Two Sides of a Coin: Strategy and Operational Effectiveness
Strategy decides long-term existence while Operational Effectiveness helps you stay afloat
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The top five companies globally by market capitalization has shown great amount of growth in their value over the last few years. Perhaps, it is important to understand the reason why these companies have such high market capitalization and Price to Earnings ratio. Definitely investors are betting high on them.
Figure 1. Market Capitalization of Apple Inc., Alphabet Inc., Microsoft Corp., Facebook.com, Amazon.com (Source: stockrow.com)
Do these companies have a robust Strategic Positioning which is difficult to emulate? Is their Operational Effectiveness far ahead from their competitors? Are both these aspects equally important or one is more important as compared to the other?
Michael E. Porter clearly explains these two aspects "Strategic positioning attempts to achieve sustainable competitive advantage by preserving what is distinctive about a company. It means performing different activities from rivals, or performing similar activities in different ways" and "Operational effectiveness means performing these activities better – that is, faster, or with fewer inputs and defects – than rivals"
Operational effectiveness has been a matter of great importance and perhaps will remain one for companies at large. Companies spend disproportionate amount of time and effort to continuously push its efficiency levels and for good reasons. Reducing cost leads to healthier margins, which makes it more comfortable in terms of managing liabilities. Lean processes, automation, optimal team structure etc. are some of the levers companies deploy to ensure efficient operations.
If you see this from an individual's perspective, we manage our operational expenses carefully and optimize it to stay within the budget we may have set for ourselves. This is not different from how a company manages its house by setting a budget and then deploying operational lever to manage expenditurethereby reducing budget variance as much as possible. But is it good enough to be operationally efficient? Will it help ensure long term existence?The simple answer is NO.
"When your topline is at risk, any effort to reduce cost is a diversion of organizational priorities"
Time and again companies have been disrupted by competitors and changing market trends catching them off-guard and throwing them out of business. There are innumerable such examples where companies were not able to transform themselves and lost market share to competition or went out of existence. It is important that one focuses on crafting a Strategy that makes some aspects of the organization unique and difficult to replicate by competitors. This requires a lot of rigor and continuous effort rather than an annual planning exercise followed by execution focus throughout the year.
"Itis important to understand what increases the value of the company vs. what will help it to stay afloat"
While Operational Effectivenessinitiatives can bring about discipline, avoid process waste and enable cost reduction, it cannot lead to a sustainable competitive advantage. Executives while joining a company bring the best practices of their previous company through tacit knowledge and when implemented in the current company are able to duplicate it. This will lead to better profit margins in the short terms but the economic benefit in the long term will get distributed with other stakeholders like the customer, supplier, employees etc. Hence, measuring the savings from Operational Effectiveness initiatives standalone may not be appropriate to the growth in value of the company or its long term existence.
Free Cash Flow (FCF)is a good indicator of the overall performance (and therebyequity price or value) of a company and is calculated as Operating Cash Flow (OCF) minus Capital Expenditure (CapEx). OCF is the cash flow a company generates from usual business activities and a positive OCF provides the company with the ability to invest in the business and expand its asset base through CapEx. A company can generate more OCF and thereby more FCF by boosting its Earnings as well as by reducing its Working Capital.
"It is the potential Future Earnings that makes a company valuable"
The potential Future Earnings hinges on how robust is the company Strategy and whether it is able to preserve the uniqueness of the company. This in turn determines the long term sustenance of the company. The Future Earnings can be modelled based on current performance as well as putting an estimated value to the future performance and is open to subjectivity.
"Key questions is what factors influences the perceived Future Earnings of a company?"
In Figure 1, we saw the market capitalization of these five companies grew substantially over the last five years. This is mainly due to strategic interventions made time and again helping these companies to create a strong strategic positioning making investors believe in higher earnings potential compared to rivals. Figure 2, below explains how a company can move from its current position to a higher value position by making strategic interventions during the journey. These interventions help companies adjust to changing market trends and riding on them, beat the competitor actions by responding appropriately, making relevant acquisitions and also by proactively identifying and addressing white space opportunities.
While what has worked for one company, may not work for the other, there are a few things to keep in mind which will help them make such interventions and to become more valuable.
1. Challenge the status quo: It is extremely important for companies to keep reinventing themselves. While you may be in a comfortable position today, you need to keep looking out for the next big wave which you can ride. A patent can protect a pharma company for few years or a technology IP can help a Hi-Tech Company to drive above industry average profit until competition catches up sooner or later. Hence, you need to keep looking out for the secular trends and ensure you are geared up for that by making appropriate interventions through investments and transformations. The agility with which you adapt will drastically increase your value.
2. Find your sweet spot:Every company faces an opportunity cost when they prioritize investments. It is extremely important that you invest in areas which is aligned to your company strategy. A lot of value gets destroyed when acquisitions are made without much synergy but mainly for the purpose of diversification. The question one should be ready to answer is "Will it help me find my sweet spot in the marketplace?"
3. Learn from Competition: You can be the market leader or a challenger, it doesn't matter till you are watching your competition and learning from them. The market leader typically lacks the innovation and nimbleness displayed by niche competitors whereas the challenger typically tries to cover its ground by developing Me-Too offerings and being a fast follower of the leader. It is important that you pick up the best aspects from your competitors but find out how you adopt them without losing your uniqueness.
4. Invest in innovation:When the market is moving very fast, innovation is best brought from outside through acquisitions to fill capability gaps. However, acquisitions can be costly and counter-productive sometimes. Hence, it is important to have an innovation strategy that supports your business strategy and balancing between inorganic and organic innovation. Also, innovation requires investments and sometimes it can get de-prioritized over other things in the absence of strong leadership.
5. Build a team of thinkers and doers: Some leaders feel Execution is everything. This is partly correct as a good Strategy but a lax Execution doesn't yield desired results. Conversely, the best execution of a wrong Strategy leads to worst results leading to existential threat for the company. Hence, it is very important to have a balance of thinkers and doers.
(Views expressed are author's personal and don't necessarily represent any company's opinions.)