John – Page 3 – Bates Creek Consulting

Seeing into the Fog

Bill James an article back in 2004 that deserves a read titled “Underestimating the Fog” (Baseball Research Journal No. 33, 2004). The article talks about using statistics to test hypothesis about baseball. The questions he asked dealt with whether a good catcher helps a pitcher or whether there is such a thing as clutch hitting.

Some questions can be answered through statistical analysis and some cannot. Mr. James is talking about problems that cannot be solved with the amount of data we have at hand. The fog is the uncertainty in the underlying data, which is sufficiently random enough to swamp the small effects of the particular question we are examining. Some questions, Mr. James states, will never be answered using these tools. The nature of the game won’t generate enough data, and the randomness of each factor is significantly higher than the effect we are trying to isolate. Mr. James concludes that his tools may not be good enough to see through the fog to identify if there is real skill. There is too much random noise to know for sure.

Business has a lot more fog than baseball. Baseball has a rulebook, trained umpires and is played by highly skilled individuals that have taken years to become the best. Business has no rulebook, there are no umpires and there are no playoffs and no finish line. The amount of randomness and volatility in life is so much greater than in any sport.

In business strategy selection is often done in a cloud of uncertainty and random factors. Often the factors outside our control will make the most significant differences in results, without regard to the strategy we select. Ignoring these random factors is pretending that there is nothing bad (or good) hidden in the fog. How then do we pick a strategy, since we may not control the market, or the competitors, innovation or what the Fed decides tomorrow? I suggest three things to focus on.

Be Prepared to be Lucky

I wrote up a company as a buy once and coaxed some clients into investing. Within a couple of months the company was bought at a significant premium to the original stock price. My analysis did not consider a potential buy-out (although they paid remarkably close to my target market price) and I hadn’t expected a buyout. In this case I was lucky – not good. Acquisitions, good and bad news, CEO turnover, product failures and successes can’t always be foreseen by investors.However, you can be in a position that if you are lucky, you get paid.

I like the real option approach, akin to the Scott Adams approach in his book “How to Fail at Almost Everything and Still Win Big: Kind of the Story of My Life”. A real option is a right to do something but not the obligation. Mr. Adams spent years looking for projects that could result in success. If circumstances were favorable he invested in the project, if not, he abandoned. From an investment perspective, buying value stocks is about investing in undervalued companies that are improving, with the hope that a) they will continue to improve and b) others will notice and bid up the stock price. And sometimes you get lucky and the firm gets bought out.

There is an old saying about “the harder I work the luckier I get”. Usually old sayings are repeated because there is a kernel of truth. Being prepared to be lucky means you have to be prepared for success.

Be Prepared to be Unlucky

The one thing portfolio managers do better than individual investors is that they are prepared to sell when they are wrong. Sometimes luck doesn’t work in your favor. I have a client where a key customer has lost 50% of their business due to new state regulations that were unfavorable. Sometimes shit just happens. Being prepared for luck to work against you means having back up plans and reacting quickly and appropriately as new information is learned.

Charlie Munger recommends decision trees, where he plots out how circumstance, action and luck will generate results based on the probabilities assigned. Mr. Munger is planning on both good and bad luck and still looking for a positive result.

Unfortunately what we often define as “bad” luck is just the absence of good luck. You can’t plan a July wedding in Michigan and not plan for rain.

Be Prepared for more Fog

Mr. James concludes his article “…we may have underestimated the density of the fog. The randomness of the data is the fog. What I am saying in this article is that the fog may be many times more dense than we have been allowing for. Let’s look again; let’s give the fog a little more credit. Let’s not be too sure that we haven’t been missing something important.”

The fog of business shouldn’t preclude us from selecting a strategy. There are random factors that can outweigh our actions within the firm. Recognizing the fog is thick means planning for volatility both random and systematic. Because we can’t see through the fog, it shouldn’t make us think there is nothing in the fog, or that we can’t make plans or investments.

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Dr. John Zott is the CFO for Carlson Wireless Technologies, and Principal consultant at Bates Creek Consulting. John is the chair of the Careers Committee at FEI Silicon Valley, a senior adjunct professor at Golden Gate University and comments regularly on issues that affect consumer businesses. If you are a former student, colleague or would just like to connect – reach out.

Finding the Right Senior Executive

Recruiting talent is probably one of the most important jobs of a management team. Unfortunately it is a pain. Deciding who to hire takes time and requires a lot of thought. The consequences of the decision are great, which causes risk adverse executives to procrastinate and delegate the decision making to a committee.

