Aiming High

  • Date:01 Nov 2015
  • Type:Company Director Magazine

The dynamics of change mean it is more important than ever that boards align their governance processes with the goal of sustained superior performance, writes Professor Paul Kerin.

Sustained superior performance is every firm’s goal. But achieving that goal is hard – and it’s getting harder. So what can you do about it?

Economists define superior performers as firms that earn “excess returns” – that is, returns on investment (ROIs) above their costs of capital. On average, firms do not earn excess returns and firms that do, generally don’t for long.

Historically, sustained superior performance was generally the result of a sustainable competitive advantage(s). However, more than a decade ago, I wrote that the half-life of competitive advantage was less than three years. It’s even shorter now. In 2004, I found that for S&P/ASX 200 companies that earn excess returns in any one year, almost half of those excess returns were gone within two years and 80 per cent disappeared within five years. Very few firms are lucky enough to possess what Warren Buffett calls a “moat” – such as Coke’s brand image – that can protect a competitive advantage (and hence excess returns) indefinitely.

Excess returns always get noticed by potential competitors, but traditional barriers to competition (such as scale economies) often helped sustain excess returns in the past. However, in today’s world, technology advances, new business models and global competition are increasingly making many traditional barriers and competitive advantages (such as local scale) irrelevant. As a result, changes in industry leadership are increasingly commonplace. Recent examples include mobile phones, retailing, video games and watches. The probability that industry leaders are overtaken within five years has more than doubled in recent decades.

As the environment in which firms operate is changing faster than before, strategic decisions must be made more often, more quickly and under greater uncertainty. Some pundits have overstated what this all means for the very nature of firms and provided pat solutions (such as “innovation” or “empowerment”) that aren’t of much practical use to boards. However, the changes in the way our world operates do mean that firms need to reconsider how they think about strategy and how they govern themselves.

Firms should certainly try to sustain competitive advantages when it is feasible and economic to do so. However, as “excess return” opportunities are increasingly short-lived, firms need to focus more on the early identification and fast exploitation of new sources of temporary excess returns. To sustain excess returns, they need to be able to do this on an ongoing basis and ride a series of temporary waves of excess returns. Furthermore, in an increasingly uncertain world, creating options and experimentation is much more valuable.

Therefore, the strategic frameworks and processes (such as five-year plans) that were widely adopted in more stable times decades ago, and which many firms still employ, are becoming less useful.

What are the implications of all this for boards? While it is tempting to get involved in the shorter-term strategic deliberations necessitated by a fast-moving world, the speed of change actually reinforces the need for boards to operate at a higher level.

Given heightened uncertainty, boards need to ensure that they and their executive teams understand the most likely scenarios as to how key uncertainties will be resolved and that their firms have the underlying capabilities, assets and cultures to best exploit the future opportunities that those scenarios may generate. Boards will increasingly need to employ CEOs who are street-smart, can deal with ambiguity and are more willing to take risks (while not jumping at shadows).

As firms need to move more quickly and make decisions under greater uncertainty, boards need to ensure that governance processes and mindsets support this approach. CEOs need more freedom than in the past. Boards need to ensure that they don’t unduly constrain them and that bureaucracy and other impediments to change are minimised. While medium-term strategic planning will remain useful, boards need to regard plans as fluid and not insist on adherence to all elements when things change.

Boards also need to recognise that many investments in options and experiments will not pay off. In our fast-changing world, it is even more important to align governance processes with sustained superior performance.