."

It turned out that these trends left management as an academic discipline a little up in the air. It wasn't wasn't quite clear what business schools should be teaching about management. As a result, a lot of schools hired psychologists and sociologists and focused on what we call micro management (yes, really) or organizational behavior, which is the study of how people behave within organizations. On the one hand, this is clearly important information for managers. On the other hand, it's never been possible to convincingly (i.e., scientifically) show that any particular ob technique leads to better firm performance. Basically, ob focuses on reducing absenteeism and turnover while increasing what's called "organizational citizenship behavior," which is doing things for your employer that aren't, technically, your job. For example, the person who takes it upon herself to empty and clean the lunch room refrigerator is demonstrating OCB. Frankly, it's all sort of a mess of warring medium-term theories and we can't even say with certainty that employee satisfaction is a good thing for the company.

This left Harvard with a problem. HBS does not see itself as being in the business of churning out middle managers and vice presidents of human resources. It sees itself as being in the business of turning out CEOs whose value is in their ability to lead their company to sustained high returns. Before the focus on planning and scientification, they did this by hiring retired CEOs to come in and tell war stories to the graduating MBA students. This is probably as good a way of teaching strategic management to managers as any, and survives today in the Harvard case study method. But it's very ad hoc and highly unscientific.

The other problem facing Harvard was that there's no obvious place for economists in this new management education. Economists are social scientists, but they assume that over time there are no meaningful firm level differences. All firms, in the long run, are fungible in economic theory. So it's not just that economists don't have much to say about the proper strategy to pursue to obtain sustained high returns, it's that they don't think that there can be any such thing.

All this came to a head in the person of a economics student at HBS name Michael Porter. Porter was studying IO (industrial organization) economics, which is the branch of economics that advises policy makers on how the legal environment should be structured to promote competition within industries. Porter, true to his training, accepted that firms within the industry would, in the long term, all look identical and thus there was no point on wasting time on firm strategy. But he turned IO economics on its head and started educating executives on how to use lobbying and industry-level devices (e.g., trade associations and collective bargaining agreements) to reduce competition within the industry and block entry of new firms, allowing all of the established firms in the industry to share sustained high returns. Basically, the Porter school (Porter, by the way, would object to this as an overly simplified summary of his views) teaches that the most important strategic decision made in business is about what industry to enter, after which there isn't much any individual firm can do to set itself apart from its competition. After that, all you can do is work together with your "competition" to try to rig the game at the industry level.

Porter's success at Harvard, and Harvard's success at educating CEOs, seems to me to explain much of what we've witnessed over the last few decades. (Porter published his early and most influential work in the late 70s and early 80s.) The co-dependent corporate state and the corrupt bargains struck by management, labor and government owe quite a bit to the presence, at the top of the corporation, of CEOs educated to think that management consists of rigging the game.

What Is Strategic Management?

The three of us are PhD candidates in Strategic Management. That raises the obvious question: what is Strategic Management?

Strategic Management is a branch of the social sciences that tries to explain variability in organizational performance. In other words, we try to give systematic, causal, "law-like" explanations for why some firms out-perform other firms. Because we're "social," we think that the key is people and their interactions. Because we're "science," we try to find generalizable explanations based on empirical evidence.

The tools that we use to study these questions come from economics, psychology and sociology, which are generally accepted as being Strategy's parent disciplines. Although we use their tools, we are not economists, psychologists or sociologists. We like to think that Strategic Management has its own unique domain. Unlike economists, we think that markets can be inefficient in and thus a particular firm can have a monopoly on know-how or resources that give it a competitive advantage over some period of time. We're not quite psychology because we think that organizations are more than just groups of people and, in fact, that at least part of the reason people organize is to overcome the psychological limitations of the individual. We're not sociology because, um, I'm not quite sure. I think it's because we judge organizational structures based on objective measures of performance rather than the well-being of members of the organization.

So, why do some organizations outperform other organizations? If we really knew, we'd have to stop, but here's what we think we know: A lot has to do with the environment in which the firm finds itself. What nation the organization is operating in makes a difference. The single most important factor is what industry the firm is competing in. Some Strategy scholars would stop there. They don't think that firm strategy makes much difference, or that firms don't really have a choice in strategy. Those of us who think that firms do have a choice, and that it does matter, think that, next to industry, how well the firm's strategy fits its environment is the most important factor in determining performance; firms with better fit outperform firms with worse fit. Finally, we believe that, because markets are inefficient, firms can have unique capabilities or resources (they must be rare, valuable, inimitable and non-substitutable) that allow for sustained above-average risk-adjusted returns. At the moment, the hot area for Strategy scholarship is knowledge: firms perform well if they are better than the competition at gathering, sorting, distributing and exploiting knowledge.