Hiring a senior team member is even more complicated. Frequently there is a contract that needs to be negotiated, options, bonuses, other perq’s and job responsibilities to be decided. A new member of the senior management team has to work within their functional group (e.g. marketing or finance) and within a senior management group. So a lot of executives have say about the process.

I won’t rehash a bunch of techniques for getting the right person. I recommend “Who: The A Method for Hiring” by Smart & Street. There are a lot of books on how to hire although relatively few about hiring a senior executive.

The root problem is simple. We are all trying to hire someone who can do the job and and fit in with the culture. There is a lot of focus on limiting the risk of hiring which perversely can increase the chance you won’t find the right candidate.

The Downside of Minimizing Hiring Risk

There are several pitfalls in this risk oriented approach. A common way to minimize risk is to find someone who has already done the task in the same industry for another larger and hopefully smarter company. This approach has big drawbacks. First, you can’t assume that the challenges you have today will be the same in two years. Hiring a CIO with experience handling a crumbling systems infrastructure makes sense when you have a crumbling infrastructure. But are they the right candidate after it’s fixed?

Secondly, hiring from bigger, hopefully smarter firms doesn’t guarantee that the candidate knows how to succeed in your environment. A firm I was with wanted to jump start their internet initiatives and hired a head of the internet division from a big company that had a successful web site . The candidate interviewed well, was smart and knew the technology. However after joining, we found they were a caretaker manager, focused on maintaining a well functioning department that they’d inherited. The new hire didn’t know how to grow a business and left after six months having made very little progress. I see this all the time, growth firms hiring the executives from industry leaders such as Intel, Microsoft, Home Depot or Wal-Mart and being surprised to find out they’ve never actually dealt with much growth.

Another risk management technique is to hire someone you’ve worked with in the past. This is pretty common in Silicon Valley and it does limit some risks. However, the chance that someone you’ve worked for in the past is perfect for a position is remote. The risk of not getting along declines but the risk of not getting the right skills and competence increases.

In addition, most executives don’t want to repeat their same experience over and over. A lot of CFO’s get tired of the numbers and seek to move into operations roles. Any work relationship you enter where the employer is hiring one thing and the employee wants to do something else is bound to be a problem. This in some ways explains the relatively short tenure for CIO, CFO positions. After a couple of years these executives are bored and are ready to move on.

The best way to minimize risk is to follow a good hiring process. Hire people that fit and have the skills you need.

Determining Fit

Fit is a function of shared values. Defining a firm’s values takes some time and the result isn’t a black or white. I’ve successfully hired formal executives into relatively informal firms. Sometimes you can open up the values of the organization by hiring someone on the edge of the company’s comfort zone. This can be difficult for the executive (and the company) if it is too far a stretch.

I recently worked with a senior executive who lasted six months on a new position. The company is very loose, with no procedures, budgets, plans or structure. The senior management team wears jeans or shorts and the decision process is very consensus oriented. The new executive was a much more formal, process oriented executive, who worked more “top-down”. The fit issues were an issue early and they only got resolved when the new executive was ejected from the business. Failures like this are both costly and painful for the participants.

Identifying values in senior executives is a lot about understanding the stories that make up their lives. How they tell that story will help the interviewer identify the values of the candidate.

The CTO of Looker, Lloyd Tabb, commented in a recent interview on his secret question for hiring. Lloyd says he looks for “we” rather than “I” in the interview conversation. This is good advice as word choice often reflects values (although be careful, word choice can also be driven by culture and social groups). The culture at Looker is very customer and team focused and “we” oriented.

Interviews don’t often include much time for free ranging values discussions but they should. The interview process should include a meal, time away from the office and be a sufficiently long process to allow the candidate to open up about goals, plans and dreams. This is sometimes called the “open kimono” approach and it requires an equal amount of sharing from the company.

Executives searching for positions can similarly learn about the company by focusing on the process, people and surroundings as they go through the interview cycle.

Skills and Competence

Senior executives have the dual role of functional head and senior executive group member. As I noted earlier, we try to minimize risk by choosing executives from the industry. This avoids functional risk but the real risk of failure is outside the functional area.

Executives fail because they can’t effect change. It isn’t functional knowledge but the ability to get things done within the organization that makes a difference. Actual industry expertise isn’t all that helpful, as is expertise in the particular software or the particular systems the firm uses. If you are planning on turning over your management team every two years, it makes sense to hire from the industry. If you are looking to build a management team for five to ten years, then look for executives who have experience getting things done successfully.

One of the most effective firms I have worked with have the majority of senior executives from outside the industry. The new perspectives have allowed them to move a lot faster and smarter than hiring from bigger, slower moving competitors. Viewpoint diversity is valuable and new perspectives bring new ideas and fresh approaches.

