While large corporations have struggled with long-term growth, the performance of startup ventures has also been deteriorating. The rate of new business formation in the U.S. has been steadily declining for decades, as has their growth rate during the first five years. These trends pose significant problems for the U.S. economy for two reasons. First, startups have traditionally been a hotbed of innovation, growth and productivity. And second, young businesses have historically accounted for nearly all net new jobs created in the U.S. Older, larger businesses, by comparison, have been shedding as many workers as they’ve added over the past three decades, and this trend is likely to worsen with acquisition-driven industry concentration increasing across most sectors of the economy.
So if the rate of new business formation and growth has been declining for years, and seven out of every eight large enterprises have been unable to sustain above-average long-term growth, it’s no wonder the U.S. has been experiencing a secular decline in GDP growth for the past five decades.
Why is business growth so hard to sustain? The Trump administration has argued that regulatory excess and high corporate and individual tax rates have sapped U.S. competitiveness in the global marketplace. Directionally, these arguments have merit. But the trends cited above span periods of higher and lower taxation and regulatory intensity, so at best, government policy doesn’t fully explain the causes of declining growth rates. Moreover, in the current political environment, legislative gridlock dampens the prospects for major policy reform. So business leaders would be well advised to look within their own enterprises to assess what they can do to more effectively achieve the holy grail of business: long-term profitable growth.
Many observers have questioned whether long-term profitable growth is even a realistic goal for large corporations, given the challenges presented by three seemingly immutable forces in the marketplace:
• The law of large numbers, which posits the obvious mathematical reality that as a company grows, the incremental revenue required to maintain above-market growth becomes ever larger. For example, if Apple continued to grow in 2016 at the same compound annual growth rate as it had over the prior five years, it would have needed to add $68 billion in incremental revenue, i.e. more than adding the 2016 revenue of Pepsi, UPS, United Technologies or Disney! The fact that Apple’s revenues actually declined in 2016 – it’s first dip in 15 years – gave ammunition to naysayers who believe Apple’s prospects for further growth are dim.
•The law of competition, which states that companies achieving above-average returns on invested capital will inevitably revert to the industry mean because superior returns will continue to attract new entrants until profit premiums have been competed away. This certainly proved to be the case with Blackberry, whose return on assets in 2007 – the year Apple introduced the iPhone – was in excess of 30% (more than twice Apple’s ROA). Needless to say, Blackberry suffered a massive fall from grace as capable competitors attacked the lucrative smartphone market.
•The law of competitive advantage, which invokes the properties of product life cycles dictating that the sales and profit potential of all products tend to erode over time. For example, the early sales growth of GoPro’s popular line of action cameras exceeded 100% between 2011 and 2012, but steadily declined thereafter, turning negative in 2016 (-26.8%).
Proponents of these intrinsic limits to sustained growth believe that market leaders have inherent liabilities that make them vulnerable to brash upstarts. For example, in Gladwell’s revisionist view of the biblical tale of David and Goliath, dim-witted and ponderous Goliath was actually the underdog in his battle against fearless, agile, and resourceful David. But as applied to business, this viewpoint is not only flawed, but it could become a self-fulfilling prophecy of corporate failure. If management truly believes that long-term above-market profitable growth is impossible, a logical response would be to protect and harvest current assets and customers for as long as possible. But such an approach—playing not to lose instead of playing to win—only serves to hasten the decline of market leaders. The biblical Goliath may have been a ponderous oaf, but CEOs in large enterprises don’t have to be. As noted in the exhibit below, a number of business Goliaths have continued to prosper by maintaining the core values, entrepreneurial spirit and adaptability that led to their success in the first place.
How does this elite minority of superstars achieve long-term profitable growth? In my recently published book, I distill three common characteristics of growth-oriented companies:
• Continuous innovation—not for its own sake, but to deliver . . .
• Meaningful differentiation—recognized and valued by consumers, enabled by . . .
• Business alignment—where all corporate capabilities, resources, incentives, and business culture and processes are aligned to support continuous business renewal.
This simple prescription may seem common sensical and it is. But in practice, it is devilishly difficult for most companies to execute, for two reasons. First, it requires companies to simultaneously excel at both exploiting current assets and market positions while simultaneously exploring new, possibly disruptive new business opportunities. This management “ambidexterity” is actually quite difficult to master, because large corporations are heavily inclined and incentivized to protect their current core business. It is generally very hard to overcome a corporate fear of cannibalization or a sense of “if it’s not broken don’t fix it,” and “you can’t argue with success.”
