How Strategic Caution Can Limit Value Creation
John R. Cryan and Jeffrey L. Routh | January 03, 2012 | Click For PDF Version
As companies continue to recover from the financial
crisis and set their strategic plans for the future,
many are pushing agendas that emphasize “caution”.
However, an overly cautious strategy is unlikely to
yield exceptional shareholder returns 3, 5, or 10
years from now.
A “hunker-down” approach leads to inaction and
missed opportunities creating a “slow-leak” whereby
forgone investment today leads to a strategic disadvantage
This is analogous to the anecdote that if a frog is
placed in a pot of boiling water it will jump out, but if
it is placed in cold water that is slowly heated, it will
not perceive the danger and will be cooked to death.
Similarly, companies on the sidelines missing investment opportunities may not feel like anything is
really wrong but they risk being overtaken by more
aggressive competitors as the economy recovers.
Companies can under-achieve their potential by investing
too much or too little. Investing too much in
an overly aggressive strategy is more risky as large
scale failures make for splashy headlines and financial
pain that is unmistakable to shareholders.
However, that shouldn’t imply that an overly conservative
approach is better as under investment and
missed growth opportunities can be damaging to
shareholder value just like over investment.
Illusory Appeal of “Conservative” Strategies
The global economy is awash with economic uncertainty,
sovereign debt crises, ambiguous regulatory
and tax regimes, decreased consumer confidence and
consistently high unemployment. It is easy to understand
the appeal of a strategy of caution.
After all, executives must have confidence and conviction
in the outcome of their decisions in order to
proceed. Unfortunately we humans are simply
“programmed” to dislike uncertainty; for the most
part uncertainty leads to inaction.
Consider how over and under confidence impacts
M&A activity. The January 2006 confidence index
published by Chief Executive magazine found CEO’s
to be very optimistic about investment conditions and
not surprisingly M&A was quite strong that year. In
2010, CEO confidence dropped by nearly 50 points
and M&A activity declined by 60%.
With the current economic uncertainty, many executives
feel more confident in their ability to cut costs
and constrain outlays than in their ability to seize
investment opportunities created by the downturn.
The Human Blockade
A litany of common human biases impact executive
decision making and in the context of growth and
investment there are a few that are truly important
for executives to be cognizant of and actively mitigate
to arrive at better and more balanced decisions.
1. Loss Aversion
Decision makers generally have an aversion to loss
whish sounds rational on the surface. After all, who
likes to lose? What it really means is that decision
makers have a natural tendency to avoid the potential
for even a small loss even if it means forgoing the
possibility of a larger gain. This tendency grows in
the wake of a loss.
We studied companies that incurred goodwill and
intangible write-offs or impairments and examined
their reinvestment rate over the next three years
compared to the reinvestment rate of companies
without write-offs. The reinvestment rate measures
the proportion of cash flow generated that is reinvested
in the business via capital expenditures, R&D,
leases, working capital and acquisitions.
In all but one time period, companies that incurred a
charge systematically under invested during the next
three years. On average the companies with impairments
reinvested 9% less of their cash flow back into
This translates to nearly $80 billion of forgone investments
or roughly $135B of unrealized enterprise
value at the prevailing average enterprise value to
gross assets ratio. The negative consequences of these inactions are enormous. The cumulative impact
of the forgone investment is the equivalent of not creating
Bristol Myers Squibb (BMY), Honeywell International
(HON) and Nike (NKE) combined!
It seems the executives at the companies who experienced
a write-down had a heightened aversion to loss
leading them to under invest in the years following
their write-off. These companies span a wide variety
of industries and likely had similar investment opportunities
to their peers that did not suffer a writedown
yet they chose to reinvest less cash flow back
into their business.
It is common for Boards and Executives with a loss
fresh in their minds to “shorten the leash” to avoid
making the same mistake twice. This may not be a
2. Recency Bias
The companies in our study that underinvested following
a loss may have put too much emphasis on
their recent experience when considering their next
opportunity to deploy capital. This is often referred to
as a "recency” bias.
