The New Rules of strategy – part 3

Forget war games, mind teach your leaders to play poker…

Warfare, there football, seek chess and martial arts are popular models for business, appealing to the competitive instincts of those whose drive takes them to the top of large companies.  Sun Tzu’s The Art of War has long been a staple for teaching strategy, with war gaming particularly popular with macho executives who believe they would have made great Seals or SAS soldiers.

But what makes these analogues so appealing – the simple ‘I win, you lose’ nature of two player or two side games – also limits their value.  They simplify the competitive environment that most businesses face to such a degree that they offer limited value beyond amusing the participants.  As argued previously in an article in Strategy, the philosophy engendered generates a sub-optimal approach.  Beating competitors is treated as a direct objective when in business it is best achieved obliquely – viewed as an outcome of achieving other objectives, namely delivering superior value to customers in a profitable way.

An alternative and much better analogy to business strategy is poker.  Poker also suffers from the disadvantage of encouraging exclusive focus on competitors.  But in other ways it is more comparable and strategists can learn a lot from good poker players.

The first similarity is in the competitive environment.  Being a multi-player game, poker is far closer to business reality.  It also mirrors the typical trajectory of competitive evolution as over time the number of players reduces and chips become less evenly spread, allowing and the strongest to use their financial advantage to bully weaker players out of pots.  In those circumstances the weaker players have to pick the hands they play very carefully in the same way that weaker players have to focus on the niche markets they choose to compete in.

Secondly, as in business, most poker gains are made at the expense of the ‘fool at the table’.  Spotting who this is in a business situation clarifies which competitor’s customers should be targeted.  Recognizing when you are the fool – and leaving the table or competitive environment to play elsewhere – is critical to preserving your assets.

Randomness plays a far greater part in corporate fortune than successful business leaders or management researchers acknowledge.  Success at poker requires making the best of randomness – the cards dealt – through skill in betting.  Whereas luck roughly evens itself out over the long term, the profits from poker do not.  Successful players make the most of their good luck – extracting the maximum when they have the best hand (and others have a good enough hand to continue betting).  Similarly they avoid the latter situation – over-betting when they have a hand that could potentially win but doesn’t.  Making the most of good fortune is equally applicable in business.  A business that finds itself in the right place at the right time will do well.  But one which really capitalizes on its luck rises to a new level.

Strategy is also about placing bets – on geographies, customer groups, product markets, technologies and business models.  In poker it is far better to bet and raise aggressively on a few hands than call on a large number.  This requires patience, especially in periods where hand after hand is weak.  Playing too many hands results in funds being spread too thinly with insufficient prioritization of investment towards the best opportunities, making it less likely that significant gains will be achieved.  Equally a business that tries to do too much will usually fail in all or most of its initiatives.  In both strategy and poker, focus – the strength to say ‘no’ – is all important.

A fifth similarity is that both require decisions to be made when uncertainty exists.   Success at poker requires assessing the likelihood that you have (or will end up with) the winning hand and comparing that with the returns on offer.  This requires the facility to calculate probabilities of success, for example a card being dealt that will give an unbeatable hand or the chances that the current hand will win.

But most people struggle to discriminate rationally between probabilities.  We have a tendency towards seeing probability in almost binary terms as either one or zero.  By requiring a probabilistic approach, poker encourages are more gradated view of likelihood.  And through having to make probability-based decisions in the context of likely returns, the chances of accurately assessing which investments should be progressed will be increased.

However betting decisions aren’t just about calculating probabilities, they also require a certain amount of intuition where other players are concerned.  That ranges from assessing what cards they hold from the way they have bet both in the current hand and previously to reading tells when another player is bluffing to working out when they came be bluffed.  The discipline of trying to guess other players’ cards ensures good poker players do not become trapped in an egocentric bubble where they just focus on their own hand.  They have to put themselves in their opponents’ shoes, something that strategists need to do to avoid the trap of competitor neglect – underestimating competitors’ reactions to a new initiative such as a product launch.

