BAI Online | Banking Strategies | September/October 2005

Strategy continues to elude corporate America, says Michael E. Porter, one of the world’s leading authorities on competitive strategy. In his second appearance in Banking Strategies, here’s a preview of what he’ll have to say when he returns to the stage at the BAI Retail Delivery Conference & Expo on November 16, 2005 in Orlando, Florida.

| SYNOPSIS | Corporate strategy is ultimately about helping companies develop some unique value that provides long-term competitive advantage, says Harvard professor and best-selling author Michael E. Porter. Pressures from the capital markets tend to encourage CEOs to focus on short-term stock performance, which can run counter to what’s needed to build economic value over time, Porter says. Failing to make their companies distinctive, some CEOs use mergers to make them bigger. Porter says favorable tax treatment on shareholder dividends provides banks and other dividend-payers an economic incentive to build earnings.

Even the newbie student of Investments 101 knows that the function of a publicly traded company is to create shareholder value. And yet Harvard University Business School professor, strategy legend and best-selling author Michael E. Porter contends that today’s efforts to grow shareholder value often run counter to what’s needed to pursue a corporation’s long-term economic value.

It’s a “radical statement” from one of the leading influences on corporate America over the last 20 years and a return keynote speaker at the 28th Annual BAI Retail Delivery & Expo, November 15-18 in Orlando. Porter first spoke at the conference in 1997, when the industry was $5.8 trillion in assets, after deregulation but before the Internet boom and bust. In the accompanying interview with Banking Strategies, Porter sought to distinguish between strategic growth and mergers and acquisitions: “Merging is not strategy ... We need to start moving into the next phase, which is one of strategy — the phase in which individual banks make choices about how they are going to be distinctive, how they’re going to be unique, how they’re going to set themselves part.”

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About Michael E. Porter

Fast forward to 2005 and a $9.6 trillion industry coping with regulations involving accounting, corporate governance, risk management, and bank security unanticipated eight years ago. The once-lowly branch office is enjoying a renaissance, sparking an unprecedented wave of new branches. And yet Porter still feels the need to define strategy. “People will say, ‘My strategy is to internationalize.’ That may be a good thing to do, but it’s not a strategy,” says the tireless teacher.

In our earlier interview, Porter urged executives to “learn to say ‘No.’” Today, as you’ll read, he encourages senior management to resist other tendencies, including the temptation to make short-term moves to boost stock price and please impatient investors.

One result of a short-term focus, Porter says, is the preference to compete narrowly on a “best practices” basis rather than to take on the arduous task of devising a means of differentiating for the long term. “Do you want to compete to be better at the same thing, like cost control? Or do you want competition to be different?” Porter asks. “I think most banks are competing to be better — how to have the lowest cost, the lowest fees — rather than competing to be unique.”

Today, as in 1997, the banking industry is driven by what Porter terms a “growth mania,” often manifested in value-destroying mergers. Lacking a differentiating strategy, Porter says, bank CEOs turn to making their companies bigger or broader — and therefore even less differentiated. “The pressure to do deals is still very great,” Porter says. “We have not figured out a way to counteract that.”

“Big banks just get bigger” is Porter’s explanation for why Harvard B-school students see little new or exciting in banking. One exception and an area where Porter does find strategic opportunity in banking is payments. As an advisor to Scottsdale, Ariz.-based eFunds Corp, Porter has been studying the siloed, fragmented nature of payments. “The opportunity to transform the area is huge,” he says.

BANKING STRATEGIES: When you look at the state of American business today, do you feel encouraged or discouraged?

PORTER: It’s a very mixed bag. We certainly have made great strides in applying more disciplined thinking to strategy choices. The field of strategy, my principal field, has become mature and well established. Most organizations now acknowledge the need for strategy. All of that is good.

Having said that, I still find a surprising lack of clear strategic thinking in companies. There are several underlying reasons for that.

One, the notion of strategy is still not well understood. “What is a strategy?” is a question that I ask a lot and get a lot of different answers. People define strategy in ways that are actually dangerous. For example, they will say, “My strategy is to be number one or number two in my business.” While that may be an aspiration or goal, it’s not strategy. And it may force you to make acquisitions, to get into other product segments where you bring little that is different.

Another common mistake is to equate strategy with a certain kind of action. People will say, “My strategy is to internationalize.” That may be a good thing to do, but it’s not a strategy. Strategy is fundamentally about how you’re going to be unique in delivering some kind of value where you have a competitive advantage.

In my earlier work, I focused mostly on how to perform disciplined analyses of an industry environment and of a company’s competitive advantage. But in the work on my new book, I’ve come to see that the challenges holding back these companies are often even more basic. One of them is simply establishing consensus on what strategy is and how strategy is different from simply getting a little bit better every day, or pursuing “best practices.”

