Friday, August 9, 2019

Seeking Attractive Industries


When you check the research, the greatest determination of an organization's success is the industry in which it operates.  Profitable markets spawn profitable businesses.  

Several studies come at this conclusion, from different directions. Perhaps most notably, McKinsey has published some great analysis of what they call the "industry effect," showing the economic profits along power curves for different types of firms.  That industry drives performance is no doubt true: the data is clear and it’s compelling.  


Chart: McKinsey & Company, "The industry effect"  Extracted from web-site article on Insights.  
Source reference Strategy Beyond the Hockey Stick, book written by Chris Bradley, Martin Hirt, Sven Smit

But, the data can also be deceiving.  Because when we read things like this we’re typically looking for advice, to see how how the info applies to our own situations. “What does this mean to me?” we want to know.   In this case, McKinsey's finding probably doesn't mean too much.  Not only is the “industry effect" apt to be mostly irrelevant, it can also be dangerously misleading. 

Such research answers the question “What’s most closely correlated with success?” or even “What explains success?”  It does not answer the question “What business should I as an individual pursue or what business should we as a company diversify into?”  

It’d be a big mistake to conclude from McKinsey’s research that the firm should pursue opportunities based primarily—or even mostly—on the attractiveness of the target industry.  Obviously, we can’t ignore the entire issue of internal compatibility.  As the consultants will tell you, market analysis is easy, change management is hard.  In fact, when you balance the basic considerations of strategic expansion— internal compatibility and external opportunity—internal compatibility factors invariably weigh heavier.  

Why?  Because we’re never starting from ground zero. Businesses have dedicated assets in place, strengths and weaknesses, and experience with key industries or operating agendas.  For a given entity in any given game, we’re building on existing experience.  In reality, the question is not what best explains success in the abstract or for companies in general.  The question is “Along which path are we able to out-execute our competitors?”  (Note this doesn’t mean we have to execute particularly well. It only means we have to be able to out-perform the average competitor.)     

A way to see the glaring fallacy is to consider how this would hold for individual career decisions.  Career data would certainly show that, say, surgeons and investment bankers command higher than average compensation.  But, of course, we couldn’t conclude from this data that if you personally wanted to make more money you should pursue a job as a neurosurgeon.  On average, surgeons and bankers may make more, but, you’re not concerned with the average person, you’re concerned with you.  Specifically, you’re concerned with the expected value—the payoff—you would get in a career shift.  And odds are that for a given person the expected compensation impact of a switch to neurosurgery would be negative.  Why?  Again, we’re not starting at ground zero.  As individuals we’ve studied topics, developed strengths and interests, and we’ve accumulated experience and contacts in specific industries and functions.  If you’ve taught middle school for 25 years, your expected earnings for staying in education will undoubtedly exceed that of a switch to med-school—even if the data shows that doctors earn more than teachers.  In short, in contemplating career moves, you’ll weigh internal factors much more heavily than you will external factors.  

Thus, we arrive at a paradox: while the external market is the most important explanation (post-facto) of economic profitability, it’s probably the least important factor in the strategy decision.  Put another way, such results are remarkable at the macrolevel—for the theorist —and irrelevant at the microlevel—for the practitioner.