SIGNALING, THE PRISONER’S DILEMMA, AND GAME THEORY
A related signaling concept is the prisoner’s dilemma, as it is frequently referred to in corporate battles. As the story goes, two people are arrested for a murder and separated so that they cannot communicate. The police do not have enough evidence to convict either man, but if they can convince either man to confess and testify against the other, they will then have a strong case against one of them. The police promise each a lighter sentence if he turns state’s evidence against the other. If they both refuse to confess and implicate each other, they will go free for lack of evidence. But what each prisoner does not know is how the other will act. Can one trust the other to keep quiet?
THE PRISONER’S DILEMMA
In competitive situations such as prevail in the airline industry, this scenario is similar to two companies that maintain high prices, each trusting the other to do the same. It is always tempting to break this silent pact, because a price war could result in the elimination of the other carrier. If they decide to cooperate in this unstable arrangement, they are both caught in a prisoner’s dilemma.
All forms of signaling will be doomed if a competitor acts “irrationally.” In that case, any attempt to call a competitive truce would go unheeded because in an irrationally competitive mind, winning, rather than maximizing profits, is the goal.
Game theory is the formal study of competitive interactions. It analyzes possible outcomes in situations where people are trying to score points from each other, whether in bridge, politics, war, or business. You do this by trying to anticipate the reactions of your competitor to your next move and then factoring that reaction into your actual decision. Computers’ powers of calculation have allowed game theory to become a practical business tool. In 1994 a Nobel Prize was awarded for the study of game theory.
That same year, game theory gained wider acceptance when it was used extensively by bidders in the federal government’s auction of 120 megahertz of air frequency for PCS, personal communication services. The FCC set up such a complicated bidding system that sophisticated decision-making tools were a necessity. With multiple bidders and fifty-one markets to auction off, bidders used applied-game-theory programs to analyze their competitors and make their bids. After 112 rounds of bidding, the government raised $7.7 billion.
PORTFOLIO STRATEGIES
If signaling sounds like fun, its enjoyment is eclipsed by the pleasure MBAs take in playing portfolio games. Portfolio strategy is considered the highbrow area of corporate level strategic planning. It is the dominion of MBAs and of the elite management consulting firms headquartered in Boston and New York. In the 1960s, many academics and executives believed that if a corporation could put together the right portfolio of unrelated and countercyclical businesses, it would be immune to economic downturns. Accordingly, the concept of diversification became the craze of the decade. A prime example is General Electric, a company that was involved in 160 businesses during the sixties.
But in the 1970s, when profits declined and Wall Street became dissatisfied with unrelated diversification, boards of directors ran to consultants for help. They wanted to know what businesses they should be in, which they should continue in, and which they should sell. Cash was scarce and a strategy had to be found that would help funnel their limited capital to the best prospects.
As you might expect, each consulting firm developed its own theory and matrix model to answer the portfolio management problem. Knowledgeable MBAs are familiar with the four major portfolio models, and you should be too.
THE BOSTON CONSULTING GROUP’S GROWTH/SHARE MATRIX
The Boston Consulting Group’s (BCG) model uses market growth rates and relative market share to classify companies into four categories. Their studies showed that high market share was highly correlated with higher ROI (return on investment) and lower costs because of learning curve effects. Therefore, the theory suggests that it is best to have a stable, high market share in some businesses to fund the cash needs of other businesses. There are four classifications that rest on that premise.
THE BCG BUSINESS PORTFOLIO CHART
The Star is a high-market-share business in a high-growth industry. Stars grow and finance themselves. Google, the Internet search engine, is a good example of a self-financing growth company. Its profit margin of 33 percent on sales of $29 billion in 2010 was ample to meet its cash needs for new and existing projects. Characteristically, these types of companies exist in competitive markets and require vigilant managements to maintain their enviable positions on the BCG matrix.
Cash cows are high-market-share businesses in low-growth industries. These gems provide the cash to fund other businesses. Yesterday’s stars, tobacco companies, are today’s cows. In Altria’s case, the money generated from Marlboro was used to buy food companies and pay dividends. Needless to say, Altria’s goal is to keep its dominant share in the low-growth tobacco industry in the United States and keep “milking the cow” if it can.
Dogs are small-market-share businesses in low-growth industries. These businesses are going nowhere and consume corporate cash and management’s time in an attempt to stay competitive. In the steel industry many companies are dogs. Their plants and equipment need expensive modernization, but with softer demand and increased foreign competition, they do not warrant additional investment by their parent companies. As a consequence, boards of directors that agree with this assessment have let their steel plants rust.
Question marks are small-market-share businesses in high-growth industries. To grow they need cash. Some strategists call them “problem children.” If they become successful, they will become stars, and later, cash cows. If they fail, they either die or become dogs as their industries mature. Start-up biotechnology and nanotechnology firms such as Human Genome Sciences and Nanophase Technologies, respectively, fall into the question mark category. Expensive research has to be funded in the hope of producing a miracle drug.