The second big class of problems with strategy is a series of organizational and other factors managers have to contend with that actually make it quite difficult to maintain a clear strategy. One of these would be the capital markets. Twenty years ago, the average share of stock was held for many years. Today, it’s held for less than a year. The interests of investors are increasingly mis-aligned with the real interests of the company.

This is a radical statement, I know. Many believe our capital markets are the most efficient in the world, and they probably are. However, I have come to believe that the interests of the many shareholders and the interests of the company are not the same. Shareholders are worried about what’s going to happen to the share price during the period when they expect to own the stock, which for those trading and setting the price, is probably less than a year. The company, meanwhile, needs to worry about its fundamental capacity to create economic value over time, which depends on the inherent competitive advantages that can be built.

The worst mistake a company can make is to listen too closely to the capital markets to determine what you should do. Yet there are enormous pressures to do that. As boards and shareholders have gotten more activist, there’s more pressure from the Street to focus all your time boosting the share price rather than grow economic value.

Another problem is the continuing evolution in accounting rules. We now have a world in which extraordinary write-offs and restructuring charges are literally the norm. So it’s increasingly unclear what you’re really looking at when you examine a company’s economic performance. What are you really measuring? If we undid all those restructuring charges and looked at the actual return on the actual investment, the picture would look a lot less pretty.

Accounting policy is more about liquidation values, about making sure that every item on the balance sheet is not overstated, rather than trying to capture whether a company is earning an attractive return on its invested capital, which is the number one goal for a business. If a business is not earning an attractive return on capital, it is not creating economic value. The focus on earnings per-share, profit before amortization, and other funny, flaky measures that don’t accurately capture return on capital is distracting for strategy choices.

There has been one piece of good news — the dividend tax rule change, which is having a fundamental impact on corporate performance. Before, paying dividends was viewed as a sign of brain death. The only way to drive up the value of the company was capital appreciation, and the only way to do that was to grow faster than your industry, which is pretty hard to do. So we had all kinds of risk taking and ill-advised strategic moves to drive share prices up.

Now you can choose to just make a lot of money and pay dividends. And you can do that with honor. This is a very healthy development for strategy. When you’re thinking about having to pay and sustain dividends, you’re linking the company’s strategy choices with its true economic interests.

The banking industry, by the way, has always been relatively high yield in terms of dividend payouts. So I think this will actually help the banking industry because those dividends will be more valued and appreciated.

BANKING STRATEGIES:Yet we still see in banking what appear to be “growth for growth’s sake” deals. Does executive compensation play a role in that, i.e., larger companies simply pay their executives more?

PORTER: The connection between executive compensation and strategic choices is a very important one. One thing that has finally been recognized is that if you overweight compensation to stock options, almost no matter how you design those options, you’re going to create immense pressure to try to boost the share price. That led to many of the excesses we’ve seen.

Now we’ve seen companies modify those executive compensation packages recently and we’re seeing a significant fall in options, at least in the companies I’m involved with. We’re seeing more restricted stock. In general, there is also a movement away from equity and towards cash compensation and bonuses. I think all of that is good. But the effect of company size on salary and bonuses is perverse.

I also believe that mergers are opportunities to really confuse actual company performance. It used to be worse with pooling-of-interests accounting, which was a wonderful vehicle for obscuring results. You could take write-offs and charges and make yourself look like a hero. That’s been tightened up a little bit, but mergers still distort true return on investment.

A lot of the bank growth mania has to do with this focus on the short-term. Selling shareholders almost always vote for mergers because they accelerate their premiums. Buying shareholders also think they can get some juice out of the deal with short-term synergies and write-offs. And yet the evidence is that scale is overrated.

We go back to this kind of strategic thinking over and over again. There’s some inexorable pressure to get bigger. And often to get bigger, you have to get broader. We saw this in the most extreme form in the 1960s with the conglomerate movement, where companies would just buy anything. All the conglomerates got dismantled, but today the pressure to do deals is still very great. It’s built into the incentives of management, and we have not figured out a way to counteract that.

It’s interesting to see so many companies going private now. That may just be a function of the tremendous amount of private equity available looking for something to do. But I also think some companies understand that the public marketplace isn’t necessarily the best ownership/governance structure to build long-term economic value.

BANKING STRATEGIES: Here at Harvard, you lecture to some of the best minds in the country. Are many of your students attracted to financial services?

PORTER: Jamie Dimon is a graduate of Harvard Business School (HBS). But overall, banking — at least commercial banking — has not been one of the hot career pipelines.

A lot of HBS grads have gone into investment banking and private equity, which are seen as more glamorous and with more financial upside. There’s also been a large flow of HBS grads into consulting of various kinds. Through that route, a number probably end up in banking.

But banking itself has long been in a consolidation mode so there haven’t been a lot of new, exciting startups. Big banks just get bigger. During the Internet bubble, you had companies come up like E-Trade and E-Loan, but generally banking hasn’t been a field where a lot of new things happen. It’s not the place where students feel they can be part of something exciting.

