Dirty laundry: Who is hiding the bad stuff?

Are firms sometimes inclined to conceal negative information, for instance in their communication to shareholders?

Some years back, two researchers – Eric Abrahamson from Columbia Business School and Choelsoon Park, at the time at the London Business School – examined this question systematically. Their answer – perhaps not surprisingly – was “yes”.

Fortunately, however, they did not stop there. Because perhaps the more interesting question is, “who is concealing the bad stuff” or, put differently, which firms are inclined to hide their dirty laundry?

Eric and Choelsoon investigated so-called letters to shareholders of 1118 companies as published in these firms’ annual reports. There is quite a bit of evidence that these letters to shareholders form one of the main communication devices of firms to their shareholders and that they have some real impact on companies’ share price. Eric and Choelsoon, through computer analysis of the wording of these letters, made a measure of how much negative information was disclosed in them.

In addition, they collected information on a bunch of other variables, such as the firms’ (subsequent) performance, the percentage of outside directors on their boards, shares held by those outside directors, institutional ownership of the companies, auditor reports, etc. And they uncovered some pretty gritty stuff.

So, their finding number one was: Company Presidents - who formally write these letters - are tempted to lie and hide their company’s bad news. I reckon that is only human. My guess is many of us might be tempted to tone down our failures (and play up our achievements a bit) in such very public statements, to not feel embarrassed and make ourselves look successful. But there are things that can be done, in terms of corporate governance, to stem their & our natural inclination to obscure the truth.

That brings me to finding number two: Eric and Choelsoon showed that having outside directors on the board made firms lie less. The more outside directors firms had the more forthcoming they were with their bad news. Similarly, having large institutional investors prompted firms to be more open about their failures in these letters to shareholders. Large institutional investors tend to monitor the firms they invest in quite closely, which apparently gives them less opportunity to conceal the negative stuff.

But then came finding number three: If we gave our outside directors shares in the company, the results flipped…! Firms that had outside directors who also were quite major shareholders were less forthcoming in disclosing their bad news. It seems that having an ownership stake in the company created a conflict of interest for these people which induced them to stimulate their firm to hide its dirty laundry rather than disclose it.

Moreover, having lots of small institutional investors – who don’t scrutinise companies as strictly – also made the results flip: Firms with lots of small institutional investors hid their bad news more often, probably because they were afraid these investors would run at the slightest hint of bad news (which they are indeed known to do), which could snowball and send the firm’s share price plummeting. To conclude, having outside directors may be a good thing, but only if they don’t have a lot of shares. Institutional investors may be a good thing too, but only if they do have a big stake.

By the way, interestingly, Eric and Choelsoon also found that those companies that did not disclose their bad news were exactly the companies whose top managers would quickly sell a whole bunch of their privately-held shares shortly after the release of the (overoptimistic) letter to shareholders. Guess corporate crooks don’t only lie; they also steal.

"Reverse causality" – sorry, but life's not that simple

“In Search of Excellence”, “Built to Last”, “Profit from the Core”; you may have read some of these best-selling business books.

They usually follow a simple yet appealing formula. They look at a number of very successful companies, see what they have in common, and then conclude “this must be a good thing!” Yet, reality – and strategy research – is a bit trickier than that.

One conclusion many of these business books draw is that one should focus on a limited set of “core activities”. For example, “Profit from the Core” authors Chris Zook and James Allan find that 78% of the high-performing firms in their sample of 1,854 companies focus on just one set of core activities, while a mere 22% of the low-performing companies did. Hence, they conclude that companies should focus.* Simple isn't it? Yeah, but a bit too simple...

What this “advice” ignores is that often underperforming companies diversify into other businesses in order to try to find markets that are more rewarding for them. Thus, their “non-focus” is the result of poor performance, rather than the cause! In contrast, it’s very common that very successful companies narrow their strategic focus in order to concentrate on the business that brings them most success. Again, their focus is not the cause of their success; it is the result of it. Our best-selling-business-book-friends may be reversing cause and effect; recommending everybody to apply more focus may be dubious advice at best!

Similarly, many of these business books conclude that the high-performing companies they looked at all had very strong and homogeneous corporate cultures. Hence, they conclude: create a strong corporate culture! Seductively simple again... Unfortunately, not so sound.

It is a well-known effect in academic research that success may gradually start to create a homogeneous organisational culture. Again, the coherent culture is not the cause of the company’s success, but the result of it! What’s worse, a narrow, dogmatic corporate culture may be the foreboding of trouble. When the firm’s business environment changes – and all environments eventually do – it makes the company rigid and unable to adapt; a phenomenon known as the success trap.