All this animal talk is fun until it is your business that the consultants label a dog. Dogs are not necessarily bad businesses. They just aren’t the type of businesses that large corporations want in their portfolio. Wall Street investors demand a level of sales growth and cash generation that dogs cannot provide. Many millionaires have been minted as the dogs’ management and buyout artists have taken these companies off larger corporations’ hands. My acquisitions course was taught by a number of visiting “professors” who had profited nicely from the housecleaning of large corporations’ troublesome critters.
Portfolio strategies have their drawbacks. They assume that businesses in a portfolio have no significant linkages, which is often not the case. Many collections of businesses share technical, marketing, and support functions. Using shared resources is difficult when using portfolio concepts because they dictate a continual juggling act of companies to maximize growth and cash. Historically, with few exceptions, only investment bankers and advising consultants have profited from the juggling transactions of trading the BCG animals. The other beneficiaries of company juggling are the managements of these portfolio companies. If a business is not working out, there is no need to fix it. Just sell it to them!
MCKINSEY & COMPANY’S MULTIFACTOR ANALYSIS
McKinsey & Co. takes a different approach to portfolio juggling. In response to dissatisfaction at General Electric in 1970 with the BCG’s two-variable model, McKinsey developed its own. The guidance is the same from both models: sell, hold, or invest in a business in the portfolio. In McKinsey’s vocabulary, you harvest a cash cow and divest a dog.
The model has two general variables that govern a business evaluation: industry attractiveness and business strength. McKinsey’s model is not simple. Each variable is determined by a number of industry factors. In any given industry, some factors will be of greater importance than others.
The McKinsey model has nine quadrants versus BCG’s four. The six generic courses of action dictated by the model are:
; Invest and Hold
Invest to Grow
Invest to Rebuild
Selectively Invest in Promising Areas of the Business
Harvest, Milk the Cow
Divest, Sell the Dog
Although the McKinsey model is attractive because it takes into account many factors, nonetheless the evaluation is subjective. As shown by the matrix, the individual factors culminate in a “high,” “medium,” or “low” assessment. For example, Wal-Mart’s sales growth is accessible through its published annual report, but how can one objectively quantify Wal-Mart’s “image”? It is a component that McKinsey uses in evaluating a business’s position in its matrix. It’s all subjective.
THE MCKINSEY COMPANY POSITION / INDUSTRY ATTRACTIVENESS SCREEN
ARTHUR D. LITTLE’S SBU SYSTEM
Arthur D. Little (ADL) is another bastion of MBA portfolio experts. ADL has cooked up a system that revolves around the SBU, the strategic business unit. When similar businesses of a corporation are grouped into SBUs, portfolio strategies become less complicated because there are fewer units to worry about. Businesses in different SBUs have little association with one another other than the financial ties imposed on them by the parent corporation.
The ADL portfolio process has four steps:
1. Classify all the businesses of a corporation into SBUs.
2. Place the SBUs into a matrix.
3. Evaluate the conditions of the industries in which each SBU operates.
4. Decide.
ADL’s matrix has twenty-four quadrants compared to McKinsey’s nine. The two variables that are operative in ADL’s model are industry maturity level and competitive position. Needless to say, these are similar to McKinsey’s and BCG’s. However, ADL vocabulary derives its inspiration from traffic signals rather than the animal world. SBUs either with high market share or in an attractive market are classified as green. Those caught in the middle are yellow. And the poor prospects with low market shares or in mature markets are branded red, as shown below.
THE ADL STRATEGIC BUSINESS UNIT MODEL
Based on their traffic light classification, the consultants devise appropriate strategies for each SBU owned: build, maintain, or liquidate. For green SBUs there are many different strategies available. For the red ones, the options available are constrained by the poor “conditions” in which they find themselves. Once the SBU is classified, the consultants turn to their palette of generic strategies such as focus, penetration, or diversification to construct appropriate tactical plans.
OTHER STRATEGIC CONSULTING FADS TO KNOW ABOUT
In any strategic marketing analysis, as mentioned in the marketing chapter, you should evaluate your own company’s core competencies in the context of evaluating your competition. Beginning in 1990, consulting firms made an entire assignment out of investigating what your company does well. For example, at Frito-Lay, the distribution system is key.
Another popular assignment in 1990 was to focus on customer retention. Bain & Co., the theory’s leading exponent, created an entire practice out of it. The goal of such an assignment is to figure out how to create loyal customers and retain them. To accomplish that, companies and consultants perform extensive consumer research to understand customer buying habits and satisfaction. Consultants examine the customer base to discover who the best customers are so that they can be singled out for special treatment. Often the “best” customers generating the most sales are not the same as those generating the most profits. In addition, systems are set up to gather and store customer data so that marketers can easily and effectively contact the customer. It is more effective to retain good customers than to constantly churn new ones.
