676: The key strategy question most boards do not answer, and cannot answer

0:02And when there is no vision, the people perish. We choose to go to the moon. If today were the last day of my life, would I want to do what I am about to do today? Change will not come if we wait for some other person or if we wait for some other time. We are the ones we've been waiting for. Welcome to the Strategy Skills Podcast, where strategy partners teach you the tools and techniques to solve mankind's greatest problems.

0:48Hi everyone, it's Michael and today I'm going to continue our series on looking at how technology, AI, quantum and so on is changing the fields of corporate strategy, business strategy, corporate finance and specifically we want to look at how the world would change, how the routines, tools, and processes we use change if we could remove two barriers. One is the physical capacity constraints of humans, like managers who run the analysis, and then the intellectual capacity constraints of humans, who obviously have certain ceilings in the way they process information, what they can visualize, what they can hold in their head, and so on.

1:30Now, in a previous video, I looked at the Porsche example, where I said that, well I didn't say it Porsche announced that they're basically over the next few years going to retrench more than 20 percent of their workforce and they've elicited the reason that it's about dropping sales in China then like everything we do when we analyze opportunities and sometimes we have clients who work at these companies and want us to think about what they're going through they give us a problem we've we have our own internal tools that do that for us So we basically put in the problem statement as given by the newspaper headline.

2:09We ran it through Michael. I've discussed all this before, so I'm not going to focus on it. But the bottom line is that at this point, Michael is working with what Michael has been told about Porsche. Then Michael develops a proposal on what Porsche should do. And then going forward, our system examines what Porsche should do. So when you put in the question for Michael, Michael does one of two things. One is that it starts analyzing what's happening. And Michael will tell you if what you're doing can be done, cannot be done, if it's good for the business, if it's bad for the business, and if it's not adding value, why are you doing it?

2:48At the same time, Michael starts building a digital clone of the company. So Michael is building a clone of the company, basically a virtual company that optimizes for increasing value in the business. And then Michael pushes that clone across different modules to test how that clone will behave. Now I'm going to bring you to one of the most interesting capabilities Michael has. Pull up the one we've run on Posh AG. So you can see here, there's nothing you have to do in any of the modules. At one or two places, you have to load maybe your resume. But really, everything that we create comes from the problem statement.

3:25And since that's been locked in, there's nothing more to be done here. Now, when companies think about what to do, they always look at whether you're going to hit the benefits case. What is the risk of implementation? Can this be done? And everyone talks about the risk of implementation like it's the most important risk. The risk of implementation is not the most important risk in corporate strategy. I'm going to repeat that because it's very important. The risk of implementation is not the most important risk in corporate strategy. What we look at is we'd say, let's assume you successfully implemented the proposal, in this case, the proposal that Michael generates as a set of recommendations that Porsche needs to follow.

4:07If it's not just going to survive the 20 % job cuts, but it's going to survive the fundamental shift in its business. And Michael's pretty articulate about what needs to happen. In a previous video, we covered that detail and proposal and so on. In corporate strategy, the risk that matters to us is as follows. Once the strategy is successfully implemented, what new risk has been added to the business? I'll repeat that. Once the proposal or strategy has been successfully implemented, what new risk has been added to the business? Just the opposite of what most people say. They say we have a strategy.

4:46The risk is the risk of implementation. Let's just focus on that. No. So the reason you have to ask about the risk that's introduced when you implement the strategy is because of how corporate finance works. Risk goes up if your earnings and your costs or your earnings move in the same direction. They're correlated. Asset classes that are highly correlated are highly risky. Think about your investment portfolio. Every investor, investment advisor you would have would tell you you need to diversify, you need to diversify, you need to diversify. Companies are the same. If you roll out a strategy for a company whereby the result of the strategy being correctly implemented means that more of your revenue tends to move together up or down, you've introduced more risk to your business.

5:35Now think about this, right? Porsche has many revenue lines. They've got the Macan, they've got the Taycan, they've got the 911, they've got the 718, they've got the Boxster, and I'm probably missing some here as well. The point is these out, these are all revenue lines. And they've got sales in different countries, right? So they've got sales in China, United States, Germany, Middle East, and so on. Now, if Porsche wanted hypothetical numbers, if Porsche wanted to generate$20 billion in sales or earnings, it could do that by selling different combinations of models. It could sell more Taycans, less 911s.

