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INSIDE this issue The New BRICS on the Block: Which Emerging Markets Are Up and Coming?
How Sovereign Wealth Funds are a source for developmental change
Why Firms Own Production Chains
Pushing digital marketing content without strategy
Understanding the Oracle
Good Management Weaves Gold
No one can blame a company for wanting to put an unhappy incident behind it
When the Going Gets Tough
A hourse of another colour
Managing a disaster
Predicting Innovation Winners and Losers: Start with the Design
The Next Microsoft: Hereâ€™s a partial list
The New BRICS on the Block: Which Emerging Markets Are Up and Coming? Published: January 19, 2011 in Knowledge@Wharton
Building on the foundation of the well-known
BRIC countries -- Brazil, Russia, India and China -- a new set of up-and-coming emerging markets is gaining attention. The so-called "CIVETS" countries -- Colombia, Indonesia, Vietnam, Egypt, Turkey and South Africa -- are now touted as hot markets because they have diverse economies, fast-growing populations, relatively stable political environments and the potential to produce outsized returns in the future. Far-flung geographically and shaped by vastly different cultural, religious and political structures, the CIVETS show the potential to develop rapidly and reward those willing to take on emerging market risk beyond the moreestablished BRIC countries, experts say. The BRICs were christened a decade ago by Goldman Sachs then-chief economist Jim O'Neill. Goldman Sachs now predicts that the BRIC's combined GDP will surpass U.S. GDP by 2018 and that they will account for half the global economy by 2020. The CIVETS owe their
acronym to the Economist Intelligence Unit (EIU), which forecasts the countries will grow at an annual rate of 4.5% during the next 20 years. That's only slightly below the 4.9% average predicted by the EIUfor the BRIC nations, and far above the rate of 1.8% forecast for the world's richest -- or "G7" -- nations. (For what it is worth, a civet is a nocturnal, cat-like mammal found in at least two of the CIVETS countries -Indonesia and Vietnam.) In a recent survey conducted by Knowledge@Wharton and the global communications firm Fleishman-Hillard, a majority of corporate executives, investors and business leaders indicated that they would be interested in doing business with multinationals in the CIVETS countries. Respondents said they were most attracted to CIVETS because of low labor and production costs and the countries' growing domestic markets. When asked to identify weaknesses, the survey participants cited political instability, corruption, a lack of transparency and infrastructure, and homegrown companies without much of a reputation or brand identification. According to Wharton management professor Witold Henisz, while there are a total of 150 emerging markets worldwide, a catchy name and new focus may give multinationals and investors more incentive to look toward these lesserknown countries. "An acronym is a simplification, but it calls attention to growth opportunities in rapidly growing markets abroad that managers need to come to understand," he says. The Knowledge@Wharton/Fleishman-Hillard survey of 153 corporate and business leaders found a range of enthusiasm for different CIVETS. When asked to say which of the six countries offered a "great deal of opportunity" or "some opportunity," 86% cited Indonesia, followed by South Africa (84%), Turkey (82%), Vietnam (77%), Egypt (61%) and Colombia (56%). A significant set of respondents (42%)
predicted that by 2020, the CIVETS countries would be on a level playing field with the BRICs in the global economy. When compared to the BRICs, the CIVETS are much smaller. Indonesia is, by far, the largest with 242.9 million people, followed by Vietnam with 89.5 million, Egypt (80 million), Turkey (77 million) and Colombia (44 million). By contrast, Russia has a population of 139 million, Brazil has 201 million, India 1.2 billion and China 1.3 billion.
'Frontier Markets' Henisz says size is one reason the decision to invest in the CIVETS countries is not as clear-cut as it is with the BRICs. A Western company might be willing to accept some missteps in China because the rewards would be so great given China's size. Entering a CIVETS country, however, is a more complicated strategic decision, he notes, and will probably come with added pressure for short-term results, compared to larger countries where companies might be willing to stay the course. "China is so critical that if you mess up the first year, you can stay around. That's not so clear about, say, Colombia -it's not seen as mission critical." Wharton management professor Mauro Guillen points to another important difference between the two blocs. Unlike China, Brazil, India and other emerging markets like Mexico, the CIVETS lack established multinational corporations to act as platforms for further economic development, although that could happen in the future. "What makes the BRIC group unique is that not only are they big, but they have their own companies that are destined to be very important outside their own countries," says Guillen. The EIUacknowledges that the CIVETS do not have the economic power to "reshape the global economic order" as much as the BRICs and their combined GDP will only amount to one-fifth the
size of the G7 nations' combined GDP by 2030. Instead, the CIVETS are second-tier emerging markets that have relatively sophisticated financial systems and do not face runaway inflation, massive current-account deficits or public debt, according to the research firm. "With emerging markets there is always risk," cautions Guillen. "But whenever you have risk, if you are savvy you are going to make a nice return. This is a difficult game, but it is an interesting one." Romeo Dator, a portfolio manager at Texasbased U.S. Global Investors, which specializes in emerging markets and natural resources, says the only CIVETS country his firm has invested inis Indonesia, which, according to Bloomberg, had overall investment returns of 57% last year. The others, Dator notes, are still too small for major fund investments which need greater liquidity. The BRICs, he adds, are still far from mature, and the CIVETS "are almost like frontier markets, a step below the emerging markets in terms of size." When does a country graduate to "emerging" status? Dator points to one sign: "Once you start seeing ETFs [exchange-traded funds] developed around them, that means there's enough interest and it's worth looking into." Michael Geoghegan, chief executive of HSBC, is a CIVETS promoter. In a speech to the American Chamber of Commerce in Hong Kong last year, he remarked, "Any company with global ambition needs to act now [with] regards to these markets. In today's world, you can't afford to wait for business. You have to go where the business is." Each of the CIVETS presents opportunity and risk, according to emerging market analysts and Wharton faculty: Colombia: Following years of high-profile drug wars, Colombia remains a small market, but has always been a dynamic economy with some key
industries, including fresh flowers, oil and coffee. Indonesia: The largest of the CIVETS, Indonesia has a huge, sprawling population and has already benefited from investment by the U.S., China and Japan, but political and social stability is never certain. Vietnam: A low-cost alternative to China for manufacturing, Vietnam has ambitious plans to grow its economy despite a Communist government. Egypt: Although Egypt has a well-educated, prosperous population in its Nile Valley cities, much of the country remains poor and the country has a high level of debt (80% of GDP). The political future beyond the rule of President Hosni Mubarek is cloudy, and the country could face religious turmoil. Turkey: Not a destination for manufacturing because costs are already high, Turkey remains a promising regional center which has benefited from relative stability and ties to the West in a volatile part of the world. Membership in the European Union would be a plus, experts note, but religious turmoil might hurt its economic prospects. South Africa: Although it faces problems with unemployment and HIV/AIDS, South Africa has strong companies, a well-developed business infrastructure and can serve as a gateway to southern Africa. Henisz notes that in addition to their internal strengths, Turkey, Indonesia and South Africa have some companies that are strong in their regions, which might make these countries especially interesting for companies or investors looking to gain additional traction beyond a single country's borders. "They could be a platform for investment the way Ireland was for Europe," he says, adding that these countries could also provide opportunities for "reverse learning" about business approaches to their
regions (as opposed to the traditional model of applying Western business methods to foreign markets).
Resisting Generalization According to the survey results, respondents agree that the most important factors positioning CIVETS companies to compete in the global economy are: the value of their products and services (75%); GDP growth in their countries (74%); their financial position (53%); innovativeness of products or services (45%); and recognition of their brands outside their home countries (28%). Respondents also characterized the strengths and weaknesses of CIVETS-based multinationals in the global marketplace. The top response (85%) was that these companies need more visibility to get the respect of leading companies in the United States and Europe. That was followed by 67% of participants who agreed that these companies lack appropriate transparency and corporate governance standards to compete internationally; 66% who felt the companies do not have the public policy or public affairs expertise needed to compete; 64% who said the firms do not have the marketing and branding capabilities to succeed in the global marketplace; 52% who felt multinationals in CIVETS nations do not have the communications capabilities to succeed in the global marketplace; and, finally, 51% who felt CIVETS companies are limited in their global thinking. When asked what they look for in determining whether a CIVETS country has the potential to be on a level playing field with one or more BRIC countries, the respondents' top consideration was political stability. According to Wharton finance professor Franklin Allen, the CIVETS countries are so different, it is hard to generalize about politics across the group. He cites income inequality, religious fundamentalism and regional volatility as issues to watch for when evaluating investments in
these markets. "You have to look at the politics carefully in each of the countries." The era in which foreign investors had to fear nationalization of assets has largely faded, but foreign governments can still add risk to investment projects, perhaps through heavy taxation or regulation. "There are very few countries where the government believes that they should own the means of production. That's why we don't see political risk as too much of a problem, but I would be surprised if it went away for good," Allen adds. "It may take other forms. Government debt problems may [result in] taxation being much higher -- although we have got a ways to go before I think that would happen." In 2005, Goldman Sachs' O'Neill came up with a new concept for the next generation of emerging markets -- the "Next 11" or "N11," made up of four CIVETS and seven other countries. O'Neill, who is now chairman of Goldman Sachs Asset Management, notes that Colombia and South Africa were not included in his N11 because their population size restricts their ability to grow into large markets. "Our N11 Group would also include Bangladesh, Pakistan, the Philippines, South Korea, Iran, Nigeria and Mexico, and these 11 would be a more diverse and attractive group," O'Neill says. The EIU, in turn, narrowed that list down. Nigeria, according to the research firm, is too dependent on commodities. Iran's politics and international relations are too unstable. The Philippines -dubbed a "perennial underperformer" -- also suffers from weak, unstable politics, according to the EIU. Political instability will hold back Thailand as well, and Pakistan's security problems are acute. Bangladesh, meanwhile, is too poor and vulnerable to the effects of climate change. O'Neill plans to release a paper this month elevating Mexico, South Korea, Indonesia and Turkey, along with the BRICs, to a new status as "Growth Markets." The EIU left Mexico and
South Korea off its list because they were already successful and were "old news" to investors. Wharton faculty point out that Russia, which remains dependent on natural resources and has faced political ups and downs, does not really rank with the other more successful BRICs. However, Henisz notes that Russia illustrates the gamble with any emerging market strategy, and he suggests that five or 10 years from now, one or more of the CIVETS may be laggards. "I'm not laying odds on which ones, but one or two will be outliers," he says. Republished with permission from Knowledge@Wharton (http://knowledge.wharton.upenn.edu), the online research and business analysis journal of the Wharton School of the University of Pennsylvania.
