Musings on the credit crunch: Built to last?

Why is it that some financial organisations are weathering the financial storm better than others? In the UK, the Spanish Santander banking group has just bought up the branches and deposits of the failing Bradford and Bingley building society. It seems that Santander is going from strength to strength, and the reason according to an article in the Independent newspaper is a combination of the strictly regulated nature of the Spanish banking system, the fact that Santander has avoided getting involved in the complicated and risky forms of loans that are now biting other organisations, and that Santander has been profiting from buying up a string of ailing organisations.

All this got me to thinking about business in general and the question of why it is that some companies are more successful than others. The business section of bookshops are full of tomes extolling the secret of business success. Of course, the skeptical mind cannot help wondering why, if there is a "menu" for creating long-lasting success, not everyone is managing to do this? I am reminded of what the racing driver Lewis Hamilton said recently, to the effect that he was determined to "cut out the errors" in order to win the F1 world championship. If it is so straightforward to not make errors, why were errors made in the first place?

It turns out, though, that most of the authors of business success books are little more than snake oil salesmen. Perhaps I'm being a little unfair here, as I'm not suggesting they are setting out to deceive, but nonetheless they appear to be deluding themselves and thus flogging nonsense to others. Phil Rosenzweig has analysed the research behind business success books in "The halo effect... and the eight other business delusions that deceive managers". One of the key flaws behind much of the research is that authors frequently analyse the performance of only successful companies. So if you find that most of these companies are led by a CEO who has a burning passion for the company mission, then the conclusion is that this is a behaviour that helps create company success. But wait a minute, what if the leaders of failing companies also have a burning passion for the company's mission? Well, who knows, because those companies weren't researched.

Another key flaw - and this is where the halo effect comes in - is that much of the research involves interviewing the leaders and employees of these successful companies. In these successful companies, both groups of people have good things to say about the way that the organisation goes about its business, about the enthusiasm and teamwork of everyone involved, and so on. But the problem here is that these comments are made in the full knowledge of the organisation's performance. That is, the story being told about the way the company operates is coloured by knowledge of its success. Rosenzweig describes experimental research in which people worked in groups on a problem solving exercise. Each group was then given feedback, except that the feedback wasn't genuine but randomly determined for each group. Group members then rated how well they had done on a range of issues. In a nutshell, groups who had randomly received positive performance feedback thought that they had worked together well as a team, whereas those randomly receiveing negative feedback did not.

It also turns out that the companies identied as "great" or "visionary" in books such as Built to Last turn out to have a long-term performance that is nothing special in relation to the market as a whole. In fact, the main factor in operation appears to be regression to the mean. For example, the book In Search of Excellence, published in 1982, identified 43 "excellent" American companies. Rosenzweig follwed up the performance of these companies post-1980 (when the original study ended). By 1984, during which time the S&P 500 index almost doubled, only 12 of the "excellent" companies outperformed the market, whilst the other 23 failed to keep up. Similar figures were observed for the period to 1989. (By the way, the now-troubled Fannie Mae was just one of 11 companies to be identied has having gone "From Good to Great" in the book of that name).

To take the title of another book, are some companies "built to last"? Rosenzweig notes that of the 500 S&P companies existing in 1957, just 74 were still in the S&P forty years later: "The other 426 were gone - nudged aside by other companies, or acquired, or bankrupt. And of the 74 survivors, guess how many outperformed the S&P 500 over that time period? Only 12 out of 74. The other 62 survived, yes, but didn't thrive." (Rosenzweig, p.102). Thus, the evidence indicates that the companies that last the longest are not actually the highest performers.

More rigorous research indicates that managerial performance does have some influence on company performance, but to such a modest level that it shouldn't be the stuff of headlines or bestsellers.

What the figures above indicate are that it is incredibly hard to predict the performance of companies. But when things go wrong, it seems everyone has a diagnosis, usually one of two polar opposites: either a company strayed too far from its core, or it failed to innovate. Much of the time, though, it's not clear whether these explanations really hold water at all. Indeed, pundits sometimes want to have it both ways, criticising a company for being unadventurous, but then when the company does something innovative and still suffers falling performance, the opposite criticism is introduced - they strayed too far from their traditional customer base.

I note that here in the UK, prior to the credit crunch, the opposition party often claimed that the successes of the economy were little to do with the government, but were the result of policies that were put in place when the previous government was in power. Now the opposition story is different - the current crisis is all the fault of the government who have failed to regulate the City! I'm no expert, but I can't help feeling the truth may lie somewhere in between. Whilst few people predicted the current problems, nonetheless there have been some mutterings about the potential problems caused by the complexity of derivatives. On the other hand, during times when things are going really well it would be a brave government who says they're not going to allow their organisations to engage in the same practices that seem to be working elsewhere (though see the comment about Spain and Santander earlier). I find it hard to imagine that most opposition parties would have been doing anything different if they had been in power.

I'll finish with this quote from the British investment banker David Freud, about his dealings in the City:

"The currency was not cash but chaos. Transactions invariably took place at the edge of feasibility conducted under a competitive background under great time pressure. I found few committees of experts considering all the available evidence in wise conclave. Much more typical were decisions taken on the fly, by whoever happened to be available, based on a fraction of the full information. "
(From "Freud in the City", 2006, pp.355-6)