Paths to Improved Business Growth When the Federal Reserve’s Policies are Ineffective

The United States is entering a period of unprecedented economic uncertainty regarding the effectiveness of Federal Reserve (FED) monetary policies. The asset management and expansion practices of S&P 500 companies have already changed and substantially reduced the effectiveness of lowering interest rates to stimulate economic growth. Practitioners of all sized companies are reassessing their expectations that the Federal Reserve can effectively stimulate growth and planning accordingly.

Overview

The National Bureau of Economic Research (NBER) reported that the recession officially ended in June 2009.[1] Yet the annual rate of economic growth remains below a long term average of 3.0 percent. While it may be tempting to think that all businesses have shared equally in the pains of a slow recovery, it is not an accurate view. Many practitioners believe that big businesses are growing faster than ever because they can leverage their large scale to grow faster in markets outside the United States. However, such globalization patterns do not increase GDP. In the past monetary policies could be counted on to stimulate economic growth for all businesses. As shown in this article that is no longer the case.

In 2016 the FED’s Chair Janet Yellen presented a paper at a Federal Reserve Bank of Kansas City symposium in Jackson Hole, Wyoming, entitled “The Federal Reserve’s Monetary Policy Toolkit: Past, Present, and Future.”[2] The Chair stressed that the proven way the FED had stimulated economic recovery and growth from past recessions was to reduce its lending rate to member banks (i.e. discount rate). Specifically, the discount rate, which is the rate that the FED charges member bank to borrow funds in the short run to maintain required reserves, dropped an average of 4.3 percent for the last three recession recovery cycles. Similar rate changes exist for the federal funds rate which is the rate that banks charge each other for short-term loans to maintain required reserves.

If the United States economy had gone into recession in March 2017 when the discount rate was 1.50 percent and the FED followed their previous recovery rate policies, the discount rate would have been lowered to -2.8 percent. With inflation at two percent the real or adjusted discount rate would have been -4.8 percent. There are no precedents to predict what rational economic behaviors would have been for banks, businesses, and households.

In addition, the FED acknowledges that uncertainties exist on multiple levels, which include how to increase the current discount rate of 1.75 percent to 5.0 percent or higher, how many asset purchases would be needed to maintain the unemployment rate at or near 5.0 percent in a future recession, how phasing out interest rates on bank reserves and asset purchases would affect bond markets and bank liquidity, and how fiscal policies and shocks from worsening economic conditions in other countries would affect the effectiveness of U.S. monetary policies. How should practitioners plan for these uncertainties?

This article postulates that the ineffectiveness of the FED’s expansion policies requires businesses to adapt their business tactics and strategies. At the heart of the matter large businesses have already adapted to the Global Information Age by focusing on Intangibles and Goodwill asset investments which are not bank financed. While the FED and its member banks still assume that lower interest rates will increase business investments, practitioners can no longer rely on physical capital expansions to stimulate economic growth. Small and mid-size businesses are encouraged to understand what large companies, such as the S&P 500 companies, have done and adapt their Global Information Age investment and expansion strategies to increase their growth. More than a dozen suggested actions and strategies are discussed below.

Why the FED’s Monetary Policies are Ineffective

In 2017 it is easy to focus on the uncertainty facing businesses and the national economy from the Trump Administration’s proposed fiscal policies. These policies include reducing taxes, increasing government spending for infrastructure projects, eliminating regulations, and replaces the Affordable Care Act. In a period of such fiscal change the only certainty is that market conditions will not remain the same. In such a period monetary policies can be seen by practitioners as a way to provide economic stability and stimulate economic growth. In 2016 Larry Summers determined that monetary policies contributed to secular stagnation growth in the United States.[3]

Historically, the FED’s most effective tool has been its ability to reduce the discount rate to engage a change cycle that ends up stimulating economic growth. Unfortunately in 2017 the FED does not have this monetary policy tool available to stimulate the U.S. economy. Figure 1 provides a view of an annualized federal discount rate for the last 20 years.[4]

The discount rate averaged 4.0 percent from 1990 to 2017 and since 2008 the average has been 0.78 percent. The FED historically pushed the discount rates up during periods of economic growth and then decreased the rate to stimulate the economy out of recessionary economic conditions. The FED did this in 2001 and in 2008. In the 2001 recession the FED was able to move the rate from 6.00 percent to 1.33 percent and promote economic recovery. In 2008 the FED moved the rate from 6.25 to 0.50. While reasonable people can disagree about the length and extent of the recovery since the Global Financial Crisis (GFC) there is little doubt that the current discount rate of 1.75 percent cannot be effectively lowered.

With historically low FED discount rates since 2009 many economists and practitioners ask why bank financed physical capital expansion has not stimulated economic growth? Two reasons are postulated in this paper: (1) banks did not know if household savings would rise with low interest rates, and (2) large businesses have changed their asset management investment profiles and their priorities for bank financing.

Since 2008 banks interest rates offered to household savers has remained within 0.5 percent of the FED’s discount rate. With low interest rates households have not historically increased their savings account balances. Traditionally, banks do not increase their loans without additional savings because such actions reduce their liquidity ratios. In retrospect the period from 2009 to 2015 turned out to be historically different. Savings account amounts increased with low interest rates. Banks discovered that they no longer needed to raise interest rates to increase savings amounts from an ageing demographic base in the Global Information Age. Banks used the unexpected additional deposits to buy back stock, pay dividends, increase cash balances, and acquire other institutions.

With regard to bank/business lending for physical capital expansions a schism occurred in 2008-2010. In this period businesses went to their banks to access credit lines to sustain the downturn and were denied access. Business/bank relationships have been tenuous since then. Do you remember the case where McDonald’s went to its bank and was told no additional credit was available for a proposed investment in their restaurants? The Great Recession can be characterized as the period when businesses lost trust with bank financing. Since then businesses have financed capital project expansions using their own cash, long-term debt, and equity financing. Compustat data for the S&P 500 companies from 2008-2015 shows that Goodwill and Intangible assets have risen to 17 percent of corporate assets while Plant and Equipment has remained close to 1.3 percent.[5] With bank financing tied to physical capital expansions the connections between banks, businesses asset management, and economic growth are broken.

A Business Actions List for consideration in 2018-2019

While the previous section focused on how the actions of the S&P 500 companies and the FED led to stagnant U.S. economic growth, this section suggests what small, mid-size, and large companies can do to offset the downside of ineffective monetary policies and improve business growth when monetary policies are ineffective.

Small corporations should carefully examine alternatives to bank financing of future expansions. Corporations deemed small business (in general, net after-tax income of $2.5 M or less) should carefully review all financial advantages afforded by the Small Business Administration (SBA). The SBA is a focal point of the Trump Administration, and it will receive greater funding and visibility. There are numerous programs including, but not limited to: (1) SBA 7(a) loans; (2) SBA 504 loans; (3) Certified Development Company loans; (4) CapLines loans; and (5) Export Working Capital loans. Further, and not directly related to the SBA, are other government financing methods to both small and large corporations. These include, but not limited to: (1) Industrial Revenue Bonds; and (2) business and industry loans through the U.S. Department of Agriculture which can be broadly defined.

Practitioners of all medium and small sized businesses should also assess how to better leverage bank relationships as S&P 500 companies have since 2009. Specifically, large corporations have connected the availability of increased cash in banks to cheaper long-term debt financing. Why should not all businesses follow this trend?

Practitioners should also be concerned that increases in cash positions by large businesses and banks signal that an economic downturn is increasingly likely. So time may be limited. Recessions are cyclical. The duration between the last five recessions was six to nine years. The current recession clock started in July 2009 according to the NBER. In 2017 the United States economy is well within the duration range. While there is no certain date for the next recession, uncertainty is rising. In 2018-2019 the recession clock will pass above the duration range.

If a recession occurs and the FED maintains low discount rates, end strategies for small and mid-sized companies must include acquisitions by large companies. The following list of actions is appropriate for small to mid-size business managers to consider and discuss as paths to improved business growth and increased acquisition value:

  • Increase Total Corporate Goodwill Value

Increase return on equity (ROE) to 15 percent or higher. Using the DuPont System, practitioners can determine what processes the business does well and which need improvement. The DuPont equation is:

ROE = (net income / sales) * (sales / assets) * (assets / equity)

or said differently:

ROE = net profit margin * asset turnover * equity multiplier.

  • Increase Intangibles

Insure that any copyrights or patents are filed and up to date. Review, and if necessary, enhance legal protections to preserve and safeguard projected account receivables.

  • Hedge Commodities

Companies should consider hedging commodities to assure raw material prices and adequate supplies.

  • Work harder on Customer Satisfaction

It is imperative that smaller companies gain customers since they translate into increased Goodwill. Strategically prepare for this now by rethinking and reconnecting with those factors that drive customers to your company.

  • Push Innovation and Product/Service Extensions to engage in Global Supply Chains

Examine core business competencies and conceptualize how to extend utilizing current output with only minor changes. Are there any industries that can successfully use your products and services as interim outputs?

  • Enhance Strategic Business Models

Examine the possibilities of entering new markets with new products and services through alliances or mergers and acquisitions on a global level. It is a very good time to acquire these extensions, but at prices that reflect the potential for U.S. and global economic downturns.

  • Expand Long-Term Debt Financing Positions in 2018-2019

As S&P 500 companies have done seek available bank funding to finance long-term debt.

  • Return Off-shore Monies to U.S. Banks

Renegotiate banking relationships with better credit terms and investment opportunities for off-shore monies returning to the United States. Small to medium sized businesses can determine the benefits from lower corporate tax rates and allocate available funds to high priority capital projects in the United States. In a shifting trade deficit, practitioners can expect more on-shore opportunities, specifically in holding accounts.

  • Increase accumulated Cash Positions

Make plans to accumulate more cash for a recessionary cushion. Practitioners should revisit tactics to determine how to improve short-term revenue collection and credit targets and enhance cost spending controls. In effect practitioners should seek to lower their exposure to a problematic national downturn. Revisit cash management with banks based on new controls and accounts payable management processes.

  • Leverage Equity Positions

Seek equity positions to increase owned shares. Buy back as much stock as possible when overvalued equities reset. With a refocused cash management position this increased liquidity should give poised practitioners a chance to foster growth during a financially weak period.

  • Expect increases in the value of U.S. Currency against other National Currencies

Bet against the U.S. currency to take advantage of poor monetary transmitters. The FED cannot reduce interest rates to reduce the value of the U.S. dollar relative to other currencies. Furthermore, the FED’s tools cannot reverse potential effects of a changed domestic policy from a shifting federal government agenda.

  • Consider strategic Job Relocations

Relocate jobs to rust-belt states to take advantage of shifting tax and perspective identifies. In a recessionary crisis, the supply of labor will present practitioners with renewed opportunities in capital and labor markets. Market opportunities will differ by state.

  • Analyze 2018-2019 Industry Opportunities

Reassess defense, healthcare, and infrastructure construction industries. The FED will not be able to stimulate the economy, but fiscal spending priorities are likely to stimulate higher growth sectors/industries that practitioners can penetrate by partnering with established business entities.