FUNDS THAT LEAVE A LASTING LEGACY
How Sovereign Wealth Funds are a source for developmental change By Professor Nuno Fernandes - January 2011
Sovereign Wealth Funds (SWFs) have been making headlines around the world during the global financial crisis. Investors are noting their potential global impact and the effect that they can have on investment strategies at a time when lack of confidence in the financial markets has driven many investors and funds away from corporations. They are also becoming increasingly prominent thanks to some huge investments – tens of billions of dollars – into major Western financial institutions, including UBS and Merrill Lynch, as well as less-familiar companies such as Madame Tussauds and MGM Casinos. Some analysts predict that SWFs will manage more than $10,000 billion within the next five years – five times that controlled by the private equity and hedge fund markets combined.
A different sort of fund Although exact definitions vary, SWFs are essentially state-owned funds that invest in international markets. They hold positions –
although rarely controlling stakes – in nearly 20% of companies worldwide and operate in nearly every country in the developed world, as well as in a handful of emerging economies. But what makes SWFs so different from other funds is that they consistently take a long-term investment view, because their underlying aim is to leave a legacy for future generations. This approach is in sharp contrast to that of hedge funds, mutual funds and so forth, which tend to take a short-term perspective: how much money can I make this year? Am I going to beat the index? This long-term investment approach also means that SWFs have great potential for assisting and shaping developmental change. Indeed, we are already seeing SWFs playing a more prominent role in social development. In the Middle East, for example, many SWFs now see themselves as social development funds. This might mean inviting the companies in which they invest to market their products in the home market, or influencing decisions about where to site offshore production facilities. Mubadala, a fund in Abu Dhabi that invested 8.1% into US computer chip maker AMD, is a good example of an SWF acting in this manner. It has parlayed its involvement with AMD into a 20% stake and a profitable spin-off of its manufacturing operations, via a joint venture with the Advanced Technology Investment Company of Abu Dhabi. It noted in its annual report that it was playing a role in the social development of Abu Dhabi – something that fits very well with the state’s overall economic development objectives, which prioritize the creation of full-scale sustainable businesses.
The benefits of SWF ownership SWF investment has a considerable impact on company value: when an SWF invests in a company, the value of the company increases by 15%. This suggests that general shareholders
benefit – a lot – from SWFs investing in their companies. Furthermore, the impact of SWFs goes beyond that of the typical institutional investor, as the market usually pays a much higher premium for businesses in which SWFs have a stake than in organizations that are owned by general institutional investors. All else being equal, the market prefers SWFs to any other institutional investor. And this is not just a market phenomenon. Companies with SWF investment also outperform other companies when measured on actual performance – profit margins, return on assets, return on equity, and so forth. This shows that the higher valuations results are not an irrational market aberration. SWFs add value in three main areas. First is the cost of capital. Firms that have sovereign wealth funds as investors have lower cost of capital than other firms. That is traditional investment theory; when you have a lower cost of capital you will be able to take more investment projects and pursue more growth opportunities – and that is appreciated in the market. Related to this is capital stability. Once firms have an SWF as an investor, they have better access to capital should they need more in the future. Unlike other types of institutional investors, SWFs typically provide guaranteed capital in case of future funding needs, thus reducing uncertainty regarding the company’s future financing ability. The second benefit is an expanded product market: companies that have an SWF investor will also get privileged access to the product market in the country or region in which the fund is based. The third is related to the takeover market and corporate governance. SWFs can save companies from hostile takeovers or corporate raiders. Their long-term investment approach and associated legacy and development objectives play an
important part here because they avoid strategies that pursue short-term value at the cost of destroying consolidation or scale. Unlike most other investors, they are willing to block valuereducing acquisitions in the companies in which they invest.
Here to stay SWFs may only have come to the forefront of public attention during the recent global economic crisis but there is no doubt that they will become increasingly important part in the world’s markets. They will continue to invest and they will maintain their involvement in local development, thanks to their vision of achieving long-term financial and strategic returns from their investments for their home countries and regions. This commitment and strength can be a powerful source of value creation for any company that has a SWF as an investor. Markets have not seen investors like this before because the vast majority are short-term oriented. Sovereign wealth funds are very different. They are stable investors that want to stay for the long term. This is a new and very good source of capital for corporations that we have not seen before. Nuno Fernandes is Professor of Finance at IMD, the leading global business school based in Lausanne, Switzerland.He directs IMD’s Strategic Finance program. This article is republished courtesy of IMD http://www.imd.org/
Why Firms Own Production Chains
But a recent study titled "Why Do Firms Own Production Chains?" by Chicago professors Ali Hortaรงsu and Chad Syverson finds that although companies operate production chains, they do not necessarily use these links to facilitate the Research by Ali Hortaรงsu and Chad Syverson movement of inputs made by upstream plants to Ali Hortaรงsu is professor of economics at the downstream plants that make the final goods. In University of Chicago Department of Economics. fact, only a very small fraction of upstream units are dedicated to their firms' downstream Chad Syverson is professor of economics at the operations. Thus, most companies that own University of Chicago Booth School of Business. vertical production links do not function in the way that is talked about in much of the academic literature and the business press.
Vertical integration does not necessarily mean that a company's upstream plants supply inputs to its downstream operations. In fact, it is more likely that they do not.
Most people think that a firm owns a production chain for the sake of making the parts that go into its finished products. Ford's River Rouge complex in Dearborn, Michigan, which was once the largest integrated factory complex in the world, is a classic example. It contained almost every facility needed to produce Ford's vehicles, from refining raw materials to assembling automobiles. Other examples of such vertically integrated firms include power plants that control their own coal mines, oil companies that extract crude oil and sell gasoline, and clothing companies that create their own fabrics. In this view, the aim of vertical integration is to ensure a steady supply of quality inputs that would ultimately prove cheaper than sourcing the same materials from outside the company. Although not everything can be produced internally, the transactions costs of searching and bargaining for the right inputs and making sure that a supplier sticks to the terms of a contract may induce firms to produce some of the inputs they need in order to avoid these costs, according to Nobel Prize winner Ronald Coase, a professor emeritus at the University of Chicago Law School.
Still, companies with vertically linked operations do exist and may choose such a structure for reasons that have nothing to do with supplying inputs. "It makes us rethink why firms expand vertically and what they are really trying to do," says Syverson. Instead of moving physical goods from one plant to another, Hortaรงsu and Syverson propose that the primary purpose of vertical ownership is to mediate the efficient transfer of intangible rather than tangible inputs within firms. These intangibles include managerial skills, marketing and sales expertise, and knowledge from research and development (R&D). This explanation is consistent with previous research that suggests that it may be harder for firms to get the exact intangible components they need outside of the company, unlike physical goods that would be relatively easier to obtain from the market. As a result, a firm may be better off transferring the skills and knowledge that it already has within the company to other business units as it expands.
Outward Bound The authors analyzed about 30,000 upstream plants that were owned by firms that had at least one downstream unit. These upstream operations reported almost 3 million shipments of their products during the sample period.
Of these shipments, only a very small share was delivered to downstream plants in the same company. In fact, the typical upstream plant ships only 2.6 percent of the value of its output to downstream units within the firm. One-third of these plants report no internal shipments at all. Even upstream plants that could be considered relatively big suppliers of inputs to their companies' downstream operations still sell about 40 percent of their output outside the firm. The exception to this general pattern is a small set of establishmentsâ€” about 2 percentâ€”that are dedicated to serving the downstream needs of their company. In general, the fraction of plants that ship to downstream units falls steadily as the share of internal shipments rises, but then suddenly shoots up to reflect this special group of upstream producers that deliver 100 percent of their output internally. Thus, most of the stories about vertically integrated firms are really about those 2 percent of upstream plants. "The vast majority of the remaining plants are not anywhere near that," says Syverson. "They are much closer to the other end of the scale where they are not shipping anything inside the firm." Several checks to test the robustness of the study's results reveal the same patterns. The traditional view that firms choose to own plants to control their supply of inputs appears to be unfounded in most cases. Thus, companies must have other motivations for choosing a vertically integrated structure.
