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Mar 20

The capitalist’s dilemma

N.B. The following are extracts from an article published in the Harvard Business Review in June, 2014 – it remains highly relevant today

Professor Clayton Christensen and Derek van Bever of Harvard Business School  have embarked on a fascinating study into what may be holding back growth in the USA and elsewhere given ‘corporations are sitting on mountains of cash but failing to invest in innovations which might foster growth’

They identify three different types of investment in innovation which have quite different impacts on the growth of jobs and prosperity:

  • Performance improving innovations which upgrade old products or services with new and better – these create few extra jobs as customers simply buy the new versions instead of the old

  • Efficiency innovations which help companies make and sell existing offerings at lower prices – they can even reduce jobs – they can also release capital for other more-productive uses

  • Market creating innovations which create whole new classes of customers, even sectors e.g. computers – the moves from mainframes to minis to PCs to smartphones – at the start, only a rich few could afford a computer – 50 years on, just about everyone can – such innovations usually generate many new jobs, both internally to meet the increased demand and externally in supply chains

Key features of these market creating innovations are also:

  • They have an enabling technology that drives down costs as volume grows

  • They reach many new customers who were unable to afford the first offerings e.g. Ford’s Model T

The problem is that companies invest mostly in efficiency innovations which often eliminate jobs, some invest in performance improving innovations which tend to maintain the status quo, and few invest in market creating innovations which generate most new jobs and so growth

Why so?

Because the financial measures and norms used to determine the attractiveness of investments are seriously flawed – RoCE, RoNA, IRR, DCF etc. all make market creating innovations appear much less attractive because they bear fruit in five to ten years and are risky whereas efficiency and upgrade investments usually pay off in one or two years and shoulder much less risk – and most venture capitalists prefer safe bets, not adventurous punts

Indeed, the average shareholding period for external investors is only about 10 months, which pressurises executives to maximise short-term returns (or else!)

However, one might expect longer-term investors, like Pension Funds, to press for more market creating investments to secure their longer-term returns needed

Not so

Most now suffer from depressed returns, unfunded commitments and longer life expectancies – their funds are not growing fast enough to meet their obligations, so they also look for quick payoffs

Hence the capitalist’s dilemma:

‘Doing the right thing for long term prosperity is the wrong thing for most investors’

The authors put forward some worthy suggestions on changes needed:

  • Tax financial transactions to reduce high frequency trading

  • Introduce rewards for shareholder loyalty

  • Wake up business schools to teach finance and strategy together, not separately as now

  • Establish measures/ tools to analyse innovation pipelines and identify opportunities for long-term growth creating investments

They sign off by quoting Peter Drucker: “The point of a business is to create a customer” and ask for contributions to help devise solutions to this dilemma ‘for the long-term prosperity of us all’

Over to you

 

 

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