Time to return to growth?

Returning to growth in the asset management sector is unlikely to be about getting back to business as the industry knew it before the crisis. The conditions are likely to be very different and the route to success will follow a different, more demanding path.

by Professor Paul Verdin, Solvay Business School (uLB, Brussels) and KuLeuven, Belgium

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Growth? At a time when we seem to be used to ‘crisis = business as usual’, and where we seem to have reached the point where many market participants, observers and policymakers are considering bad news as good news, on the basis that the worse it gets the less the chance it will get much worse or stay that bad… it may seem like an odd moment to be talking about growth again.

First priority after the earthquake and the clean up has been obviously to contain further damage and tighten our management of risk. Second priority, as a result of the often dramatic drop in revenue and new business, has been to cut and control costs and dramatically so for some. Both priorities remain high on the agenda. But suppose we have stopped the bleeding, suppose we have regained confidence and have upgraded our processes to avoid the dramatic situations still in vivid memory; how and when will we ever get back to growth?

Growth Is Not A Strategy, Growth Is The Result of A Good Strategy

In order to answer that question, let us remind ourselves that most often growth in and of itself is not a good strategy, it is not even a strategy. It is more useful to see growth as the result of a good strategy. Most successful companies, those that have been successful over the long haul in a sustained way, have shown tremendous growth. Most often that growth was the result of their success in the market and in the business they developed, re(de)fined or (re)invented, rather than the result of a simple focus on size or growth, as it was in markets as they existed. Nokia, RyanAir, Toyota, Dell, to name but a few that we have been watching over a significant period of time, or Cisco, Medtronic, Kellogg or even Goldman Sachs which were shown as long-term winners in Jim Collins’ recent update. They have become bigger and bigger, even to the point of dominating their market or industry, not because they were bigger - certainly not at the start - but because they were just better at what they were doing. They managed to out-manoeuvre and outperform their initially much bigger rivals or incumbents.

While there are certainly areas and parts of asset management that are subject to significant economies of scale or where size or market share per se may be the name of the game, let’s not forget that even today’s big players most often started out small. In addition, many smaller ‘boutiques’ or focused players show a significantly better return or overall performance than some of their larger peers. If growth is the result of success and not the other way around, then what can we say about the determinants of success?

The Factors of Success…

Let us start by reminding ourselves that there is a lot we really don’t know… if only we knew, it would be the holy grail of the asset management industry, in several ways, one everyone has always been looking for any time, any day, all the time everywhere… however, there are a few things we have learned from research undertaken to date, even though most of what we think we know relates to what we can exclude from our list of prime factors of sustained, long-term success.

In a long-term international study covering a broad range of industries and countries and using different measures of performance, including Economic Value Added (EVA) and Market Value Added (MVA) as distinct from traditional accounting measures, we found that by and large it is not in the first place the sector, the industry, nor even the country or the state of the economy that influences long-term company success. All external factors, in our calculations, accounted for only about 10% of performance differences altogether.

These results did not remain uncontested by those consultants, researchers or market participants who spent their time searching for ‘attractive markets’, ‘growth markets’, segments or countries, or looking for the next newest, biggest or highest-growth markets to bet on. However, our results are rather robust and roughly in line with several other studies from different perspectives, with alternative data and statistical techniques. Even Michael Porter, the pioneer of market or industry attractiveness as a cornerstone of strategy development, reported no more than 18% for industry or market factors.

These findings may be seen in broad support of the famous words of Peter Lynch, celebrated investment guru who made the well-known fidelity Magellan fund great, where he stated “if it’s a choice between investing in a good company in a great industry, or a great company in a lousy industry, i’ll take the great company in the lousy industry any day. It’s the company, stupid!”

Our basic but important observation therefore remains that companies are successful because of what companies do, and don’t do. Conversely, and perhaps not less relevant if provocative in these challenging times, the same seems true with respect to down-side: “firms don’t fail because of what the world does to them, but because of what they do to themselves,” as Jim Collins put it.

Similar conclusions emerge from recent studies on the ‘stall factors’ that make companies stumble on their path to growth. Most companies’ growth stalls at some point, as there are only very few consistent and long-term winners in any market or industry. And stalling is mostly due to company-specific factors, a whopping 70% of a strategic nature and 18 % organisational factor, while only 12% can be attributed to uncontrollable external factors. In other words: don’t blame the economy, and don’t blame the market or the industry. Equally so, do not count on them to get you out of this downturn and get you swiftly back to growth.

Back to Basics: Growth is About Creating Value

How then can we prepare for growth? ‘Back to basics’ is a response we often hear these days, especially in financial businesses, asset management included. There is obvious value and truth in that, but what does it mean? In our view it means returning to the roots of successful strategies, something that arguably successful companies never lost sight of. Others might have overlooked this in their attempt to cut corners, improve short-term financial results or search for fast growth above and beyond what their own value proposition, business model or organisation could bear and sustain.