Some of the worst hires are candidates with industry experience in weak firms with “it was someone else’s fault” stories. Every career has a clunker or two in it, but senior executives have to be responsible for where they go to work. If an executive has been forced out of three or four firms and can’t give a reference from any of them, it’s a red flag.

A senior executive has to be open to new approaches, but have standards they will always keep. Hiring a senior executive that won’t say no to the CEO is a waste of company resources and a disservice to the firm and the shareholders. As a hedge fund analyst, if I saw a CEO that dominated the management team, it was usually an excellent short.

A rule of thumb is that every senior executive should have the skills and abilities that could result in them serving as a CEO, either with this company or with another company. If I don’t see that ability, I pass. I am sure most of these executives will not serve as CEO’s, the opportunities may not come up, they won’t want to put in the time and effort or it isn’t a good fit personally. But having the communication skills, the curiosity, the optimism and the leadership that CEO’s have will make them better members of the senior management team. And that is the best way to minimize risk.

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Sales Forecasting, Budgeting and Igor’s model

As a CFO I have struggled with sales forecasts and budgets. Either I am presented with a list of sales initiatives that add up to a multiple of the sales plan (I call it the “whatever sticks” method) or I get a sales plan that lacks any detail at all besides a growth rate which is similar to previous years rates (the same as last year method). Both outcomes leave me unsatisfied.

The “whatever sticks” method usually is a brainstormed list of ideas that haven’t been resourced or have an effective plan of action. Because the total ideas add up to a big number everyone goes into the new year excited for results, only to be surprised by the end of the first quarter when the numbers don’t turn out. The estimates for sales were often the “seven sunny days” types, which counted on a lot of luck.

I used to call this the church potluck dinner problem. Every one brings a wonderful dish to the potluck. When you begin loading up the cheap paper plate, the salad gets mushed in with the beans and the jello ends up leaking into your chicken. As the line goes on, you realize you’ve run out of room for other attractive dishes and you build a second level of food. And the plate bends as it gets wet creating more unattractive mashups and nothing tastes right.

The “same as last year” method does a better job of focusing on the current business but it generated few new ideas. Projects that needed resources weren’t identified and budgeting was based on history. If any portion of the current business was changing the plan wouldn’t be accurate and we’d be playing catch up. The sales plan should include a list of action items that are assigned, have deadlines and are likely to increase sales. Otherwise the “same as last year” plan is based on hope and not action.

I used to teach a class where we’d use a linear regression equation to forecast sales of public companies. It works. The CFO/CEO should have a separate statistical model for sales. Sometimes it is more accurate than budgeting and it always provides insights when reviewing the plans.

Sales and profits are a function of taking a chance. Risk-less profits don’t exist and all sales efforts entail investment with an expectation of a return. I’ve written before about Frank Knight’s comments about risk and uncertainty (see here). Sales efforts are generally uncertain – we don’t know what will work and what won’t, but we need a method to organize and prioritize actions. If we develop a list of sales initiatives, how are we to sort through and assign probabilities or guesstimates of effectiveness? When will we know we have enough quality, resourced initiatives? I’ve found a simple insight by Igor Ansoff that can provide some help overcoming this problem. Igor Ansoff was a management theorist who laid out a simple 2×2 matrix, on one axis markets on the other products.

I usually draw this using the axis: Same/New Customers and Same/New Products. The list of sales initiatives are assigned to one of the four boxes. For example, opening new units for a retailer is New Customers : Same Products and is shown as “Market Development” on the chart. Obtaining more of a key customers business is Current Customers/Current Products or Market Penetration as titled on the chart. Line extension or Product Development is adding additional product or services to the offering to our current customers. In the chart the Diversification strategy is in red, and that’s a good color for this approach. New Products/New Customer strategies are startups.

Using the Ansoff Matrix helps identify the uncertainties and the holes in your plans. The holes are identified as you assort the strategies into the boxes. The uncertainties can be estimated by box. Market Penetration strategies will tend to be cheaper, more numerous with small payoffs and high chance of success. Market and Product Development will have worse chance of success then Market Penetration but will have a high payoff. Diversification will have the lowest chance of success. As a CFO, I rarely include in a sales budget a diversification strategy, mostly because I’ve been burned. Many (most) diversification strategies fail and all should be tested thoroughly before counting on them for sales.

With the Ansoff Matrix you can assign a standard deviation and mean result to success for each of the initiatives and then simulate a 1000 trials of the expected strategies. Many strategies are one-tailed or are options, which can result in a positive payoff, but only if certain conditions occur. Summing the range of results for the strategies selected gives a more accurate representation of potential sales and can set expectations realistically.