BANKING STRATEGIES: You first spoke at BAI’s Retail Delivery conference in 1997. Did you personally have much interaction with the banking industry after that speech?

PORTER: Not a whole lot. Whenever I give a speech, there’s an inevitable surge of interaction, discussion and email exchanges. But I have been focused in other areas. Most recently, I’ve been finishing a book on competition in healthcare so I’ve spent a lot of time working with physicians, hospitals and health plans.

I do have a long-term relationship with Scottsdale, Ariz.-based eFunds Corp., in the payments area. There are many impressive things happening in the world of credit cards, debit cards, identity theft, the IT backbone for the payments system, and the like. There are a lot of interesting changes in that field, which is really important. The payment area is still quite fragmented. This may be one of the most exciting areas in financial services in coming years. The opportunity to transform the area is huge.

BANKING STRATEGIES: What are the strategic choices and opportunities in payments?

PORTER: What surprises me is just how inefficient and siloed the whole payment system still is. Different companies process debit cards, credit cards and checks. There are many fragmented parts cobbled together. It’s difficult to integrate data across the client and really understand a financial institution’s or retailer’s position. While First Data Corp. is big, they are built from acquisitions that have never been integrated. So even the industry leader is siloed.

BANKING STRATEGIES: In its drive to lower costs, banking — like many industries — is increasingly turning to outsourcing. Is this a positive trend or not?

PORTER: The challenge in outsourcing is always, how far do you go and how do you understand the true savings that you’re going to achieve? When is outsourcing really efficient? There’s a tendency always to underestimate the actual cost of outsourcing, and possibly over-estimate the savings. I think companies underestimate the complexity of dealing with outsourced vendors and integrating and coordinating across the various parts of their business.

There’s also another complicating question, which is: when do you outsource to some outside company and when do you offshore in your own facility, where you actually maintain managerial control and intellectual property control? Many managers have been too quick to outsource as opposed to just offshore.

One of my rules of strategy is that the more you outsource, the harder it is to have a competitive advantage. If you’re laying off many functions to outside vendors, what’s your advantage? All of your competitors could do that too. You may save some cost but it’s going to make you pretty similar to everybody else. So I think the outsourcing trend is correlated with the lack of differentiation in companies.

There’s no doubt an economic advantage to outsourcing, but where do you draw the line? Do you want to outsource your call centers, for example, which are a key way you interact with your line customers? Do you want those people to be somebody else’s employees that are reading from your script one minute and somebody else’s the next? Those are really interesting and important questions. One of the advantages of offshoring, or establishing your own company overseas, is that you can still do things your own way.

One of the topics I talk a lot about now is what kind of competition do you want to have? Do you want to compete to be better at the same thing, like cost control? Or do you want competition to be different? I think most banks are competing to be better, how to have the lowest cost, the lowest fees, rather than competing to be unique. They compare themselves to each other rather than think about how they can meet a different need, serve a specific customer group. Instead, they try to serve all customers, with few exceptions.

BANKING STRATEGIES: Banks do tend to get out of businesses when they’re slow and get back in when their hot ...

PORTER: I think that relates to the point I made earlier about financial markets. When something like mortgage banking gets perceived as a growth area, the analysts and shareholders quiz managers about their mortgage position. If the managers admit they are not strong in that segment, they get penalized. From an economic value point of view, that’s completely irrational.

I believe that leadership is understanding the real goal. Shareholder value is the result of addressing the real goal. If you earn an attractive, sustained return on capital, your share price is guaranteed to improve, although it may not move exactly on a straight line and it may not go up in one day. Keeping the financial markets in perspective is one of the fundamental challenges facing executives.

Some years ago, I started at HBS a program called New CEO Workshop dedicated to serving newly appointed CEOs of very large companies, those with at least $1 billion in revenues. We now offer the workshop twice a year, with a maximum of 12 CEOs who are personally invited.

In these sessions, we end up talking a lot about this issue of what is the goal of the company and how do you think about the shareholders? I’m optimistic that awareness is building on some of the points I’ve been making, but gosh, there has been almost a cult in American business that it’s all about shareholder value.

BANKING STRATEGIES: One problem you must have in your work is that when you analyze a particular company, it’s only a snapshot in time. A company that’s successful today may not be so tomorrow. Do you find that frustrating?

PORTER: I think you learn from long-term stories. In my new book, I talk a lot about cases over time — the good lessons and the unfortunate lessons. It’s very dangerous to declare somebody a success. What I’m trying to get at is the underlying principles of good strategy, but also what distracts companies from following those underlying principles.

One of the themes of my new book is that many obstacles and impediments stand in the way of strategy. You not only have to create a strategy, but maintain it over time against all these distractions and often subtle pressures.

Questions or comments about this article? Post them at the Banking Strategies blog.

Mr. Cline is senior editor of Banking Strategies.