CHAPTER TEN

Leading in an age of upheaval: how to be a 21st century leader

We live in volatile times and it will change management.

The new hyper-unpredictability is reflected in the stock market. It defied the predictions of market commentators who, at the beginning of 2011, predicted that the Australia would put in a strong performance. Commentators were gob-smacked by the volatility.

CommSec economist Craig James, who has seen many turbulent times in the market, says he was taken aback by the global anguish caused by the crisis and the speed at which it happened. No-one, he says, was expecting that. “It shows what can happen in the interconnectedness of the global markets,’’ James says. “The speed this time around was a whole lot quicker in terms of the events and the way they affected each day. Nowadays financial markets won’t give you an inch. Unless you act quickly, you will have a mess on your hands.”

In an interview with Bloomberg, Morgan Stanley’s Asia chairman Tom Keene gave a blunt assessment of the volatility. “Over the last 25 years, we had an average of one crisis every three years. The gap this time is 18 months. The scale is bigger. And now we have product contagion from subprime to mortgage backed securities, back to cross-border contagion within the euro-zone. This interplay between cross-border and cross-product contagion is very difficult to unravel.”

With Europe teetering on the brink of deep recession and indications that China’s economy may also be slowing, commentators expect the volatility to continue. Stock markets around the world are gyrating, consumer and business confidence is down, industries like retailing are being hit by seismic structural change and there is political uncertainty. Add to that the basket-case otherwise known as the Eurozone, and the likelihood of more bailouts and possible defaults, the US credit rating getting downgraded and shaky US economic fundamentals. Future Fund chairman David Murray has told reporters that this level of volatility is likely to continue to continue for at least 20 years. Debt levels around the world, he says, will not be resolved in weeks, months, or even years. He says investors should be conservative. The same would apply to managers.

Economic drivers of volatility include global competition, unpredictable capital markets, and rapidly evolving business models. But other sources of instability come from areas far outside economics: government regulation and deregulation, undisciplined government spending, political risk, disruptive technologies, new media, the effects of the 24 hour news cycle, energy shocks, terrorism, political upheaval in developing countries and so on.

Banks are right at the centre of this volatility, and their ability to withstand financial shocks will be put to the test by the International Monetary Fund which has announced that Australia will be one of 18 countries that it will target this year amid fears that Europe’s sovereign debt crisis could cause a repeat of the 2008 meltdown of global markets. The IMF says Australia was included in the first lot of countries to face increased scrutiny because of its large and interconnected financial sector.

Australian banks are a good example of managing volatility. By keeping their exposure to Europe and the US subprime market low, they have prepared for the worst-case scenarios.

This in itself is challenging management models. Traditionally, management was about continuous improvement, outsourcing, cost-cutting and managing budgets. The aim was to leave the organisation faster and more efficient. This has not changed. But now, there is a greater focus on management innovation. Managers now need to watch trends closely so that the organisation is not swept away. It’s about catching the next wave. This is a big challenge for managers. They can price risk but pricing uncertainty and volatility is more difficult.

Douglas Dow, an associate professor of business strategy at Melbourne Business School, says managers should get used to the volatility, they can’t avoid it. He says they need to consolidate during stable periods but plan for constant change and creative destruction, watching out for market trends. “Some people say companies need to be in constant change but the problem is human beings don’t deal with constant change that well,’’ Dow says. “You can’t co-ordinate. You can’t be in a constant state of change; you would have a dysfunctional organisation unless it’s just an organisation of two people. It’s almost a game of leapfrogging. Once a firm gets into a strong position, they would want to resist change for good reason. So they have got to look for these periods of stability but keep an eye on how long they can maintain that to see when they should jump.”

“Apple for example is doing that with their iPhone, looking for a period when they can exploit profits from what they have. They are working on the next one but don’t want to launch it too soon because otherwise they don’t capitalise on what they have, and it creates so much instability and people can’t cope with it.”

Companies should have scenario-mapping teams that report to the board and work with suppliers and customers to identify potential threats. Twenty-first century risk management is not about predicting the future. It is about systems and relationships that create an organisation agile enough to withstand volatility and respond appropriately. Twenty first century management is about creating organisations more prepared for the unpredictable.