Considerations and discussions of these actions are important first steps. Practitioners will choose different paths to meet their specific situations. Regardless of the paths taken the effectiveness of the actions should be judged on improved future business growth rates and future acquisition values.

Conclusion

A shifting domestic agenda presents practitioners with a realistic and rapidly approaching economic scenario. The U.S. economy faces serious existential questions regarding risk and volatility against a poorly positioned FED and continued ineffective monetary policies to stimulate economic growth. Trade, immigration, and geo-political decisions, the U.S. currency, and the recession clock combine to present practitioners with an increasing level of downside risk. Practitioners who take advantage of pre-recession financing opportunities, recognize the risks ahead, map out the consequences of key monetary and fiscal policy actions, and solidify their equity-based positions and liquidity through cash management are more likely to succeed in this economic environment. In a real sense, it is better to adapt strategies and act today than be dependent on the Federal Reserve tomorrow.

 

[1] CNN Money, accessed July 10, 2017 on http://money.cnn.com/2010/09/20/news/economy/recession_over/index.htm

[2] Yellen, J (2016), The Federal Reserve Bank of Kansas City Designing Resilient Monetary Policy Frameworks for the Future Symposium: “The Federal Reserve’s Monetary Policy Toolkit: Past, Present, and Future”, accessed January 15, 2017 from https://www.federalreserve.gov/newsevents/speech/yellen20160826a.pdf

[3] Summers, L., Secular Stagnation and Monetary Policy”, Federal Reserve Bank of St. Louis Review, 98(2), Second Quarter 2016, pp. 93-110.

[4] ”FRED Discount Rates INTRDSTUSM 193N.” Chart. St. Louis Federal Reserve Bank, accessed April 20, 2017, https://fred.stlouisfed.org/series/INTDSRUSM193N

[5] Compustat, S&P Capital IQ, North America, Fundamentals Annual, accessed on June 15, 2017.

2017 Volume 20 Issue 2

2017 Volume 20 Issue 1

2016 Volume 19 Issue 2

2016 Volume 19 Issue 1

2015 Volume 18 Issue 2

2015 Volume 18 Issue 1

2014 Volume 17 Issue 3

2014 Volume 17 Issue 2

2014 Volume 17 Issue 1

2013 Volume 16 Issue 3

2013 Volume 16 Issue 2

2013 Volume 16 Issue 1

2012 Volume 15 Issue 3

2012 Volume 15 Issue 2

2012 Volume 15 Issue 1

2011 Volume 14 Issue 4

2011 Volume 14 Issue 3

2011 Volume 14 Issue 2

2011 Volume 14 Issue 1

2010 Volume 13 Issue 4

2010 Volume 13 Issue 3

2010 Volume 13 Issue 2

2010 Volume 13 Issue 1

2009 Volume 12 Issue 4

2009 Volume 12 Issue 3

2009 Volume 12 Issue 2

2009 Volume 12 Issue 1

2008 Volume 11 Issue 4

2008 Volume 11 Issue 3

2008 Volume 11 Issue 2

2008 Volume 11 Issue 1

2007 Volume 10 Issue 4

2007 Volume 10 Issue 3

2007 Volume 10 Issue 2

2007 Volume 10 Issue 1

2006 Volume 9 Issue 4

2006 Volume 9 Issue 3

2006 Volume 9 Issue 2

2006 Volume 9 Issue 1

2005 Volume 8 Issue 4

2005 Volume 8 Issue 3

2005 Volume 8 Issue 2

2005 Volume 8 Issue 1

2004 Volume 7 Issue 3

2004 Volume 7 Issue 2

2004 Volume 7 Issue 1

2003 Volume 6 Issue 4

2003 Volume 6 Issue 3

2003 Volume 6 Issue 2

2003 Volume 6 Issue 1

2002 Volume 5 Issue 4

2002 Volume 5 Issue 3

2002 Volume 5 Issue 2

2002 Volume 5 Issue 1

2001 Volume 4 Issue 4

2001 Volume 4 Issue 3

2001 Volume 4 Issue 2

2001 Volume 4 Issue 1

2000 Volume 3 Issue 4

2000 Volume 3 Issue 3

2000 Volume 3 Issue 2

2000 Volume 3 Issue 1

1999 Volume 2 Issue 4

1999 Volume 2 Issue 3

1999 Volume 2 Issue 2

1999 Volume 2 Issue 1

1998 Volume 1 Issue 3

1998 Volume 1 Issue 2

1998 Volume 1 Issue 1

What Can Managers Learn from Silicon Valley Venture Capitalists?

Successful organizations are often those that continuously learn and innovate. While this impetus for learning and innovation may come from familiar sources, less familiar origins of insight may provide the stimulus for creativity[1] and the identification of new breakthrough product-markets.[2] While venture capitalists (VCs) play a vital role in the development of new firms and even new industries, their insights are primarily provided to those companies directly financed by them. This article reviews the primary roles of venture capitalists and relays key management advice from Silicon Valley VCs normally reserved for their portfolio firms in order to share new insights that may spur innovation among managers of firms beyond Silicon Valley.

Venture Capital 101

The roles of venture capitalists are, of course, multifaceted. In brief, venture capital is a type of private equity focused on financing the growth of high potential new ventures of a variety of industries at various stages of their growth. To accomplish this VCs create a venture capital fund, for which they convince institutional investors, limited partners (LPs), to commit significant capital for the purpose of taking ownership stakes in high potential private companies. Acting as agents for their limited partner investors,[3] VCs set the parameters of the fund (e.g. stage and industry focus of the fund’s portfolio companies), and then identify high potential private firms to invest in after conducting extensive due diligence. Their job is not over at this point as they guide, support, and cajole the firms they invest in to pursue optimal strategies to potentially lead or create industries rather than simply developing new companies. In order to return their LP’s capital and an adequate return on that capital, VCs must guide a sufficient number of their fund’s portfolio firms to significant growth and a successful liquidity event (exit) through an acquisition or an IPO. Please see Figure 1 for a graphical representation of the VC business model.

Figure 1:

Venture Capital Business Model

So what can managers who are not directly part of this venture capital centric entrepreneurial ecosystem learn from these purveyors of capital and guidance? To provide current advice from practicing venture capitalists, I conducted a short survey of some of the Silicon Valley VCs who regularly provide insight for a related ongoing quarterly research study of venture capitalists’ confidence.[4] In the survey for this study, I asked each VC to offer one or two pieces of advice to business managers that they have found to be effective in guiding their portfolio firms. I also asked if I could cite them. Each agreed. The VC responses were placed in context of relevant underlying theory in entrepreneurship and innovation to validate the commentary as durable wisdom for business professionals. In the following please find a review of their responses along with my analysis.

Venture Capitalists’ Advice for Managers

Highlight Leadership Rather Than Management to Spur Innovation

Bill Reichert of Garage Technology Ventures offered “two recommendations for business leaders who want to drive innovation and growth in their companies.” First, Mr. Reichert insisted to:

…ban the title ‘manager’ and the word ‘management’ from your vocabulary. You don’t want ‘managers’ in your organization. You want leaders, up and down the organization. Managers seek stability, which is best attained by avoiding anything that rocks the boat. Managers suppress conflict, ‘Shut up and do what I tell you to do.’ Leaders seek out opportunities to innovate and make things better. Leaders invite diverse and differing perspectives, knowing that better solutions come from the clash of competing ideas. Disagreement and conflict are not bad, if channeled toward achieving shared goals. ‘Managing innovation’ is an oxymoron.

Underpinning Mr. Reichert’s argument, Ireland et al.[5] concludes that entrepreneurial leaders can foster an entrepreneurial mindset in their organizations by protecting innovations that threaten the current business model, making sense of new opportunities, and questioning the dominant logic of the organization.[6] And Blatt asserts the importance of cognitive conflict (the debate of ideas) in enhancing performance among cohesive teams.[7]

Supporting the aforementioned primacy of leadership, Dag Syrrist of Vision Capital observed “…governance and near-termism are restricting large companies more than small companies, especially public ones.” Mr. Syrrist continued, saying:

…generally, senior executives in larger companies have less time and freedom to try and do new things versus the same position in smaller firms…In my experience senior executives in large companies have a laundry list of innovative and valuable things they think would and could make a huge difference in all sorts of ways that would directly impact even near-term key performance indicators (KPIs), but they do not have time or free budget to do anything outside their overburdened near-term to do list… So my number one advice to managers at mid to large size firms, is get bosses that will let them spend x% of time and budget on new things. I worked with a $40B company that had two SVP’s called ‘pathfinders’—they clearly got this idea, and freed them from day-to-day crap. It’s hard to do because Wall Street and EPS drive all aspects of all large public companies in the end, and there are very few Steve Jobs or Mark Zuckerbergs out there.

Focus on a Meaningful Outcome and Chart the Milestones to Achieve It

Tim Draper of DFJ, shared, “My advice to managers is to make sure everyone is pulling in one direction; all motivations should center around a single goal. That goal should be clear and exciting. Financial incentives should align with the outcome you aspire to.” Jeb Miller of Icon Ventures stressed, “Have a strong conviction in your long-term vision. Startups can make adjustments along the way, but you need to have conviction in your long-term vision in order to convince others (employees, investors, customers) to join you for the ride.”

Bob Bozeman of Eastlake Ventures also emphasized focus on something that is “worthwhile.” Mr. Bozeman elaborated on this notion, saying:

You can only stay focused on one thing—make it something worthwhile. Often people pick goals that are opportunistic to get a fast win. Worthwhile things are not always easy but they are worth the focus and breaking down into an executable plan that can make life worthwhile too. When the long-term goal has a high worthwhile factor then the short-term steps (sometimes called work) are bearable.

Mr. Bozeman explained further “Connect short-term to long-term and vice versa. To some people the BIG picture is everything and to others tactical is everything. People that keep long-term goals in mind while getting things done effectively create the momentum that leads to success.”

Ensure a Company-wide Culture of Customer and Sales Orientation

The second point that Mr. Reichert underscored is:

Everyone sells. Nurture a culture in which selling is appreciated as one of the highest arts of entrepreneurship, right alongside innovation. Too many cultures disparage selling as an unfortunate necessary evil, and sales people are too often held in low esteem. Everyone in the company should have an orientation toward creating value for customers. Everyone should understand how to sell and love to sell the company’s product or service.

To amplify this effect, Bob Bozeman of Eastlake Ventures suggested “TEAMING.” He specified “Don’t be a loner—connect to the team that coordinates to get hard things done more effectively. This is the people factor in business and connects individual contributors to achieving the required momentum and being part of the overall success.” Underlying this point, Blatt maintains that developing a communal schema and clear contracting practices can help reduce affective conflict and support team cohesion and performance.[8]

Consider Startups’ Priorities, Opportunities, and Pitfalls

Kurt Keilhacker of Elementum Ventures indicated “One of my own phrases I cite to my first-time CEOs is ‘The CEO ultimately owns three responsibilities: The recruitment of the right people at the right stage, the securing of the right capital at the right price, and the advancing of the right strategy at the right market.’” Dag Syrrist of Vision Capital added that:

…Smaller companies can compete with larger ones simply by virtue of being able to do things; they are not limited to only those things that can move big needles in a big way. So, one way to think of this is that in startups the hard part is to decide what NOT to do. Because the future is unknown and there is no predictable revenue or near term growth the challenge most small companies have is doing too many things, thinking it’s a hedge against being wrong when in fact what it does is dilute each effort often into nothing. So we invented the idea ‘to pivot’ which is just another way of saying we were wrong. As the business grows this changes as the business is better understood, and it’s more about execution and cranking the production. This makes it obvious what to do, less time and money to do ‘new’ things, and as the company gets really big there is nothing left in terms of free time, budget or imagination.