The Role of Intangible Inputs To understand why companies own production chains, the authors first look at how plants that belong to a vertically integrated structure are different from other plants. HortaĂ§su and Syverson find that plants with vertical links are significantly more productive, larger in terms of output, and more capitalintensive than similar establishments that are not part of an integrated company. For instance,
vertically linked plants produce 4.5 times more output than other plants in the same industry. Moreover, it seems that these plants were already bigger and more productive even before they were brought into the company. The authors also observe that a vertically integrated company is usually larger than other firms that are not integrated. Thus, it is possible that the size of the firm rather than the structure of the company can explain why integrated plants tend to be larger and more productive. That is, upstream and downstream plants are typically of this "type" because large firms own bigger and better facilities, an explanation that has nothing to do with the merits of vertical integration itself. Indeed, the authors find that vertically linked plants tend to belong to big firms, and big firms tend to have better performing plants. These results are consistent with the view that the firm is an outcome of a matching mechanism where two groups want to get together to produce something of value. A marriage market, for instance, is composed of highly skilled men and women as well as lesser skilled candidates. As one would expect, highly skilled female candidates typically match up with highly skilled male candidates. In the same way, the study's results suggest that firms with high-quality plants search for other high-quality facilities to bring into the company. In particular, companies build up their business by acquiring plants that complement their management skills and other expertise and knowledge in marketing, sales, and R&D. Thus, even though most integrated companies do not move physical inputs along the production chain, such intangible inputs can be efficiently transferred within a vertically integrated firm. In other words, firms own production chains because their intangible assets are a good match for the company's plants. The result is that vertically integrated production chains are found
in the largest firms composed of the best performing plants.
Why Firms Expand If this alternative explanation for vertical ownership is correct, then the distinction between an upstream plant and a downstream plant no longer applies. Managerial skills and other similar inputs are just as likely to be transferred from a firm's downstream units to its upstream units as the other way around. Moreover, vertical integration may not be too different from a horizontal expansion of the company. When a firm expands horizontally, it typically goes into a new market that is not far from its current line of business, with the expectation that the company's strengths can be carried over to the new facilities. Such an expansion need not involve a transfer of physical inputs. Management skills and other types of expertise, on the other hand, are expected to flow to the new businesses. Vertical expansions can operate in the same way. In this case, companies are obviously expanding into related markets because the businesses they acquire can supply or buy from each other, although that is not necessary. Whether companies expand vertically or horizontally is just an indication of the direction that the business is going, but the motivation is the sameâ€”to find markets where they can excel. HortaĂ§su and Syverson find some support for the notion that management skills in vertically integrated companies are transferred to newly acquired businesses. When a plant is bought by an integrated company, the plant's labor productivity and capital intensity go up due to an increase in physical capital from the new investment and a decline in hours worked. In fact, the fall in hours worked is mostly due to a decrease in hours worked by nonproduction workers rather than production workers. The relative decline in nonproduction workers is
consistent with replacing the plant's old managers with the firm's own set of managers who will run the newly acquired plant. Capital intensity also would be expected to rise upon integration if the company expects that its managers or other intangible inputs have the expertise to use the machines and equipment it acquires to make the new plant more productive. This article is republished courtesy www.ChicagoBooth.edu/capideas.
Pushing digital marketing content without strategy By John Zerio, Thunderbird Professor
Social media gurus talk a lot about the how. They teach how to create buzz on Twitter, win friends on Facebook and boost search engine results on Google. These are the technical elements of digital marketing. Organizations measure success by the exposure they generate. They count page views, followers, fans and comments. The more the better. But in the rush to push content online, many organizations never stop to consider their digital marketing strategy. Are they creating the right relationships with the right people? Are their messages aligned with customer expectations? And do these messages reflect the organization’s true personality — so that hype matches reality when a Facebook friend or Twitter follower calls customer service or meets an agent in the field? Quantity was king in 2010, but organizations that plow ahead in the new year without answering these fundamental questions will pay a price. A better approach for 2011 includes strategic thinking about digital marketing. Conversations should start with the CEO, who gets paid to drive strategy and lead change. The typical 2010 practice — which left social
media activity to marketing and communications departments acting in isolation — is no longer good enough. Organizations need commitment from top to bottom. Social media activity must occur at many different levels because organizations engage with customers, suppliers and community members at many different levels. CEOs and other leaders set the tone when they reach out to internal and external audiences with their own blogs, Tweets and status updates guided by organizational strategy. We live in exciting times. Every person with Internet access has a voice, and every message has the potential to go viral. Global managers must adapt to these changes, which is partly why I launched a digital marketing course at Thunderbird in 2010. We cover many new topics in the classroom, but some things never change. Organizations still need good products and services. They need technology and innovation. And they need understanding of their customers. Assuming an organization has these three things, opportunities for competitive advantage will abound in 2011 as leaders integrate social media activity with overall strategy. John Zerio, Ph.D., is an associate professor of global marketing at Thunderbird School of Global Management in Glendale, Arizona. He speaks English, Portuguese, Spanish and French, and has extensive experience as a consultant to multinational corporations in Brazil, Japan and Mexico. In 2010 he launched a Thunderbird course in digital marketing. He also leads the Thunderbird Brazil Winterim, “Sustainability in Action.” This article is republished courtesy of http://knowledgenetwork.thunderbird.edu/researc h/
Understanding the Oracle Professor Prem Jain’s book on Warren Buffett compiles 20-plus years of study into a practical guide for investors, big and small. By Chris Blose Although you will never hear him say it, plenty of other people are willing to call Warren Buffett a genius. Authors write breathless biographies about the CEO and chairman of Berkshire Hathaway, and his investment prowess has earned him the moniker “Oracle of Omaha.” Fair enough. Buffett’s company consistently beats the market and has grown at an annual rate of around 20 percent for more than 40 years, so when it comes to investing and business sense, calling him a genius seems about right. However, when it came time for Prem Jain, Elsa C. McDonough Professor of Accounting and Finance at Georgetown University’s McDonough School of Business, to write a new book about Buffett, he was less concerned with painting yet another biographical portrait of Buffett the genius and more concerned with answering a question: What can we learn from him? Jain has spent more than 20 years studying and teaching Buffett’s investment philosophies. His book, Buffett Beyond Value: Why Warren Buffett Looks to Growth and Management When Investing (2010, John Wiley & Sons), reads as a culmination of those efforts and as a guide to investors, big or small, who want to apply Buffett principles to their own investments. Of course, learning from a genius is easier said than done. “If it were easy to copy Picasso and Mozart, then there would be thousands of Picassos and Mozarts,” Jain says. Picasso could teach you how he paints, and Mozart could teach you how he
plays and composes, but in the end, something would still be missing: the thought process and the creative spark behind their work. Buffett’s medium may be money, but the idea remains the same. By poring over Berkshire Hathaway’s books and annual reports, Buffett’s letters to shareholders, and many other types of sources, including Buffett’s own substantial writing, Jain attempts to look into Buffett’s thought process. “I cannot claim that I have figured out exactly what goes on in his head,” Jain says. “That is impossible. But by looking at the available information, including information about how he has made investment decisions, one can come up with one’s own arguments, which is what I have done.” Mind-reading is, as it turns out, unnecessary. “The idea is that even if you don’t do as well as Buffett has, which is unlikely, even if you have a fraction of his success, you’re going to be well above average,” Jain says.
Value and Growth Buffett often has been cast — in popular media, books, and even on Wikipedia — as a value investor. Jain believes that is only part of the story, though. In the book, Jain defines a value investor as “someone who invests in stocks that have such characteristics as low price-to-earnings (P/E) or market-to-book (M/B) ratios It also refers to those people who buy stocks after the market prices have fallen substantially.” On the whole, value investment represents a conservative, lowrisk approach to the market. To combat the idea that Buffett is simply a value investor, Jain turns to the facts. Under Buffett, Berkshire Hathaway has acquired shares of stocks at or above the market’s P/E ratio: CocaCola, Burlington Northern Santa Fe Railway, American Express, and others. Additionally, while traditional value investors buy low and sell high, when a stock reaches or exceeds market
value, independent of time, Buffett holds onto stocks for long periods of time to let them grow — 10 years on average. Jain also turns to numbers for evidence. “An average return on investment in the market is about 9 percent over the last several decades,” he says. “Buffett’s returns are in the neighborhood of 20 percent. Value investing might produce about 11 or 12 percent, and if you can beat the market by that 2 or 3 percent, you’re doing well as an investor. But there’s a huge gap between what value investing produces and what Buffett has produced.” So what accounts for Buffett’s success? To Jain, the answer lies in part in Buffett’s combination of low-risk value investing and carefully calculated growth investing. In traditional growth investing, returns are very high — but so are risks. Buffett is well known as an investor who limits his risk. For example, he typically does not invest in technology because he admits to not understanding that market and not being able to predict the future of technology companies, so he avoids such disasters as the dotcom bubble bursting. However, like growth investors, he does look for companies likely to grow consistently over time. As examples, Jain offers Wal-Mart, Home Depot, Starbucks, and other companies as modern growth stocks that lack the risk of something like a tech stock. Jain recommends examining a company’s earnings over several years, because companies that have strong earnings and growth over several past years are likely to yield growth in the future, too. A long-term view also comes with some simple mantras: Act rationally. Be patient. Don’t panic. Buffett’s cool headed attitude may account for why he did not unload massive amounts of stock during the ongoing recession as many others did; in fact, he wrote an op-ed piece in 2008 in The New York Times saying it was a good time to buy, not sell.