Successful strategies obviously require a lot of things, many of which we cannot mention here. At a minimum, however, they should be based on a relentless focus on creating value for the client, the customer or the market, above and beyond and ahead of what we call the capturing of value for the shareholder and management. Of course, it is value capturing that entire chunks of the financial markets were very good at, without paying sufficient attention to the underlying sustainable value to the customer, the client and the market. In a sense, they put the cart before the horse. And the temptation to do so is always around the corner in a world of finance where numbers, discounted cash flows, expected earnings and financial ratios, represent our best estimate of future potential rather than actual or proven performance based on delivered results.

Let us illustrate this by considering a simple 2x2 matrix (see figure 1), representing different combinations of value creation and capturing. It is not intended as a kind of ‘portfolio matrix’ but rather an illustration of the dynamics confronting companies no matter what business or part of the business they are in.

Figure 1

Entire pockets of financial markets, asset management included, have had an easy time benefiting from easy value capturing without creating much, as illustrated in position 1. Long before the crisis struck, i remember some asset managers observing “…Paul, we are off the chart!! …We are earning good money by capturing value but actually destroying value to our customers…,” referring to the overall negative performance of most asset managers compared to their benchmarks or indices. That indeed would put them in quadrant 1 with negative value creation - while still making handsome returns to managers and shareholders of asset management companies.

While the Going is Good…

While position 1 seems like a dream, enjoy it while it lasts because dreams don’t last forever. Sooner or later competition catches up, (de)regulation strikes, technology shifts or the market changes. This is something we have been able to observe in many industries over the last few decades, for instance in telecoms, utilities, pharma or even in energy or diamonds… Sometimes this occurs much later or slower than expected, as in different parts of financial services and asset management, sometimes though with a bang as in the ‘big bang’ of deregulation and most recently in the financial crisis.

The immediate reaction of market participants may vary but usually passes through one or more of the following, starting with denial: ‘it won’t happen to us’, ‘we are different’, ‘not so soon’, ‘we will worry about that later’ or ‘professor, this does not apply to us – we are a Swiss Insurance Company’. Then inertia follows, for instance: the ‘knowing-doing gap’, ‘tomorrow we will change’ or ‘let’s enjoy the ride while it lasts’. There may be other excuses for not changing or reacting to what we know and see coming. Then we can try to fight back and hold on to privileged dominance through lobbying or other defensive tactics such as alliances, (anti-)competitive practices or agreements or, last but not least, mergers and acquisitions inspired by ‘buying the competition rather than beating them’,‘growing market share’ or ‘industry consolidation’.

Deliberate attempts to reduce transparency or sneak in price increases in the wake of increasing competition are popular choices, as sometimes preached by desperate consultants or practiced by short-term opportunists, especially in today’s high-pressure environment. One-off cost-cutting or restructuring programmes, while obviously unavoidable in certain areas and conditions, also belong here, which i broadly refer to as ‘playing the horizontal game’ trying to move back on the horizontal axis to position 1.

Sooner or later however, one risks being pushed into the lower left corner (position 2), not an enviable place as value added or value creation for customers is low and the possibility to capture any value severely reduced. This is typically the situation of commodity businesses or commodity traps: ‘we are stuck’. It is possible to escape however, but only through long, hard work. By arduously climbing the mountain of innovation or value creation; moving up along the vertical axis.

This is exactly what most CEOs had in mind when asked about their top strategic priorities. “Either you innovate or you are in commodity hell”, said Samuel Palmisano at IBM following Lou Gerstner’s dramatic turnaround starting from the customer. Or Jeff Inmelt, CEO of GE: “Constant reinvention is the central necessity at GE… we’re all just a moment away from commodity hell.” These are joined by many more, at least so it was before the crisis. And while the crisis may have made this challenge all the more difficult, the fundamental requirement should not have changed. There is no other way, however much our current effort and attention may be focused on the short-term fire fighting or cost-cutting.

Value Creation and Innovation

In our view value creation in competitive markets is about innovation, providing ever more value to the customer. And the more competitive your market gets, the less you should focus on the competition, because the only way to beat that competition is to deliver better value to customers. Even today there are really only two ways to consistently create value and innovate: either go for ‘cost innovation’, the continuous, relentless innovation in the business model, value or supply chain in order to continuously offer ever lower prices to customers. Or go for ‘value innovation’, the continuous search to offer ever better and greater value to customers, based on the drivers and attributes of value they perceive and appreciate. Current recessionary times may have added pressure to this last option by forcing improvements in value for money strategies.