BP Wants Back into the Deep End of the Pool: Feedback in Complex Systems

The New York Times reported this week that BP, in spite of the multi-billion costs of the gulf disaster, is "staking its future more than ever on deepwater wells". ("With Sale of Assets, BP Bets More on Deep Wells, by Jad Mouawad, July 20, 2010. See: http://www.nytimes.com/2010/07/21/business/21bp.html?scp=1&sq=BP%20deep&st=cse) This enthusiasm for going off the deep end stands in stark contrast to the response of financial institutions to the recent financial crisis. Banks fell all over themselves to swear off risky lending, wanting to avoid any appearance of appearing to do what they had trumpeted as a key growth business just months prior.

Markets have responded quite differently, too. The equity value of BP has dropped by roughly $80 billion since the explosion of the Deepwater Horizon drilling rig, prompting some analysts to argue that the stock is oversold. Without commenting on the value of the stock, it is interesting to consider the fact that the firm’s equity capital remains at around $100 billion, in spite of what is largely considered to be the worst oil spill in history. As society grapples with this corporate disaster, we’ve recently been reminded of another: the Bhopal, India Union Carbide leak. Last month, seven former employees of Union Carbide in India were convicted of “death by negligence” stemming from the terrible industrial accident in 1984 that left thousands dead. Just as BP survives (to date, anyhow) with very substantial equity value, so did Union Carbide survive the Bhopal disaster, continuing to operate until it was purchased by Dow Chemical in 2001 for roughly $10 billion. Conversely, Lehman Brothers collapsed in 2008, unable to find creditors willing to keep it afloat. It declared bankruptcy in September 2008, having begun the year with the stock trading over $60. Lehman, of course, physically harmed no one, nor did they spill any toxic substances, and yet the firm’s value fell faster and farther than either BP or Union Carbide.

BP’s 40% market capitalization fall in one week, though, would be a move of 10-15 standard deviations (depending on the volatility assumption) – a decidedly non-normal, non-linear result that points to BP being a complex adaptive system (one of the characteristics of which is non-linearity and non-normality). Numerous researchers have written about organizations as complex adaptive systems, and each of these cases noted here show ‘emergent’, i.e., completely unpredictable outcomes that are a part of such systems. Strange, surprising things happen to complex systems – accidents, market collapses, etc.

Complex adaptive systems are also characterized by feedback systems, which is where BP and Union Carbide begin to deviate from Lehman Brothers. Manufacturing firms, or firms that traffic in hard assets, have substantial negative feedback loops, in that outside entities can assess the values of the firm. Oil reserves and manufacturing facilities are both readily valued and readily transferred – the external feedback is clear. However, firms that deal in intangible assets, such as Lehman Brothers, are based on social constructions. Lehman’s output and skill was clearly not readily valued – who could say how good or bad they were? Bernie Madoff, too, famously turned out to be a social construction – he had no value whatsoever.

Firms whose value stems from a social construction have powerful positive feedback loops, and, at times, little to no negative feedback loop. Social construction begets social construction, in that there is more value for me in buying something from Lehman Brothers if you value and buy it too. This type of complex adaptive system can see value perceptions get way out of balance. Even worse, they can correct very quickly: when socially constructed value perceptions turn sour, the negative feedback loop is reinforced, too, and can run unfettered. Thus, banks can’t survive a run on the bank, while manufacturers can survive terrible, terrible catastrophes.

What does this mean? Is there anything to be done for a firm dealing in intangible products and assets? Not much, actually. Where there are no hard assets or readily valued, transferable resources to anchor the firm, it can evaporate (thus, ROA is a meaningless figure for many service firms). Firms can seek to protect themselves with assets that can be valued and transferred, of course. Enron began as a firm dealing in hard assets, but grew its socially constructed trading empire until it dwarfed the hard asset businesses. Firms that deal primarily in intangibles should think about what hard assets they do have. If there’s no relief there, it’s essential to view each business opportunity with regard to both profit potential and reputational risk. Financial firms for years have spoken of "front page Wall Street Journal risk", but clearly many had forgotten about it.

Lastly, this is an area where diversification may offer some help. In fact, Lehman tried to sell its money management subsidiary, Neuberger Bergman, to generate needed cash, but it ran out of time, and it was sold after the bankruptcy declaration. A portfolio of brands can provide the firm protection against reputation loss in one brand, unless they’re linked too closely in the eyes of customers (Neuberger Bergman, as a brand, stood on its own). Of course, strong brands can help bring along weaker brands, so those associations have upside, too. The management of reputational assets is of the utmost importance for service firms, because of the nature of these complex system feedback loops. When those assets go up in smoke, as they can, it becomes, simply: "everybody out of the pool!".

What is 'Three Guys and a Strategy'?

"What is 'Three Guys and a Strategy'? Actually, it's more like three guys and a bunch of ideas about strategic management, applied to today's business world. We are three guys pursuing (as of the moment) doctorates in strategic management who find the world a fascinating place. We've been fortunate to learn a lot of theories on management and organizations from some really smart people, and this is our way of stepping out of the ivory tower (or, more accurately, our grimy doctoral student cubicles) and seeing what those ideas have to say about what's going on.

Please join us by sharing your ideas, too! Thanks for reading."

- David Cohen, Chris Meyer, Sudhir Nair