In short, Buffett combines the best principles from value investing and growth investing into his own philosophy that defies the dichotomy between the two.
The People Matter As Jain illustrates through several case studies, Buffett does not assess a company’s growth potential based solely on ratios and other financial analysis. He looks at those numbers, of course, but he also looks at what he considers an even more important resource: people. In his analysis, Buffett places a premium on the quality of a company’s management and corporate culture. His qualitative approach complements the quantitative approach of crunching a company’s financial numbers. It also speaks to his belief that consistently well-run companies will yield growth over long periods of time. Jain offers an analogy: You walk down a city street that features multiple coffee shops. One has a line out the door, but the other is basically deserted. You may wonder about the difference. “They’re selling such traditional products that there must be something other than the products alone,” Jain says. “In that case, I would say that the successful coffee shop probably has strong management and employees behind the counter.” The quality of a company’s products is important, but often its management is what helps it stand out in a crowded marketplace. Buffett has a knack for finding good managers, Jain says. And when he finds them, he keeps them. The book offers the example of three jewelers owned by Berkshire Hathaway: Borsheim’s, Helzberg Diamonds, and Ben Bridge Jeweler. In each case, Buffett got to know the owners and managers personally and became impressed enough with them to want to purchase their businesses, once he had reached the right price.
“While they are all retail jewelry stores, Borsheim’s, Helzberg Diamonds, and Ben Bridge Jeweler are run as separate businesses under the Berkshire umbrella,” Jain writes. “The principal reason is managers who made those businesses successful in the first place by keeping costs low and customers satisfied.” The jewelry example illustrates several of Buffett’s attributes: a long-term approach to investment, faith in strong management, and the belief that if something is already working well, there’s no need to change it. These are principles even smaller investors — who are unlikely to buy entire companies — can adhere to in purchasing their own stocks. Put simply, do your research, but make sure your research goes beyond the numbers.
Competence and Confidence Another of Buffett’s core concepts rings true for ordinary investors, too: Stay within your circle of competence. To illustrate, Jain offers another analogy. “When you take a sick child to the doctor’s office, the doctor will not get nervous because the doctor thinks, ‘OK, I can fix this child,’” he says. “The mother might be throwing fits because she doesn’t understand what is happening. You need to be in the same situation as the doctor, not the mother.” Buffett was in the doctor’s position back in 1967 when he acquired two insurance companies, National Indemnity Company and National Fire and Marine Insurance Company, for $9 million. Buffett knew the insurance business well, and his understanding of that business has grown over time with big-time acquisitions such as GEICO, which became a wholly owned subsidiary of Berkshire Hathaway in 1995. In fact, insurance remains the company’s main business. Buffett and Berkshire have succeeded in insurance because of a thorough understanding of the
industry. The lesson for everyday investors is to pick your areas of focus carefully. If you already understand a particular industry well, search for and invest in the best of the best within that industry. And if you want to branch out beyond your current circle of competence, gather expert opinion and learn as much as possible about the new field you wish to enter. Buffett did not know much about jewelry when he purchased Berkshire’s first jeweler, but he turned to the expertise of the managers who had impressed him so much. With competence comes confidence, and confident investors tend to succeed more than those who scare easily, Jain points out. Perhaps that is why he devotes two chapters of the book to the psychology of investment. You must ask yourself important questions before diving into investing, Jain says. Can you be patient when the market hits trouble, or will you follow the herd and sell, sell, sell? Are you flexible enough to change your thinking when you must? Do you think rationally or act on impulse? Can you learn from your mistakes? In the end, Jain hopes his book will not only delve into Buffett’s mentality, but also into the reader’s and potential investor’s. He writes with a general audience in mind, but he backs up his assumptions and recommendations with a wealth of data, both quantitative and qualitative. The book has been well received critically, and Jain already has sold rights to translations including Chinese (both Cantonese and Mandarin) and Thai. Praise and sales are nice, but Jain insists his intent in writing Buffett Beyond Value was much more intellectual than commercial. “Warren Buffett has written so much, and he claims that most of the things he does can be copied,” Jain says. “This was my challenge. I took upon myself a challenge to understand
Buffett, with academic rigor.â€? This article is republished courtesy of Georgetown Business http://msbmedia.georgetown.edu
Good Management Weaves Gold into the Bottom Line A new Stanfordâ€“World Bank field experiment in Indian textile plants finds the most compelling evidence to date that management matters. by Kathleen O'Toole In a manufacturing center four hours from Mumbai, India, the last working elevator in a textile weaving plant grinds to a halt. The looms and workers on the second floor need more cotton yarn to weave horizontally into the vertical warp threads in order to make cloth. But the factory owner is away on a sales trip, and no one else in this 24-hour-a-day, 7-day-a-week factory of 200 employees is authorized to pay for elevator repair. A cadre of workers is left with no option but to carry 1,200-pound spools of yarn up the stairs. "You might wonder how a factory owner who refuses to delegate authority on this level can stay in business," says John Roberts, a Stanford Graduate School of Business economist who has studied this cloth-weaving factory and many others that make shirting, suiting, or home furnishing fabrics for the Indian domestic and Middle Eastern markets. Indeed, economists and industrial policy makers have long puzzled over astounding differences in
the productivity of companies in the same industries or same countries. For example, U.S. plants making cement, block ice, white pan bread, and oak flooring display 100% productivity spreads. On a country comparison basis, India's per capita gross domestic product is one-seventeenth that of the United States. "A natural explanation for these productivity differences lies in variations in management practices," says Stanford economist Nick Bloom (at left), who, along with John Van Reenen, a visiting professor from the London School of Economics, has developed methods to compare management and productivity across industries and countries. They find strong correlations between management and productivity, but correlations are not proof of cause and effect. News media, book publishers, business schools, and government officials all talk about the importance of management, Bloom says, but many workers, economists, and even some of his MBA students and managers taking GSB executive education classes are skeptical. Some of Bloom's and Roberts' peers in economics believe that bad management practices can't exist in competitive industries, except in the short run. For example, in their view, companies in developing countries may not be adopting quality control systems that are
common in countries with higher wages because wages are so low that repairing defects is cheap. Hence, their management practices are not "bad," but the optimal response to low wages. A second reason for skepticism, Roberts says, is the complexity of management, making it hard to measure and quantify. While some business educators believe there are "best practices" that are universally good and that all firms would benefit from adopting, others hold the "contingency view" that every firm is already adopting optimal practices, which are different from firm to firm. In a rare feat for economics, Roberts, Bloom, and three colleagues were able to provide experimental evidence that a core set of management best practices does exist. In a 2-year field experiment that ended in 2010, they compared Indian textile factories in the same labor market and showed that those that adopted so-called best practices improved their productivity about 10% within a matter of months, while a control group did not. The scholars also detailed the impediments that kept firms from adopting better practices. Besides Roberts and Bloom, the researchers are economist Aprajit Mahajan of Stanford; Benn Eifert, a recent doctoral graduate of the University of California-Berkeley; and David McKenzie of the World Bank. The $1.3 million experiment was made possible by a variety of grants, with the largest support provided by Stanford's Graduate School of Business and Freeman Spogli Institute for Inter-national Studies. The researchers worked with Accenture consultants to expose 20 mid-size Indian textile plants owned by 17 firms to management practices commonly employed in U.S., European, and Japanese manufacturing plants. The factories, a small fraction of those in the towns of Tarapur and Umbergaon, India, were assigned randomly to a control group of 6 plants or to a "treatment" group of 14 plants. Based on
their prior textile experience, the consultants chose to promote 38 practices such as routines for recording and analyzing quality defects, production, inventories, and order fulfillment. They encouraged preventive maintenance, clear job assignments, and incentive pay based on performance. Photos taken before any changes were implemented show storerooms of yarn in disarray, factory floors littered with tools and other safety hazards, and haphazard handwritten records of product defects. While such disarray might work fine for a single artisan, Bloom says, firms with hundreds of employees performing complex operations need formalized management practices to support coordination and motivation. The study began with consultants spending a month in each plant diagnosing problems and constructing databases for recording metrics such as output, efficiency, quality, inventory, and energy use on an ongoing basis. They then provided each treatment and control plant with a detailed analysis of its management practices and performance. "The control plants because we needed performance data for systems to generate explains.
were given diagnostics to construct historical them and help set up ongoing data," Roberts
Next the consultants spent 4 months with the 14 plants randomly chosen for "treatment." The consultants' job was to persuade plant managers to implement the practices and also to help them implement, fine-tune, and stabilize the procedures so that they could be carried out readily by employees. For example, one of the practices implemented was daily meetings for management to review production and quality data. The consultant attended these meetings for the first few weeks to help the managers run them and provide feedback.