Putting themselves in other players’ positions provides a further benefit, enabling poker players to shape the pay-offs their opponents will receive through the size of the bet they place.  The bigger the bet (relative to the amount of money in the pot) others have to make, the lower their return will be and the more confident they need to be to call.  Good players shape the returns on offer to persuade others to fold when they still have an outside chance of winning – asking them to make a bet where the returns are two-to-one when the odds of success are just one in four.  An analogous business situation would be announcing a big investment in a new manufacturing facility that will reduce a company’s operating costs and expand industry capacity.  Only those with a strong enough position (or those that think you are bluffing) will follow suit, with others exiting.

Finally poker provides lessons about how to control the emotions that lead to reckless play – hope, fear and greed.    Greed leads players to bet too much, both when they have a winning hand (with the result that no one calls) and when they overestimate the strength of what they have.  The latter is analogous to the overconfident over-optimism that plagues investment evaluations, particularly of potential acquisitions.

Hope is also costly.  In business this happens frequently, notably with the estimated revenues of new product launches, cost savings of transformation initiatives and synergies from acquisitions being fuelled more by wishful thinking than rational thought.  In poker there is a saying: “Might your hand win this pot? Then fold it.”  Calling in the hope of drawing a particular card is dangerous – and more likely to happen if a lot of chips have already been sunk in the pot.  That is the biggest risk – investing emotionally in a hand or strategic move (not least because of having invested financially) and only weighing evidence that supports continued investment.

One reason for this is fear, or loss aversion to use how it is described in behavioural economics.  We should be rational and accept losses when they’re inevitable.  Instead we will do almost anything to avoid them.  Rather than writing off a failing project, we are more likely to throw more money at it in an attempt to avoid recognizing a loss.  Poker players who take this approach see a rapid diminishment of their chip stack.  Good players recognize that each new card changes the situation.  No matter how strong their hand appeared initially, if it now looks like a loser, the odds are that the miracle card that would make it a winner will not appear.   They realize that to protect their chip stack, they need to fold rather than continue betting.

Both strategists and poker players need to ask themselves whether the odds are favourable relative to the cost-benefit of further investment.   You have to speculate to accumulate – the key is to invest (bet) when it’s truly worth it.  Hanging on in the hope that you get lucky or because you fear losing what you have already invested is radically different from making a conscious bet against the odds when the return justifies the risk.

Games have explicit rules and a range of defined outcomes.  Being closed systems they are imperfect models for the complex open systems in which businesses operate.  Poker is no exception.  But success in poker requires a mind-set and skill-set that help strategists counteract a number of biases, particularly those wrought by hope, fear and greed.  These include comparing pay-offs with probabilities, putting themselves in opponents’ shoes, managing exposure while maintaining options, targeting particular competitors and influencing their behaviour.  In both, uncertainty prevails requiring a combination of probabilistic analysis to establish the parameters and intuition to make the final judgement.

Intuition has an emotional component – a feeling or gut instinct about a situation.  But good intuitions are informed by reason, experience, memory and knowledge.  It is the ability to tell informed intuitions apart from those fuelled by destructive emotions that distinguishes good poker players – and strategists – from poor ones.

…But don’t obsess about ‘winning’, focus on creating value to extract value…

The limitation of poker as an analogy for business is in how directly players compete.  In business companies don’t wrestle or race each other, competition takes place indirectly through the decisions made by customers.  Success is achieved obliquely.

Too great a focus on beating competitors risks creating confusion between outcomes and objectives.  The latter is what a business can pursue directly.  It is the equivalent of athletes setting themselves a performance objective – running a certain time at a certain date in the future – and gearing their training to achieving that.  Objectives are achievable, within the control of the individual or business concerned, but outcomes are not – external factors are involved.  For example, the athlete may set a target time that he or she believes will win Olympic gold and achieve it, but if someone else breaks the world record by a significant margin, the outcome will be silver rather than gold.  Outcomes are influenced by achieving performance objectives, but not controlled by them as outside parties are inextricably part of the process.

