Are Unique and Complex Strategies Undervalued by Capital Markets?

Monday, 03. February 2014

Michael E. Porter has faced a lot of criticism lately. First, Rita Gunther McGrath overthrew his concept of sustainable competitive advantage in her well-received book The End of Competitive Advantage. And now the recently published Harvard Business Review article Strategy: The Uniqueness Challenge questions his differentiation theory, at least partially. According to Porter, differentiation is one of the three basic types of competitive strategy, and, in many cases, probably the most promising. Todd Zenger, Professor of Business Strategy at Washington University in St. Louis’s Olin Business School and author of the HBR article, however, is convinced that the financial markets systematically undervalue companies with unique and complex strategies – even though these strategies are often the most valuable.

His attention was first drawn to the issue in 1999 when a former student working at Monsanto forwarded him a report on his company by an analyst at PaineWebber. Back then, Monsanto was “a portfolio of businesses—bundled under the label ‘life sciences.’” Monsanto’s strategy was “that these businesses could share their mutually beneficial R&D.” But the capital markets “didn’t buy into this theory” and “analysts began pressuring Monsanto to unbundle.”

The report stated: “Proper analysis of Monsanto requires expertise in three industries: pharmaceuticals, agricultural chemicals and agricultural biotechnology. Unfortunately, on Wall Street...these separate industries are analyzed individually because of the complexity of each.” Therefore, PaineWebber advised Monsanto that it would “probably have to change its structure to be more properly analyzed and valued.”

Zenger’s comments: “…the report candidly admitted that analysts’ choices about what companies to cover were based in part on how much effort was required to do so. In other words, the primary benefit of Monsanto’s unbundling would be that analysts could more easily understand the company.”

To gain an overview of the scale of the problem, Zenger and his colleagues conducted a study examining 7,630 companies that were publicly traded in U.S. capital markets from 1985 to 2007. As an indicator for the uniqueness or complexity of a strategy, they used the number of industries a company was active in compared to industry average (counting the number of Standard Industrial Classification (SIC) codes). To find out whether uniqueness and complexity affected the level of analyst coverage, they counted the number of analysts covering each company and how many other companies each of those analysts covered. The latter, they considered as an indication whether covering the company in question was particularly time-consuming. Their conclusion was that “the greater effort required for a complex or unusual strategy discourages coverage.” The article cites other studies supporting these findings.

For Zenger, the real source of the problem, however, is the fact that strategies are generally very difficult to evaluate. After all, the true value of a strategy reveals itself only in hindsight after it has been successfully implemented. He concludes: “…decision makers in companies of all types and sizes confront the challenge of selling difficult-to-evaluate strategies in a market with a restricted ability to evaluate. And the more unusual and complex the strategy, the harder is the task of selling it.”

In this situation, many managers choose the easy way out. Rather than holding on to their unusual strategy, they yield to the pressure of capital markets. This is largely due to the incentive system which is designed to create short-term shareholder value discouraging managers from pursuing valuable long-term strategies that can be punished by investors. “This battle is fundamentally over who should control the company—managers or investors,” Zenger concludes.

For managers who still want to pursue their differentiated strategies, Zenger suggests two possible options: “They can make strategic information more accessible, or they can find investors who take the long view.” The latter, he suggests, may mean taking the company private—a strategy which appears to be gaining in popularity lately. “Private equity,” Zenger argues, “regularly supports new and highly uncertain technology ventures, which are difficult to understand and costly to evaluate.” He adds, “going private ensures that your investors have an incentive to incur the costs of accurate analysis and investment.”

The article reminds the reader of the actual purpose of strategy work: to actively shape the future of a company—with lots of creativity and the courage to take calculated risks. The fact that not all investors are willing to or able to carry the risks associate with a strategy is hardly surprisingly. Therefore, managers who do believe in their strategies should follow Zenger’s advice and take the extra effort to look for the investors that best fit their company’s needs.



Literature

McGrath, R. Gunther (2013). The end of competitive advantage: How to keep your strategy moving as fast as your business. New York: Perseus Books.

Zenger, T. (2013, Nov.) Strategy: The uniqueness challenge. Harvard Business Review (online edition). http://hbr.org/2013/11/strategy-the-uniqueness-challenge/ar/1