Taking these extra steps focuses the management team on strategies that generate a difference, while still staying within the level of resources the company possesses. Realistically if you are a star and finish your sales objectives by mid-year, you can just generate a new set and begin again (or get back in line for seconds!)

The way to solve the church potluck problem is to focus on a few things to eat and to leave some room on your plate for later in the line. The way to solve sales budgeting conundrum is similar. Being picky is good for management teams and good for a potluck.

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Four thoughts on how to deal with Hedge Fund Investors

After being a public company CFO, I spent some time as hedge fund analyst. During that twelve years I spoke with a lot of management teams, watched hundreds of investor presentations and read a
roomful of disclosure documents.

The most interesting change in perspective was 1:1 meetings, when we’d be in a room with the CEO and CFO and we’d have an hour to ask questions. Sitting in those meetings on investor side of the table was a lot easier than being a CFO. However, the biggest difference in the two positions is time span.

When you run a company you are thinking about time differently than a hedge fund portfolio manager. Projects take years and to turn the ship is hard. Profitable business investments have to be identified, planned and implemented. If you are a hedge fund manager, you can reshape your portfolio in an afternoon, and exit your positions within a week.

Elliot Jacques wrote about the “time span of discretion” which dealt with the time frame where the executive was focused. Most senior managers are focused on the coming 6-12 months. Most fund managers are focused on the next 2-3 months. I’ve argued before that senior management needs to raise its focus from making this year to a process of making every years’ numbers. Thinking further out will not help your discussions with a short term investor. I’ve come up with four ideas for you to think about when dealing with professional investors and the hedgies.

1) Prepare your company presentation as a story.

Most stock analysts are intense, smart, educated and inexperienced. When they make mistakes it is usually based on relying too much on book learning and too much reliance on models. Most risk isn’t covered in an excel spreadsheet, and at best they generate a couple of point estimates for EPS based on simplistic assumptions. Their lack of experience makes them open to a good story. A well constructed narrative will sway an analyst, even if the story is simplistic and inaccurate. Good stories have a beginning, a middle and an end. There are characters. A good story has a coherent theme and is easy to remember.

2) Keep your messaging consistent.

Because analysts often lack the experience to tell if a management team can deliver, they simplify and judge on message consistency. If you separate a CFO and CEO at a stock conference and quiz them individually about recent events at the company, you will often hear two stories, which is a problem. If the words in the 10k don’t align with the slide deck then there is another inconsistency. Hedge fund analysts are a little more savvy, they are paid more and they have been burned a few times. They are less swayed by a story and are more tuned in to the results.

Off the cuff remarks and meetings at the bar are a danger to management teams. I once heard a senior executive announce that they had to work the weekend on the budget. It was April. What does “having to work the weekend on the budget” mean in April? It means you are off plan. Analysts are not your friends and there are no “off the record” conversations.

3) Be prepared.

A management team presents the strategy to the board, to executive management, to senior management, to the employees and to the investors. If the investor presentation doesn’t sound practiced, then how much has management communicated to the company? If your presentation isn’t crystal clear, clear enough that a person with a high school education can understand, then you probably haven’t presented it the 20+ times you need to if you are going to convince the employees. Repetition equals retention. Management teams that are not practiced fail. After valuation, this was my most reliable source of ideas. If I heard a management team stumble through the presentation of a complicated new strategy that would require thousands of employees to do something different (say make panini’s at Starbucks), I knew I had a winner short idea.

4) Don’t take it personally.

A hedge fund trades in and out of stocks a lot. Selling your stock doesn’t mean they hate your company. It just means that they’ve found something that will move more or sooner than your company. We shorted a lot of good companies because we have to hedge our other positions, that is what we are being paid to do. I went to a lot of meetings without a preconceived notion of whether a stock was a long or a short. We’d be short for an event or a tough quarter, and then would go long. Management teams that obsessed with whether the analyst is a “long” or a “short” wasted their efforts. Keep your ego out of it, manage what you can manage and make the company better.

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Retrospective Thinking and You!

*Santa Cruz Small Boat Harbor Lighthouse*

McKinsey recently published a survey about whether CFO’s are ready for tomorrow’s demands on finance. For the most part it is not terribly helpful. The additional roles include the “new” fields of risk management and compliance. These tasks have been with us for decades, but today there is a department with the title. My experience with big consulting firms is that they offer good input at a high price. (However, I read everything Tim Koller writes for McKinsey and you should too. I’d classify his insights as great ideas.)