Cash Efficiency

Shomit Ghose of Onset Ventures stated:

The two most important words for startup managers? Cash efficiency. Cash efficiency must always be a primary consideration for entrepreneurs in the startup fray. Companies without a relentless focus on cash efficiency are doomed to fall among the 90% of startups who fail. So once funds are raised, spend every dollar as if it’s your last. Focus your spending in two key areas: customer validation and building your management team. If you can use your funding to demonstrate market need as shown by paying customers and revenue growth, then you can look forward to continued up-rounds, over-subscribed financings, eventually leading to a tidy exit via M&A or an IPO.

Jeb Miller added “Spend cash prudently. The best returns for all parties are usually generated by capital efficient business models that spend wisely.”

Conclusion

While all the advice from venture capitalists may not be applicable to every organization’s day-to-day operations, their insights may provide unique perspectives that could give business leaders, from startups to public corporations, an edge in strategically guiding their firms through an increasingly dynamic and competitive landscape. The key themes emphasized by the responding venture capitalists include a focus on leadership, culture, and finance. Table 1 highlights dimensions of each of those themes.

Table 1:

Silicon Valley Venture Capitalists’ Advice for Managers

Ironically, the primary advice from venture capitalists to managers is to lead rather than to manage and to recruit leaders throughout the organization. Leadership begins with setting a clear and exciting vision and maintaining focus on that vision and using it to inspire colleagues and recruit the right team of leaders. Once that team is in place, encourage debate to get to the best solution and spur innovation. Ensure company-wide focus on a meaningful goal and connect short-term milestones to achieving this long-term goal while budgeting time and capital for continued opportunity scanning and experimentation. Meanwhile, build a culture that affirms a strong customer orientation and honors selling and cash efficiency.

Venture capitalists are revered for their ability to guide new CEOs in developing fast-growth businesses that disrupt industry incumbents and take or create market share in the process. In this Darwinian environment,[9] VCs rely on the leadership of the CEOs they support to communicate an inspiring vision and build a team and organizational capabilities every day to achieve it. Managers of established organizations may benefit from considering the priorities that Silicon Valley venture capitalists demand to achieve uncommon results, particularly as the rate of technological change and global competition increasingly impacts firms of all sizes and industries.

 

[1] Baer, M. (2010). The strength-of-weak-ties perspective on creativity: A comprehensive examination and extension. Journal of Applied Psychology, 95: 592-601.

[2] Christensen, Clayton M.; Johnson, Mark W.; Rigby, Darrell K. (1992). Foundations for Growth: How to identify and build disruptive new businesses. MIT Sloan Management Review, Spring 2002, Vol. 43 Issue 3: 22-31.

[3] Denis, D. J. (2004). Entrepreneurial Finance: An Overview of the Issues and Evidence. Journal of Corporate Finance, 10: 301 – 326.

[4] Cannice, Mark V (2004 – 2017, quarterly). Silicon Valley Venture Capitalist Confidence Index Research Reports. ProQuest and EBSCO, Volumes 1 – 13, quarterly: 1-5.

[5] Ireland, R.D., Hitt, M.A., and D. Sirmon (2003). A Model of Strategic Entrepreneurship: The Construct and its Dimensions. Journal of Management, Vol 29 (6): 963–989.

[6] Ibid.

[7] Blatt, R. (2009). Tough Love: How Communal Schemas and Contracting Practices Build Relational Capital in Entrepreneurial Teams. Academy of Management Review, Vol. 34 (3): 533 – 551.

[8] Blatt, R. (2009). Tough Love: How Communal Schemas and Contracting Practices Build Relational Capital in Entrepreneurial Teams. Academy of Management Review, Vol. 34 (3): 533 – 551.

[9] Cannice, M. and Bell, A. (2010). Metaphors used by Venture Capitalists: Darwinism, Architecture and Myth. Venture Capital: An International Journal of Entrepreneurial Finance, Vol. 12: 1 – 20.

 

 

2017 Volume 20 Issue 2

2017 Volume 20 Issue 1

2016 Volume 19 Issue 2

2016 Volume 19 Issue 1

2015 Volume 18 Issue 2

2015 Volume 18 Issue 1

2014 Volume 17 Issue 3

2014 Volume 17 Issue 2

2014 Volume 17 Issue 1

2013 Volume 16 Issue 3

2013 Volume 16 Issue 2

2013 Volume 16 Issue 1

2012 Volume 15 Issue 3

2012 Volume 15 Issue 2

2012 Volume 15 Issue 1

2011 Volume 14 Issue 4

2011 Volume 14 Issue 3

2011 Volume 14 Issue 2

2011 Volume 14 Issue 1

2010 Volume 13 Issue 4

2010 Volume 13 Issue 3

2010 Volume 13 Issue 2

2010 Volume 13 Issue 1

2009 Volume 12 Issue 4

2009 Volume 12 Issue 3

2009 Volume 12 Issue 2

2009 Volume 12 Issue 1

2008 Volume 11 Issue 4

2008 Volume 11 Issue 3

2008 Volume 11 Issue 2

2008 Volume 11 Issue 1

2007 Volume 10 Issue 4

2007 Volume 10 Issue 3

2007 Volume 10 Issue 2

2007 Volume 10 Issue 1

2006 Volume 9 Issue 4

2006 Volume 9 Issue 3

2006 Volume 9 Issue 2

2006 Volume 9 Issue 1

2005 Volume 8 Issue 4

2005 Volume 8 Issue 3

2005 Volume 8 Issue 2

2005 Volume 8 Issue 1

2004 Volume 7 Issue 3

2004 Volume 7 Issue 2

2004 Volume 7 Issue 1

2003 Volume 6 Issue 4

2003 Volume 6 Issue 3

2003 Volume 6 Issue 2

2003 Volume 6 Issue 1

2002 Volume 5 Issue 4

2002 Volume 5 Issue 3

2002 Volume 5 Issue 2

2002 Volume 5 Issue 1

2001 Volume 4 Issue 4

2001 Volume 4 Issue 3

2001 Volume 4 Issue 2

2001 Volume 4 Issue 1

2000 Volume 3 Issue 4

2000 Volume 3 Issue 3

2000 Volume 3 Issue 2

2000 Volume 3 Issue 1

1999 Volume 2 Issue 4

1999 Volume 2 Issue 3

1999 Volume 2 Issue 2

1999 Volume 2 Issue 1

1998 Volume 1 Issue 3

1998 Volume 1 Issue 2

1998 Volume 1 Issue 1

High Performance Work Systems

In their quest to compete successfully in today’s difficult economic times, many business leaders have opted to cut labor costs, hire part-time employees to avoid costly fringe benefits, and adopt a “lean and mean” management approach to running their organizations. While it is foolish for companies to spend money unwisely in managing human capital, a growing body of research evidence also confirms that “high performance work systems” (HPWS) are worth the investment of time and effort. Aligning human resource practices to treat employees as valued owners and partners adds value and optimizes opportunities to create and maintain competitive advantage.

Seven Practices of High Performance Work Systems (HPWS)

HPWS 6The focus of this article is to explain the key elements of HPWS and to identify why creating partnerships with employees makes economic sense for employers in today’s knowledge-, wisdom-, and information-based economy. Understanding the findings of recent research about this high trust and high empowerment management philosophy may enable business practitioners to avoid the mistakes that “conventional wisdom” can lead to and that have been increasingly acknowledged as the cause of much organizational dysfunction and decline.[1]

HPWS systems emphasize employee involvement and reflect a commitment to creating an organizational culture based upon commitment rather than control. At the same time, the cultures of high performance organizations emphasize the pursuit of excellence and expect employees to be well-qualified, highly competent, and constantly engaged in improving the organization.[2] Management experts have extensively researched HPWS and have identified common management practices that create competitive advantage and enhance organizational performance.[3] The following is a summary of seven human resource practices for producing higher profits through engaging employees as full owners and partners in an organization’s success.[4]

1. Ensuring Employee Security

Despite the trend of many businesses to engage in downsizing and hiring part-time and contract employees to avoid creating obligations to employees, the evidence has shown that organizations who engage in these practices have rarely created new wealth or improved the long-term bottom line of their organizations.[5] HPWS systems advocate creating high-trust partnerships with employees that build commitment and promote extra-mile and extra-role behavior that are critical for success in the modern organization.

Lincoln Electric, a successful electric company, adopted a program years ago that guaranteed employment to workers after three years on the job. Employment security policies that demonstrate a commitment to employees and their welfare work best when combined with the careful selection and hiring of employees who fit the needs of organizations and who match their job requirements. A number of scholars have reported evidence that organizations that implement policies that ensure employee security build trust with the people who are hired and find that their employees perform better and are more committed to their organization’s success.[6]

2. Selective Hiring

Carefully evaluating new hires requires that organizations are precise in identifying the critical skills and attributes of their employees in the first place.[7] Hiring to fit requirements of the job makes more sense than simply hiring candidates with the best academic pedigrees or who look the best on paper. Identifying attributes like character, respect for others, and a service orientation that do not change through training actually improve employee retention and long-term fit.[8]

Enterprise Rent-A-Car, now the largest car rental company in the United States, has successfully used selective hiring to identify “people people” from “the half of the college class that makes the upper half possible.”[9] Their focus on hiring former college athletes and fraternity or sorority members with excellent interpersonal skills has helped Enterprise to succeed in creating its superb customer service reputation which has helped the company to earn its top position in the car rental industry.[10] Focusing on hiring the right people has been cited by management scholar Jim Collins as a key difference in those companies that are “great” rather than simply “good.”[11]

3. Decentralized Decision-Making

Organizations that establish HPWS cultures recognize the importance of clearly identifying goals and objectives. In implementing those goals, HPWS companies delegate decision-making throughout the organization and empower their employees to deliver outstanding service to customers and achieve optimal organization results.[12] Incorporating well-trained and supported self-managed teams that enjoy autonomy and broad discretion in making decisions demonstrates the high trust in employees that characterizes HPWS.

