Tag Archives: investing

Putting a Spring into Business Models

Are we thinking wrongly about business models and, for that matter, about the models that apply to many other activities, too?

While most of us think in linear terms, we respond to stimuli in a very non-linear way and this is why our models fail us.

A good example is that of traffic – the way it bunches up and stretches out as drivers slow and speed up, with each reacting to the vehicle in front – it’s much more like a spring or elastic band being stretched and let go, than linear.

Look at how consumers react to shortages of items. It really is much the same – an impending shortage leads to people purchasing a little more to tide them over, while a stock-out position either leads to brand switching or to buying extra once the item is back in stock, so the consumer doesn’t run out again. This, of course, means demand that follow a wave pattern, rather than a straight line.

However, every inventory-ordering system I’ve seen works in a linear fashion, leading to inevitable periods of over-stock after a shortage and accelerated stock-out if an impending shortage is discerned.

Doesn’t this equally apply to investors? Think about how the stock market reacts to news – it almost always over-reacts, whether positively or negatively, and then settles down. Again, although, we expect a “rational” (read: linear) response and our models are built in this way, the actual pattern of prices is anything but linear.

I have little doubt that it is this that leads to huge market “melt-downs” as automatic sales are triggered in response to the over-reaction to an event which leads to more automatic sales, and so on. Look at global stock markets early this year – do we honestly believe that the total value of companies was half (or less) what it had been six or seven months earlier? There’s no question they were worth less as earnings were impaired, but were they really worth so much less? The answer might be found in the big increase in share prices from March – perhaps it wasn’t a bull market as some were calling, but simply a correction to the over-reaction during the last half of last year, and things seem now to have stabilised. At least until the next piece of news…

The answer, it seems to me, is to rework our models to allow for human response to situations: the inevitable over-reaction and consequent wave patterns in demand, share prices, traffic and just about everything else. By allowing for this sort of response and predicting the effects, we can dampen them in the same way that a car’s shock absorbers dampen the effect of a bump on the suspension/springs.

The Perils of ‘Quarteritis’

FT ringing the Closing Bell at the NYSE

FT ringing the Closing Bell at the NYSE (Photo credit: Financial Times photos)

It appears that one potentially good thing to emerge from the global economic meltdown is a return to sensible business planning and cycles.

One of the scourges of many businesses – this started in the US and spread out from there – is ‘Quarteritis.’ Not strictly speaking a disease, but something that has probably resulted in a lot more suffering than most diseases, ‘Quarteritis’ is about an overarching focus on ensuring each quarter’s financial results are significantly better than those of the quarters that went before.

While we all want to be part of, and invest in, businesses that have good growth, the fact is that business, like most things in life, moves in cycles and the best long-term businesses are those that plan for the long-term, not just the next quarter. A short-term focus leads to rash decisions, decisions that might be good to “save this quarter” but disastrous in the medium term.

To illustrate: in the IT industry two popular results of this are distributors being forced to take huge amounts of excess inventory in a quarter (“channel stuffing”), or new distributors/resellers appointed suddenly to get a new stock order into the current cycle.

Both of these have similar results over succeeding quarters – reduced profitability for all concerned, stretched payment terms, credit limit issues meaning needed products cannot be ordered and, potentially, delays in releasing new products while excess inventory is moved out of the channel.

By taking the longer-term approach to ensuring that all parties in the channel can grow profitably, vendors may not grow as quickly in the short-term but will ensure happier customers – at all levels in the supply chain – and so more loyalty and a more sustainable growth well into the future.

Wasn’t it this short-term focus – albeit in the financial markets this time – that ultimately caused the current crash? Executives and others were induced by means of massive bonuses to find ways to grow well above the market average and so started giving mortgages to those that could never afford them, and repackaging these as “high quality” loans. Frankly, this would have been considered fraudulent in many places – it’s certainly ethically very bad anywhere – and it was only a matter of time before implosion happened.

However, those involved had already taken their money and run… Isn’t it this short-term bonus-driven culture that’s behind the trend to shorter and shorter tenure by CEOs of public companies? Can CEOs really be effective when they’re only in place for a few years?

It’s time we started looking at the longer term sustainability of business, and rewarding people in ways that encourage this and I, for one, am pleased to see a number of governments leaning in this direction. Authorities and shareholders should claw back bonuses paid for fraudulent practice, especially when taxpayers have to bail out the companies as a result. CEOs, and other officers, should be rewarded, and lauded, for long tenure and sustained growth.

Business needs to get back to a solid footing and good practice – we should support those that are trying to move in this direction.

Amazon

Amazon (Photo credit: topgold)

This blog piece was first published in Sep 2009, so it’s good to see that there’s growing acceptance of the need to look longer-term as this video from INSEAD clearly points out – Prof. Javier Gimeno talking about how “short-termism” undermines a company’s long-term competitiveness.