Why the Big Mo Is Bad Business
By Robert F. Bruner
Editorial
The Washington Post
Tuesday, August 20, 2002
The breathtaking volatility of today's markets betrays deep struggles about what it means to grow. Each dawn of an earnings season more resembles the nighttime spectacle of an uneven fireworks display, complete with surprise, amazement and unfulfilled promise. Absent from all this has been critical reflection on the intellectual underpinnings of the current crisis.
Fifty years ago Richard Weaver argued that, to use the title of his critique of the modern welfare state, "Ideas Have Consequences." It's time to raise that banner again, to understand that it isn't the markets that failed us, it's us -- specifically in the way we reward corporate growth.
It is easy to appreciate the popular appeal of growth built upon momentum. Momentum thinking drives strategies that seek to maintain hot streaks, such as investments that focus on buying past winners and selling past losers. It can be exciting, to be sure: One follows the pro with the hot hand.
Securities analysts pump up the excitement by hyping quarterly results. Boards of directors peg executive compensation to momentum in earnings and share price. CEOs stretch organizations to produce growth, often with serial acquisitions or bet-the-ranch investments. Accountants and chief financial officers risk their careers to manufacture acceptable earnings gains. All this feels so natural.
Unfortunately, foreseeing changes in a hot streak is impossible. It produces reactive behavior and ignores the fact that he who lives on rising momentum dies on its descent. Given the grinding nature of capitalism -- Joseph Schumpeter's process of creative destruction -- high growth rates prove extremely hard to maintain over time.
Enron's stock price, for example, grew at 32 percent compounded from 1985 to 2000. The world economy during the same period grew at perhaps 7 percent. At those rates, Enron would have owned the world economy in about 30 years. Yet, momentum can be a powerful narcotic to decision makers: The habit is hard to kick and, because of the exponential shape of its early growth curve, produces an increased craving that ultimately leads to the downfall of the firm.
Interviews of senior managers at Enron, conducted by Samuel Bodily and me in 2000 and 2001, reveal a firm that created true economic growth in the early 1990s. But as the company's growth slowed because of rising competition, losses on big investments and the difficulty of opening new markets for its trading model, Enron -- struggling to maintain its high rate of growth -- embraced the excesses for which it is now damned.
Tyco hit the wall when the stock market slumped and it no longer had high price-earning ratios with which to continue its strategy of rapid growth by acquisition. WorldCom shifted expenses into capital expenditures in an effort to maintain its earnings growth rate. Business history offers numerous other examples of momentum thinking: Insull Utilities in the 1920s, Ling-Temco-Vought and Automatic Sprinkler in the 1960s, Baldwin-United in the 1980s, and Boston Chicken and US Office Products in the 1990s.
All of these business failures teach a fundamental economic truth: The growth that matters most is in economic value, not in earnings, assets or revenue. The momentum manager seeks growth for its own sake. The value manager knows that not all growth is good (i.e., some growth may be too risky or unprofitable). The momentum manager seeks to sustain growth. The value manager seeks to sustain economic profitability.
The momentum manager seeks to present a smooth, seamless record of advance. The value manager embraces the quirkiness of business: Opportunities and threats are surprising, large economic profits are usually only temporary and localized in market space. The momentum manager trusts illusion; the value manager trusts reality.
Managing for economic value requires a shift in thinking among corporate directors, CFOs, accountants, securities analysts and investors. Earnings growth would be higgledy-piggledy, rather than smooth. Analysts would have to focus on such metrics as economic profit, discounted cash flow or expected internal rate of return compared with cost of capital. Companies would have to rise to new heights of candor with their owners.
What the tragedies of Enron, Tyco, WorldCom and Global Crossing share is that, like Peter Pan, these companies refused to grow up. They refused to admit frankly to shareholders and to themselves that their very high rates of growth were unsustainable. This may call for a deeper transformation of companies and their leaders than is comfortable to most.
Investors, too, would need to shed the narcotic lure of momentum thinking. Central to this would be to accept greater volatility in reported results. Americans have been adjusting to rising economic volatility since the United States abandoned the gold standard in 1971. They have been through Paul Volcker's interest rate policy change in 1979 and the waves of deregulation, trade liberalization and innovation. Volatility is a fact of economic life.
Ideas do have consequences. At the center of the present crisis in business are beliefs about what markets truly value. More laws and regulations about accountants, transparency, governance and compensation may help at the margin, but until CEOs, analysts and investors reject momentum thinking, one can predict with confidence only the periodic recurrence of the difficulties we now condemn.
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The writer is distinguished professor of business administration at the University of Virginia's Darden Graduate School of Business Administration and executive director of the school's principal research center, the Batten Institute.
© 2002 The Washington Post Company
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