"The treatment intervention led to significant improvements in quality, inventory, and production efficiency," the researchers wrote in a summary. "The result was an increase in productivity of about 10%, a 60% reduction in defects, and a substantial increase in profitability of about $200,000 on estimated average-plant sales of $7.5 million." In contrast, the control group factories registered less than a 1% gain in productivity. For GSB strategy Professor William Barnett, the researchers "not only identified improvements in firms' measureable performance, they also specified the process by which it happens in terms of changes to management practices. Those changes were made with the same management, which demonstrated that achieving better practices is a learning process." That suggests a greater role for executive education programs in developing countries, says Barnett, who codirects the business school's Center for Global Business and the Economy with Roberts and former Secretary of State Condoleezza Rice. Yet reaching firm managers in rapidly developing economies won't be easy, Roberts and Bloom say, because sales representatives for services besiege them. "We think we were able to get permissions to do our study partly because of the Stanford name," Bloom says. In rapidly developing economies, such as India, China, and Brazil, Roberts adds, sophisticated management practices do exist in high-tech firms and in others that have had broad exposure to multinational companies, but practices are less systematic in other industries, such as textiles. The processes that were successfully introduced included recording machine downtimes and the reasons for them, clearly marking the floor where each machine should be, daily updated visual aids on procedures and efficiencies per
machine, and spare parts purchased, recorded, and stored.
In quality control, the practices included monitoring, recording, and meeting to discuss defects on a daily basis, developing a clear grading system for the product and an action plan based on defect data. Previously at some plants, defects were logged in handwriting but only referred to if a customer complained. Now defects are analyzed so they can be corrected the next day and not repeated. In the "treated" factories, Bloom says, display boards now make productivity statistics visible on the shop floor, and incentive pay is based on the data. Factories often lost track of yarn supplies. Now they have them organized and counted so designers can fashion uses for them. The Accenture consultants asked standardized questions to learn why a given practice had not been adopted previously. Cultural practices and legal institutions played a role, but, Roberts says, the primary impediment to change is limited knowledge. "We saw a significant uptake in preventive maintenance in our treatment firms but not in the control firms, who heard about it in the initial consulting. Even in the treated firms, consultants had to persuade the owners to try preventive maintenance on a sample of machines first. They needed to see proof it paid off over time." When asked why they had not done preventive maintenance before, factory workers indicated "either it was because they never heard of it, or they didn't believe it worked, or they thought they were pretty good at what they did already." "It's really the same story as with the U.S. auto industry in the '70s to '90s," Roberts adds. "At first they didn't adopt Toyota's lean product techniques because they didn't know about
them. Then they knew about them but didn't believe they would work in their plants. Finally they needed help implementing them."
as senior managers. Having better data from the plant freed him up to open two more plants because he didn't need to be there every day."
The management of the Indian textile factories was highly centralized, which also makes change difficult. While the average company had four levels of management, all the important decisions were made at the top level.
Another conclusion of the field study was that modern management leads to computerization and probably a changing workforce.
"A typical company is one guy and his two brothers who own the entire firm," Bloom says. "They are the only people who would make any substantial decisions involving money, hiring, or product change. Everyone executes what they have been told to do. In America in a similar situation, plant managers have capital budgets; they can hire and fire and have some choice of product mix." The reason for centralization is the degree of theft risk the Indian family owners face, Roberts says. The Indian court system has huge backlogs, so it is hard to rely on laws as a disincentive to theft. Bloom adds: "If the owner lets the plant manager buy yarn, he may buy this from a friend paying 110% of market rates and then get a juicy kickback. So to get around that problem the owners typically make all the major decisions." Better management practices helped decentralize decision making, the researchers found. "Once I'm getting daily updates from the factory on outputs and inputs and efficiency, I don't need to be on the scene as many hours to check up on stuff," Roberts says. "For example, if I am monitoring daily yarn inventory and purchases I would notice suspicious jumps in prices or missing inventory. "In our best managed firm, the family had only one adult male, so he had to be at the plant every day because they do not use nonfamily members
"When you need to produce daily charts, you need computer-literate managers and analysts, so you start to change the educational composition of the factory," Bloom says. "This wasn't obvious to us in advance, but it could be one reason that in the United States, for example, it's harder and harder to earn a good living if you are not very well educated. You can see in India that these management practices are bad news for the illiterate factory worker and good news for the guy with more skills." Some theoretical work by researchers suggests that computer literacy may drive a widening income gap, and this research would support that idea, Roberts says. The study showed "substantial productivity gains from adopting lean manufacturing practices," says GSB economics Professor Kathryn Shaw, who is well known for her careful studies of firms' human resource management strategies and the productivity impact of management practices in U.S. steel mills. The Indian textile plant study, she adds, "is uniquely able to answer the question, Why don't more firms in developing countries like India adopt modern manufacturing practices?" "The insider econometric methods used in this study and answers obtained," she says, "have produced a research paper that will be highly valued and quoted forever." This article is republished courtesy of Stanford Business Magazine http://www.gsb.stanford.edu/news/knowledgebase .html
No one can blame a company for wanting to put an unhappy incident behind it.
WHEN THE GOING GETS TOUGH
But a new study by Tuck assistant professor Ellie Kyung suggests that the way consumers remember negative events, such as a product recall, can affect how distant they feel from them and how likely they are to assign blame to those involved.
We’ve heard about the financial aspects of the recent economic crisis, but what about the human capital side? A down economy, with bottom lines suffering and massive unemployment, presents a host of potential problems and opportunities for corporate managers. Employees may behave differently than in rosier times, and it takes canny management to be alert to the new dynamics. For instance, those workers fortunate enough to have jobs may nonetheless have been subjected to pay freezes or even cuts, a sure drag on incentive. How then does their employer hope to motivate them to do more than just “mail it in”? And with corporate profits squeezed, pressured employees may be more focused on their losses than their gains, a mindset that could tempt them to stretch ethical boundaries more than they might have when gains were the norm. As for those companies who are, or expect to be, in a hiring mode, they have an unusually large pool of job applicants from which to choose. Should an applicant’s relevant experience automatically make him or her a better hire, or are there unforeseen complexities when they bring their experience to the new organization?
Kyung and her co-authors attribute this to the underlying mindsets people can bring to bear when recalling the past. Those with a concrete mindset seek more specific and detailed information, which leads to a more complex reconstruction of the memory. This not only makes the event feel as though it occurred more recently, it also leads consumers to take mitigating circumstances for these negative events into account more and blame involved parties less. People with an abstract mindset, on the other hand, recall things in a more generalized way. Such memories feel as though they occurred in the more distant past, one consequence of which is a greater tendency to hold parties more accountable for negative events.
New research into organizational behavior highlights the particular challenges of managing in a recession
E. Kyung, G. Menon, Y. Trope, “Reconstruction of Things Past: Why do some memories feel so close and others so far away,” Journal of The following excerpts of three papers by Stern Experimental Social Psychology, 46(1), 2010. faculty present research that will provoke a thoughtful contemplation of the dynamics of "Republished with permission from Tuck news human organizational behavior and how to http://www.tuck.dartmouth.edu manage it.
HOW TO INSPIRE MOTIVATION Getting more than your money’s worth as a manager means treating employees with respect and fairness, not just providing decent paychecks
By Steven L. Blader As any manager can attest, motivating employees to go the extra mile is no easy task, even in palmy times. In periods of economic distress, when companies are under unusual financial pressure, it is especially important to gain employees’ long-term commitment and loyalty. Understanding how to motivate a workforce during such downturns will serve organizations well not just through the rainy days but through a recovery as well, when other job opportunities may beckon. With my colleague, Tom R. Tyler, University Professor of Psychology at NYU, we set out to test our prediction that identification with the organization, pride, and respect would be critical to whether employees feel valued and motivated enough to contribute more than is required. If this proved to be true, we reasoned, it could help companies solve the eternal puzzle of how to retain and motivate their employees.
The Organization Man We knew from previous research that the extent to which employees relate to the organization they work for – their group engagement – is a critical factor in how they fulfill their roles there. A key element of that engagement is their social identity, which we define as a multidimensional construct that works to produce the implications of group membership on the concept of self – a kind of mirroring of group values and shared identity that contributes to an individual’s selfimage. The social identities employees form around their work groups and organizations are strongly related to whether they will do more than is required of them. This extra performance is called extra role behavior, and it is essential to an organization’s viability and success. In order to better understand what motivates such extra role behavior, we explored its relationship to social identity, but we also investigated the interplay of social identity and group engagement
with two other elements of organizational life that are known to influence employees’ engagement with the group: how fairly they believe they are treated by their company (their judgments of procedural justice) and how fairly or well they believe they are compensated (their judgment of their economic outcomes).
