Smart Growth

Building an Enduring Business by Managing the Risks of Growth

Edward Hess

• Publisher: Columbia University Press
• Year: 2010
• ISBN:
  9780231521758
• Topic: Business
• Subtopic: Corporate Finance
• Index: Business

Wall Street believes that all public companies should grow smoothly and continuously, as evidenced by ever-increasing quarterly earnings, and that all companies either "grow or die." Introducing a research-based growth model called "Smart Growth," Edward D. Hess challenges this ethos and its dangerous mentality, which often deters real growth and pressures businesses to create, manufacture, and purchase noncore earnings just to appease Wall Street.

Smart Growth accounts for the complexity of growth from the perspective of organization, process, change, leadership, cognition, risk management, employee engagement, and human dynamics. Authentic growth is much more than a strategy or a desired result. It is a process characterized by complex change, entrepreneurial action, experimental learning, and the management of risk. Hess draws on extensive public and private company research, incorporating case studies of Best Buy, Sysco, UPS, Costco, Starbucks, McDonalds, Coca Cola, Room & Board, Home Depot, Tiffany & Company, P&G, and Jet Blue. With conceptual innovations such as an Authentic Earnings and Growth System framework, a seven-step growth funnel pipeline, a Growth Decision Template, and a Growth Risks Audit, Hess provides a blueprint for an enduring business that strives to be better, rather than simply bigger.

CHAPTER 1

Defining the Growth Mental Model

What Is a Mental Model?

A mental model consists of beliefs or assumptions that are firmly held even without regard to whether those beliefs are true.¹ These beliefs drive behaviors and become part of a person’s cognitive makeup. If believed by enough members of a community, those beliefs can become a group’s mental model, an industry’s mental mo del, or even a society’s mental mo del.² Everyone creates and uses mental models. How we define ourselves or the goals of business provides the contours of how we process information. Information challenging our mental models, which are not easily subject to dislodgment, is often rejected.³ One of my colleagues calls this result “cognitive blindness,” because we do not even process information that disagrees with our models of how we view the world.

Think about how companies de fine their business. Is Ma rs Foods a candy company or chocolate company? The answer to that question defines their business alternatives. Defined as a candy company, it would not consider selling chocolate covered vitamin Ctablets for children. But defined as a chocolate company, it may consider doing so because it broadens its market to vitamins and chocolate covered medicines.

Another example, Coca Cola, used to define itself as a carbonated beverage company. What would the company Coca Cola look like today if it had earlier redefined itself as abeverage company? Perhaps Coca Cola would have bought Starbucks. It could ha ve cha nged the scope of its potential market significantly earlier in its history. UPS did try to expand its market space in 1998 when it changed its definition of itself from a package delivery company to a synchronized commerce solutions provider. The difficulty UPS encountered in doing so reflects how entrenched the previous mental model of the company as a package delivery company, and the structures and processes in place to support it, had become.

Peter Senge, in his book The Fifth Discipline, de fines me ntal mo dels as “deeply engrained assumptions, generalizations, or even pictures that influence how we understand the world and how we take action.”⁴ Mental models, once formed, are hard to topple, often becoming axiomatic and accepted by new members of a group or industry without fresh critical inquiry of their rightness or validation.

What Is the Growth Mental Model?

The pervasive mental model about growth that guides the business activities of most business leaders and managers is: “grow or die.” This mental model permeates entrepreneurship, private company, and public company thinking. Googling “ businesses, grow or die” yields over 4 million hits. Early evidence of the pervasiveness of “grow or die” comes from the opening line of a June 28, 1954, Time magazine article entitled: “The New Magic Word in Industry.”

Likewise, in the book, Mergers and Acquisitions from A To Z, authors Andrew Sherman and Milledge Hart state in their introduction: “In business there is one simple rule: grow or die.”⁵ In 1973, Random House published a book by Dr. George Land entitled Grow or Die: The Unifying Principle of Business Transformation, which Random House nominated for the Pulitzer Prize and National Book Award.