More broadly this also explains why executives are
slow to reinvigorate growth investment as the financial
crisis is still fresh in their minds.
Mitigating the impact of these biases requires robust
and integrated strategic planning and risk management
processes. Evaluating potential gains and
losses simultaneously with the same analytical rigor
leads to a balanced approach to decision making.
In addition, properly designed incentives and performance
targets must encourage prudent risk taking.
To accomplish this, incentives must be designed
so that executives reap the full gains of success and
feel the full pain of failure for the decisions they take.
Managers often anchor their decision making in preconceived
biases or “anchors”. For example, in September
2011, two different publications reported on a
capital investment survey quite differently. One
used the headline Businesses Boost Orders for Equipment,
Machinery while the other reported CapEx
Numbers Reflect No Expansion.
These articles imply different sentiments regarding the economic outlook. If the executives from one
company read the first article and those from another
company read the second article, they might come to
vastly different decisions if they faced a similar investment
decision. In reality, the investments might
yield the exact same positive Net Present Value
(NPV) for their respective companies but the anchor
bias might cause one to make the investment and the
other to pass on it.
Without knowing it, their thought processes may be
influenced by the article which becomes an “anchor”
or point of reference. A single article may not be
enough to cause an anchor bias on an important decision,
but a barrage of overly upbeat or downbeat
news can change the way executives perceive their
These anchors become swing factors that cause companies
to be too aggressive or too conservative.
These biases can lead executives to make poor decisions
based on their initial “gut” feel. Understanding
and compensating for these factors will help to remove
“emotion” and improve the decision making
These types of biases help to explain why two people
can look at the same analysis or read similar news
stories and interpret them completely differently.
4. Confirmation Bias
Anchoring is particularly unfavorable when paired
with a confirmation bias where an executive has a
preconceived thought that is confirmed through receipt
of external information.
For example, today many executives are hesitant to
invest in the future as we come out of the downturn
and the ongoing negative news stories provide confirmation.
It is reminiscent of when Franklin Roosevelt’s
famously said the “only thing we have to fear is
Conversely in 2007 and even more so in 1999, the
general business mood was quite positive in most
executive suites and external news only served to
reinforce this euphoria. Executives were more likely
to proceed with investments when in reality many
investments made at the peak did not turn out very
well. Companies made more acquisitions and bought
back more stock when prices were at their highest
which made it very difficult to deliver solid returns to
Overcoming Decision Making Biases
All of these decision making biases can significantly
influence a executives’ predisposition towards a particular
choice, even if it is not the optimal alternative.
They must learn to rely less on information
that validates their instinct and instead seek out
more information and advice that challenges their
Well conceived fact-based analysis can help to overcome
these biases. Of course, it’s important to ensure
that the analysis isn’t biased as well. It is not uncommon
(or helpful) for decision support analysis to
embed overly conservative assumptions at the bottom
of the economic cycle and overly optimistic assumptions
at the peak. Despite many years of economic
cycles, most forecasts don’t anticipate them.
Decision makers must come clean with themselves
and accept that they are biased. While it may sound
like an Abbott and Costello routine, if executives believe
they are less biased than others - well that in
itself is a bias.
So how do you overcome this bias? Surround yourself
with opposing ideas, encourage debate and bring in a
trusted independent advisor (either internal or external)
who is not vested in the outcome of the decision
and/or is not the champion of the idea.
Often their unbiased perspective will identify risks
and opportunities that those closest to the decision
had not considered.
Creating long term shareholder value requires
investment in the business and it requires business
leaders to avoid being satisfied with the status quo
(yep that’s a bias).
Moving from a “hunker-down” mentality to a more
opportunistic strategy requires overcoming many
inherent biases both at the organizational and personal
level. Executives should take solace in the fact
that on average over time most companies get it
right, but should always seek to improve.
John R. Cryan (firstname.lastname@example.org) is
Partner and Co-Founder of Fortuna Advisors LLC
Jeffrey L. Routh (email@example.com)
is a Senior Associate in the firm’s New York Office