Creating teams can lead to greater initiative, but effective self-managed teams require extensive training, accountability in reporting the progress of assignments, and ongoing support to optimize their effectiveness. Effectively using company work teams that are well trained and supported by an organization’s top management team creates accountability at the organizational level. This is where accountability among interdependent team members is most important and where vital customer-related work gets done.[13] Creating a culture of collaborative accountability reinforces organizational values and increases personal ownership at all levels.[14]

The Ritz-Carlton Hotel chain is famous for the quality of its customer service. Ritz-Carlton’s management approach achieves service excellence by decentralizing decision-making to all of its employees. Those employees each have the discretion to spend up to $2,500 when they believe doing so best serves the customer and meets with the hotel’s mission. A compelling body of evidence about organizations that excel in providing great service confirms that decentralizing decision-making and empowering employees can pay off with increased customer satisfaction and higher profits.[15]

4. High Results-Based Compensation

Developing a compensation system that rewards employees at all levels when the organization succeeds promotes commitment to shared goals and increases employee awareness of their roles in contributing to profitability. Compensating employees contingent upon organization performance is most effectively adopted as part of a high-performance culture that incorporates profit sharing throughout an organization.[16] The logic of contingent compensation is implicitly equitable and fair and confirms to employees that they will share in the fruits of their work. Group-based profit sharing or gainsharing also creates a social system of accountability to the organization and to other team members.[17]

Whole Foods, an American supermarket chain that specializes in natural and organic food products, is an exceptional example of an organization that has created such a social system as part of its commitment to excellence and high quality.[18] The company has been listed as one of Fortune’s “100 Best Companies to Work For” every year since that list was created and has received numerous awards for honoring company values. Paying for performance also requires companies to develop far more effective measures of what constitutes excellence, while also communicating to employees how they create value for customers and for the company.

5. Training by Commitment

Virtually every HPWS organization emphasizes training by commitment as contrasted with training focused on control-oriented management systems. Training employees in how to resolve problems, to take responsibility for quality, and to take the initiative in suggesting changes in organization work methods demonstrates trust in the quality of employees hired and an acknowledgement of employee buy-in to a results-based compensation program. In contrast with many organizations that deem training to be a frill that can be eliminated, HPWS systems carefully determine the type of training that is most needed to achieve organizational goals and then invest heavily on helping employees to optimize their ability to succeed. Research evidence suggests that engaging employees in work-related team training increases their ownership and commitment and their ability to contribute to the achievement of critical organizational goals.[19]

The Men’s Wearhouse clothing chain is noted for investing far more heavily in employee training than its competitors and creating an employee supportive culture[20] and has prospered by doing so—recently acquiring the Joseph A. Banks brand in 2014. In today’s highly competitive global marketplace, great companies understand that they must create a “learning culture” corporate-wide so that all members of the company can contribute to adding value and improving service quality.[21]

6. Reduced Status Barriers

A basic assumption of an HPWS is that good ideas and organizational improvements can come from employees at all levels of the organization. Wage inequality and the use of symbols like language, dress, physical space, and benefits can send a message to employees that an organization views status hierarchically, rather than treating every employee as if he or she is both valued and valuable. Stephen R. Covey repeatedly noted that great organizations seek to build high trust cultures by nurturing and developing people, rather than by controlling them.[22] Treating employees like valued partners by reducing status barriers, by empowering employees, and by treating employees with dignity and respect builds trust and commitment.[23]

The two co-founders of Kingston Technology, the largest independent producer of DRAM memory modules for personal computers in the world, typify the reduction of status barriers in their highly successful and extremely profitable company by 1) working in open cubicles, and 2) not having private secretaries. Although the artifacts of an organizational culture may send a message about status barriers and how employees are valued, the most important way that leaders demonstrate their attitudes about employees is by creating a culture that values, trusts, and empowers employees.[24] Leaders of organizations communicate the importance of how employees at all levels are valued by the policies, practices, and rewards that are provided throughout the organization.[25]

7. Sharing Key Information

sharing1The sharing of financial, strategic, and performance information conveys to employees that they are trusted partners who can utilize this important information to assist their organization to achieve its goals. Highly motivated and well-trained employees need information to be able to contribute to their organization’s success. Sharing information and providing the training in how to use it to achieve goals makes implicit sense, yet many traditional organizations refuse to do either and pay the price in lost opportunities and reduced trust.[26]

Springfield ReManufacturing Corporation, the highly successful employee-owned break-off of International Harvester that specializes in remanufacturing transportation products, has developed an “open book management” system that basically equates to sharing information with employees to enable them to perform their jobs, achieve common goals, and achieve greater control over their individual lives.[27] Information shared throughout the organization is critical in a world economy that is based upon the knowledge and wisdom that the organization applies.[28]

Integrating All Seven Practices

Companies that employ HPWS most effectively incorporate all of these seven human resource practices. The research about HPWS has confirmed that companies that attempt to piece-meal the application of these concepts are far less successful than companies that develop an integrated way to build high commitment, high trust, and high performance.[29] Today’s organization must be capable of achieving both alignment and adaptability, although simultaneous achievement of these two qualities may seem inherently counterintuitive.[30] Achieving these seemingly mutually exclusive organizational outcomes can be accomplished, however, by incorporating the key human resource management (HRM) elements that make up an HPWS. Organizations that succeed in the modern economy ask employees to stretch to achieve challenging goals, demonstrate the discipline to meet performance demands, show a willingness to support and assist team members in accomplishing assignments, and earn the trust of others by demonstrating their commitment to the long-term welfare of the organization and its members.[31]

Ultimately, the commitment of the top management team and leadership at the top are responsible for creating an aligned and committed corporate culture that is essential to creating an effective HPWS organization. A growing body of evidence suggests that organizational leaders who adopt aligned HPWS systems are rewarded by employees who are more committed to their organizations and more willing to engage in the extra-role behaviors that are key to organization profitability and competitive advantage.[32] Those who lead great organizations must understand the complexities that are critical to success in the modern organization, be committed to values that resonate with employees, and embody those values in their own lives.[33] The good news for small and medium-sized organizations is that, when implemented with a focus on a culture-wide integration of values, HPWS systems can benefit those organizations as well as large and more complex companies. Companies and their leaders who fail to incorporate aligned HPWS features are likely to find themselves in a competitive position that rapidly deteriorates in the modern fast-moving economy, ultimately putting those companies out of business as they fail to keep up with an ever-changing world.[34]

 

[1] Stanford’s Jeffrey Pfeffer is the most well-known scholar who has addressed the dangers associated with organizational leaders applying this conventional wisdom in organizations. His description of this recurring error is well articulated in Pfeffer, J., (1998). The Human Equation: Building Profits by Putting People First. Boston, MA: Harvard Business School Press.

[2] Stephen R. Covey, noted repeatedly that high commitment and high competence were essential elements of organizations built upon the creation of high trust organization cultures and noted that these organizations had extremely high expectations about their obligations to customers and stakeholders and sought to constantly raise the bar of organization excellence. See Covey, S. R., (2004). The 8th Habit: From Effectiveness to Greatness. New York: Free Press.

[3] Among those who have identified those practices are Zhang, M., Fan, D., and Zhu, C. (2014). “High Performance Work Systems, Corporate Social Performance, and Employee Outcomes, Exploring the Missing Links.” Journal of Business Ethics, Vol. 120, Iss. 3, pp. 423-435; Huselid, M. A, (1995) “The Impact of Human Resource Management Practices on Turnover, Productivity, and Corporate Financial Performance.” Academy of Management Journal, Vol. 88, Iss. 3, pp. 635-672; Lawler, J., Chen, S. J., Wu, P. C., Bae, J., and Bai, B., (2011). “High Performance Work Systems in Foreign Subsidiaries of Multinationals: An Institutional Model. Journal of International Business Studies, Vol. 42, No. 2, pp. 202-220, and Pfeffer, J., (1998), op. cit.

[4] The notion of employees as owners and partners and the role of organizational leaders as stewards who owe a complex set of duties to those employees has been well described in Block, P., (2013). Stewardship: Choosing Service Over Self-Interest (2nd Ed.). San Francisco, CA: Berrett-Koehler Publishers.

[5] An often-cited study of the negative effects of downsizing and the importance of creating an organizational culture that treated employees as committed partners in long-term organization improvement is provided by Cameron, K.S., (1994). “Strategies for Successful Organizational Downsizing.” Human Resource Management, Vol. 33, Iss. 2, pp. 189-211.

[6] Information about employment security and its integration with other integrated HRM programs and practices at Lincoln Electric and other organizations is described in Gramm, C., and Schnell, J., (2013). “Long-Term Employment and Complementary Human Resource Management Practices.” Journal of Labor Research, Vol. 34, Iss. 1, pp. 120-145. Pfeffer (1998), op. cit. also provides evidence about companies that benefit by rewriting the employment contract to provide employees with greater job security.

[7] Carefully evaluating performance expectations and characteristics of new employees is identified as a key to success in Collins, J., (2001). Good to Great: Why Some Companies Make the Leap . . . . and Others Don’t. New York: HarperCollins.

[8] The importance of organization fit and the leader’s role in identifying the importance of key elements that determine a candidate’s fit within an organization is identified in Bottger, P., and Barsoux, J-L., (2012). “Masters of Fit: How Leaders Enhance Hiring.” Strategy & Leadership, Vol. 40, Iss. 1, pp. 33-39.

[9] Enterprise’s approach to hiring was cited in O’Reilly, B., “The Rent-A-Car Jocks who Made Enterprise #1” Fortune, Vol. 134, Iss. 8.

[10] Ibid.

[11] Collins, J., (2001), op. cit. The importance of identifying and hiring the best people and getting “the right people on the bus” is well explained as a critical characteristic of the best organizations.

[12] The relationship between delegating and empowering employees and creating a high performance organization culture is reported in Catermole, G., Johnson, J., and Roberts, K., (2013). “Employee Engagement Welcomes the Dawn of an Empowerment Culture.” Strategic HR Review, Vol. 12, Iss. 5, pp. 250-254.

[13] The key elements of creating successful organization teams that are well trained and supported by adequate organizational resources are explained beautifully in Scholtes, P. R., Joiner, B., and Streibel, B. J., (2003). The TEAM Handbook. Madison, WI: Oriel, Inc.

[14] This point is well made in Wriston, M. J., (2007). “Creating a High Performance Culture.”Organization Development Journal, Vol. 25, Iss.1, pp. 8-16.

[15] The success of Ritz-Carlton and a number of other outstanding organizations that have improved service and increased profitability is well documented in Inghelleri, L, and Solomon, M., (2010). Exceptional Service, Exceptional Profit: The Secrets of Building a Five-Star Customer Service Organization. New York: AMACOM.

[16] Explaining how to establish and implement a pay for performance compensation system and the benefits resulting therefrom is explained in Abernethy, W. B., (2011). Pay for Profit: Designing an Organization-Wide Performance-Based Compensation System. Memphis, TN: Performance Management Publications

[17] The importance of creating an organization culture that rewards performance and emphasizes mutual accountability is identified in Rhoades, A., (2011). Built on Values: Creating an Enviable Culture that Outperforms the Competition. San Francisco, CA: Jossey-Bass.

[18] The role of Whole Foods in creating an HPWS culture is well articulated in Pfeffer, J., (1998), op. cit.

[19] This point is made well in many studies and is summarized in Laszlo, A., Kathia, C., and Johnsen, C.S., (2009). “From High Performance Teams to Evolutionary Learning Communities: New Pathways in Organizational Development.” Journal of Organisational Transformation and Social Change. Volume 6, Iss. 1, pp. 29-48.

[20] The Men’s Wearhouse training program has been described many times including at Infante, V. D., (2001). “Men’s Wearhouse: Tailored for Any Change that Retail Brings.” Workforce, Vol. 80, Iss. 3, pp. 48-49.