The renowned management consultant Ram Charan also talked about grow or die in one of his books.⁶ Other business authors Robert Tomasko and Bo Burlingham acknowledge and question the universal applicability of the grow or die axiom.⁷

Even newspapers and ma gazines publish a rticles about grow or die. Paul Brown wrote in the New York Times on November 13, 2007: “If you Google ‘grow or die’ you get more than 11 million hits. So, clearly, there is something to the idea that if a business is not expanding, it is withering away.”⁸ Likewise, Jerry Useem, wrote an article appearing in Fortune magazine on April 30, 2007, entitled “The Big . . . Get Bigger” and stated, “But that’s what ‘grow or die’ really means: You’d better grow, and also, you’d better grow the size of that growth.”⁹ James Surowiecki, in a New Yorker magazine article (June 9, 2008) entitled “All Together Now?” wrote, “CEOs of public companies often feel what you might call the ‘grow or die’ imperative.”¹⁰

The acceptance of this mental model is not limited to a few a rticles. Fast Company magazine held two workshops in October and November 2007 called “Grow or Die.” Bill Breen, writing in Fast Company (December 19, 2007) in an article entitled “Living in Dell Time,” stated that “Michael Dell is fond of saying that in the high-tech business, you either grow or die.”¹¹

By no means exhaustive, these are examples of the broad acceptance of the chief axiom of business—grow or die. Under this axiom there are only these black or white choices. Surprisingly, I found no author or researcher who explained either the origin or the empirical justification for the axiom. People have accepted it seemingly without questioning its basis. Likewise, I found no studies testing the validity of the assumption that a business must grow or die or stating the scientific basis of the axiom.

Smooth and Continuous Growth—Wall Street Rules

While the belief that a business is either growing or it is dying permeates the business environment, if you are a leader or manager of a public company, your Growth Mental Model likely includes the following:

1. Public companies should continuously grow.

2. The growth of public companies should be smooth and linear.

3. Such growth should occur predictably every quarter.

These beliefs have been en shrined into “Wall Street Rules” that effectively reward or punish businesses for how well they adhere to the Growth Mental Model’s mandates. The Wall Street Rules create significant pressure for public companies to meet or beat quarterly earnings estimates and to continuously grow from year to year as well as quarter to quarter. Quarterly earnings estimates are supposed to be not only higher than the same quarter’s previous year’s earnings but also higher than the previous quarter’s earnings. Company managers correctly believe that if quarterly or year-to-year estimates are consistently met, they will be awarded with higher stock market valuations because investors value the predictability of earnings. The penalty for failing to meet quarterly earnings estimates often is a material stock price decline.¹²

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What is interesting is that these Wall Street Rules have been accepted without a ny formal ado ption by a ny regulatory body or industry st andards body. The high stakes of quarterly earnings estimates have resulted in a serious, perhaps unintended, consequence—the creation of the “Earnings G ame”: the manufacture or creation of non operating or noncore earnings by companies solely to meet quarterly earnings estimates.

There are at least four ways public companies can produce earnings: (1) the authentic way, which entails either selling more goods or services to more customers in arm’s-length transactions or by operating more efficiently or productively ( “Authentic Earnings”); (2) creating earnings through legal accounting elections, valuations, reserves, and judgments, or changing credit policies; (3) managing the timing of earnings by deferring expenses, accelerating income, channel stuffing, or deferring investments; a nd ( 4) manufacturing nonoperating earnings by either selling assets or engaging in nonoperating financial transactions. For meeting quarterly earnings estimates all four types of earnings count the same. And, as Chapter 2 describes, six research studies conclude that it is very difficult for a company to consistently grow relying on only Authentic Earnings.

As a result, to satisfy Wall Street Rules, most companies have to re-sort to playing the Earnings Game: creating earnings using the three nonauthentic ways, each of which results inalucrative fee business for accounting, legal, and investment banking firms that help companies create or manufacture earnings to erase the deficit between Authentic Earnings and estimated earnings. The fact that many firms reap substantial profits from helping companies co mply with the Wall Street Rules en - trenches the rules and the Growth Mental Model more de eply into the psyche of public markets, irrespective of their validity as a measure of a company’s strength.