The CFO survey had one question about capital expenditures which caught my attention. Only 30% of the CFO’s agreed that their company “has a formal process to review investments made 3-5 years ago.” This is a big problem as firms that don’t check on their performance don’t learn from their mistakes. Retrospection is hard and I get why you don’t want to do it. Ben Franklin said “Experience keeps a dear school, but fools will learn in no other”. When a management team makes a mistake and doesn’t learn from it then we even less smart than the fools.

I know that everyone cares about the stock price. Stock prices are driven by the return on investment in the projects the management team selects. Poor project selection means poor investment returns and poor stock price performance. Measuring returns informs future investments and identifies opportunities. It creates accountability. It is the difference between taking a class in investing and trading in the stock market for a living. Great investors track their wins and losses and try to learn from both, although the losses are always the most informative.

After being a CFO I took a turn as a hedge fund analyst. About 10 years ago I went to a stock presentation where Coldwater Creek was touting their secondary offering. The plan was to open new units that would generate great returns, earnings and a high stock price. The management team offered up very compelling ROI’s over their first three years of investment in a new unit. I got to ask one question: “how many of these stores have reached their three year anniversary and did they perform similarly to the forecast?” The answer was they had no units that had yet reached the three year life. I wanted a follow up question but the CEO wisely picked on another analyst. Simply put a pro-forma financial model is not the same as actual results. Coldwater Creek never achieved those planned returns and the $32 stock is now worth 2¢.

I worked with a major US bank and was told that the way to promotion was to make a lot of loans fast. When inquired about what happens when they inevitably go bad, I was told that the rotations typically lasted 24 months, and the problems didn’t show up until after you’d left the department. Credit problems were never tracked back to the initial bank officer, just assigned to the executive that then held the portfolio. The difficult job at the bank was in following one of these “fast-trackers” and constantly dealing with a crappy portfolio. This strategy worked until there was a slow down in growth and executives were stuck in the job for 48 months. As Warren Buffett says “ Only when the tide goes out do you discover who’s been swimming naked”.

Recently I heard that the average Silicon Valley CFO lasts 28 months in a job. I’ve never seen a financial analysis on a public company that didn’t go back at least three years if the data is available. The analysis usually go back at least five years and I’ve seen some that go back ten years. We do that to get a sense of how capital has been deployed though the firm’s history. I’ve written here about how hard it is for senior executives to change a business model. Returns on investment are persistent with companies generally moving towards the mean return for the industry. Some of reversion is due to luck evening out, and some of the reversion is due to management teams responding to incentives, both bad and good. If the management team knows that they will be held accountable for capital investments, they have a big incentive to do a better job.

I get that everyone wants to focus on the future and no one wants to poke through past errors. As investors, we are relying on CEO’s and CFO’s to invest the assets of the company wisely. As executives, that means taking a hard look at how capital has been invested, what we did wrong, what we did right and what that teaches us.

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Why Your Staff Quits

Nothing gets done until someone does something. Those someone’s are your staff. Recently a friend quit her job for a new better position closer to home. I couldn’t help but thinking that part of the reason she left was due to how she was treated.

I am not a great “people” person. I am better than Christian Wolff from “The Accountant” as I don’t shoot people and I do have the reputation of being a decent boss. CFO’s in general tend to be quieter than other exec’s, more introspective, we do spend an inordinate amount of time analyzing information, have a large body of technical accounting knowledge and normally emotional intelligence isn’t a prerequisite for the job. Whether you are great at this or not, there are three things I’ve learned that a any senior executive can do to improve their relationships at work. And good relationships lead to lower turnover and higher work satisfaction.

1) Respect your staff. In the movie, Jerry Maguire, Rod Tidwell wanted “quan”. Quan is loosely translated as respect, admiration for skill and the money. Most professionals want their time and skills respected. I hated waiting outside my bosses office for a meeting to begin. I hated getting slide changes for the board meeting 30 minutes before the directors arrived. Respect your people’s efforts. Many senior executives feel more comfortable micro-managing and doing their employees work. Don’t be surprised if your staff doesn’t like it.

2) Talk to your staff. I believe in weekly one on one meetings. The purpose of the meeting is to go over current projects and planning, but you must leave time for the personal. I always started the meeting with a check in and if that was good proceeded to work related issues. Your staff doesn’t leave its humanity at the door when they come to work. Many of my meetings dealt with personal issues, smoothing out work disputes, and understanding more about my staff’s interests, goals and dreams. Unfortunately, a lot of what we do in modern corporations is repetitive and can be a bit dull. If there isn’t a pressing problem, I didn’t cancel the meeting but I’d cut it a little short and we’d focus on mutual interests. If there is a pressing problem the check in was usually cursory. Personal chat is distracting if you are on a deadline.