Indeed, the authors of “In Search of Excellence” – Peters and Waterman – published in 1982, who analysed 43 of "the most excellent companies in the world", also concluded that a strong corporate culture was a necessity for business stardom. However, if you look at their list of 43 "most excellent companies” today, only three or four might still make the list (Johnson & Johnson, Intel, Wal-Mart, Mars); the remainder has gone down or disappeared altogether.

Hence, remember that “association is not causation”. For example, that successful companies are associated with a very focused set of business activities and strong corporate cultures does not mean that this is what caused their success. Importantly, trying to replicate these symptoms of success may actually prevent you from attaining it.


* For more insight into these type of effects, see for instance the work of Stanford Professor Jerker Denrell

Successful managers – incompetent for sure

The world of business is risky. That’s inevitable. We can analyse all we want, plan, debate, gather information and think it through till it gives us a migraine, sometimes things just don’t work out and nobody could have foreseen it.

So what makes for a good risk manager? Well, it is someone who carefully chooses the best odds. He will sometimes win, and sometimes lose. But, always, he will make quite deliberate and careful trade-offs between his assessment of risk and return; the most expected return for the least risk. Sometimes good managers accept a low return when it is safe (like buying government bonds); sometimes they accept a lot more risk in return for a higher expected return (like investing in the stock market).

Bad managers are those people who just don’t get it. They accept worse average returns for higher risks. And this is where it gets tricky.

Because if they accept very high risks, in spite of lower average returns, every once in a while one of these morons will actually hit the jack-pot…*

That is, if we take the top 1 percent – and only this 1 percent – of top performers, they’re likely to be those people who don’t get it at all… but just got incredibly lucky!

The same is true – as Stanford’s Professor Jim March asserted – for CEOs. The ones that are the eye-catching top-performers are likely the ones who just don’t get it. The dangerous thing is that they are also the ones with the absolute highest return in their business. Therefore we naively believe that they “do get it” and, in fact, are quite brilliant. Moreover, that’s what they start to believe as well… (“I win again; I must be brilliant…!”). Yet, they got lucky once, the might get lucky twice, or three times (at which point we start to notice them) but eventually their luck will turn (the names of Bernard Tapie, Jeff Skilling, Cees van der Hoeven and Conrad Black come to mind).

The same is often true for fund managers, and other people who are trying to make money on the stock market. The top performing funds are not necessarily the best ones when it comes to ability.

For example, have you ever come across these competitions in which people receive a starting sum to “play the stock market” and after 6 months or so the person with the highest return gets the award or even a job? Stupid scheme by design: The person with the highest return is by definition the one that really did not have a clue. Because the only way to win such a “contest” is by making the most silly, illogical and risky allocation of funds, and get lucky. Skillful, careful players will not lose their money, and likely get a decent return, but won’t be the ones to come out on top.

And the issue is: some bloke will get lucky. Ninety-nine out of a hundred cases it will go wrong, but the ultimate winner is dumbo number one hundred. The contest by sheer design ends up picking a nit-wit.

Hence, watch out for “top performers”, in any business or situation which involves risk. The one coming out on top is likely to be a moron, who just got lucky.




* In statistical terms, good managers have a normal distribution around a relatively high average; bad managers have a lower average return but a distribution with “fat tails”. Consequently, because of the long right-hand tail, the top performers stem from the “bad managers” distribution/pool.

The hidden cost of equity

What’s all the noise about being a public company anyway? I recently asked the CEO of a FTSE 250 company “what’s the advantage of being listed?” She shrugged and said “I don’t know; it can give you access to some capital I guess but, apart from that…”.

Of course it is rather “sexy” and exciting. Many CEOs don’t just want to be a CEO; they want to be the CEO of a public company. But what really are the advantages of having your company listed on the stock exchange? Naturally, selling equity is a source of money, but of course there are other sources of capital which could suffice for your investment plans. But, alright, I’ll give you that; it’s one potential source of money.

Yet, I would say this source comes at a cost. Investment bankers will be able to spell out to you – in much much, much detail... – what the advantages and disadvantages are of the various sources of capital, including equity. However, I think they’re forgetting one.

I recently spoke to Bill Allan; CEO of THUS (the former Scottish Telecom). Some years back, they all of a sudden were elevated into the FTSE 100. He admitted that, at once, he found himself having to spend the majority of his time dealing with fund managers, analysts, investors, the business press, etc. Of course this was a relatively unusual and extreme situation; the telecom bubble launched THUS into the FTSE 100 when they weren’t quite ready for it. However, all the CEOs of public companies that I have talked to, in private, will admit that they spend about 30 percent of their time dealing with “the stock market” (i.e. fund managers, analysts, institutional investors and the wider public). Simply put, they wouldn’t have to do this if they weren’t listed.