[21] The importance of creating an organization-wide culture of learning and its impact on organization commitment and profitability is explained in Senge, P., (2006). The Fifth Discipline: The Art & Practice of the Learning Organization (2nd ed.). New York: Doubleday.

[22] Covey’s insights are well stated in many of his writings, particularly in Covey, S. R., (2004), op. cit., and in Covey, S. R., (1998). “High Trust Cultures.” Executive Excellence, Vol. 16, Iss. 9, pp. 3-4.

[23] Pfeffer, J., (1998) op. cit., and Block, P., (2013) op. cit., join with Covey, S. R., (2004), op. cit. in identifying the importance of an organizational culture that promotes “power with” rather than “:power over” employees.

[24] These points are clearly made in Schein, E. H., (2010) Organizational Culture and Leadership (4th ed.). San Francisco, CA: Jossey-Bass, Pfeffer, J., (1998), op. cit.,and Covey, S.R., (2004), op. cit.

[25] Schein, E. H., (2010), op. cit.

[26] Pfeffer, J., (1998), op. cit.

[27] Springfield Manufacturing’s CEO, Jack Slack, has enumerated his company’s achievements in Slack, J. and Burlingham, B., (2013). The Great Game of Business, Expanded and Updated: The Only Sensible Way to Run a Company (2nd Ed.). New York: Crown Business.

[28] Both Covey, S. R., (2004), op. cit. and Christensen, C. M., (2011). The Innovator’s Dilemma: The Revolutionary Book that Will Change How You Do Business. New York: HarperBusiness emphasize this point.

[29] For a detailed explanation of key elements in creating aligned HRM practices, please see Ulrich, D., Younger, J., Brockbank, W., and Ulrich, M., (2012). HR from the Outside In: Six Competencies for the Future of Human Resources. New York: McGraw-Hill.

[30] See Patel, P. C., Messersmith, J. G., and Lepak, D. P., (2013). “Walking the Tightrope: An Assessment of the Relationship between High-Performance Work Systems and Organizational Ambidexterity.” Academy of Management Journal, Vol. 56, Iss. 5, pp. 1420-1442.

[31] Gibson, C. B., and Birkinshaw, J., (2004). “The Antecedents, Consequences, and Mediating Role of Organizational Ambidexterity.” Academy of Management Journal, Vol. 47, Iss. 2, pp. 209-226.

[32] In addition to the many sources already cited herein, please see Gong, Y., and Chang, S., (2008). “How Do High Performance Work Systems (HPWS) Affect Collective Organizational Citizenship Behavior (OCB)? A Collective Social Exchange Perspective.” Academy of Management Annual Meeting Proceedings, pp. 1-6.

[33] The key role of leaders in creating an aligned organizational culture is well described in many organizations. See Schein, (2010). Organizational Culture and Leadership. San Francisco, CA: Jossey-Bass; Paine, L.S., 2002. Value Shift: Why Companies Must Merge Social and Financial Imperatives to Achieve Superior Performance. New York: McGraw-Hill; Pava, M., (2003). Leading with Meaning: Using Covenantal Leadership to Build a Better Organization. New York: Palgrave Macmillan; Caldwell, C., (2012). Moral Leadership: A Transformative Model for Tomorrow’s Leaders; Daley, J., (2010). “Creating a Culture of EXCELLENCE.” Entrepreneur, Vol. 38, Iss. 3, pp. 81-87.

[34] Ulrich, D., et al., (2012), op. cit. identifies the importance of aligned human resource practices and Christensen, C. M., (2011), op. cit. documents the importance of keeping pace with innovation and best practice in the global economy.

2017 Volume 20 Issue 2

2017 Volume 20 Issue 1

2016 Volume 19 Issue 2

2016 Volume 19 Issue 1

2015 Volume 18 Issue 2

2015 Volume 18 Issue 1

2014 Volume 17 Issue 3

2014 Volume 17 Issue 2

2014 Volume 17 Issue 1

2013 Volume 16 Issue 3

2013 Volume 16 Issue 2

2013 Volume 16 Issue 1

2012 Volume 15 Issue 3

2012 Volume 15 Issue 2

2012 Volume 15 Issue 1

2011 Volume 14 Issue 4

2011 Volume 14 Issue 3

2011 Volume 14 Issue 2

2011 Volume 14 Issue 1

2010 Volume 13 Issue 4

2010 Volume 13 Issue 3

2010 Volume 13 Issue 2

2010 Volume 13 Issue 1

2009 Volume 12 Issue 4

2009 Volume 12 Issue 3

2009 Volume 12 Issue 2

2009 Volume 12 Issue 1

2008 Volume 11 Issue 4

2008 Volume 11 Issue 3

2008 Volume 11 Issue 2

2008 Volume 11 Issue 1

2007 Volume 10 Issue 4

2007 Volume 10 Issue 3

2007 Volume 10 Issue 2

2007 Volume 10 Issue 1

2006 Volume 9 Issue 4

2006 Volume 9 Issue 3

2006 Volume 9 Issue 2

2006 Volume 9 Issue 1

2005 Volume 8 Issue 4

2005 Volume 8 Issue 3

2005 Volume 8 Issue 2

2005 Volume 8 Issue 1

2004 Volume 7 Issue 3

2004 Volume 7 Issue 2

2004 Volume 7 Issue 1

2003 Volume 6 Issue 4

2003 Volume 6 Issue 3

2003 Volume 6 Issue 2

2003 Volume 6 Issue 1

2002 Volume 5 Issue 4

2002 Volume 5 Issue 3

2002 Volume 5 Issue 2

2002 Volume 5 Issue 1

2001 Volume 4 Issue 4

2001 Volume 4 Issue 3

2001 Volume 4 Issue 2

2001 Volume 4 Issue 1

2000 Volume 3 Issue 4

2000 Volume 3 Issue 3

2000 Volume 3 Issue 2

2000 Volume 3 Issue 1

1999 Volume 2 Issue 4

1999 Volume 2 Issue 3

1999 Volume 2 Issue 2

1999 Volume 2 Issue 1

1998 Volume 1 Issue 3

1998 Volume 1 Issue 2

1998 Volume 1 Issue 1

UPDATE: Benefits of International Portfolio Diversification

In my 2007 article (Vol. 10, Issue 2) I studied the issue of risk reduction through international diversification. Using data from the U.S., Germany, and Japan during 1999 to 2002, the analyses supported the findings of the existing literature that the co-movements among the U.S. and German stock markets were significant. The Japanese stock market, on the other hand, had almost no significant effect on the movement of the other markets. The implication was that both German and Japanese investors should consider investing in each other’s markets for effective portfolio diversification while American investors can realize diversification benefits in Japan. However, diversification benefits are minimal for American and German investors who would like to invest in each other’s markets.










Photo: Dave Di Biase









The article also provided support for the hypothesis that international market correlations increase after unexpected exogenous shocks. The implication is that diversification benefits may be reduced after such events. The tests of stability of market co-movements were based on before and after analyses of the September 11, 2001, terrorist events in the United States.


In a follow-up article published in 2008, my co-author and I investigated same issue (global equity market integration) but utilized data from five selected Exchange-Traded Funds (ETF) representing the U.S., Taiwan, Australia, Spain, and Austria during the period of 2001-2004.

The findings were in line with the earlier research in that while the interdependencies among the five markets are significant, there is still room for international portfolio diversification. For example, investing in Austria provides diversification benefits for American, Taiwanese, and Australian investors. Investors from Taiwan can realize benefits by investing in Europe and in Australia, but not in the U.S. On the other hand, Austrian investors can diversify portfolios by investing in the U.S., Taiwan, and Australia. Finally, the study of the effect of the Iraq war on the co-movement of the equity markets provided mixed results for the hypothesis that the international market correlations increase after an exogenous shock.

Finally, after the great recession of 2008-2010, the interest has shifted to the concept of volatility. Closer observers of the equity markets have been paying a lot of attention to volatility measures such as VIX index, known as the fear index. Typically, investors become optimistic when they think a stock is headed higher and turn bearish when they think the opposite. The VIX indicator works as a signaling device informing the investor whether or not the markets have reached an extreme position.

My current research (2012) investigates volatilities across different equity markets. If equity markets are in fact integrated, an unexpected event in one market may influence not only returns, but also volatility (measured by standard deviation) in the other markets. The analysis of volatility is particularly important because the information it provides for the riskiness of assets.

The sample includes the U.S. and Canada from North America; Germany from Europe, and China from Asia with the following ETFs: U.S.: SPY: The SPDR S&P 500 ETF. Canada: EWC. The period studied was January 2008-December 2010. After calculating daily volatilities and unidirectional correlation coefficients and applying MARMA (Multivariate autoregressive moving averages) to the resulting data, the results indicated that the U.S. market volatility measured by SPY had the most marked effect on the volatilities of the other market ETF. While both Canadian and German ETF volatilities seem important to explain the volatilities in other markets (U.S. and to a lesser extend China), the spillovers seem to become more pronounced as we moved from 2008 to 2010. The findings imply that investment and fund managers with access to news on other markets may react to changes faster than those who do not. In addition, the results also imply that investors should not only rely on current news to guide their investment decisions but also take into consideration international news for there are spillovers. Since volatilities can proxy for risk, there are implications for both individual and institutional investors in terms of further examining pricing securities, hedging, other trading strategies, and framing regulatory policies.

Click here for the original article: “Benefits of International Portfolio Diversification”

References:

Yavas, B.F and Rezayat, F “Integration among Global Equity Markets: Portfolio Diversification using Exchange-Traded Funds,” Investment Management & Financial Innovations, 5 (3) (2008): 30-43.

Yavas, B.F and Rezayat, F. “Market Volatility: A Study of Equity Markets of US, Canada, Germany and China.” Journal of Banking and Finance, Submitted, 2012.