3) Listen to your staff. If they are dissatisfied it will come out. Usually you are told multiple times before an executive quits. Listening means quieting your voice and engaging with someone else’s story. Listening includes more than just the words. Word selection, intonation, facial expression, eye movements, body position are some of the elements of good listening. Listening takes an effort and your staff can sense when you are putting that effort out and when you aren’t.

Dale Carnegie was right, simply smiling and listening can make a difference in relationships. Often a simple thank you to the staff is all that is required. Turnover is a normal, but lots of turnover occurs because your staff doesn’t feel the quan.

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How Financial Metrics Change when Firms Grow

Ichak Adizes consults with firms about managing corporate lifecycles. He states that there are 10 stages of the corporate lifecycle, one pre-start, four growth, four declining stages, and one for organizational death. There is a lot of good material here for a senior executive to consider, but I am just going to focus on the growth side.

Adizes breaks the 4 growth stages into Infancy, Go-Go, Adolescence and Prime. The problems that growth firms face are all the same. It’s always: people, time and money. However, in a growth environment there are different priorities for financial metrics at different times in the cycle.

Firms in Infancy are focused on cash flow. You’ve only got so much cash and so much research and development to do. We define in months our “runway” left by the amount of cash you have divided by burn rate. When you are out of runway, the firm has to be aloft or you are out of business. In Infancy, it is spending on the right things that must be managed by the senior management team. Treat every spending priority as if you had 6 months of cash left. Good employees believe in the vision and are committed. Budgets are check book oriented. Don’t forget the balance sheet because stretching vendors isn’t generating free cash flow!

Go-Go firms are focused on sales growth. That is what makes them fast growers. In this phase the key financial metric is sales. The company wants as much sales as it can get at a good margin. The focus is on selling to firms that pay on time and offer a good margin. Selling a big order to a distributor who is known for slow payment and low margin isn’t as important as selling to five smaller customers for cash up front and a decent gross margin rate. The best hires are able to step in at any level and take care of the customer. Accountability is diffused and procedures are changed on the spot.

Firms that reach Adolescence struggle with balancing the entrepreneurial spirit with professional management. The key people that could do every job in the department now become assigned to one job and they chafe about the lack of “make it happen” attitude. Profits become more important to the company. I’ve had meetings with CEO’s who complain about the lack of expense discipline after hearing story after story from them about how they’d shipped product timely without any thought of costs. Instilling discipline, procedures and process isn’t easy and it has to be balanced against the flexibility that helped the company grow sales quickly. Adizes says this is the most difficult stage for firms and for founders. Budgeting can become a battle rather than a collaboration. Good executives focus on steady process improvements and increasing accountability.

As firms mature into the Prime stage the company balances profit growth, controls and cash flow. Return on investment and risk management become important for the CEO/CFO to manage. The strategy is working, profits and sales are increasing and there is a good balance between entrepreneurial spirit and control. The locus of effort is in longer term planning rather than on day to day operations. Watch for signs of creeping bureaucracy and procedures that kill initiative. New initiatives require taking risk and too much risk management means that the business will stop investing in the future. The senior management team should be setting stretch goals and pushing the company to think outside itself. The focus has to be on the future and maintaining performance.

Eventually if the company is unable to balance return on investment with sales growth and risk management efforts result in too few initiatives taken, the company begins to decline. I’ve followed dozens of mature firms that talk a lot about growth in sales and earnings but don’t grow consistently. Plans are all short term in nature which contribute to the choppy results and don’t create a long term competitive advantage. Often there is increased turnover in the executive ranks, rather than solve the problems we choose to change the players. The focus of the firm is inward, rather than outward. Often sales increases are driven by large increases in invested capital as growth is forced, rather than planned. Discussions about how mergers will help the management team achieve the bonus plan become relevant.

It is easier to stay in the Prime phase than to recover from a fall. To get back to Prime requires leadership by the CEO/senior management team and commitment by the Board to focusing on the profitable core of the business. Firms that fail to face previous mistakes and poor capital allocations can struggle for years.

Dr. John Zott is the CFO for Carlson Wireless Technologies, and Principal consultant at Bates Creek Consulting. John is the chair of the Careers Committee at FEI Silicon Valley, a senior adjunct professor at Golden Gate University andcomments regularly on issues that affect consumer businesses. If you are a former student, colleague or would just like to connect – reach out.

Becoming a more rational executive, five good techniques

I teach behavioral finance. That is the study of how people make financial decisions and how those decisions differ from the perfectly rational. We are currently in the part of the semester that deals with corporations and how they vary from perfect rationality.

