Wednesday, August 6, 2008

An economic parable - Part 2

I continue from yesterday's post, in which I took us through a somewhat simplified scenario as to how a company, content and strong in its market, can be induced through the pressure of shareholders (and, in the real world, stock analysts) to abandon that core market for a more attractive one.

It is painfully obvious that I'm not writing about a pickle business moving from Grand Rapids to Chicago, but about the movement of the focus of many businesses from the United States to China and India. The parallels are clear, from the market of eight times the size to the attractive low-cost production. I tried to demonstrate how it might be that a company might lose its core market, whether it be Grand Rapids or the whole country:
What we've done, of course, through perfectly logical and sound business practices, is to put all our eggs in the Chicago basket. If we don't ever quite make it there, we'll have no business at all. We're out, or virtually out, of the Grand Rapids market, and, since the demand for pickles is still pretty much where it was, other pickle makers will come in - there is no turning back for us.
This seems like crazy behavior to a lot of people, especially when applied to the larger U.S. market. We still have a lot of money to throw around, so why would any company become so besotted with the developing countries as to neglect the U.S.?

To show why this is, I have to show a graph that has been incredibly influential in American business thought, the Boston Consulting Group growth-share matrix:

[Wikipedia image at the link above]

To properly explain its importance is extremely difficult; if you haven't seen this before, rest assured everyone at the upper reaches of your employer has. There have been other models that have tried to compete with this simple, 30-year-old concept, but this stands head-and-shoulders above, despite most people's simplistic understanding of it. It has been misused and misinterpreted (as you can read at the link), but it is regarded as gospel by a surprising number of companies and their executives.

Very simply, this is a chart that's used to allocate resources. The company takes its various products (or divisions) and plots them on the matrix using market growth rate vs. relative market share. [The terms that BCG used have become lingua franca in the business world.] It identifies each of these components as stars, question marks, cash cows, or dogs.
  • Dogs are those components for which there is low growth and low market share; there is nothing good that can be done with them, and they should be eliminated. When GE looks to sell its refrigerator unit, it's because they've decided that the market is mature, implying that growth will be low, and that their market share is too small.
  • Question marks are those for which growth is high, but share is low. These are the ones that require the most management attention, because the growth implies that a lot of resources will be needed, but it will be in the service of little business. These are the ones that will be culled; the company gets rid of the ones that will never work. The rest will get an infusion of money and time to grow market share, the intent being to make stars.
  • Stars are high growth and high share. These will require large amounts of resources, but they can be worth it if they can become cash cows; those resources are needed, however, to stave off a drop in market share that would move stars to dog-dom.
  • Cash cows are low growth and high market share units. They don't require a lot of resources, just enough to maintain their share, but they generate a lot of cash.
Wikipedia contends, in line with the theory, that "every corporation would be thrilled to own as many [cash cows] as possible." This seems plausible, because the cows throw off tons of cash with very little investment, but is wrong.

Classic theory suggests that stock price is the present value of future cash flows, but no one believes that any more. Stock price is a matter of perception, of whether the company can outperform the market, and the time horizon, once infinite, is now amazingly short. Money moves so easily in the market that the institutional investors have to be convinced that your company is better, right now, than all possible competitors. (I will not spend time in this post talking about how corporate compensation programs have added to this pressure.)

So too many cash cows, though very lucrative, make a company's growth potential too small. Executives prefer stars and even question marks - this is the fundamental shift since the creation of the model. There is some recognition of this problem; once again, from Wikipedia:
Perhaps the worst implication of the later developments is that the (brand leader) cash bulls should be milked to fund new brands. This is not what research into the FMCG markets has shown to be the case. The brand leader's position is the one, above all, to be defended, not least since brands in this position will probably outperform any number of newly launched brands. Such brand leaders will, of course, generate large cash flows; but they should not be 'milked' to such an extent that their position is jeopardized. In any case, the chance of the new brands achieving similar brand leadership may be slim—certainly far less than the popular perception of the Boston Matrix would imply.
Again, I cannot stress enough how few people, in actual practice, understand the above paragraph. The push for "stars" is overwhelming, while the cash cows exist merely to throw off cash, and they're subject to being discarded as soon as the stars generate their own cash.