Think about it: that’s quite a cost. If you have a good company and you decide to float it (starting to sell equity on the stock market), all of a sudden, you lose 30 percent of your top management capacity!

Are you sure that’s worth it? That’s 30 percent which they could have spent on cultivating the organisation, motivating employees, thinking through opportunities for future growth, integrating acquisitions, etc.

Moreover, many CEOs end up not particularly liking the 30 percent… It is a lot of hassle, pressure and a bit of a pain, having to tell (and defend) your “story” over and over again, to people who really don’t have much in-depth knowledge about the company and its business, often haven’t received any training in developing or even understanding strategy, and occasionally may not have much talent for or affinity with it anyway!

How do you quantify this cost of being listed? I don’t know; it is difficult to put a number on such a thing (which is probably why we don’t pay much attention to it in the first place!). But I will assure you that many CEOs will privately tell you – be it while whispering behind the palm of their hand – that being listed isn’t so sexy and exciting after all. And, if they still had a choice, they would do without it.

The Abilene Paradox

It is a well-known phenomenon from social psychology that people are reluctant to voice minority opinions. My guess is you may recognise this issue and feel it yourself sometimes; when a whole group of people seems to agree on something (a course of action, proposal, etc.) but you have doubts about it, there is a bit of a psychological hurdle to speak up against it. And if you do collect the courage to speak up against it, you do so reluctantly, ready to take the heat.

And we’re right to be reluctant to speak up. Research also shows that minority dissenters are often “punished”, in the sense that people in the majority group get irritated, will blame you for the deal falling apart, may even start to give you the cold shoulder if not spit in your tea when you’re not looking.

Therefore, quite often, people don’t speak up at all if they disagree with a particular course of action, if they feel they would likely be the only ones against it. Instead, they stay quiet.

And there is an interesting consequence to that. We only know that others disagree if they actually speak up. If they don’t speak up, we are inclined to conclude that they do not disagree! As a result, it may be that we stay quiet because we assume that everybody else is in favour while, in reality, lots of others are making the same erroneous assumption…! In social psychology, this phenomenon is known as pluralistic ignorance or the “Abilene Paradox”.

The first person to describe the Abilene Paradox was Professor Jerry Harvey, from the George Washington University. He describes a leisure trip which he and his wife and parents made in Texas in July, in his parents’ un-airconditioned old Buick to a town called Abilene. It was a trip they had all agreed to but, as it later turned out, none of them had wanted to go on. “Here we were, four reasonably sensible people who, of our own volition, had just taken a 106-mile trip across a godforsaken desert in a furnace-like temperature through a cloud-like dust storm to eat unpalatable food at a hole-in-the-wall cafeteria in Abilene, when none of us had really wanted to go”…

Of course, this phenomenon is not restricted to people in Texas. Actually, it happens in the world of business too. Professor Jim Westphal, from the University of Michigan, for example uncovered evidence of the Abilene Paradox among boards of directors.

He collected data on 228 boards of medium-sized American public companies using a variety of databases and questionnaires. He found out that outside directors often did not speak up against their company’s extant strategy, although they had serious concerns about it. At the same time, they greatly underestimated the extent to which their fellow directors shared these concerns! As a consequence, underperforming companies undertook fewer initiatives to change their strategy, and they persisted with their failing course of action.

That's the Abilene paradox: Nobody may think we’re sailing a good course, but if nobody is willing to rock the boat – thinking we’ll be the only one – we may end up continuing as is, until we all go under...

Company cloning – how to change a winning formula

I am sure many of you know some of the ludicrous examples of when companies expanded into a foreign market and failed to adapt to the local circumstances.* It can be because they didn’t adapt their product, their way of doing business, or even their name.

For example, United Airlines famously handed out white flowers on flights from Hong Kong, where white flowers represent death and bad luck. India’s M.P. Been Products was used to printing a swastika on all their products (a symbol of good luck in many far eastern countries); it did not go down well when they launched “German Pilsner”, while also Japan’s “Kinki Nippon Tourist Company” noticed it attracted quite some unwelcome customers when they first expanded abroad.