A Complex Dynamic Our first hypothesis was that employees’ social identity will be positively related to their extra role behavior. The second was that social identity is shaped by employees’ procedural justice judgments; furthermore, social identity accounts for the effect that employees’ fairness judgments have on their behavior. Our third hypothesis was that social identity is shaped by how employees evaluate their economic outcomes. We tested these hypotheses in each of two field studies. Our first study was conducted in a work group within a major financial services organization where economic concerns are especially prominent. In the second study, a broader and larger test, employees worked in diverse jobs in diverse industries and locales. In both studies we queried employees and, with their permission, their supervisors. The results in both studies not only supported all our hypotheses, they exceeded our predictions insofar as they indicated that social identity is an even stronger influence than we expected on employees’ motivation to go the extra mile. Furthermore, social identity largely explained the effects of procedural justice and economic outcomes on employee behavior. Determining that social identity provides the mechanism by which these organizational conditions relate to employee behavior provides critical insight into understanding how, when, and why efforts to shape the context of employees’ work experiences may affect their behavior. It also contributes to the growing acknowledgement within psychology that the collective self – the aspect of the self most
closely linked to social identity – plays a fundamental role in shaping employee behavior. The results for the way employees think about their compensation are especially interesting. It is traditionally believed that pay, benefits, expectations of promotion (and thus, hopes for greater pay), and other similar factors affect behavior because of their economic or instrumental value. Our findings here suggest that a primary way in which economic outcomes may affect behavior is through their impact on social identity.
Practical Implications These findings suggest that the basis of employees’ relationships with their organizations is primarily linked to the role the organization plays in affecting how employees think and feel about themselves. Many important practical implications follow from this insight. First and foremost, the company has great power to motivate their employees if it can help them develop social identities that are grounded in the organization and in their particular work groups. The results also indicate two important levers that organizations can use to encourage the development of social identity. First, they can operate in ways that employees regard as procedurally fair, instituting fair decision-making processes and extending fair quality of treatment. Second, they can provide economic outcomes that employees regard favorably and that encourage employees to link their social identities to the organization. The key to successfully applying any of these insights is doing it loud and clear. Employee judgments of procedural justice are susceptible to a wide array of subjective influences, and as such, merely implementing fair procedures isn’t enough. Organizations must also ensure that employees are well aware that such procedures are in operation. Another challenge is to provide economic outcomes in ways that actually encourage the
development of a strong social identity. Financial incentives must be dispensed in ways that lead employees to regard their relationship with their organization positively. When such incentives are provided in an environment marked by threats or guided by obligations, it becomes less likely that economic outcomes will positively affect social identity or behavior. Even more, when employees must force their organizations to provide them with better economic outcomes – for instance, by looking for alternate jobs, getting outside offers, or taking collective actions – then it is unlikely that their achieving their goal in this manner will foster social identity or motivate them to work extra hard. Of course, the practical implications of these studies are influenced by the level of employee in question. Among employees at lower socioeconomic levels, for whom resources are literally critical, the impact of financial incentives on behavior may be more direct. Similarly, social identity may be less likely to shape behavior among employees who have tenuous links to the organization, such as temporary and contract workers, and among workers that do not share demographic group memberships or values with the organization. Still, the results of this and related research clearly suggest the potential value, under many circumstances, of social identity for understanding employee attachment to organizations and, moreover, of social identitybased ways of stimulating higher levels of extra role behavior in hard times.
STEVEN L. BLADER is associate professor of management and organizations at NYU Stern. This article is republished courtesy of http://www.stern.nyu.edu/Newsroom/SternBusines s/index.html To be continued in the next issue with “Bad Behavior”
A horse of another colour Tomo Suzuki says international accounting standards need to recognise difference. By Anthea Milnes Since the end of the Second World War, international standardization has been the holy grail of accounting. Now, finally, International Accounting Standards (IAS) and International Financial Reporting Standards (IFRS), developed by the London-based private regulatory body, the International Accounting Standards Board (IASB) have been adopted or partially adopted in more than 130 countries around the world and are set to become the norm in even more. Of the world’s leading economies, only the US and Japan still remain on the outside and they may well join the IFRS fold in the next few years. The benefits of International Financial Reporting Standards (IFRS) seem obvious. Companies operating across borders want to compare “apples with apples”, investors considering opportunities in different countries, want to make decisions based on information they understand and trust. At first sight, it seems like a “no brainer”.
The other side of the story But Tomo Suzuki, Reader in Accounting at Saïd Business School, believes that the new accounting standards are not the gift to companies and investors that they seem. “You imagine that if you standardise accounting across the world, you can compare X, Y and Z,” he says. “But that’s wrong. It’s philosophically wrong and practically wrong.” Suzuki cites the example of plantation industries in Southeast Asia, the main industries in this part of the world, to illustrate the problems with IAS /
IFRS. Indonesia is the world’s leading producer of palm oil. Palm oil is the country’s main export and is used in everything from chocolate, to cooking oil, to cosmetics. The plantations work as follows: in year one you plant seeds; then for the first four years, the oil palm tree is too small to bear fruit; in the fifth year the farmer processes the first oil palm fruits, extracts the oil, sells it, and starts to make a profit. “So what profit curve do you imagine for a palm oil business?” Suzuki asks “Perhaps one that shows zero profit for the first four years and then increasing profit thereafter?” It turns out that under IAS 41 “Agriculture”, which uses “fair value accounting”, the palm oil plantation makes a huge profit in year one, due to the fair valuation of palm oil trees as assets, and less thereafter as the fair value of assets decrease. This is based on the “fair value” model that uses discounted cash flow techniques, under which all future cash flows, usually over 25 years in the plantation industries, are estimated and discounted to give their fair values. “According to IFRS accounting, as soon as the farmers plant their trees, they are making a profit and that is shown on the financial statement of the company,” Suzuki says. “If you were an investor, you would demand dividends. If you were the Directorate General of Taxes in Indonesia, you would demand tax. But no money has come in, and so the company would have to arrange a loan to pay the revenue and the dividends. The government is happy because it wants to encourage foreign direct investment by adopting IFRS. But the next year there might be a hurricane and the company would be bust.” The investor wins in the short term, but potentially at the cost of the farmer, and the long term health of the industry and the country’s economy.
Playing games London Stock Exchange listed plantation firms are already subject to IAS, but their financial
statements reveal novel and controversial accounting practices which may undermine the operation and finance of plantation firms. “Fair value sounds very good,” Suzuki says. “The rhetoric is very persuasive – transparency, comparability, fairness, objectivity – but this method is based on looking at the market value of a company if it’s sold at a given moment in time, not on an understanding of local businesses.” Hi-tech Western investors may want to value palm oil plantation companies, rubber companies or timber companies based on Fair Value models, but that doesn’t mean that this kind of calculation should form the basis for regulated financial accounting. “It’s just an investment calculation which analysts should do,” Suzuki says. Company accounts have different purposes and different audiences, and the implications of IAS / IFRS for fraud, creative accounting, corporate governance, borrowing, sustainable business, and business ethics all need to be considered alongside the needs of Western investors. Another example of possible game playing with the new standards is the nuclear power industry. Constructing new nuclear power plants is a pressing need for many countries, who want to use nuclear power as a practical way to meet energy demands while avoiding burning fossil fuels. Currently, however, because of IFRS, it is almost impossible for companies to raise money to finance new nuclear plants, because of the calculation of the valuing of the liability of nuclear waste. However, in theory, nuclear waste could be reclassified as an asset, as it has the potential to be recycled as an energy source. Will the plants ever really recycle this waste? Who knows? And if the company can project a profit will they care? “Under old-fashioned historical cost accounting, we didn’t need to play that sort of game,” Suzuki
IAS / IFRS and developing economies Suzuki’s research into the socio-economic impacts of International Financial Reporting Standards (IFRS) fed into India’s road map towards financial convergence, which was announced on in January 2010. Suzuki recommended that rather than adopting IFRS wholesale, India should consider carefully converging with the international standards, where appropriate, based on wider stakeholder consultations. He also recommended caution in applying IFRS to India’s Insurance industry and public sector corporations, for the sake of the sustainable growth of the country and the welfare of Indian public. Both recommendations have been adopted in the country’s financial accounting policy announced in January. “Salman Khurshid, Minister of Corporate Affairs of India, is cautious about these new accounting standards,” Suzuki says, “because it’s just changing the mentality of business people, encouraging them to focus only on short-term profit.”
Adoption versus convergence But isn’t that a problem that applies to all accounting standards? Surely no set of standards can be sensitive to every industry, purpose and audience? “It’s about the balance of standardisation and diversification,” Suzuki says. “We’ve lost sensitivity to local things. I think this is an example of the West being a bit arrogant.” Suzuki does not deny that there is a need for standardisation in some contexts, but he suggests that there is no need to regulate in this area. “Given these local differences and challenges,” he says, “why not let jurisdictions converge rather than adopt International Accounting Standards wholesale? For economies that are declining such as Japan, there may be benefits in
adopting IFRS, but for developing economies, the benefits are not so clear.”