Now it's time to link this to the larger economic picture. You would expect that, if a grocery store used this model, it might divide its business by product, comparing dairy to produce to frozen food and so on, seeing which should be emphasized in the store. A grocery store chain might use the model that way, but it could also divide the stores by geographical location.

Commonly, one would expect the model to be used by product line, so a conglomerate would compare its refrigerator business to its jet engine business, and make decisions as to retention and investment that way. But geography is at least as good a way of looking at it, and I suspect that many companies are applying the BCG model along those lines.

So let's look at world markets, at least as perceived in the executive suite. Europe is a place with a lot of competition, making market share a problem, and growth is quite uncertain. Unless an American company is already fairly well established there, any business in Europe probably falls into the question mark category (if not a full-fledged dog). Unless an executive can come up with a good reason to stay, chances are a lot of companies will not spend a lot of time and effort on Europe.

China and India are seen as potentially gargantuan in terms of growth. Any company that can establish their influence in those countries sees the future there as stars, big stars. They'll spend whatever they have to in order to gain a foothold in these huge areas, will invest massive amounts of time and money.

And the United States? Our growth rate, especially as compared to the projections for certain developing countries, is pitiful. No one projects that we're going anywhere dramatic soon; we have no burgeoning middle class to buy huge numbers of goods. The company may enjoy a solid market share today, but our relative freedom to competition makes maintenance of that share more costly than it might be elsewhere. We're the classic cash cow, and we may be approaching the end of that cycle - remember, cows can become dogs very easily. No company who looks at it this way will invest much in the U.S.

We put all this together, and we see what is happening. American companies, which fancy themselves world players, no longer see their own country as worth much. Oh, they'll take what they can out of it, milk it like the cow it is, but keep in mind that investors are looking for growth. Even the smallest move of cow to dog will prompt an abrupt departure.

And that is my prediction. I believe that, not so long from now, a major U.S. corporation will get out of the American market altogether. When you look at GM's results for this past quarter, it doesn't take a CPA to see that the North American market is dragging them down. Europe and Latin America-Africa-Middle East were profitable, Asia-Pacific contributed just a small loss, and North America represented a loss of, remarkably, $9.3 billion. It is quite possible that GM already sees North America as a dog, and it's not clear that they can afford to prop that up forever.

It is impossible difficult to conceive of a scenario in which GM stops selling cars in America, but continues to make them in America. We remain the wage leader, so that scenario will never make sense. And with that goes all the ancillary businesses that depend, in whole or in part, on GM. Who will sponsor football games if GM leaves this market?

You can argue that there are flaws in this thinking, that China and India's growth cannot sustain itself forever, that America is still a great economic engine. But the relentless short-term horizon of today's business leaders coupled with the evaluation models and common beliefs make some aspect of this close to inevitable. And that's when we start to see serious problems, a downward spiral of economic investment that has only been hinted at so far.


Greg said...

Androcass: Take your argument to the limit, it says that the US may become a manufacturer for products that are sold in other countries. So long as the dollar remains weak, I'd agree with that. But more importantly, I think the US is continuing to shed manufacturing activities across the board. Besides aerospace and semiconductors, in what manufacturing sectors does the US hold a strong position anymore?

However, I do believe that the US continues to hold a strong position in creative fields. I use a broad definition that ranges from entertainment (movies, popular music) to consulting, software and internet. I think there's still a cultural component to US society that makes it hard to reproduce a Hollywood or Silicon Valley or Wall Street elsewhere in the world. But I could be wrong.

Androcass said...


It's not impossible that, in some areas, the U.S. will retain some manufacturing that is done for other countries, but I did point out that I considered it quite unlikely that GM, for instance, would make cars in the high-wage country for consumption in other countries. We would need to see a very great change in our relative labor cost, which is not impossible, but that would impose major changes on us (how do we support a 60-1 ratio in the cost of higher education vs. that of India, as just one example?).

The question as to the cultural component is a big one, probably deserving a post of its own. I'm not quite as certain that the U.S. will remain unique in all those areas; we need to separate the aspirational from the true values (that is to say, I think the dominance of Hollywood is driven somewhat by fascination with our lifestyle. If India becomes more culturally and financially interesting to the rest of the world, well, Bollywood sure churns out a lot of product.). I'm going to ponder that point some more.

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