Thursday, May 26, 2011

Hail Mary, Full of Grace

Life is like an analogy.

— Aaron Allston

I am a fan of the carefully chosen analogy, O Dearly Beloved. Perhaps you have noticed this. Analogies can be persuasive rhetorical devices, both illuminating and clarifying difficult topics by drawing attention to their similarity to situations and things with which we are more familiar. Using an analogy can reveal aspects of the subject in question which would otherwise be difficult to perceive. A well-chosen analogy can make the reader say, "Why, yes, of course. Why didn't I see that? How clever."

But analogies can be dangerous, too. In particular, analogies can encourage an over-facile equation of things which are fundamentally dissimilar based upon a few, selected characteristics they share in common. This can lead an author and reader to draw unsupported conclusions, or to extend the analogy to other aspects of the subject to which it does not truly apply. Carried too far, an unsupported or overextended analogy can conceal more than it reveals, or beg the more interesting questions at hand in favor of cheap and easy parallelism. Carried to an extreme, a faulty or weak analogy can even suggest an incorrect interpretation of events, or counterproductive behavior.

Analogies are like spices: a judicious application can enhance and bring out the flavor of a dish; too much can overwhelm it and even change its character entirely. Sriracha, anyone?

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So, for example, I am innately suspicious of the most common analogies which businessmen (almost always men, natch) use to characterize business: war and sport. While certain characteristics of these phenomena have obvious parallels in the world of business—high-stakes competition against determined opponents, a focus on developing and maintaining strategic and tactical advantage, and the importance of disciplined and coordinated teamwork, for example—there is a great deal of business which is not at all like either sport or war. In particular, no-one usually dies in business, and standard business methods do not normally include the destruction by attrition of an opponent's personnel and matériel through the overwhelming application of violent force. This is a—if not the—key definitional characteristic of the aims and methods of war. Without this core quality, business is nothing like war, except in the most superficial aspects listed above.1

By the same token, businesses compete in a far more fluid and undefined competitive space than do sports teams. There are no regularly scheduled games, championships, or league rankings in the world of business. Competition among businesses is not governed by a rigid, highly codified system of rules, overseen and enforced in real time by independent officials who can intervene with absolute authority. Business competitions rarely result in easy to understand outcomes: Coke, 23; Pepsi, 21. Finally, unlike sport, business is not at its core an entertainment, or play. It is deadly serious, and it involves almost all of us as direct participants and competitors. Employees are not fans. While sports fans can have a lot of emotional capital at stake (and money, too, if they wager), they do not lose their jobs, get laid off, or suffer pay cuts if their favorite team loses the playoffs. In its form and essence, sport is simple, clean, and relatively static. Business is nothing of the kind.2

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Hence, you may understand why I am less than enthusiastic about a recent article written by Roger Martin, the Dean of the Rotman School of Management, which appeared in the Harvard Business Review. In it, Professor Martin draws an extended—if not exhaustive—analogy between the behavior of business executives and American football quarterbacks. His basic complaint, if I read him aright, is that, unlike quarterbacks who play to accomplish real results (i.e., winning), public company CEOs run their businesses to satisfy market expectations. That is, they manage to their company's stock price, not to its real financial and operating results.

Here is what Mr. Martin has to say:

CEOs routinely go to the microphones to apologize or make excuses for missing the analysts' consensus earnings estimates — even if their real results are substantially up. And executives routinely take extreme and risky actions at the end of fiscal periods in order to juice results to hit those consensus earnings estimates.

Why is it that what is inconceivable in football is standard in business? The answer is that compensation is largely based in the expectations market in business and is strictly based in the real market in football. CEOs have a large portion of their compensation based on the performance of their company in the stock market, so CEOs spend their time shaping and responding to expectations. Quarterbacks have no part of their compensation based on the performance of their team against the point spread, so they focus completely on winning games.

Football has figured this out a lot better than has business. Football focuses its key players on the real game; business focuses its key players on the expectations game. Football gets 100% useful activity from its key players; business has them engaging plenty of their time in non-value-adding activities, like talking to analysts. It is time business learned a few things from football.

Perhaps Mr. Martin has been addled by enthusiasm for his analogy, but I think this is pretty silly advice. For one thing, quarterbacks and football players get paid for "real" results (winning football games and championships, for example) because those results are so well-defined and easy to measure. Did the Steelers beat the Bengals last night or not? That's a simple yes or no answer. Did the Steelers win the Super Bowl or not? Ditto. On the other hand, how do you measure success in business? Is it that net income increased by 15% year over year, or revenue by 10%? Is it that your company gained three points of market share, or reduced its outstanding debt by 10% with free cash flow?