In business, extracting value from a relationship is an outcome, and one that is dependent on successfully creating value for the other side.  Unfortunately we are often too egocentric to recognize this.  This tendency to be egocentric in our thinking was neatly captured by the philosopher Ludwig Wittgenstein in a conversation with a friend.

“Tell me,” Wittgenstein asked, “why do people always say it was natural for man to assume that the sun went round the earth rather than that the earth was rotating?”

“Obviously because it just looks as though the sun is going round the earth,” replied his friend.

“Well, what would it have looked like if it had looked as though the earth was rotating?” responded Wittgenstein.

Egocentricity undermines our business judgments in a number of ways, notably in the underestimation of competitor actions and reactions.  It also blinkers the approach to stakeholders.  There is an overwhelming focus on the ‘what is in it for me?’ side of the equation.  To trump our innate egocentric tendencies, we need to think first of how we create value for the other side of a relationship and only when we have maximized that seek to extract a fair share of the value created.

Obviously the starting point for any business is having customers.  Without customers to serve, a business has no reason to exist.  Creating a compelling value proposition for customers is the starting point for any company seeking growth and profitability.

The best example of this is Amazon whose success can be attributed in large part to the focus it places on creating value for customers.  (One commentator recently cracked that “Amazon, as best I can tell, is a charitable organization being run by elements of the investment community for the benefit of consumers.”)  Rather than using its scale to maximize the profit margins it achieves, Amazon has done the opposite and trained its investors to accept lower profitability, with any upturn (e.g. from buoyant volumes) being used to fund longer term investments in serving customers.

As well as delighting customers, this approach has the advantage of keeping competitors at bay, leading the same commentator to conclude “Competition is always scary, but competition against a juggernaut that seems to have permission from its shareholders to not turn any profits is really frightening.”

Amazon’s quarterly investor calls conclude with the CFO saying “We believe putting customers first is the only reliable way to create lasting value for shareholders.” Moreover it genuinely means it and the evidence supports the validity of this logic with Jeff Bezos ranked second (behind Steve Jobs) in a 2012 survey of the long term value created by CEOs for their shareholders.   By focusing first on creating value for customers (rather than extracting value from them) Amazon has created significant value for itself.

…And creating stakeholder value to create shareholder value

The focus on winning and extracting value from other parties is compounded by the distortions introduced by narrow framing, in particular that introduced by the concept of shareholder value.  This has come under increasing scrutiny in the last couple of years with Michael Porter, Roger Martin and the managing partner of the consultancy McKinsey arguing that such an approach is flawed from a philosophical point of view and that shareholders should not be set above other stakeholders.

As a result the shareholder value versus stakeholder value debate has taken on a quasi-religious tone, when the distinction is actually moot.  The two ideas are easily reconciled – shareholder value is an outcome of creating value for all stakeholders.  No company will survive if customers, employees, partners, suppliers and local communities do not support it.  So it is no surprise to find that there is a body of research showing that companies explicitly focusing on looking after stakeholders sustain superior levels of profitability.

Proponents of shareholder value accept this but argue that looking after stakeholders is just good business sense.  But explicitly focusing on shareholder value (and implicitly excluding the other groups) reduces the chances of good business sense prevailing.  As we argue in the section on biases of perspective, narrow framing of objectives and goals results in sub-optimal performance.  Improving performance on one metric can often be achieved through damaging performance on another (e.g. focusing on volume to the detriment of gross margin achieved and vice versa) to the long term disadvantage of the business.

Also one of the best ways to increase profits for shareholders in the short term is to extract more value from other stakeholders – squeeze prices paid to suppliers, cut back on staff benefits, increase costs to customers by cutting back on customer service and cut corners on environmental and social responsibilities.

But all this comes at a cost to long term relationships.  Sustained profitability requires attracting and retaining valuable employees, customers, partners and suppliers.  In turn this demands a focus on balancing the value created for and value extracted from all stakeholder groups.  Making this the explicit objective – and not relying on implicit business sense when shareholder value is being prioritized – increases the chances of it happening.

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