In 1993, James Champy and Michael Hammer’s book Reengineering the Corporation set a new consulting fad in motion. Their “reengineering” consultancy CSC-Index drafted on their book’s success and provided expert advice on how to rethink everything your corporation may do. As reported in the Boston Globe in April 1995, “Managers should abandon hierarchal structures in favor of employee teams, to develop systems that cut across traditional fiefdoms such as sales and marketing, and to use computer technology to eliminate a lot of paper-pushing and paper-pushers.”
Stern Stewart & Co. innovated in the financial area by creating a method of restating a company’s income so that management could concentrate on improving its stock performance. Economic value added (EVA) or market value added (MVA) was a new strategic consulting concept that gained importance in 1993. EVA is the difference between a company’s net operating income after taxes and its cost of capital. Accountants have called the measure “residual income” for years, but Stern Stewart modified it and coined the EVA term.
EVA = ANOPAT − Cost of Capital % × (Adjusted Total Assets − Current Liabilities)
ANOPAT means the Adjusted Net Operating Profit After Taxes
The idea is that a company’s financial performance should be judged by the return generated after deducting the cost of capital provided by shareholders. The GAAP accounting measure of “net income” used on financial statements does not do that. During a consulting assignment the client company would learn the new methodology, and its management would be guided toward strategies focusing on the factors that could possibly boost its stock price.
GLOBALIZATION AND STRATEGY
The world is becoming increasingly economically interdependent. Thus strategic planning on a global scale has become a timely concern. The MBA buzzword is globalization. It is a rather nebulous term, but it is a “hot” topic and efforts are made to interject the word global into all MBA courses and writings.
The possibility of globalization depends on the classification of the industry in which a business operates. If an industry is national in nature, it can successfully operate without being threatened by large multinational corporations (MNCs) swooping in and either trying a hostile takeover or competing in some sense. Baking and trucking are two examples of national industries. Automobiles and computers, on the other hand, are examples of global industries. The necessity of heavy research spending and significant learning curve effects tend to favor large MNCs. Whatever the industry, forces are at work that either facilitate or impede globalization.
Forces encouraging globalization:
Improved Communications and Transportation—Fax, cable, satellite, supersonics
Fewer Trade Restrictions—Lower tariffs, duties, uniform regulations
Convergence of Consumer Needs—People everywhere are beginning to have the same tastes.
Technological Complexity and Change—Emerging high-tech industries require larger investments and worldwide efforts to keep pace with rapid change.
MNC Rivalries—MNCs fight for world domination of their particular industries.
Forces hindering globalization:
Cost of Coordination—More managers, communication costs
Geographic Restraints—Transportation constraints and logistical barriers of operating over wider areas
National Differences—Taste preferences, usage, media, language, distribution channel differences
Protectionism—Tariffs, government subsidies, regulatory approvals
The debate over which classification, global or national, an industry belongs to is not as important as investigating the forces that do or don’t make it so. If a company finds itself in an emerging global industry, it must take action or it will be overtaken by others. Because the classification lies on a spectrum that ranges from national to global, the courses of action available are also in that range. A threatened automaker could lobby the government to close its market to foreigners to make an industry national. On the other hand, in the same situation the automaker may choose to pursue an aggressive expansion strategy, as Chinese manufacturers have done.
When speaking of globalization, MBAs often refer to Thomas Friedman’s The World Is Flat (2005). He viewed the world as a level playing field in terms of commerce because of technological advances. Friedman outli
nes what he calls “flatteners” that “converged” to create an integrated, hypercompetitive, global marketplace.
SYNERGY AND STRATEGY
Synergy is the benefit derived from combining two or more businesses so that the performance of the combination is higher than the sum of the individual businesses. When you are making portfolio acquisitions and divestitures, synergy becomes a key issue. Mistakes are often made when the synergistic effects of combining businesses are not explicitly defined and quantified. There may be possibilities for shared production, distribution, and markets, but these linkages or interrelationships must be scrutinized before including them in the price of an acquisition or merger target. In a merger, the target company has to be valued so that the appropriate number of shares of the parent’s stock is exchanged for the target’s.
The four types of business linkages are:
Market Linkages
Customer Bases—same buyers
Distribution Channels—same path to the consumer
Brand Identifications—transference of a brand’s name and equity to other products
Technological Linkages
Operations Technologies—factory processes
New Product Technologies—research
Information Technologies—data collection, databases
Product Linkages
Product Line Extension Possibilities
Excess Production Capacity—to be used for other products
Materials Procurement—buyer power with suppliers enhanced
Staff Functions—The same accountants and personnel staff can provide services across product categories.
The Ten-Day MBA 4th Ed. Page 31