Managing a disaster
Institutions such as the United Nations It's not a pleasant thought, but another major Conference on Trade and Development and the disaster is going to happen, sooner or later. Nitin World Bank are pushing for adoption of IFRS Bakshi believes that we can both learn from how around the world, but Suzuki has a different disasters were managed in the past and also find vision for accounting standards – one which better ways to manage and recover from the next prioritises sensitivity to context and to audience, major global setback. Moreover, he believes that and which takes account of sustainability and relying on governments alone is not wise. Stuart society as well as financial returns. He has been Crainer asked Professor Bakshi about his views. invited to share his vision at the World Bank in You’ve received recognition for your Washington DC in September, at least for the case research in helping companies and of IAS 41 in plantation industries. This article is republished courtesy of http://www.sbs.ox.ac.uk/
governments avoid disruptions in business continuity when disaster strikes. No one wants to think of a disaster as a regular occurrence, but you seem to be introducing the idea.
We’ve always had disasters, but what’s new in the modern business environment is the globalisation and interdependency of the world economies. According to the UN, 2009 was the mildest year in the last decade in terms of number of natural disasters, yet accounting for 245 disasters compared to a high of 434 in 2005. Some 58 million people were affected in 2009 and the economic losses tallied up to an astounding $19 billion. Companies like General Motors, for instance, are operating in more than 50 countries. So the likelihood of being hit by a disaster is fairly high for such firms. When it does happen, there can be huge consequences for the supply chain network.
The flood in Pakistan is one fairly recent world disaster. Most people focused on the humanitarian consequences, not the supply chain. Certainly, the humanitarian aspect is most critical. However, there is another dimension to the matter. Americans, for example, may watch such a disaster and feel compassion for the people of Pakistan, but they may not realize that they are
affected by the crisis too, albeit economically. Pakistan is a major supplier of raw material to the garment manufacturers. This flood leaves the garment industry grappling with the problem of making alternate sourcing arrangements. They are, no doubt, searching for another source right now, probably in Sri Lanka, Bangladesh or Vietnam.
You are not saying that business disruption outweighs humanitarian concern. I’m saying that the two concerns are not entirely divorced from each other. There is significant overlap between what governments need to do to help people recover from a disaster and what businesses need to do to resume normal operations. The same holds true for prevention of disasters. This overlap between “humanitarian logistics” and “business continuity” is where I wish to contribute. My focus is on getting the public and private sector to think in terms of cooperation. I have two major interests: the first is the management of disruption — I’m talking about catastrophic disruptions such as natural disasters, terror strikes and economic slowdowns. The second is elaborating on the role of the private sector in creating a society that is resilient to disasters.
Managing disruptions Let’s first talk about the management of disruption. What does that mean? When you think of the management of disruption, you are talking about strategies you might put in place before, during and after the disruption. So, before a disruption, you would do a risk assessment (identification and measurement of the risk); monitor the risk; and you would try to mitigate the risk, i.e., reduce the likelihood of a disruption occurring and reduce the scope for losses in case an adverse event
were to occur. During the disruption, you continue to use mitigation strategies directed at containing losses. After the disruption you’re looking at recovery, such as workers returning home after the hurricane or a flood evacuation and, on a bigger scale, resuming port or airline operations.
And what role do you see the private sector playing in creating a society that is resilient to disasters? The traditional view has been that public safety and security are entitlements provided by the government to citizens. Governments are beginning to see that this is just not viable anymore. There is a need for the private sector to get involved. For instance, retailers have channels and resources for distributing their products to the customers in a very short time, and they have fantastic communication infrastructure as well. In the event of an evacuation triggered by an extreme event, why not capitalise on this infrastructure, which is already in place, rather than try to recreate it from scratch, from the government’s point of view?
Are you suggesting that the communication and logistical infrastructure of Tesco and Sainsbury, which is already in place, would get relief to disaster victims faster than the government can? I am suggesting they may have developed supply channels and resources that could be used during a natural disaster. With appropriate oversight from the government, the retailers would be happy to volunteer their help in difficult times, as it facilitates early resumption of business and is reflective of the organization’s commitment to CSR. Indeed, I see scope for alignment in the objectives of the government and the private sector. In my research, I have been trying to identify and elaborate on the role of the private
sector in creating a resilient society.
How do you see the private sector working with a government during a disaster? The primary concern is protecting lives and restoring normalcy as quickly as possible. The private sector can certainly help facilitate these objectives. Certainly by adhering to safety best practices and investing in early warning systems, disasters such as the Bhopal tragedy in India (1984) and the BP oil spill in the US Gulf Coast (2010) can be avoided. By not restricting itself to not causing the problem, the private sector can be part of the solution at large by sharing its knowledge, infrastructure, and human resources in crisis situations. Finally, the Insurance sector has an important role to play in efficiently redistributing the risk from disasters across the various stakeholders in society.
Working together Getting all the players to work together sounds like a monumental task. I think governments are warming up to the idea because they know they need to respond more quickly and be more creative in times of disaster. The private sector has already thought about a lot of these contingencies in the context of Business Continuity Planning. Rather than having a government-centric approach to emergency management, we need to involve the private sector and individuals much more. Public-Private partnership for disaster management is where the future lies. Your view of disruption risk avoidance strikes me as pretty creative. You’ve stepped back and assessed the situation from a supply-chain perspective. What brought you to this perspective? In an article I co-wrote with Professor Paul Kleindorfer, ‘Co-opetition and investment for supply-chain resilience’ (Production and
Operations Management 18, no. 6, 2009), we proposed that suppliers and buyers should jointly invest in supply chain security. We also showed how collaboration can be implemented and that it’s economically smart. You also have been part of a team of professors that wrote about the security of international ports. It has attracted a lot of media attention. Do you find that a sign that your work is making a difference? Yes, well, those 20-foot by-8-foot by 8-foot metallic boxes carried by large ships are the infrastructure underlying international trade. It wasn’t long after September 11 that the United States and the UK realised the significant risk to national security they present — weapons and instruments of terrorism could be smuggled in. As a result, the US mandated that, by 2012, 100 per cent of US-bound containers at international ports had to be inspected. But there is a problem with that mandate: it will take a lot of time, cost a lot of money and create significant congestion at the ports. If congestion increases rapidly or grows beyond control, that will affect international trade, and therefore GDP. I have worked with Stephen Flynn at the Center for National Policy and Noah Gans at the Wharton School to describe how to effectively manage this congestion by suggesting that the private sector get involved. (‘Estimating the operational impact of container inspections at international ports’, is available at: http://papers.ssrn.com/sol3/papers.cfm?abstract_i d=1664386.)
Could you elaborate on that? Currently the US or UK governments maintain their respective national inspection infrastructure. If each of the two countries were to unilaterally inspect containers without involving the private sector, then it would be burdensome and, quite possibly, infeasible. I have examined the advantages and disadvantages of the two methods of container inspection that
are the most likely to be used. There has been a lot of debate about what is feasible and what’s not, but only one system — an adapted version of what is called the SFI approach — is capable of being scaled up to satisfy the scanning and radiation detection requirement mandated by the US law. It involves rapid screening using relatively low-cost drive-through portals followed by a more careful scrutiny of only those containers that raise an alarm in the initial screening. Thisprotocol allows it to handle 100 per cent of all container traffic bound for the US, as well as other destinations, on a cost-effective basis. Terminal Operators, who are members of the private sector, have stepped forward and volunteered to invest in the equipment and to manage the inspection process as part of their Business Continuity initiatives. With adequate government oversight, this would constitute a sensible approach since the Terminal Operators are best placed to manage congestion at the terminal.
You have just published a new paper about the power grid system. Should they be managed differently? The idea there is that national infrastructure, such as a power grid that uses traditional fossil fuel for power generation, could be vulnerable to disruption – unintentional or otherwise. This is true anywhere in the world but particularly so in some developing nations. Firms that are outsourcing work to a developing country might want to think about funding backup micro-grids powered by solar or wind energy as an alternative power source. Then, in case the national grid is not available for whatever reasons, they could still function using the micro grid. Furthermore, this reduces the attractiveness of the national grid as a potential target for terror strikes. The point is to build on the idea of involving the private sector in achieving resilience.
What other private-sector expertise can be applicable to the study of disruptions? To provide an example, with regard torisk assessment, I think the companies that collect and interpret near-misses have a lot to offer. Du Pont is a leader in tracking near-miss statistics. This is a chemicals company that has to manage potentially dangerous processes. They represent undesirable events in a pyramid structure in order to identify and measure risk. For each adverse event, there are a number of events with limited impact and even more with no impact. So, at the top of the pyramid is the worst case — say fatalities or serious injury — the ultimate undesirable event. At the bottom, they may be a lot of minor events such as oil spills on the shop floor. These events, closer to the bottom of the pyramid, are referred to as near-misses. The company may have very little data on fatalities, but many oil spills obviously point to the fact that things are not running all that smoothly in the organisation, and are a leading indicator that you might have fatalities if you don’t investigate and address the cause of the oil spills. Tracking near misses can give insight into how to effectively manage safety within the organisation.