We now live in uncertain times. Markets are convulsing day after day with wild swings in prices. Word gets out that Europe will work out a rescue plan and stocks soar. Then they fall again when it appears the rescue plan is not really a plan at all and it appears the world might be entering a double dip recession.

Tom Keene, the Asia chairman of Morgan Stanley, summed up today’s volatility in an interview with Bloomberg news service “Over the last 25 years we had an average of one crisis every three years,’’ Keene says. “The gap this time is 18 months. The scale is bigger. And we now have product contagion from subprime to mortgage-backed securities, back to cross-border contagion within the euro zone. This interplay between cross-border and cross-product contagion is very difficult to unravel.”

Managers are now wondering what they need to do to be on the front foot with this volatility. What precautions should they take? Is it about having a strong balance sheet with lots of buffers? Is it about being better able to predict exchange rates? How do they ensure the organisation has the courage to ride out uncertainty and not make snap decisions? The volatility presents a challenge for businesses and entrepreneurs: how do you manage perpetual growth and innovation in the face of unknowns? How do you maintain growth no matter how the market changes?

Traditionally, management was all about re-engineering, continuous improvement. offshoring, outsourcing and cost cutting to make the business faster, and more efficient. Now the focus has shifted to management innovation, of staying ahead of the trends, not getting swept away and catching the next wave.

It’s a management problem. People are starting to realise that no matter how much you divide and subdivide risk and volatility, it will not go away. Markets are good at pricing risk but hopeless at pricing uncertainty and volatility. It’s a problem examined by former trader turned academic Nassim Nicholas Taleb, now an advisor to the International Monetary Fund, in his book The Black Swan (Random House, 2007). Taleb says that a ‘black swan’ event lies outside regular expectations and has an extreme impact. The 9/11 terrorist attacks and the unpredicted rise of Google are just two examples of black swans.

Taleb’s thesis is that humans are simply not wired to predict black swan events. We think we know what’s going on in a world more complicated than we realise. We overestimate our capabilities, attribute our achievements to our skills and our failures to matters that are behind our control, instead of taking responsibility.

Still, there are some things we can do. First, executives need to look at the interconnectedness of a globalised world driving some of this volatility. Terrorist attacks have led to wars in Iraq and Afghanistan. The subprime mortgage meltdown in the United States destroyed markets and shareholder wealth in ways that few had anticipated. Organisations as seemingly unconnected as French, Chinese and American banks, Australian hospitals, US schools and other education institutes, local governments and bond insurers around the world were caught off-guard. Places like Iceland, Ireland and Dubai, once the standard bearers of the financial services revolution, were brought to their knees by events no-one expected. The subprime crisis resulted in a global recession that has now morphed into the European debt crisis, which threatens to sink the world into global depression. There is one big lesson here: greater interdependency means that risks are no longer local and routine, and seemingly unlikely and disparate events can be devastating. To assume otherwise means less agility.

Nonetheless, there are ways for companies and executives to manage the volatility. In his latest book Great by Choice (Random House, 2011), management writer Jim Collins and his co-author Morton T Hansen, a management professor at the University of California in Berkeley, say that volatility has always been with us, it’s not a twenty-first century advent. “The premise behind this work is that instability is chronic, uncertainty is permanent, change is accelerating, disruption is common and we can neither predict nor govern events,’’ they write. “We believe there will be no “new normal”. There will only be a continuous series of ‘not normal’ times.

“The dominant pattern of history isn’t stability, but instability and disruption. Those of us who came of age amidst stable prosperity in developed economies in the second half of the twentieth century would be wise to recognise that we grew up in an historical aberration. How many times in history do people operate inside a seemingly safe cocoon, during an era of relative peace, while riding one of the most sustained economic booms of all time? For those of us who grew up in such environments … nearly all our personal experience lies within a rarified slice of overall human history, very unlikely to repeat itself in the twenty-first century and beyond.”

The forces of volatility are not just economic. They also include government regulation or deregulation, undisciplined government spending, unpredictable political risk, technologies, new media, the amplifying effect of 24 hour news cycle, natural disasters, terrorism, energy shocks, climate change, political upheaval In emerging countries, and disruptions that are as yet unforeseen.

The writers look at a data set that ends in 2002, years before the upheaval, uncertainty and chaos of the 2008 financial meltdown. Nevertheless, the lessons we draw from Great By Choice are not supposed to apply to one particular moment of economic turbulence. It examines how businesses should adapt to a world “full of rapid change and dramatic disruption.”