I teach behavioral finance. This is the study of how people make financial decisions and how those decisions differ from the perfectly rational. We are currently in the part of the semester that deals with corporations and how they vary from perfect rationality.

Anyone who has spent any time in business knows that business life is not perfectly rational. There are big ego’s, incorrect incentives, limited analytical resources and group think. The hierarchical nature of large institutions also increases the likelihood that the organization won’t respond timely, which is also irrational.

When we do the class I collect stories of corporate irrationality from the students. There are many. We also brainstorm techniques for staying rational at work.

Here are five techniques for CFO’s to add rationality to decision making. Three of these approaches can be attempted prior to embarking on the strategy, the last two are ways to are for after you’ve taken a path and it isn’t working.

1) What is the base rate for success on this strategy? Why should our efforts be any different than the base rate?

This technique is basically applying your circumstances to historical base rate stats, which is called Bayesian inference. A common application I’ve used this technique is estimating the likelihood of success for a new product. The base rate for product failure in the market is between 40-90%. For example, we’ve come up with a product concept that we feel is good, but faces several technical hurdles to reach the market. The chances of product success is then a function of the chances of success on each of the two steps: finishing the product and obtaining success in the market. Identifying the risks improves the planning process.

2) Conduct a pre-mortem. This is a concept that Gary Klein wrote about in the HBR, September 2007. The idea is to imagine that your project or strategy has failed spectacularly and then ask the question “Why did this happen?”. Hindsight is a powerful tool and it changes your perspective. Problems that were lurking in your subconscious get a chance to be aired. The resulting list of “reasons” for failure become improvements to the plan. Identifying timing, resource or scope issues prior to beginning the project results in cheaper and easier fixes. CFO’s are often the department of “no”. This technique allows you to get the whole team to think critically about a plan without being the wet blanket.

3) Stay intellectually and emotionally distant enough to use your judgement. Optimism and confidence in business are great. Being a part of a team that is conquering a market is a peak experience but that experience can blind CFO’s to reality. Denise Shull writes about using emotion to make better decisions. CFO’s and CEO’s, if good, live both inside the organization and outside. The outside perspective means that you are aware of the challenges within the business and secondly you can look at the business with a clear mind. Founders are, in general, terrible at this, but professional management can’t be.

Here are two techniques for after you are involved in a project that you think might be going bad.

4) If we knew then what we know now, would we still go ahead? This is a way of focusing on the sunk cost question. A full commitment to an ok strategy is better than a weak commitment to a great strategy. I’ve been in a lot of projects where significant investments of time and energy have been invested and then we find out a key fact that makes the project a lot less attractive. However, because we are all fully committed we ignore when key facts have changed.

5) “What would happen if somebody took us over, got rid of us — what would the new guy do?” asked Andy Grove of Gordon Moore in 1985, and this question is relevant for every senior executive. Firms get into ruts. Sometimes the answer is clear but because of institutional momentum management teams never think about the obvious choice.

5 Customer Perspective Questions for CFO’s

Great CEO’s and CFO’s see both the inside and outside of the firm. The inside perspective is natural, it is the default mode in corporate life. The outside viewpoint is harder but it offers a wealth of insights. Although there are many outside perspectives, a crucial one is the customer’s viewpoint. When I work with a company I am vitally interested on how customers perceive the product and the company. Here are five questions you can ask yourself about the customer’s perspective.

1) Do you respect the customer? The customer perspective doesn’t come easy to finance executives. I’ve heard senior executives refer to their customer base as stupid and cheap, and similar to cows. Although you don’t have to use your company’s products to be a good executive, it helps.

2) Do you get customer feedback? There is a saying “the best fertilizer is a farmers’ footsteps.” Great executives get in the field and see how customers react to the product. I hate business travel, but there is no substitution for getting great customer feedback. Although CFO’s can’t spend the same amount of time the CEO spends talking to customers it is an important part of the executive role. I know a lot of marketing execs swear by big data analytics. I love big data but stories drive passion and illuminate the data.

3) Are your customers thrilled or merely satisfied? Are we promising one thing and delivering another? Often the internal “story” we tell in the office is not connected to the reality in the field. My rule of thumb is to never give a customer something they don’t want and won’t pay for. Additional features increase price without increasing value. Engineering teams will design the ultimate product, management egos get wrapped up in featurism, and pretty soon that great little software tool bloats up. Be clear about what you are promising, make sure it is what the customer wants and then deliver on that commitment.

4) Are your operations streamlined to deliver on the promise you’ve made to the customer? The CFO has a key role in identifying where efforts (and costs) should be placed. Sometimes you centralize (and sometimes decentralize) but figuring out the best tradeoff in location, cost and service can increase profits significantly.