And it’s a problem of all time. Coca Cola, when entering the Chinese market in the 1920s with less than moderate success, translated the sound of its name into Chinese characters, only to find out later that it, fairly unappealingly, translated into “bite the wax tadpole”. Even further back, England’s East India Company just might have lost control over India in 1857 when it continued to supply bullets encased in pigs wax to its Indian soldiers; the tops of which had to be bitten of before they could be fired. Since it was adamantly against their religion to eat pork, it seemed to have greatly whetted their appetite for pacifism.

The message that always comes with these examples is: “Adapt to local circumstances, stupid!” Don’t just implement what you’ve been doing somewhere else, but implement an altered form of it; adapted to the local context.

Well, in spite of these examples, I am not so sure…

Organisations and their business models are incredibly complex systems, consisting of many tangible and intangible elements. And often we don’t quite know what is causing their success – and, what’s more, often people from the company itself don’t quite know what is making it a success... Take the phenomenally successful Southwest Airlines. Is their success due to their swift logistics, the standardization of their procedures, materials and airplanes, their coherent corporate culture, leadership style, recruitment procedures, etc.? We don’t quite know; probably a combination of all of the above (and more).

Take Starbucks. Is it so successful because of the quality of their coffee, the training of their personnel, the lay-out of their bars, the logistics of the coffee-making processes, the ambiance, etc.? Well… probably all the elements interact, and create the competitive advantage in combination.

The problem of such a complex system is that when you change two or three elements of it, you don’t quite know what will happen… Because all the elements interact, you may be screwing the whole thing up in ways you hadn’t anticipated and won’t even be able to untangle and understand.

Therefore, Professors Gabriel Szulanski and Sid Winter – from INSEAD and the Wharton School – recommend: “replicate”. That is, before even thinking about making local adaptations, copy exactly what you have been doing before at some other locality. Only once you’ve got it working, adapt it, very slowly, one step at a time.

Consider again Starbucks. It was originally replicated by its founder, Howard Schultz, modelled perfectly on an Italian espresso bar. “But it doesn’t look at all like an Italian espresso bar!?” you might shout. Very true. But initially – the first one in Seattle – it did. There was standing room only, full fat milk, opera music, personnel with bow-ties, etc. Only when Howard got that to work, he slowly started to make some alterations, through trial-and-error, one step at a time. Had Howard tried to make all sorts of adaptations right from the outset, it may not have worked at all.

Thus, rather than trying to create local perfection from scratch, first be cautious and modest: replicate exactly, get it to work to an acceptable level, and only then think about very gradually introducing some alterations.


* See, for instance, the book “Blunders in International Business”

"Selection bias"

During World War II, American military personnel noticed that some parts of planes seemed to be hit more often than other parts. They analysed the bullet holes in the returning planes, and set out a programme to have these areas reinforced, so that they would be able to withstand enemy fire better.

This may seem natural enough but it also contains a fundamental error. It’s called selection bias.

Assume, for the sake of the argument, that planes got hit in all sorts of places. If the areas which formed vital parts of the machine were hit (call it part A), the aeroplane was unlikely to make it back to base; it would crash. If the bullets hit the plane in parts which were not so vital (part B), the plane was much more likely to at least make it back home.

Then, military personnel would inspect the plane and conclude “darn, this plane also got hit in part B! We’d better strengthen those places…”

Of course, the military personnel were wrong. Planes got hit in part A just as often as in part B; it’s just that the first ones never made it back home. What’s worse, strengthening part B was exactly the wrong thing to do: those parts weren’t so vital; it is part A which needed strengthening!

This is why we call it “selection bias”; we only see a selection of the outcomes, and therefore draw false conclusions. And the world of business is full of it.

Consider, for example, the popular notion that innovation projects require diverse, cross-functional teams. This notion exists because if we analyse some very path-breaking innovation projects, they were often staffed by such teams. However, it has been suggested* that diverse, cross-functional teams also often created the biggest failures of all! However, such failures never resulted in any products... Therefore, if we (only) examine the projects which actually resulted in successful innovations, it seems the diverse cross-functional teams did much better. Yet, on average, the homogeneous teams – although not responsible for the few really big inventions – might have done better; always producing a reliable, good set of results.

Similarly, we applaud CEOs who are bold and risk-taking, using their intuition rather than careful analysis, such as Jack Welch. However, risk, by definition, leads some to succeed but it also leads quite a few of them to fail, and slip into oblivion. Those CEOs we never consider; it is the risk-takers that happen to come out on top that we admire and aspire to. Yet, if we’d be able to see the full picture, of all CEOs, innovation teams, and fighter planes, we just might have reached a very different conclusion.

* See the work of Professor Jerker Denrell from Stanford Business School: Some of the examples used in this text are partly based on his work.