2017 Volume 20 Issue 2

2017 Volume 20 Issue 1

2016 Volume 19 Issue 2

2016 Volume 19 Issue 1

2015 Volume 18 Issue 2

2015 Volume 18 Issue 1

2014 Volume 17 Issue 3

2014 Volume 17 Issue 2

2014 Volume 17 Issue 1

2013 Volume 16 Issue 3

2013 Volume 16 Issue 2

2013 Volume 16 Issue 1

2012 Volume 15 Issue 3

2012 Volume 15 Issue 2

2012 Volume 15 Issue 1

2011 Volume 14 Issue 4

2011 Volume 14 Issue 3

2011 Volume 14 Issue 2

2011 Volume 14 Issue 1

2010 Volume 13 Issue 4

2010 Volume 13 Issue 3

2010 Volume 13 Issue 2

2010 Volume 13 Issue 1

2009 Volume 12 Issue 4

2009 Volume 12 Issue 3

2009 Volume 12 Issue 2

2009 Volume 12 Issue 1

2008 Volume 11 Issue 4

2008 Volume 11 Issue 3

2008 Volume 11 Issue 2

2008 Volume 11 Issue 1

2007 Volume 10 Issue 4

2007 Volume 10 Issue 3

2007 Volume 10 Issue 2

2007 Volume 10 Issue 1

2006 Volume 9 Issue 4

2006 Volume 9 Issue 3

2006 Volume 9 Issue 2

2006 Volume 9 Issue 1

2005 Volume 8 Issue 4

2005 Volume 8 Issue 3

2005 Volume 8 Issue 2

2005 Volume 8 Issue 1

2004 Volume 7 Issue 3

2004 Volume 7 Issue 2

2004 Volume 7 Issue 1

2003 Volume 6 Issue 4

2003 Volume 6 Issue 3

2003 Volume 6 Issue 2

2003 Volume 6 Issue 1

2002 Volume 5 Issue 4

2002 Volume 5 Issue 3

2002 Volume 5 Issue 2

2002 Volume 5 Issue 1

2001 Volume 4 Issue 4

2001 Volume 4 Issue 3

2001 Volume 4 Issue 2

2001 Volume 4 Issue 1

2000 Volume 3 Issue 4

2000 Volume 3 Issue 3

2000 Volume 3 Issue 2

2000 Volume 3 Issue 1

1999 Volume 2 Issue 4

1999 Volume 2 Issue 3

1999 Volume 2 Issue 2

1999 Volume 2 Issue 1

1998 Volume 1 Issue 3

1998 Volume 1 Issue 2

1998 Volume 1 Issue 1

What to Do when Traditional Diversification Strategies Fail – Revisited

Reduced costs of trading commissions are a welcome new benefit of using ETFs as portfolio building blocks, but the cost of the bid-ask spread can be significant if low-volume ETFs are mixed into a diversified portfolio.

[powerpress: http://gsbm-med.pepperdine.edu/gbr/audio/fall2010/dilellio-diversification.mp3]

Online investments going down

The market events of 2008 stressed the ability of diversification to protect against loss due to rapidly changing correlation amongst assets. But, as demonstrated in the initial article, “What to Do When Traditional Diversification Strategies Fail,” there is still a simple, repeatable approach based on utilizing previous year correlation coefficients to construct a diversified portfolio that reduces loss of principle.[1] The significant market gains of 2009 further challenge the benefits of diversification. So, the question now is: Does this approach to diversification also provide opportunity for significant positive gains? To answer this question, we revisit the simple diversification strategy featured in the previous article, which exploits correlation to reduce risk, to see if opportunities for gains exist.

Furthermore, a recent competition between brokers has been driving down commissions for online trades. In addition to lower commissions, some brokers have selected a subset of ETFs from a single provider, such as iShares’ affiliation with Fidelity, and waived all commissions when trading these financial products within their online platform. These reduced costs are important and may have a direct influence on the optimal reallocation frequency. So, a new question now is: With the reduction or elimination of trade commissions, is a more active strategy optimal? This article also examines this practical issue, and quantifies the overall benefits from $0 ETF commissions currently in the marketplace.

Hypothesis Revisited

This study revisits many of the hypotheses established in the previous study. The correlation coefficient threshold is validated from an updated illustration containing four asset classes: U.S. Large Caps, U.S. Small Caps, International, and Bonds. As seen in Table 1, correlations observed over 2008 suggest the same allocations against U.S. Large Caps (SPDR S&P 500 fund, symbol: SPY) and Bonds (iShares Aggregate Bond Fund, symbol: AGG) as suggested from correlations observed over 2007.[1] But, because of the continuing trend of lower commission costs, consideration must also be given to volume in the process of identifying uncorrelated assets. Volume is known to be inversely related to costs from bid-ask spreads and is empirically modeled in the following section. So, to provide a preference to higher volume funds that minimize the resulting bid-ask spread, the correlation matrix rows are generated in order of decreasing volume before eliminating highly correlated investment options. The result to the right of the arrow illustrates the result, applying this process to a four-asset class example.


Table 1- DiLellio

Table 1: Correlation Coefficients from Daily Returns Adjusted for Dividends in 2008, sorted by Average Daily Volume.


Table 2 shows the associated 2009 performance, based on holding both the four-asset portfolio as well as the suggested two asset portfolio based on the 80 percent correlation threshold. The diversification effect observed in 2008 reduced the 2009 portfolio gain from 21 percent to 14.3 percent. Reviewing the 2008 portfolio returns (illustrated in the previous article), we observe a loss of 27 percent and 15 percent, respectively, where the smaller loss occurrs when we apply the correlation threshold to portfolio construction. Thus, the two-year cumulative return from this simple illustration is -12 percent when no correlation threshold is applied, versus -3 percent when it is applied.


Table 2- DiLellio

Table 2: 2009 Performance of Naïve Allocation with and without use of 2008 Correlation Coefficients.


This updated simple illustration continues to suggest a benefit of multi-asset diversification or wide diversification, consistent with other research.[2][11] While these studies use longer history market indices, we show a more pragmatic view in the following sections, since the ETFs examined are easily traded by individuals, investment advisors, hedge funds, and institutional investors. Furthermore, ETF transaction costs can be accurately modeled, as shown in the next section. Unfortunately, ETFs are still fairly new investment products, so they do not offer the long histories available for many asset allocation studies employing equity, bond, and commodity-based indices used in the aforementioned studies.

Analysis Assumptions and Methodology

Continuing with the nine asset classes identified in the previous article, including the 136 unique ETFs available since January 2004, we have added an analysis of new zero-commission ETFs now being offered by Schwab, Fidelity, and Vanguard. Six of the asset classes are equity-based and consist of large cap domestic, large cap foreign, emerging markets, midcap domestic, small cap domestic, and domestic sectors. The three non-equity classes include commodities, bonds, and real estate. A summary of the nine asset classes represented by these ETFs appears in Table 3, where sector and large cap domestic assets have the largest representation, while bonds and real estate assets have the smallest.


Table 3 - DiLellio

Table 3: Asset Classes represented by 136 Exchange Traded Funds available since January 2004 (values are rounded to the nearest percent).


Based on the updated simple illustration from above, we continue to define uncorrelated assets using a correlation matrix generated by volume. We then eliminate lower volume assets that are more than 80 percent correlated with higher volume assets. All correlation coefficients were calculated based upon 12 months of daily historical returns developed from adjusted closing prices that included dividends and splits. For consistency, volume was also estimated using a 12-month average daily volume. This methodology follows the same rationale established in the initial paper.

Revisiting the existing assumption regarding switching costs, we have updated our methodology to address the practice of investment managers seeking “most liquid” ETFs.[4] To further improve the fidelity of the back-testing, we have also incorporated a nonlinear regression model for a bid-ask spread that grows rapidly with low volume. The model parameters are based on empirical data provided by Pankaj Agrrawal and John M. Clark in their 2009 article, “Determinants of ETF Liquidity in the Secondary Market: A Five-Factor Ranking Algorithm.”[3] This data is represented in Figure 1. The value of R2 = 94 percent obtained from the power-law model suggests that a significant amount of the variation has been explained between the bid-ask spread and the trailing volume, providing high confidence in the model’s ability to accurately reflect bid-ask costs based on volume.


Figure 1 - DiLellio

Figure 1: Bid-Ask Spread, in Basis Points (BP) versus Average Volume, with Power Law Regression model and Goodness of Fit Measure.


The model in Figure 1 is applied against hypothetical trades using month-end adjusted closing price and volume. Returns were calculated based on a naïve allocation approach that evenly spreads assets across uncorrelated ETFs. The purpose is to examine the data’s sensitivity to annual, biannual, and quarterly rebalances. To reflect the latest updates in commissions from discount brokerages such as Vanguard, trade commission are reduced from $10 to $5 per trade against a portfolio starting with $100,000 in a tax-free account.[7]

Empirical Results

Figure 2 appears to have a very similar downward trend, but contains a full five years of history. Once again, the increased correlation amongst assets classes increases over time, yielding fewer uncorrelated funds. Also note that including volume as part of the process to determine uncorrelated funds has had a marginal effect on the total number of uncorrelated funds, but the downward trend from 2005-2009 remains.


Figure 2 - DiLellio

Figure 2: Number of ETFs that are less than 80 percent correlated over previous year with higher volume ETFs (2005 – 2009).


Tables 4, 5, and 6 list the portfolio allocations against each of the nine asset classes for the annual, biannual, and quarterly rebalancing periods. In each case, the allocations begin in 2005 with a majority of holdings in large foreign equities, emerging markets, and domestic sectors. By 2009, large domestic equity increases significantly, while large foreign equities and emerging market allocations shrink drastically, as highlighted in orange. Highlighted in yellow, bond funds continue to grow to become 43 percent of the allocation, one of the largest percentages seen over the five-year study. Lastly, domestic sectors remain a significant percentage of the allocation throughout the five-year study, suggesting a cyclical pattern between the range of approximately 25 percent and 45 percent. In summary, these results indicate that the naïve allocation strategy appears to be achieving wide diversification, based on the portfolio containing between five and eight asset classes throughout the five-year testing period.[2] Furthermore, the strategy appears to have a dynamic component that, in times such as early 2009, approaches the classic allocation of 50/50 bond-equity allocation.


Table 4 - DiLellio

Table 4: Annual Portfolio Allocation Percentages with Naïve Allocation Approach and 80-Percent Correlation Threshold



Table 5 - DiLellio

Table 5: Biannual Portfolio Allocation Percentages with Naïve Allocation Approach and 80-Percent Correlation Threshold.



Table 6 - DiLellio

Table 6: Quarterly Portfolio Allocation Percentages with Naïve Allocation Approach and 80-Percent Correlation Threshold.


Table 7 summarizes the net returns based on the three reallocation intervals and includes the effect of modified and new positions incurring a bid-ask spread cost and the flat-rate $5 commission cost. Once again, the annual reallocation period appears optimal. Also, the commission costs do not appear to be driving the lower performance. When set to $0, returns increase by 0.6 percent, 1 percent, and 1.9 percent over the five-year period for annual, bi-annual, and quarterly reallocations, respectively. But, this increase is not sufficient to offset the larger gross returns provided by the annual reallocation frequency.


Table 7 - DiLellio

Table 7: Net Returns with Naïve Allocation



Table 8 - DiLellio

Table 8: Sharpe Ratio with Naïve Allocation


Alternatively, Table 8 shows the risk adjusted returns using data from Ibbotson & Associates’ one-month T-bill for the risk-free rate and William F. Sharpe’s methodology based on excess return and standard deviations.[5] Once again, annual reallocation provides the greatest risk-adjusted returns.

The cost impact on the portfolio due to the bid-ask spread is somewhat more complex than the flat-rate commission discussed above. While the the aim was to select higher volume uncorrelated funds, it is likely that a few of the uncorrelated funds had significantly lower volume. To examine the relative effect of the portfolio’s bid-ask spread against number of positions in the allocation, a scatter plot appears in Figure 3 from the quarterly allocation data. Interestingly, the lowest bid-ask spread cost incurred for a given allocation is achieved when 20 to 30 uncorrelated funds are identified. Alternatively, when only a dozen or so funds are available, the resulting bid-ask spread becomes significant. The larger bid-ask spread is also seen for portfolios with more than 40 uncorrelated funds, but to a lesser degree. The larger portfolio bid-ask spread is the result of a few low-volume ETFs needed to provide portfolio diversification, which were not available from higher volume alternatives. And because of the rapid growth of the bid-ask spread for low volume, a small fraction of the allocation towards low-volume ETFs can increase the portfolio bid-ask spread substantially.