6:11Or it could sell more in China, less in the United States, more in Germany, less in Canada, more in the Middle East, less in France, for example. So basically, there are many ways for hit Porsche to generate the$40 billion. So what we do is Michael then says, okay, of all the ways Porsche can hit the target that it wants to hit, let's plot it out. And then Michael asks the following question, the proposal that has been implemented. Does it increase the risk to Porsche's balance sheet or does it reduce the risk? Does it increase the returns on Porsche's balance sheet or does it reduce the returns?

6:51Does it increase the risk while lowering the returns or does it increase the risk while increasing the returns? So basically there's more than one way for Porsche to hit its objectives. It can do it with a different combination of model sales and or a different combination of country sales. Each way or each combination to hit its target, we call it a portfolio. And what we can do is, this is the headline. Basically what it's saying here is that when we did the analysis, we're saying that Porsche can actually increase its margins without adding a single unit of volume. That means Porsche can increase its margins and its value without selling more cars by reconfiguring what cars it sells and through which cost base, simply because the correlations are different between the revenue and the costs.

7:44So this is what we plot out here. For those of you who've studied finance, basically this is the efficient frontier. So let's explain this here, right? I'm putting an explanation so people will be able to follow this. Michael takes the proposal and treats the whole company as one portfolio. He plots the current business by return and risk, tests that position against every possible mix of them, and shows whether the company is already earning the most return for the least risk it carries. They test whether the proposal meaningfully moves that position. This is the key thing. A lot of ideas in businesses, whether they're externally generated by a consulting firm or internally generated by business units.

8:22They'll say something like, we reduce costs. That's fine. We increased time to market. That's fine. But did you increase the risk in the business? That's different. You know you increase the risk or decrease the risk in the business when you look at the direction or the correlation between your revenue base or your earnings base, your earning streams, and your cost base. This is critical. Now, this is a very powerful tool in M &A. Even if you ran this for an M &A program, whereby someone wants to buy something, you get Michael to run it, and he says, we are going to get bigger. You're going to make more money, but your risk is going to go up.

8:57So what Michael has done is he says, okay, this is the efficient frontier. That means if you plotted every single portfolio to generate Porsche's targets, they'd all sit below this line. Now what he's also done is Porsche today. This is where Porsche is today. So Porsche is earning about this profit for this level of risk. You can see the share of Porsche's money in each business here. That means for Porsche to sit here, this is what his portfolio looks like. Then you should make a cautious change. A cautious change is we take the proposal recommendations, we don't fully implement them. You can see Porsche's returns go up, goes up a little on this axis, but on this axis, the x-axis, the risk doesn't change.

9:46So what we're saying is that Porsche can earn more returns without taking on more risk. So its current risk profile, Porsche is not earning the highest returns. And you can see the way to make that change, you can see how we've rebalanced where the cash flow or the returns are coming from each of Porsche's business. But then if you go over the full plan, you can see a major shift towards the Americas. Let's just compare them. a big drop in China, a big drop in German EU manufacturing, and a big shift into the United States, EV platforms, and so on. Now, what this tells you is that using Porsche's own data, using Porsche's historical data, we can work out correlations between different revenue streams.

10:38If they're highly correlated, they're highly risky. If they're not strongly correlated, we say they're highly diversified, and that means there's less risk. Now, the board can get even more creative with this, whereby you can figure out what's your risk appetite. So maybe the board doing the old calculations, and we can also do this through Michaels to say, okay, given the amount of cash we have in our balance sheet and some which we can get from the SEC reports and the equivalent in Germany, we can know that the board doesn't want to lose, doesn't want their risk to go further than let's say 12 % here, which is your volatility of earnings.

11:14On the other hand, the board could also say, look our risk, that's your risk tolerance. Our risk appetite, which means the most amount of our risk our balance sheet can take is only 15%. So as you plot out different scenarios, you can see if the The plan, the proposal is taking you past your risk tolerance, past your risk appetite. But more importantly, are you getting the maximum return for the level of risk you have? And then Michael talks you through how that shift will take place, how the different businesses are correlated. This is a correlation matrix. And then a board memo that explains all of this.

11:52Now, and you can also invite a colleague to see it, which is very useful. Now, this is a conversation that I see almost never happening. You read the Wall Street Journal, you read the Financial Times, you read the New York Times, nobody ever says, okay, Nike does this, if Porsche does this, what will happen to the risk in the business? When they say something is risky in most media press releases and most company discussions, when they say something is risky, they mean maybe we won't be able to do it. Maybe we won't be able to pull it off. But you've got to ask yourself, what will the risk profile of the company be if you successfully pull it off?