The authors look at a set of major companies, including Intel, Microsoft and Southwest Airlines, that achieved spectacular results over 15 or more years while operating in unstable environments. They call these companies “10Xers”, as they provide shareholder returns at least 10 times greater than their industry as a whole. The authors then compare those businesses to less successful ‘control’ companies.

They reach some surprising conclusions. First, the successful leaders were not bold, risk-taking visionaries who could predict the future. Instead, they observed what worked, figured out why it worked and built upon proven foundations. They were not more visionary or more creative. Indeed, their companies did not innovate more than the less successful companies.

What they had instead was a fanatical, almost monomaniacal, discipline. “They don’t overreact to events, succumb to the herd, or leap for alluring – but irrelevant – opportunities,’’ they write. “They’re capable of immense perseverance, unyielding in their standards yet disciplined enough not to over-reach.” With innovation, it wasn’t the creativity that was the trump card, it was the ability to scale innovation and blend the creativity with discipline.

They also acted on empirical evidence. Rather than leaping into action, they did the research and groundwork first. At the same time, however, they did not favour analysis over action but relied on empirical evidence as the foundation for decisive action. Nor did they have more luck. They were just better-prepared to deal with the same sort of bad luck that hit their competitors. They did not leave themselves exposed to unforeseen events.

Nor were they fast movers. With their empirical approach, they figured out when to go fast and when not to. They were also paranoid, but it was what the writers call ‘productive paranoia’. They embraced possible dangers, and prepared themselves.

Bill Gates, for example, channelled his fear into action by keeping his workforce cheap, hiring better people, building cash reserves and working on the next software release to stay a step ahead of his competitors, then the next one, and the one after that.

That, they say, is typical of the leaders from these companies. They compare them with the explorer Roald Amundsen, the first explorer to reach the South Pole. In 1911, Amundsen and Robert Falcon Scott were racing to get to their destination and Amundsen won the race. He set ambitious goals for each day’s progress but he was also careful not to overdo it on good days or under-perform on bad ones. Scott by way of contrast over-extended himself on the good days and fell apart on the bad ones.

The writers say these two approaches mirror the two sorts of companies in their study of the 10Xers and the control group. “Paranoid behaviour is enormously functional if fear is channelled into extensive preparation and calm, clear-headed action, hence our term ‘productive paranoia’ …Like Amundsen with his huge supply buffers, 10Xers maintain a conservative financial position, squirreling away cash to protect against unforeseen disruptions. Like Amundsen sensing great risk in betting on unproven methods and technologies, they avoid unnecessary risks that would expose them to calamity. Like Amundsen, they succeed in an uncertain and unforgiving environment through deliberate, methodical and systematic preparation, always asking, “What if? What if? What if?”

Successful companies, they say, make mistakes. They face the same volatility and bad luck as competitors. What sets them apart is their ability to learn from them, self-correct, survive and build greatness in a rapidly changing world.

Keeping your company on track in volatile economic times requires focusing on fundamentals.

To get through the ups and downs, the starting point is to get as close as possible to customers. Make sure the lines of communication are open and those relationships are strong. Don’t give clients a reason to move! Look after the customers who stayed with you through this slump. Chances are they’ll be your best buyers in good times. Trying to broaden the customer base can be a risk as the customers you attract only because of a special promotion are often the least loyal. They will often be the first to abandon you when a competitor makes a better and cheaper offer. Your efforts are better directed toward winning a bigger share of existing customers’ business, working on their loyalty and developing deeper relationships.

Deloitte Private partner Mark Allsop says getting close to customers helps the business owner keep tabs on what’s going on out there. “Do everything you can to over-serve on your delivery to them so they don’t go to another competitor,’’ Allsop says.

“We always tell our clients to be mindful of opportunities because there are plenty of competitor firms that could be experiencing trouble and unable to service their clients, particularly in times like this. That could be an opportunity for small business to gain market share.’’

While the big market trends should be monitored, these are more or less the background music. More important are the measures of real economic activity that directly affect the business and are particularly relevant for your company and industry. Those might include order rates, inventory turnover and changes in consumer buying patterns.