Figure 3 - DiLellio

Figure 3: Portfolio Bid-ask spread (basis points) vs. number of uncorrelated funds is nonlinear.


Observations and Current Market Offerings

Revisiting the simple methodology previously established, we see that using correlation coefficients continues to provide a practical approach to obtaining the benefits of diversification. Reduced costs of trading commissions are a welcome new benefit of using ETFs as portfolio building blocks, but the cost of the bid-ask spread can be significant if low-volume ETFs are mixed into a diversified portfolio. Furthermore, based on a correlation threshold, the methodology applied here can include these low-volume ETFs in portfolios with smaller and larger numbers of uncorrelated funds.

These are important observations because, as of May 2010, Fidelity, Vanguard, and Schwab all offer $0 commissions on trades. These brokerage firms appear to be using this offer along with lower expense ratios, better exposure to asset classes, and lower tracking error as a discriminator.[8][9] But, expense ratios and bid-ask spreads are important costs to consider, particularly for lower volume $0 commission ETFs.[10] Table 9 summarizes the median cost for the 6 ETFs from Schwab, 26 from Fidelity, and 46 from Vanguard that are currently offered with $0 commissions when traded online. The costs are based on buying and selling the median ETF over a one-year holding period, and the bid-ask spread is based on the model in Figure 1 using average volume from February to April 2010.

Table 9 suggests that annual transaction costs associated with buying and selling $0 commission ETFs can quickly exceed 100 basis points, or 1 percent, when traded quarterly. While such evidence still may not deter day-trading of ETFs, one broker has announced limitations on trading their $0 commission ETFs. Vanguard incorporates a limit of 25 buys/sells of its $0 commission ETFs per year.[6] This announcement is clearly associated with Vanguard’s founder, John Bogle, and his belief in keeping costs low for long-term investments. Investors would be wise to consider this fundamental philosophy.


Table 9 - DiLellio

Table 9: Annual Median Transaction Cost of Reallocation using $0 Commission ETFs


DISCLAIMER: The exchange trade products analyzed in this article were chosen from those publicly available. They do not represent the author’s recommendations and were only used to support observations. Investment advice is neither implied, nor suggested.


[1] DiLellio, James, “What to Do When Traditional Diversification Strategies Fail,” The Graziadio Business Report, 12, no. 4 (2009).

[2] Mulvey, John M., Cenk Ural and Zhoujuan Zhang. “Improving Performance for Long-Term Investors: Wide Diversification, Leverage, and Overlay Strategies,” Quantitative Finance, 7.2 (2007): 175-187.

[3] Agrrawal, Pankaj and John M. Clark, “Determinants of ETF Liquidity in the Secondary Market: A Five-Factor Ranking Algorithm,” Institutional Investor Journals. Fall: 59-66.

[4] Hight, Gregory N., “Diversification Effect: Isolating the Effect of Correlationon Portfolio Risk,” Journal of Financial Planning, October (2010).

[5] Sharpe, William F. “The Sharpe Ratio,” Journal of Portfolio Management, Fall (1994): 49-59.

[6] Wiener, Dan, “Free Trading Vanguard’s Shotguns,” Forbes.com, May 4, 2010.

[7] Maxey, Daisy, “Vanguard Joins Cuts of ETF-Trading Fees,” The Wall Street Journal, May 5, 2010.

[8] Spence, John, “BlackRock, Vanguard Battle for ETF Assets – Being First Mover isn’t So Advantageous,” The Wall Street Journal, April 27, 2010.

[9] Kapadia, Reshma, “Identical Twins? Nope.” WSJ.com, April 5, 2010.

[10] Randall, David K., “Why Bargain Trades Are No Bargain“, Forbes, March 15, 2010.

[11] Gibson, Roger C., “The Rewards of Multiple-Asset-Class Investing,” Journal of Financial Planning, July (2004):58-71.

[14] Vanguard.com, Vanguard ETFs® https://personal.vanguard.com/us/funds/etf.



[i]Expense ratios and volumes were obtained from Brokerage Web sites in April 2010, including Fidelity.com, Vanguard.com, ishares.com, as well as finance.yahoo.com, SeekingAlpha.com, and are subject to change.

2017 Volume 20 Issue 2

2017 Volume 20 Issue 1

2016 Volume 19 Issue 2

2016 Volume 19 Issue 1

2015 Volume 18 Issue 2

2015 Volume 18 Issue 1

2014 Volume 17 Issue 3

2014 Volume 17 Issue 2

2014 Volume 17 Issue 1

2013 Volume 16 Issue 3

2013 Volume 16 Issue 2

2013 Volume 16 Issue 1

2012 Volume 15 Issue 3

2012 Volume 15 Issue 2

2012 Volume 15 Issue 1

2011 Volume 14 Issue 4

2011 Volume 14 Issue 3

2011 Volume 14 Issue 2

2011 Volume 14 Issue 1

2010 Volume 13 Issue 4

2010 Volume 13 Issue 3

2010 Volume 13 Issue 2

2010 Volume 13 Issue 1

2009 Volume 12 Issue 4

2009 Volume 12 Issue 3

2009 Volume 12 Issue 2

2009 Volume 12 Issue 1

2008 Volume 11 Issue 4

2008 Volume 11 Issue 3

2008 Volume 11 Issue 2

2008 Volume 11 Issue 1

2007 Volume 10 Issue 4

2007 Volume 10 Issue 3

2007 Volume 10 Issue 2

2007 Volume 10 Issue 1

2006 Volume 9 Issue 4

2006 Volume 9 Issue 3

2006 Volume 9 Issue 2

2006 Volume 9 Issue 1

2005 Volume 8 Issue 4

2005 Volume 8 Issue 3

2005 Volume 8 Issue 2

2005 Volume 8 Issue 1

2004 Volume 7 Issue 3

2004 Volume 7 Issue 2

2004 Volume 7 Issue 1

2003 Volume 6 Issue 4

2003 Volume 6 Issue 3

2003 Volume 6 Issue 2

2003 Volume 6 Issue 1

2002 Volume 5 Issue 4

2002 Volume 5 Issue 3

2002 Volume 5 Issue 2

2002 Volume 5 Issue 1

2001 Volume 4 Issue 4

2001 Volume 4 Issue 3

2001 Volume 4 Issue 2

2001 Volume 4 Issue 1

2000 Volume 3 Issue 4

2000 Volume 3 Issue 3

2000 Volume 3 Issue 2

2000 Volume 3 Issue 1

1999 Volume 2 Issue 4

1999 Volume 2 Issue 3

1999 Volume 2 Issue 2

1999 Volume 2 Issue 1

1998 Volume 1 Issue 3

1998 Volume 1 Issue 2

1998 Volume 1 Issue 1

The Four Levels of Innovation

Is innovation just a convenient buzzword? Or, is it a paradigm-changing force that allows companies to compete on the global stage? The true answer might be a little bit of both.

[powerpress: http://gsbm-med.pepperdine.edu/gbr/audio/fall2010/miner-innovation.mp3]

Making the decision to innovateHeading into the second decade of the 21st century, innovation has been a frequently used word to describe the creation of new products and services that will assist companies in surviving the market crash of 2008.[1] Is innovation just a convenient buzzword? Or, is it a paradigm-changing force that allows companies to compete on the global stage? The true answer might be a little bit of both. Some companies and organizations have overused “innovation” to such an extent that it has just become a marketing ploy to sell products that are merely rebranded.[2] On the other hand, many more companies are innovating products and services as a reaction to the economic downturn and the mere fact that drastic measures in product development need to be taken just to continue to be a viable entity in the world market.[3][4]

The purpose of this article is to create a system that will help business executives determine the importance of innovation to their company. The system will aid in assessing: 1) How much risk can we afford to take?[5] 2) How are we going to pay for development; and 3) Do we have the talent and culture to be innovative?[6][7] The concept of innovation is divided into four distinct levels so that executives and management can more efficiently assess the ability of their organizations to generate new products and services. The four categories are broken down by level of time and effort involved and, thus, it becomes important to recognize the commitment that each level demands to be successful.

Level One

The first level emphasizes minimal changes to existing products, a low amount of new investment, and very low risk. Examples at this level would be changing the color of a product or putting a new logo design on a label. Essentially all companies are capable of achieving this level, as it does not require unique skills. There are products that exist that never change or evolve over time; however these are reserved for products that hold emotional value to the public. Think of the classic American Coca-Cola. Coca-Cola has changed its packaging and updated its look many times over the years, and often the company launches different flavors and types (i.e. Coke Zero, vitamin-enhanced Diet Coke, Vanilla Coke), but the classic recipe remains the same. Conversely, they also release the old glass bottles in short supply for nostalgia’s sake.

For most products though, if changes are not made, even small ones, the public will soon forget about them, to the point of obsolescence. Therefore, most companies need to be constantly making a minimal effort to innovate at Level One.

Level Two

The second level is a higher level of changes. Level Two changes include integrating new features into existing products on the market or creating differentiated versions of the same new product to sell to various demographic groups. These new features require what can be considered a medium level of investment and risk. Think of an automobile company that debuts a standard model and then decides to come out with a deluxe version of the same car with a few additional features. Or, that same automobile company takes the standard car design, then renames it, adding different features for each world market—the Americas, Europe, and Asia for example—that the company sells to. Company leaders are typically comfortable with this medium level of investment, because they are simply making improvements on an existing product that has already proven its worth in the market, and adding features that consumers desire. Given their knowledge of the industry and talent to create their core product, company executives can decide to move forward based on an analysis of payback time for a given level of investment.

Level Three

Innovation PlanThe third level is the beginning of large financial and product risk, but it is also where the rewards are potentially larger. Before delving into this level of risk, executives will want to determine how large a market exists for their innovation so that a forecast of sales can be made to calculate return of investment curves for given levels of capital outlay. This level also requires that the business devote resources to monitoring progress and actively assessing risk throughout the development process. It is also imperative for the company to try to discern how much of their product or service sales are based on new product features and how much are based on the effectiveness of the marketing and sales campaign. If the company can determine that sales can be increased from solely a new marketing/sales campaign for an existing product, then the innovation could just involve creation of new marketing techniques. This is further evidence that the company leaders need to be aware of the cause and effect of decisions so that they can spend capital in the appropriate places. Examples of product development at this stage are auto companies realizing that SUV’s were a larger market than station wagons, or smart phones being more desirable than regular cell phones. As you can see, this level of innovation requires substantial resources—a research and development team, extensive market knowledge and analysis, design talent, and executive leadership, to name a few. Thus, not all companies are capable of innovation at this level. Executives will need to be brutally honest about the abilities of their organization and staff before proceeding toward acquiring new people and facilities to start these projects.

Level Four

The highest level of innovation is where companies are able to create innovations that change how people live. If the third level can be described as evolutionary development, than the fourth stage is the revolutionary step. The 20th century has seen many examples of products that have changed the world, such as the gas-powered automobile, the radio, the airplane, television, personal computers, and the Internet, just to name a few.