5) Is your business model congruent with what you’ve learned? Although the CEO owns the business model, the CFO is key in developing the strategic plan. I’ve always drafted the agenda for strategic planning sessions, including identifying the key strategic questions. Having a handle on the customer allows a CFO to ask the right questions, and shape the strategy so that the intersection between your company and the customer results in profits.

Alan Kay said that “A change in perspective is worth 80 IQ points.” The fastest way to be smarter about a problem is to change your perspective.

CFO thoughts on Business Models

Fortune magazine reports that Warren Buffett stated in 1988, “With few exceptions, when a manager with a reputation for brilliance tackles a business with a reputation for poor fundamental economics, it is the reputation of the business that remains intact.” Bad business models often result in poor fundamental economics. Business models are hard to get right, and often very hard to change.

A 2014 survey of CFO’s asked about reporting and earnings quality. The Financial Analyst Journal reported the (Dichev, Graham, Harvey and Rajgopal) study in their Jan/Feb 2016 edition. The survey results are full of interesting details including the estimate of 1 in 5 financial statements being “cooked” with material (10% or better) adjustments. That information is worthwhile and it is bolstered by a list of ways CFO’s can tell there is a disconnect between reality and the financial statements. The survey also identified that a goal of financial reporting was about “conveying the long-run view of the profitability…of a bundle of assets”. As interesting as this is, I’d like to focus on another aspect of the article, the sense by the CFO’s of what drives earnings quality.

The survey inquired about factors that determine earnings quality – both internal and external. The top factor was the business model of the company. The other inputs included external factors such as the industry, accounting standards and macroeconomic conditions. Internal factors included internal controls and the aforementioned business model. Clearly, management teams are accountable for internal controls, but the argument for business model is not as certain.

Management teams are hired- they don’t create the business. They are brought in for their leadership, management, talent, knowledge and skills. Consequently, much of the business model is defined before the management team starts. Good business models require a good design in the beginning and careful nurturing. As markets change, business models grow obsolete and no longer fit their markets. Watching video has increased steadily in the last 20 years and yet the local Blockbuster is now a Dollar Tree.

I once joined a company that was earning <1% operating profits, and had no growth. In one year sales were up 10+%, and operating margins increased to 4%. In the next several years, we were never able to get operating profits much above 7%. In the years after I left, operating margins averaged less than 1%, until finally it went bankrupt.

The managers who followed me were a mix, some weak, some strong, some were tactical, some were strategic. When they took the position, they were confident about generating great results, but in the end none were able to solve the business model puzzle. Earnings were invested in a series of new initiatives which never resolved the core problem. Eventually weak profitability and lousy returns on capital resulted in a steady turnover in CEO’s and eventually it was sold to private equity who split out the good assets and bankrupted the rest.

This firm clearly had a business model issue. Flat market share, low returns on capital, little ability to innovate or compete in new segments. Low earnings quality is an outcome of the business model, and tinkering is not going fix it. So what do you do with a business that has poor fundamental economic performance? Here are a couple of strategies that can work.

One way is to get a break, either a technological change, industry change or strategic option which creates an opportunity that allows the firm to innovate. Richard Rummelt discusses this approach in his book “Good Strategy / Bad Strategy”. Blockbuster knew that digital streaming would hurt their business, but couldn’t come up with a strategy that was effective. Netflix, which was in the mail order DVD business, however, did. Searching, selecting and creating this opportunity takes time, resources and patience.

Another option is to pare the business down to the profitable core, and then build up from there. The focus here is on increasing the return on invested capital. A good business invests in projects that deliver a better than market return and prunes functions and divisions that do not. Will the business get smaller? Yes, it will, but the remaining business will provide a foundation for growth.

Both of these strategies have significant downsides for management. Few business leaders are strong enough or are far-sighted enough to risk the company on a technological change. Boards don’t like risk taking and the bigger the business the bigger the inertia. Paring down a business can often mean several years of declining sales. Even if you are adding to profits by subtracting a poorly performing operations, there will be concern by the Board, by investors and even by the management team. CEO and senior executive compensation is highly correlated with company size and declining company size means declining compensation. This is a lot of headwind, which explains why there are so many firms stuck in this state.

The bottom line is that it is a whole lot easier to keep a business model working well, then to fix it after it is broken.

Dichev, I., Graham, J., Harvey, C. R., & Rajgopal, S. (2016). The misrepresentation of earnings. Financial Analysts Journal, 72(1), 22-35. Retrieved from http://0-search.proquest.com.library.ggu.edu/docview/1762049797?accountid=25283