Another important step to deal with the uncertainty is the SWOT (strengths, weaknesses, opportunities, threats) approach. In volatile times, the grounds shifts constantly so this sort of analysis becomes critical.

Volatile times provide companies with the opportunity to think strategically about where the business will be five years out and how they might build for the future. Competitors are struggling too and that opens opportunities. By looking at the landscape and talking to customers, opportunities emerge.

One often-cited example is that of Lou Gerstner. When he took over as CEO at IBM, Gerstner knew he had to take $7 billion out of the company’s cost structure in less than two years. He talked to customers. They told him that their key area of pain was the difficulty because IBM was too fragmented. Gerstner developed a new strategy where processes were streamlined, and layoffs targeted to create an integrated model. IBM today is thriving.

Like Gerstner, business owners need to take time to do a SWOT analysis and, depending on their type of business, look for new market opportunities. This requires them to realistically assess which ones have the best likelihood of success and how they should capitalise on them.

What resources are you going to need to support a new marketing strategy? Will you have to employ more salespeople? Will you need extra manufacturing capacity? Extra warehousing capacity? Most importantly, have you sat down and worked out the implications for working capital? How you will fund expansion? Will it be equity? Debt? Cash flow? Perhaps a combination of all these options? All of these will depend on the state of the market. Assessing the ups and downs of the market is therefore a critical part of forward planning.

Whatever strategy you adopt, take a conservative approach when calculating working capital projections. In many instances, getting external advice to bounce your ideas off and test your projections is a sensible option. It’s worth the investment.

For those businesses in manufacturing, product innovation should be a critical part of any planning process. Most products have a shelf life, and a strategic planning session is the ideal time to assess where your product is placed in the ups and downs of business cycle.

In a volatile climate, you need to ask whether your market share is under threat. Are new competitors coming into the market, perhaps even from overseas? Are their products better? Are they cheaper? What is your strategy for competing with a new product? Do you need to develop a different line?

In today’s skills-constrained labour market, the loss of important staff can be a threat to your business. Never take your employees for granted. Do they have career paths? Do you have relevant training programs in place? In times of uncertainty, staff are less likely to move. But when the market picks up, competitors start offering better packages to entice them away. Staff turnover tends to increase when markets recover. Every business owner needs to be mindful of this. In volatile times, it is critical to have strategy sessions focusing on staff and what skills might still be needed.

The other important part of managing through the ups and downs is to watch the cash flow. Businesses need keep their accounts up to date. The simplest way is to have a simple cash-flow spreadsheet that allows business owners to quickly see how much money is coming in and what payments have to be made. They can run them daily or weekly and should use them to see what their cash-flows are going to be in the weeks ahead.

Owners should also look at preparing regular profit-and-loss statements. These should be updated weekly, or, at the outside, monthly and within a few days of month end. This gives the business owner time to act on the information.

By adopting this rigorous approach to monitoring cash flows and profit-and-loss statements during volatile times, businesses achieve two ends. First, this makes them think more carefully about any spending; discretionary expenditure can be put on hold if the next month’s projected cash flow looks like slowing.

Second, it makes businesses more aggressive about collecting cash. It alerts the business to what’s coming in, and what is taking too long to arrive. The rule of thumb for most businesses is 30 days or less if the business can enforce it.

Certainly many businesses need to be tougher on cash collection. Sometimes it’s even necessary to halt supplies until customers pay. The worst thing small businesses can do is let payment drift out to 55 days and beyond.

A regular review of costs is best practice in a volatile environment. At the very least, it should be done monthly but many companies, particularly retailers, have gone to a higher level of scrutiny and are assessing costs weekly. Some even do it daily. The level of review depends completely on the type of business and the size of the business.

This review also gives the business owner the requisite information they need to respond if there is some drop-off in sales. Ideally in any time, business owners should conduct a review but it becomes particularly important when things are volatile.

The review should also focus on a diagnostic of the business. What are the main revenue drivers? Is it volume? Price? Can either of these be tweaked to maintain or build margins? The review should also focus on cost and expenditure. What areas can be cut, or streamlined without damaging the business? And is the business getting the most out of its assets?

Volatility is part of the business landscape. Smart businesses will identify as a time for reflection and build better processes for the good times. And for many, it offers opportunities that come from that increased reflection.