The highest level of innovation also brings the highest level of risk, as many times this level of innovation involves products or services that no one has thought of and customers do not know they want.[8] Innovating at this level requires an organizational belief system that drives employees toward realizing that their unknown project will produce a product or service that everyone will want.

The energy and passion it takes to innovate at the fourth level is not only mesmerizing, but also contagious. The energy is so intriguing that it causes people and sub-tier companies to want to participate. Similar to Level Three, company owners or executives need to evaluate the innovation to determine how successful it can be. However, the difference at this level is also determining if the company can survive the amount of time and resources it may take to complete the innovation and whether or not they will go bankrupt in the process. This is true not only for finances, but also emotional toll on employees. When it comes to fostering innovation, every employee must understand the goals of the organization and be working toward them in unison. There is nothing worse than a company executive that declares an unachievable goal, only to have the employees and customers realize it and work against its success. Only a handful of companies, such as Apple, 3M, GE consistently manage to achieve success at Level Four innovations. This level is not meant for all organizations or all executives. Caution should be taken when deciding to proceed forward.

Key Takeaways




Table 1 - Innovation Levels

Table 1 - Innovation Levels




In an effort to better understand your company and where it exists on the innovation scale, the following are four key takeaways to consider before starting down the path of becoming more innovative. Table 1 offers a quick description of the four levels of innovation.

1. Innovation requires an honest self-assessment of a company’s capabilities.

In the end, it is not important which level a company chooses to innovate at. It is more important that management has a self-awareness to know what level of investment in innovation is in line with the organization’s objectives and budget. Levels One and Two require minimal resources; they mainly just take an act of management to make the decision to perform the simple changes. With the two higher levels of innovation though, management has to set up the correct environment to foster creative thinking that is focused on developing ideas that can sell products or services. In this era of political correctness and strict company behavior, companies must be cognizant that innovation requires a culture shift, or else they will be managing a futile effort. This is where the art of management comes into play, as the executives have to get their staff moving in a new direction without sacrificing focus. The differences are not just in the structure of the company or based on a model of past success, but in a true desire to fuel the creative process with enough capital, energy, support, and drive to make a ground-breaking idea turn into a business reality. Reading about this concept may give the impression that the differences between all four levels are minimal; however there is a huge split in the mentality of the organization that needs to occur if Level Three and Four projects are started. It all starts with the correct people pushing toward completion of the innovation through all its up and downs in the development cycle. Ultimately, you may realize that innovation is not a priority in your company’s business model or culture and you may wish to keep it that way. Or you may discover that you need to recruit new individuals to your company that are more driven to innovate and create new products and services that add value to people’s lives. It is this honest assessment of the business’ capabilities that will lead executives to choose the correct level of innovation for their organizations. Healthy, well-run companies can just as easily create ground-breaking devices (Level Four) as well as simple innovations (Level One). As far as the employees go, if they are energized and motivated to improve, then creating new innovations at any level will foster a satisfying work environment.

2. Build innovation into the business model.

Eleven of the 27 companies born in the last quarter century, which grew their way into the Fortune 500 in the past 10 years did so through business model innovation.[9] The key to morphing a company into a free-thinking innovation center is rooted in the company structure. It is also essential to empower employees by supplying enough capital, time, marketing, and leadership to get the innovation from concept to production. The organization will need to give employees the freedom to create, but also hold them accountable for their performance. It is wise not to micromanage a team of creative individuals with small details and bureaucracy, but it is also necessary to monitor the effort and give them guidance toward the ultimate goal so the capital is not spent going off on tangents. Innovation expert Theodore Levitt notes, “What is often lacking is not creativity in the idea-creating sense but innovation in the action-producing sense, i.e., putting ideas to work.”[10] Managing this delicate balance of trust versus oversight is very important.

An obstacle in becoming a third or fourth level innovation company is to get the organization moving in a direction that breeds creativity. One can imagine the difficulty a manufacturing company might have in taking time away from its production schedule to generate new designs. This is one reason why many existing companies fail at innovation. Brand new start-ups have it much easier than established companies as they are not well-established in an industry and have much more freedom to try new ideas. These companies also tend to shape the culture of innovation by recruiting young, enterprising individuals who are filled with the energy of getting the business off the ground to make it a success.

3. If you reward it, it will come.

First, it is important to reward innovation, including celebrations, financial awards, recognition, and the chance to work on future innovation projects. Second, it is also important to reward innovators intrinsically by granting them the freedom to be creative with all aspects of their work environment. Lower the amount of bureaucracy and office rules to help foster a creative culture. And third, support the innovators with sufficient resources to develop their ideas and create prototypes. In their article, “Creativity and the Role of the Leader,” Teresa M. Amabile and Mukti Khaire note that innovation is often motivated through a diversity of perspectives. One example, Brown University’s brain science program that created a system in which a monkey moved a computer cursor with only its thoughts, came from the collaboration of a team of mathematicians, medical doctors, neuroscientists, and computer scientists.[11]

4. People are captivated by innovation.

A valuable point that is rooted in the human psyche of people today is that youth sells. If the following logic path is taken, it is easy to see why innovation is so important right now during our economic recession. The logic is: innovation equals new products, new products are youthful, youth is good; therefore product innovation is good. There is no denying that human beings love youth and beauty and this corresponds to current marketing/sales efforts being geared to capitalize on this fact. A quick look through magazines will reveal that many products are advertised with youthful looking people. Trying to survive and emerge from the recession many companies have realized the need to declare that they are “innovating” just to prove to the market, and maybe to themselves, that they are still a capable company that can change and adapt to the cycle of markets. However, in the zeal to declare their company is “innovative” and “youthful,” the executives need to have a plan on which products or services to innovate and how they are going to execute the effort to accomplish the goal. Just claiming the company is innovative is not enough, it has to be proven with business models and, ultimately, in the introduction of innovation products/services into the market.

Conclusion

Using the guiding principles of the four levels of innovation, business leaders can accurately target which level they want to take their company to. A strategic vision for the organization will point the organization toward the correct innovation level based on the priorities of the company, how much capital can be risked, marketing reports that indicate a specific direction, and desire of the entire organization to achieve the goal. Many different perspectives are needed, including a measure of risk tolerance and payback time. Use the four key takeaways to address how you transform your company to an innovative one, how you pick your innovation level, and why innovation is an important aspect of the business cycle.

If an organization is willing to invest in innovation, then tremendous opportunities exist. In the present business climate, innovation is a key to staying relevant and there is no one specific way to become successful. It is more important to select an innovation level, foster ideas, gather the data, and proceed to implement the project.

Innovation is important as it shows to investors and customers alike that the company is working hard to remain relevant in the world market and meeting the needs and wants of the people. This achieves the goal of producing profit, investing in the longevity of the company, and proving to the market that it can adapt to survive in tough economic times.



[1] Jessica Silver-Greenberg, “Time to Slip Into Something Less Comfortable?” Bloomberg BusinessWeek, p. 48, Issue no. 4183, June 14-20, 2010.

[2] Reena Jana, “The Innovation Backlash,” Bloomberg BusinessWeek, p. 28, Issue no. 4025, March 12, 2007.

[3] Steve Hamm, “A Radical Rethink of R&D,” Bloomberg BusinessWeek, p. 35, Issue no. 4145, September 7, 2009.

[4] Adrian Slywotzky, “How Science Can Create Millions of New Jobs,Bloomberg BusinessWeek, p. 37, Issue no. 4145, September 7, 2009.

[5] Richard Farson and Ralph Keyes, “The Failure Tolerant Leader,” Harvard Business Review, pp. 64-71, August 2002.

[6] Jeffrey H. Dyer, Hal B. Gregerson, and Clayton M. Christensen, “The Innovator’s DNA,” Harvard Business Review, pp. 61-67, December 2009.

[7] Jeffery Cohn, Jon Katzenbach, and Gus Vlak, “Finding and Grooming Breakthrough Innovators,” Harvard Business Review, pp. 62-69, December 2008.

[8] Jessi Hempel, “How Symbol Got Its Mojo Back,” Bloomberg BusinessWeek, p. 20, Issue no. 4025, March 12, 2007.

[9] Mark W. Johnson, Clayton M. Christensen, and Henning Kagermann, “Reinventing your Business Model,” Harvard Business Review, pp. 50-59, December 2008.

[10] Theodore Levitt, “Creativity is Not Enough,” Harvard Business Review, pp. 137-145, August 2002.

[11] Teresa Amabile and Mukti Khaire, “Creativity and the Role of the Leader,” Harvard Business Review, pp. 100-109, October 2008.

2017 Volume 20 Issue 2

2017 Volume 20 Issue 1

2016 Volume 19 Issue 2

2016 Volume 19 Issue 1

2015 Volume 18 Issue 2

2015 Volume 18 Issue 1

2014 Volume 17 Issue 3

2014 Volume 17 Issue 2

2014 Volume 17 Issue 1

2013 Volume 16 Issue 3

2013 Volume 16 Issue 2

2013 Volume 16 Issue 1

2012 Volume 15 Issue 3

2012 Volume 15 Issue 2

2012 Volume 15 Issue 1

2011 Volume 14 Issue 4

2011 Volume 14 Issue 3

2011 Volume 14 Issue 2

2011 Volume 14 Issue 1

2010 Volume 13 Issue 4

2010 Volume 13 Issue 3

2010 Volume 13 Issue 2

2010 Volume 13 Issue 1

2009 Volume 12 Issue 4

2009 Volume 12 Issue 3

2009 Volume 12 Issue 2

2009 Volume 12 Issue 1

2008 Volume 11 Issue 4

2008 Volume 11 Issue 3

2008 Volume 11 Issue 2

2008 Volume 11 Issue 1

2007 Volume 10 Issue 4

2007 Volume 10 Issue 3

2007 Volume 10 Issue 2

2007 Volume 10 Issue 1

2006 Volume 9 Issue 4

2006 Volume 9 Issue 3

2006 Volume 9 Issue 2

2006 Volume 9 Issue 1

2005 Volume 8 Issue 4

2005 Volume 8 Issue 3

2005 Volume 8 Issue 2

2005 Volume 8 Issue 1

2004 Volume 7 Issue 3

2004 Volume 7 Issue 2

2004 Volume 7 Issue 1

2003 Volume 6 Issue 4

2003 Volume 6 Issue 3

2003 Volume 6 Issue 2

2003 Volume 6 Issue 1

2002 Volume 5 Issue 4

2002 Volume 5 Issue 3

2002 Volume 5 Issue 2

2002 Volume 5 Issue 1

2001 Volume 4 Issue 4

2001 Volume 4 Issue 3

2001 Volume 4 Issue 2

2001 Volume 4 Issue 1

2000 Volume 3 Issue 4

2000 Volume 3 Issue 3

2000 Volume 3 Issue 2

2000 Volume 3 Issue 1

1999 Volume 2 Issue 4

1999 Volume 2 Issue 3

1999 Volume 2 Issue 2

1999 Volume 2 Issue 1

1998 Volume 1 Issue 3

1998 Volume 1 Issue 2

1998 Volume 1 Issue 1