Imagine you are the CEO of one of Britain’s oldest and possibly least innovative insurance companies, The Prudential. One of your better managers comes to you with the idea of setting up an internet bank. Or you are a supervisory board member of Mannesmann, a solid German engineering company, and your executive team suggests that the company bid for a mobile telephone license. Do you invest in the exciting new opportunity even though it does not fit with your existing strategy?
It depends on whom you ask.
Some experts will say that you should invest in a portfolio of new ventures as part of what McKinsey calls the “third horizon.” Using this logic, both Prudential and Mannesmann should have a go.
Other experts will argue the opposite: “stick to your existing strategy,” “don’t let yourself be distracted,” and “beware of becoming over-diversified.”
Who’s right? After more than 30 years working on corporate-level strategy issues as an academic, and advising companies as a consultant, I have learned to avoid coming down firmly on one side or the other.
In my new book, Corporate-Level Strategy, my co-authors and I describe three logics for making these decisions: business logic, added-value logic, and capital markets logic. The latter is only relevant in the case of acquisitions or divestments. Since both of the opportunities described above are about organic growth, we can start by applying the first two logics to help leaders decide what to do.
The first logic speaks to a basic truth: companies should seek to invest in attractive businesses. An attractive business is one in a high-margin industry that is growing. In addition, the business must have or be able to create a competitive advantage. For the Pru, internet banking proved not to be a high margin industry and although it did successfully launch an internet bank, it has not had a good return on its investment. The CEO should, therefore, have been wary about this opportunity.
Owning a mobile telephone license in German, on the other hand, was likely to be a high-margin business, and, since there were few licenses for sale, the owners of a license would have a competitive advantage. Hence, the supervisory board members should have been keen to hear more about this opportunity.
Let’s look at the second logic. It makes sense for a company to own a new business if it can create more value from owning the business than other parent companies. If not, it is likely to be outcompeted by the other companies. So how does a company create more value from owning a business than others? Sometimes the parent company has some special wisdom to bring to the table or some special assets to contribute. Sometimes, the new business adds some special value to other businesses that the parent company already owns.
Unfortunately, in the cases of Mannesmann and The Prudential, neither condition appeared to exist: both new investment projects would have failed the test of the second logic.
Putting the two logics together suggests that The Prudential should have outright rejected the proposal to create Egg, the company’s internet bank, while Mannesmann should only have invested in a mobile telephone license if it anticipated changing its strategy so that it would be able to create extra value from the new business (by for example, becoming an international telecoms company) or if it anticipated selling the license after a year or two to an international telecom company (the strategy it chose).
Since this last thought involves a possible sale of a business, we need to engage the third logic, which is about the likely state of the capital markets at the time a transaction might be needed. Are the markets likely to over or under value the asset being sold? It would be reasonable for Mannesmann to expect that one of only a few mobile telephone licenses in Germany would, when the industry consolidated, attract more than a few eager bidders. So over-valuation would be more probable than under-valuation: as a potential seller of a license, Mannesman would gain.
Let’s try the three-logic analysis on an up-to-date case: whether Apple should get into the drone business. Since Microsoft and Google are buying drone businesses, I can imagine that a manager at Apple might suggest to Tim Cook that he do the same.
Is the manufacturing of drones likely to be a high margin business? Since this is a high-tech product, and there are likely to be many different segments, the answer is probably yes.
Is an Apple drone business likely to have a competitive advantage? This would depend on the specific proposal. But, although those proposing the investment will believe that they have something unique, given the range of competitors, the probability that Apple’s business will end up with an advantage is low; Cook should be wary.
Is Apple likely to create more value from owning a drone business than other companies? It’s unlikely. Even if it is possible to create exciting apps linked to drones, it is not obvious that Apple needs to make the drones to get the synergies. Other aspects of Apple’s way of managing are unlikely to constitute “wisdom” that would be of great value to a drone business. So, added value is not likely to be high and subtracted value is possible: Cook should be even more suspicious.
Finally, is the market for drone businesses over or under-valued? Given the amount of activity recently, and the rich companies that have been buying drone assets, it is likely that drone businesses are over-valued. Even capital markets logic is against this proposal. With all three logics giving red or amber signals, Cook should say no to buying into a drone business.
The three logics will often caution a management team against a new opportunity that does not fit the company’s existing strategy. But, as the Mannesmann example shows, they do not rule out all such investments. Of course, if the company does decide to go ahead, they face the challenge to decide how to structure and manage the new unit.