Sports teams and fans track lots of statistics over the course of a season, but let's face it: the only thing that matters at the end of the day is whether they win or lose. Football teams and quarterbacks can put up better statistics than anyone else in the league, but if they don't win games, it just doesn't matter. Football is simple: over the course of a season each team in the league competes against all the others, and the playoffs and championship determine—by definition—the "best" football team of the season. There is no equivalent in the world of business. The metrics of success in business are far more multiform, variable, and relative: revenue growth, income growth, operating margins, free cash flow, market share, etc. You cannot point to a company's results at the end of a fiscal year and definitively declare that it "won" or "lost." Even if it outperformed its entire history in terms of growth, margins, and profitability, that does not mean it outperformed its competitors. There is no commonly accepted measure of absolute success in business.

Therefore, while it is relatively easy to track and incentivize football players based on whether they won or lost, and how often, it is quite tricky to pick one or two easily measured metrics to determine compensation for business executives. It makes no sense to pay a CEO solely based on operating or financial results, because that ignores industry conditions and relative performance, among other things. Why pay a CEO an incentive bonus if net income increased by 15% on his or her watch, but net income at the company's closest competitors increased by 20% or more? Why pay him or her for increasing sales if sales across the entire industry rose due to exogenous factors outside any executive's control?

There is, however, one universal metric in business—at least for publicly traded companies—which can be easily tracked and measured: a firm's stock price. Since this stock price presumably embodies the real-time, summary judgment of investors about both industry conditions and a company's individual prospects, it can act as a reasonably reliable proxy for the performance of the company and, hence (again presumably), its executives. That is why you see so many companies tie a significant portion of their executives' compensation to their stock price. Now, because a company's stock price incorporates factors external to its own performance—most notably investors' perceptions of the company's absolute and relative success—you will see corporate executives devote a great deal of time and attention to persuading investors of their case, to satisfying investor expectations, and to generally managing to the share price in addition to delivering actual results.

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But—and this is crucial—this makes all the sense in the world. Why? Because management's incentives are aligned with those of their company's investors. They want to see the share price to go up, just like investors do. In fact, for both investors and management, a rising stock price is "winning." Just like quarterbacks and their teammates get paid to win games, win playoffs, and win championships, corporate executives get paid to boost their company's stock price, because that's what their owners (employers) want them to do. Football players are incentivized to win because it makes the franchise earn more money, it gratifies the team owners' egos, and because to the best of my knowledge the NFL takes a very dim view of owners and players betting against their own teams. Corporate managers are paid at least partially in stock and options because investors want them incentivized to raise the stock price, so the investors who own the company can make money.

Now, can excessive focus on raising the stock price distract management's attention from running the business and delivering the operating and financial results over which they have real control? Sure. Does an effort to drive the share price occasionally encourage managers to engage in counterproductive and dangerous games like managing earnings and creative accounting? Of course. But no incentive system is foolproof, and no incentive system is immune from being gamed for someone's advantage.

Perhaps in his obvious enthusiasm for the apparent purity and nobility of American football, Mr. Martin has forgotten that sport is vulnerable to the very same distortions and bad behavior that he chastises in business. There is a very old set of bad, distorting, and counterproductive behaviors which afflict and undermine any sport which is focused on winning. It is called cheating.

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So, in contrast to Mr. Martin's recommendation, I would posit another. There is something important which business can teach the followers and encomiasts of sport: never underestimate the incentive, opportunity, and temptation for human beings playing high-stakes games to cut corners.

That is called human nature.

1 If you remain unconvinced, indulge me with a little thought experiment: what do you think the competition between implacable soda pop rivals Coke and Pepsi would look like if they could bomb each other's plants, machine gun each other's employees, and assassinate each other's leaders? Yeah. See the difference?
2 Before the sports mad take up pen and cudgel, let me explain. Sport operates with far fewer degrees of freedom than does business. The rules, structure, and forms of acceptable behavior are limited and highly codified, by definition. That's what makes it sport. I say this not to take anything away from the skill, beauty, and excitement which well-played sport entails. It's just that sports participants channel their energy, skill, and determination into extremely limited and well-defined channels. In contrast, business is much more like a barroom brawl.

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