Are there any other risk-avoidance or business continuity practices that you’re investigating? There is an opportunity to learn from the use of performance-based contracting in the aircraft engine industry. For example, Rolls Royce, based in the UK, uses performance-based contracts which they refer to as “total care”. That means they will supply engines to airlines and in return will get paid for the number of flying hours, the time the plane is actually flying. Under this arrangement Rolls Royce assumes responsibility to keep the plane flying. Hence, it is in its best interests to work hard to keep the
engine fault-free. The longer the plane flies without need for engine maintenance the more money it makes.
What can we learn from performancebased contracting that we can apply to disaster management?
Predicting Innovation Winners and Losers: Start with the Design
If there were a National Museum of Failed It’s very difficult for the government to monitor Products, the display cases would be full, but what various agencies and contractors are doing in would anyone come? times of disaster. However, if their reward structure incorporates some meaningful measure On display might be the Apple Newton PDA of performance, such as a recovery time objective (right), Macintosh TV, the New Coke (and to be (RTO), then presumably it will motivate them to fair, Crystal Pepsi), Tivo, various attempts at do their job to the best of their ability without the tablet PCs, and even the Jay Leno Show. need for close supervision. Obviously, predicting product winners isn’t easy, Learning can certainly occur both ways, that is, despite millions of dollars the private sector can be the beneficiary too. It consumer focus groups. makes complete sense that disaster management agencies in the public sector and volunteer organisations, such as Oxfam, would have developed expertise that might be relevant to the private sector. Disasters are going to continue to happen. The whole point is to keep improving at managing them. I would not wish for my work to be restricted to being an academic exercise. Therefore, getting this research out to a bigger audience is actually quite important. I believe that the private sector has a lot more to offer in helping create a more resilient society. This article is republished courtesy of London Business School http://bsr.london.edu/lbsarticle/603/index.html
spent on R&D and
Violina Rindova, Ph.D., studies product form design, and argues that product form is an inseparable aspect of a product innovation strategy. Her analysis shows that product form design affects both how consumers conceptualize and respond emotionally to new products. These emotional responses to novelty may be the little-understood cause of why so many companies miss the mark with their new products.
People Find Novelty Stressful “Our analysis shows that novelty is stressful and can trigger negative emotions for consumers,” Rindova explains. “So a company must find ways to help consumers overcome the stress and resolve the uncertainty that new things make us experience. Our research suggests that product form design is
key to this process. It isn’t just an ease-of-use issue, although ease-of-use is very important. At a deeper level, our sense of what is valuable depends on often unconscious expectations about how things 'should be.' So, product form design affects how consumers relate initially to a new product and how this initial emotional reaction influences how they come to think about what the product is.”
“Product developers are taking it more seriously as part of the innovation strategy of the firm,” she states. “There is an emotional component to product design, and you can choose to manage it strategically or not. You can’t separate the technological path and the product form path, but rather these notions should be integrated from the beginning of the product development process.”
One way to achieve quicker acceptance or understanding of an innovative product is to activate pre-existing understandings about the product category. Rindova uses the example of digital cameras to illustrate the point.
Rindova explains that such integration flies in the face of traditional product development scenarios, particularly in technology fields. “The engineering culture of technology and science, and the designer culture, with people trained in the arts and humanities not only have vast knowledge differences, but different logics as well,” she says.
“A digital camera is closer in technology to a scanner,” she says. “But consumers understand what a camera is, how it feels, how it functions, even how it sounds. The rapid adoption of digital cameras is, in part, related to the fact that they replicate the form of traditional cameras so closely. As a result, they are easily understood and accepted.” Although logical, this view of product form is far from the norm among technology companies. Product form is often considered a superficial design aspect, not really a source of value, but Rindova argues that choosing the right product form is essential to the competitive positioning, as well as the evaluation of the product by consumers. “The criticism of Apple’s Newton is that it failed in the writing recognition, but that was primarily because it was compared to a computer. The Palm Pilot did a lot less than the Newton, but its point of comparison was a note pad. The Newton was seen as an underperforming computer, and the Palm Pilot was an over-performing note pad.”
Product Form Becomes an Innovation Strategy Violina Rindova, Ph.D.Rindova sees an increased understanding among manufacturers that product design is a strategic decision.
“And the third constraint is that doing product form design right is expensive. There are firms, such as Apple, that have a better track record than others in achieving the balance of technology and experience, and they are able to capture premium pricing as a result.” In a continuation of her studies on product design, Rindova is currently working with colleagues in Italy studying firms such as Alessi, that have become known as “The Italian design factories” because they have successfully integrated cutting-edge design in product development for many traditional products, such as cooking pots and bottle-openers. These designers undoubtedly hope their creations do not end up as negative case histories for Rindova's research. Violina Rindova is the Ralph B. Thomas Professor in Business, the Department of Management at the McCombs School of Business, The University of Texas at Austin. This article is republished courtesy of McCombs: http://blogs.mccombs.utexas.edu/mccombs-today
The Next Microsoft: Here’s a partial list… Google in decline. Humans colonising Mars. Electric cars in your garage. Are these investment opportunities? Or simply outrageous ideas? Both, says Adeo Ressi, a founding member of The Funded.com, an online community of about 14,000 executives and entrepreneurs who review, rate and discuss venture capital sources worldwide. It’s Ressi’s business to keep his finger on the pulse of innovation. “Google is already in decline,” said the Silicon Valley-based Ressi, in an interview with INSEAD Knowledge on the sidelines of the Global Entropolis conference in Singapore. “Facebook’s advertising is vastly superior today to the Google advertising system. They are losing talent to the hot start-ups in Silicon Valley. And with giant networks like Facebook and Twitter coming on to the scene without any association to Google, I think you’re going to see their supremacy threatened and in fact diminished greatly over the next five years if not sooner.”
Forecasting the next innovations There are plenty more “big things” to come. The development of tools like Facebook Connect, a universal login courtesy of the social networking behemoth, creates a host of opportunities for companies to release products and services that accept a user’s Facebook account to log in and sign up, explained Ressi. These companies can leverage a user’s social graph to generate more opportunities in other areas like retail and publishing, for instance. “The internet provides an infrastructure that people are using in creative and new ways,” said Ressi. “You have things like social gaming which maybe delivered through a website but is not a classic website offering. It’s more of a gaming
experience but it leverages the internet and the web.” Innovations around the grid also featured in his list of game-changers including “major innovations” in electric generation and transmission, portable power, advancements in new models of electric cars and breakthroughs in the mundane but key functions like electric metering that enables households to intelligently cycle through appliances and thereby reduce electric bills. Ressi, who also runs The Founder Institute, a technology pre-seed incubator that identifies and nurtures entrepreneurial talent and ventures, anticipates much for online education. “Classic education has students in classrooms learning through traditional means that could already be enhanced through games and other sorts of digital interaction,” he said. "The bandwidth and access is so widespread, you don’t even need the classroom.” Of the 192 companies that have graduated from the Founder Institute, nearly 25 percent are related to either facilitating education or online education, Ressi noted.
Who will fund the new ventures? But with as much as a 75 percent decline in venture capital funding from its glory days of 2000, what does the sector’s trends mean for entrepreneurs and new business ventures? “There’s no question that today, the money coming in to the venture firms is at a 15-year low,” commented Ressi. “What you’re going to see over the next 18 to 24 months is a massive shrinkage in the amount of venture capital being deployed, possibly half or a quarter as much as is being deployed today. So this is the last boom period for quite some time in venture capital. And probably by late 2011, early 2012, the amount of money being invested by that group will be negligible.” The MoneyTree Report, a quarterly study of US venture capital investments, shows US$21.8
billion in investments for 2010, the first increase in investment levels since 2007. US venture investments reached dizzying levels of close to US$100 billion during the dot com euphoria.
“Entrepreneurship is never easy but I believe that as long as there are great companies being made in the world, they will find the funding to build and grow.”
However the sector’s dire predicament does not spell doom for entrepreneurial activity - there’s a lot of capital in the world looking for a place to go.
This article was written by Mrinalini Reddy based on an interview for INSEAD Knowledge.
Adeo Ressi Angel investors have filled some of the void and brought funding levels back up to about 80 percent of what they were in 2008, explained Ressi, but it’s not a “zero sum game” where one asset class equally compensates for the other. Classic private equity firms have stepped in, and, in some cases governments that want to spawn innovation and entrepreneurship in a region have come in and funded new ventures. “There’s no shortage of money to fund the companies,” he said. “It’s just a matter of who is going to be the white knight as the venture capital asset class declines to come in and fill the void.” As for Mars, the 38-year old Ressi predicts that humanity will colonise Mars during his lifetime through some sort of public-private partnership. “It’s the single most important thing that humanity can do with the current state of technology,” he said in panel remarks at Global Entropolis. Ressi sits on the board of the X PRIZE Foundation that awarded a US$10 million prize for the first private spacecraft to successfully reach 100 kilometers in space, twice within two weeks. The Foundation’s other areas of highly-incentivised prizes include genomics, automotive efficiency and private space exploration.
First published: February 21, 2011 This article is republished courtesy of INSEAD Knowledge (http://knowledge.insead.edu)
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Published on Sep 20, 2011
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