12:28Does implementing these recommendations force your revenue streams, asset streams, earning streams to move in the same direction you increase the risk? Does it force your cost inputs? You generate costs in different ways. If your costs move together in the same direction, that's also increasing your risk. So this is something that's an extremely powerful tool because if you put this up in front of your board or executive committees, they will understand it very quickly. It puts everything together on the same table, would say is that, look, this is where we are now. The proposal takes us there because it reduces one.

13:04Well, actually, yeah, it doesn't reduce your risk. You have the same risk, but it increases the returns for the same risk. Now, why would anyone turn down a chance to increase your returns for the same risk? So this idea that you can only get higher returns with more risk is only true if you're on this, what is called the efficient frontier. So you can see here, to get a higher return you have to go this way which increases your risk but if your current business portfolio is within the efficient frontier somewhere here like here you could go up but the key things for most companies is they do not actually plot this michael does it for you and it's one of the most powerful tools we have you can see we've been running different simulations for different clients and so on and also our own personal studies we are running within within the training programs we put together so this is something that's really a fundamentally different way to look at how to do strategy.

13:57And you pair this up with scenario living, which says basically, hold on a second here, every single scenario we look at in the future, when we plug this digital clone portion to the future in real time, it actually looks pretty good for us. But that doesn't tell you whether you've increased or decreased the risk in the business. That's a fundamentally different question. And that's what risk and return tells you. And of course, for the part that you're analyzing in Michael, you need to redesign that business for the digital era, which is what Michael does here. But this is a very powerful tool.

14:31It is a core part of risk that almost nobody talks about, because it's really hard to do, but we can do it here. The reason we can do this is because firms consulting by and large is built around understanding risk. That's how original thinking comes from. We are strategists. We come from strategy thinking, but strategy is made of two parts, risk and return. Most people focus on the return side. We focus on the risk side. And I can tell you that when I was building these models way back when I started my career, it would take a team of people about six to eight weeks, three, four-man team, coding on laptops, running Monte Carlo simulations overnight, collecting the results, and then plotting this curve.

15:15And because of our understanding of risk analysis and portfolio modeling that we've developed over two decades, we know how to automate the building of this. Because it's one thing to build this correctly. It's another one to build it and make it look like it's correct, which is what AI programs do. But everything we have is integrated. So this module is checking off that module, is checking off that module, is checking off that module, is checking off that module. And they're all checking whether the proposal is going to actually matter. Can the management implemented? Will this proposal work in all the likely scenarios in the future, not just the four, but using quantum programming, pushing the digital clone of the company into the future and seeing what happens?

15:57Does it increase the risk of return? Can the core business that's analysed in the proposal be redesigned for the digital era? Will it work in what we consider will be the biggest risk most likely facing companies in the world in the foreseeable future? And I'll have more on that in the future. And then what does it do for your career? But this alone is a very powerful way of looking at your business. And I can assure you right now, I would never say the majority, I would say 99 % of companies do not look at this picture. And they cannot look at this picture because it's actually hard to produce this.

16:30To model this, to code it, to add in the weights, add in the business judgment, to make it make changes the way we think, that's a very difficult thing to do. but it's an extraordinarily powerful question to ask your board. If this is the strategy which is going to increase earnings and so on, first question is, does it increase the risk of your business? And second, are you getting the most return for the risk you're currently taking? That's what boards should be discussing when you're considering directions and changes you want to make. Now, we're going to be covering lots of interesting things in the world of technology, AI, quantum, and even robotics and the way it's going to change, corporate strategy, corporate finance, business unit strategy, and so on.

17:15If you want to see the changes that are coming out with our new videos and so on, go to the firm's consulting website. In the top navigation, we have something called Newsletters, which is a sometimes daily, but definitely multi-weekly emails that we send up with our latest thinking that will include updates on these videos, sample videos, so you can see the changes we are making and the powerful tools that exist that help you to understand what's happening in the world today.

17:52Thanks for listening to this episode of the Strategy Skills Podcast. Stay up to date on all of our latest training by signing up for our email updates on firmsconsulting.com. We look forward to helping you develop your strategy, critical thinking, decision-making, and communication skills next time here on the Strategy Skills Podcast.

18:31Thank you.