The second (and related) impediment to long-term corporate growth is in capital allocation, which too often prioritizes short-term performance gains over long-term sustainable growth. This trend is manifested in two pervasive management practices that have unwittingly compromised long-term corporate and national growth, and tilted the scale towards corporate benefits at the expense of consumer and employee welfare:
• A binge in large M&A transactions, increasing industry consolidation across a wide range of industries. For example, The Economist reports that a $10 trillion acquisition spending spree since 2008 has contributed to increasing concentration in two-thirds of the US economy’s roughly 900 industries. Not surprisingly, the resulting decrease in competition has conveyed greater pricing power to many bulked-up incumbents, helping to drive up corporate profits but often at the expense of job growth and customer satisfaction.
• Unprecedented levels of corporate stock buybacks, often at the expense of value creating organic investments in long-term growth. Over the years 2006-2015, the 459 companies in the S& P 500 Index publicly listed over this period expended nearly $4 trillion on stock buybacks, representing 54% of net income, plus another 37% of net income on dividends, raising legitimate concerns as to whether too many large enterprises have been under-investing in innovation and corporate capabilities required to sustain long-term profitable growth.
In future posts, I will explore more fully the executive mindsets, behaviors and management imperatives to improve long-term, profitable growth. I’ll close here with on comment on the link between corporate behaviors and national economic growth, which has been hotly debated for years. New research, led by a team from the McKinsey Global Institute (MGI) found that companies that operate with a true long-term mindset have considerably outperformed their industry peers since 2001 across almost every important financial measure.
The MGI research team analyzed the operating metrics of 615 non-finance companies that reported continuous results from 2001 to 2015, and whose market capitalization exceeded $5 billion in at least one year. To distinguish between companies that exhibited a short- and long-term management mindset, researchers analyzed five operational and business performance indicators.
• Investment. The ratio of capex to depreciation, indicating which companies invest more and more-consistently than other companies.
• Earnings quality. Accruals as a share of revenue, indicating which companies rely less on accounting decisions and more on underlying cash flow than other companies.
• Margin growth. Difference between earnings growth and revenue growth, assuming that long-term companies are less likely to grow their margins unsustainably in order to hit near-term targets.
• Earnings growth. Difference between earnings-per-share (EPS) growth and true earnings growth, highlighting actions such as share repurchases to boost short-term EPS
• Quarterly targeting. Incidence of beating or missing EPS targets by less than two cents, indicating long-term companies are more likely to miss earnings targets by small amounts when they easily could have taken action to hit them and less likely to hit earnings targets by small amounts where doing so would divert resources from other business needs.
The analysis concluded that 27% of the sample were managed for the long-term relative to their industry peers over the entire study horizon, or clearly became more long-term oriented between the first and second half of the study horizon. The remaining 73% of companies exhibited evidence of short-term management priorities. The preponderance of management short-termism reflects growing pressure executives feel to hit near-term targets. A recent executive survey reported that 87% of executives and directors feel most pressured to demonstrate strong financial performance within two years or less, 65% say short-term pressure has increased over the past five years, and 55% of executives and directors in companies lacking a long-term culture say they would delay a new project to hit quarterly targets, even if it sacrificed long-term value.
But this bias for short-term results is misguided. The difference in financial performance between companies managed for short- and long-term growth is striking. Among the firms identified as focused on the long term, average revenue and earnings growth between 2001 and 2014 were 47% and 36% higher, and market capitalization grew 58% faster as well.
The returns to society and the overall economy were equally impressive. Companies that were managed for the long term added nearly 12,000 more jobs on average than their peers over the study horizon. MGI calculated that U.S. GDP over the past decade might well have grown by an additional $1 trillion if the whole economy had performed at the level the long-term stalwarts delivered — and would have generated more than five million additional jobs.
Nearly 65 years ago, GMs CEO Charlie Wilson stated “what was good for the country was good for General Motors and vice versa.” But Wilson’s equivalence between corporate and national welfare is only true if executives effectively manage their enterprises with a long-term mindset committed to continuous innovation, meaningful product differentiation and a corporate culture that promotes corporate agility and market responsiveness.
Follow me @lenshermanCBS. More ideas and contact info on book site: If You're In A Dogfight, Become A Cat! - Strategies For Long-Term Growth