Chief executives and investors may be about to face a profit crunch that could result in fundamental changes to the way modern corporations exist. The changes will be driven by American firms who have been struggling to wring value out of their capital investments, as measured by return on assets.
ROA is one of the better metrics for understanding the success of a company. Essentially, it measures what kind of profit companies generate from their capital investments.
The chart above suggests that since the 1960s, the effects of the great technological boom of the 20th century have been wearing off. The huge gains wrought by mechanisation, communications and infrastructure appear to have been wrung out of the modern corporation.
And the situation gets worse. According to John Hagel – chairman of Deloitte’s Center for the Edge and the former chief executive of one of the most successful venture capital firms, Sequoia Capital – the ROA of US firms is expected to decline to zero by 2022. Not an encouraging thought if you are an investor.
Hagel says at that level, the economy can’t function.
When that point is reached, a great many companies will have to redefine their business models.
Here in Australia, the performance of companies is not so bad. If you strip out the resources sector, our return on assets sits around 4 per cent.
The surge in commodities prices has clearly benefited the resources sector in the mid 2000s and there was a period of strong growth across the board, reflecting that boom.
But ROA is once again on the decline in Australia and we may be facing a similar situation to what is happening in the US.
If true, then chief executives here should be on the lookout for how their American counterparts deal with this issue.
Deloitte’s John Hagel, a 30-year Silicon Valley veteran infused with the optimism of that perennially forward-looking place, believes there will be a fundamental shift in that way the modern corporation looks. He reckons that once this redefinition is underway, a great deal of value will be unlocked.
According to Deloitte’s Center for the Edge, that shift will require companies to reshape their businesses into three broad streams; those companies that concentrate solely on infrastructure, doing highly process-driven things like manufacturing, call centres, data centres and the like; customer centric companies, who specialise in mining consumer behaviour and creating compelling products for increasingly niche preferences; and product innovators – companies who have a competitive advantage in creating new things such as design firms, software companies and the like.
Unfortunately, short term thinking among both executives and investors could mean that it will take a crisis to adapt to this new reality.
Many chief executives can’t contemplate the idea of setting in place a strategy for 2022. They are too worried about hitting their targets for the second quarter of 2012. The fund managers demand quarterly results and according to John Hagel, chief executives complain to him that they have no opportunity to take such long term bets.
But chief executives shouldn’t get off scott-free by blaming the investment community. After years consulting top companies, Hagel believes that many senior executives struggle to define company strategy, and are even worse at communicating it. It takes guts to explain to shareholders that you are reshaping the business, particularly before a crisis occurs. It is even more of a challenge to be afforded the time to do it. Just ask Arrium’s Peter Smedley.
Furthermore, many executives would rather be known as the exciting innovation guy, who creates new and exciting products, than the boring operations guy, who generates lots of cash from something as mundane as running call centres.
If Hagel is right, however, then expect more firms to shed non-core activities and specialise in just one area. This will mean that major corporations will start spinning out divisions and clearing out the layers of bureaucracy that have grown up to connect disparate company parts.
We may see more concentration of power in just a few firms. Those who can deliver economies of scale, particularly in the process driven areas like manufacturing, will get more and more contract work from those in the other two sectors.
Customer centric firms may also have an advantage in scale. It will allow them to conduct the kind of number crunching that demands powerful computers and algorithms to predict consumer behaviour. As I wrote in my piece on data mining (Coles places faith in a data revolution, April 20) companies like Target in the US are already able to predict if a customer is pregnant months before a baby's birth, by analysing changes in purchase patterns of various products, cross referenced against customer loyalty cards. The ability to predict customer needs will tilt competitive advantage away from smaller players.
That leaves innovation as the white space for up and coming players. And in some ways, outsourcing manufacturing and customer service to a few highly efficient players may help innovative companies reach scale much faster. Already, infrastructure focused players are doing that. Companies like PayPal, FedEx, and Amazon Web Services help a startup concentrate on core activities in a way that was unthinkable even a decade ago.
So will we see a much more concentrated corporate sector in the future? Well to some degree that is already happening in the US according to Stewart Jones at the University of Sydney Business School. Because of the financial crisis, major corporates have been paring down their businesses and concentrating on those areas which generate the largest cashflows.
That age old management maxim is coming back into vogue – do one thing and do it well and the shareholders will reward you.
Cleaning out the corporate fat
On the key measure of return on assets, chief executives are facing an inexorable decline that can only end with a fundamental reshaping of the modern corporation.
Want access to our latest research and new buy ideas?
Start a free 15 day trial and gain access to our research, recommendations and market-beating model portfolios.Sign up for free