A leading mutual fund innovator and business leader, John Bogle describes the Earnings Game this way:

Another example of the real-world consequences: Our financial system has, in substance, challenged our corporations to produce earnings growth that is, in truth, unsustainable. When corporations fail to meet their numeric targets the hard way—over the long term by raising productivity; by improving old products and creating new ones; by providing services on a more friendly, more timely, and more efficient basis; and by challenging the people of the organization to work more effective together...—they are compelled to do it in other ways that often subtract value from you, from me, and from society.¹³

In his 2003 Shareholder Letter, Berkshire Hathaway CEO Warren Buffett described the Earnings Game this way: “Over the years, Charlie [Munger] and I have observed many instances in which CEOs engaged in uneconomic maneuvers so that they co uld meet earnings targets they had a nnounced. Worse still, after exhausting a ll that operating acrobatics would do , they sometimes played a wide variety of accounting games ‘to make the numbers.’ ”¹⁴The pressure on management to playthe Earnings Game is immense because in reality growth does not occur predictably, smoothly, and continuously, as Chapter 2 sh ows. Consequently, in te aching hundreds of corporate middle managers a year in executive education programs, I am struck by their consistent talk about how everything they do is evaluated by its short-term quarterly earnings impact and how many decisions are made solely on that basis irrespective of the company’s mid- or long-term needs. The Growth Mental Model necessitates the Earnings Game, which distorts corporate earnings and can stifle needed long-term investments.

The do minance of the Wall Street Rules is do cumented by Professors John Graham, Campbell Harvey, and Shivaram Rajgopal in a leading survey of over 300 public company CFOs. The survey revealed that those executives believed that: (1) earnings per share is the most important financial metric to institutional investors and analysts; (2) meeting quarterly earnings estimates maintains or increases stock prices and failing to meet them decreases stock prices; (3) quarterly earnings estimates need to be higher than the same quarter in the previous year or the last reported quarter; (4) the majority of CFOs would defer creating value, if necessary, to meet quarterly earnings estimates; and (5) failing to meet quarterly earnings estimates would hurt their careers.¹⁵

To supplement the survey findings, the authors interviewed twenty-two CFOs about their views on quarterly earnings. One CFO summarized it this way: “You have to start with the premise that every company manages earnings.” ¹⁶ The authors found compelling their finding that 80% of the CFOs surveyed would either decrease discretionary spending (R&D, advertising, or maintenance) to meet a quarterly earnings target and 55% would delay starting a value creation project to meet quarterly earnings estimates. CFOs further believe it is necessary to smooth earnings to a void negative surprises because they believe investors value predictability.

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Arthur Levitt, the former chairman of the Securities and Exchange Commission (SEC), talked about the Earnings Game in a speech he gave on September 28, 1998, at the NYU Center for Law and Business where he stated:

Increasingly, I have become concerned that the motivation to meet Wall Street earnings expectations may be overriding common sense business practices. Too ma ny corporate managers, auditors, and analysts are participants in a game of nod and winks. In the zeal to satisfy consensus earnings estimates and project a smooth earnings path, wishful thinking may be winning the day over fa ithful repre senta tion.

As a result, I fear we are witnessing an erosion in the quality of earnings, and therefore, the quality of financial reporting. Managing maybe giving way to ma nipulation; I ntegrity may be losing out to illusion.¹⁷

Unfortunately, even with the public uproar and legislation passed after the accounting and corporate shenanigans of Enron, WorldCom, and others, and ten years after Chairman Levitt’s speech, the Earnings Game remains alive and well.

Earnings Game Example

Krispy Kreme’s experience is a good example of how complying with the Wall Street Rules can overtake a good business. Krispy Kreme was a successful doughnut chain based in Winston-Salem, North Carolina, that had been in business for over fifty years when it went public in 2000. Krispy Kreme’s initial public offering...

Table of contents

• Title Page
• Dedication
• Acknowledgements
• Smart Growth
• CHAPTER 1 - Defining the Growth Mental Model
• CHAPTER 2 - Smooth and Continuous Company Growth
• CHAPTER 3 - Economics THEORIES OF GROWTH
• CHAPTER 4 - Organizational Design and Strategy
• CHAPTER 5 - Biology THEORIES OF GROWTH
• CHAPTER 6 - Smart Growth
• CHAPTER 7 - Managing the Risks of Growth
• CHAPTER 8 - Managing the Risks of Growth
• CHAPTER 9 - It Is Time for Smart Growth
• Appendix
• Bibliography
• Index
• Copyright Page