Climbing up the wall of innovation however still does not offer easy solace, as it makes us go through a nightmare (position 3), even if we manage to please the customer and add real or perceived value. eventually we need to be able to translate the higher value into higher margins, through higher prices, in the case of a value innovation strategy, or through higher volume driven by lower prices in the case of cost innovation strategies. Both strategies will lead to profitable and healthy growth. But growth is not the driver of the strategy, it is the result of it. Most, in fact all, successful companies actually reach this point (position 4) of being able to add good value and capture a sufficient part of that in the process in a consistent continuous way.

We need to keep working at it, if only because of competitive pressure constantly trying to diminish or de-value our competitive advantage. Otherwise we may start slipping and sooner or later fall victim to the temptation of slipping in innovation, ignoring the customer, and eventually falling down into the lower right quadrant. The law of gravity will take over. Blinded as we will be by our own success or our own strong position, trying to hold on to value capturing while losing our value creation potential, thus jeopardising our long-term strategic health and sustainable growth.

IBM, Microsoft, Intel, to name but a few, could be seen as going through this cycle at least once before. When fighting antitrust authorities starts taking centre stage, chances are you are in the final stages of such a cycle and it’s time to face up to the next competitive cycle. The only way to avoid this ordeal is to keep innovating and facing up to competition rather than obstructing it.

In conclusion, based on many years of involvement in banking, insurance and asset management, a successful strategy should always be guided by creating perceived value to the customer, the client or the market, while of course being able to capture at least some of that value, by way of pricing (fees, commission, basis points, …), in a continuous and consistent way. An undue or unbalanced focus on either one of those two basic dimensions of strategy invariably leads to problems, even to disaster, particularly over the medium to longer term, which is exactly what strategy and growth are supposed to be about.

So, beyond risk management and cost cutting, the next if not more important challenge for long-term success is to identify the relevant drivers or attributes of value of the groups of customers or segments, we want to serve and new ways of delivering that value in a better more efficient way than ever before. Growth, therefore, can never be just more of the same as a return to the past.

In these trying times, it is a golden opportunity to be examining these questions again and go beyond the easy games of value capturing, merging and acquiring or just riding the market booms which have benefited and equally blinded many a provider in recent years.

When Will We Get Back To Growth?

How bad will it get and how long will it last before we can expect to return to easy growth? Nobody knows. It may not come in the foreseeable future. Those who claim otherwise are just fooling themselves and others as well. Economic predictions have always been hard to make “especially when they pertain to the future” as J.M. Keynes used to observe. The actual record of economic predictions according to most studies is indeed dismal.

That is particularly true in the current environment where we are witnessing major shifts and changes into uncharted territory, implying that a mere comparison to past crises here or there, while possibly useful in warning against some pitfalls, may be equally misleading. “It is time to suspend unquestioned faith in a quick return to the past and adjust to the reality of change,” as Mohamed Elerian, CEO of Pimco recently observed. “There are two types of economists right now”, according to Larry Summers, currently president of the National Economics Council in the White House, “those who don’t know, and those who don’t know they don’t know.” And continuing, through the March 2009 market lows so far, “…there is one thing we know about financial crises like these; they all end.” In the meantime “we are still in uncharted waters and no one knows what comes next,” commented Mervyn King, Governor of the Bank of England, in the Financial Times, fund management, 18 May 2009.

That leaves us little to go by, and based on what we reported and argued before, that need not be so worrying or frustrating at all. Long-term success, which is the essence of sustainable growth, will be as much of our own making as the result of spotting the right trends and riding the waves. “The real test is not whether a company has been smartest about predicting the timing of the recovery but whether it has been truly competitive in its preparation.” It will depend in the first place on taking our business into our own hands. And that requires a keen understanding of the current and future, actual and potential needs of our customers and clients, what it is that creates value for them as they see it, and how we will be able to deliver that better, cheaper, faster than our competitors in a sustainable way.

This is not rocket science to conceive or to find out. It is a continuous and relentless search-by-doing process to make it happen. We need to try and create our own growth. How exactly we do that, we cannot give you on a golden plate. In a future publication however we will try and develop some more in-depth insights and observations and point to concrete paths and pictures, while attempting to show some of the pitfalls to avoid.

Paul Verdin (Ph.D., Harvard) holds the Chair of Strategy and Organisation at Solvay Business School (ULB, Brussels) and is Professor of Strategy and International Management at KULeuven, Belgium. He was formerly Distinguished Visiting Professor at INSEAD where he has been on the faculty for over 15 years and has consulted on strategic issues and processes in the financial sector (banking, insurance, asset management) over the last 20 years. paul.verdin@ulb.ac.be