In the interview below, we chat with Roger Martin, strategy expert and dean of the Rotman School of Management at the University of Toronto.
We touch on a number of subjects in this interesting interview, including Bill Ackman, innovation, corporate responsibility, executive compensation, and how to pick out great companies. Martin is the coauthor of Playing to Win, a new book focusing on strategy written with former Procter & Gamble CEO A.G. Lafley.
A full transcript follows the video.
Brendan Byrnes: Hi, I'm Brendan Byrnes and I'm joined today by Roger Martin. Roger is the coauthor of Playing to Win, and also the dean of the University of Toronto's Rotman School of Management. Thanks again, it's good to see you.
Roger Martin: It's good to be back.
Brendan: You know a thing or two about strategy, having helped turn around Procter & Gamble. I wanted to ask you about Bill Ackman and J.C. Penney. You wrote in a blog post recently that "Bill Ackman shows almost no evidence of understanding enough about strategy to turn around a company." What's he doing wrong?
Martin: Well, I think he understands a whole lot about capital markets and a whole lot about how to make investors happy, but I'm not sure he knows how to make consumers -- customers -- happy in a way that brings about competitive advantage.
What I see with J.C. Penney is sort of a fallacy that I see often in the strategy of companies, which is that it's good enough to try to improve things. It's not. Improving is good, but only in the context of having a goal to have an advantage against competitors with some set of customers so that customers say, "I need this company."
If you just improve a company, you say, "I'm going to get their inventory turns up, or their sales per square foot up," that ends up often disappointing. I think that's, in some sense, what's happening at J.C. Penney.
They just announced a huge fourth-quarter loss. Same-store sales were down almost 30% in 2012, but the focus has been on, "Oh, we've got the new J.C. Penney" -- 10% percent of the stores are this new store within a store and it's double the sales per square foot of the rest of J.C. Penney -- "so as soon as we get the stores converted over to 100% of this our sales per square foot," which were 130 apparently, and are 260 within the little store within a store, new J.C. Penney, "everything will be fine."
But that begs the question, "Who are you competing against?" I would argue that right now, the new J.C. Penney is competing against and absolutely slaughtering an important competitor, and it's called the old J.C. Penney.
The only way that sales per square foot can be up in the new J.C. Penney, that 10%, by that much, and sales per square foot for the store overall are down that much, is what? They're taking huge, huge amounts of sales away from the old J.C. Penney.
In due course, once they've destroyed the old J.C. Penney and got its sales per square foot down to zero, they're going to have to start taking share from somebody else. What I don't see is evidence that they have that in their mind, which is "How are we going to beat Macy's, Nordstrom, Target," all the companies that one way or another they compete against.
That's strategy, having a Where to Play, How to Win against competitors other than yourself.
Brendan: J.C. Penney definitely has a strategy problem. Even bigger than that, it just seems like with declining mall traffic it's kind of an industry problem to some extent, although some of the other guys are doing much better obviously -- Nordstrom and Macy's, you mentioned.
Can J.C. Penney survive with the competition from those big boys, and can they turn it around based on strategy?
Martin: I think you can always have a strategy to win in a certain way in a certain place. This is a particularly tough one, but the key is that without a strategy I think the turnaround is actually doomed to fail.
Brendan: Let's talk about activist investors. You saw Icahn recently purchasing a 6% stake in Dell. He's got 10% of Netflix. Bill Ackman we talked about earlier, obviously J.C. Penney. He lost his proxy fight with Target.
If I'm a shareholder and I own one of these companies, should you welcome an activist investor coming in? What effect does that have on strategy?
Martin: I think it really depends. What I've seen of the activist investors... I actually haven't seen any activist investor out there be able to improve the long-run operations of the core company they've gotten involved with.
There's undoubtedly examples where it's happened, but I don't see any consistency of that.
What I see is them triggering something that makes the capital markets very happy in the short term, so when Ackman went in and said, "Fortune Brands, you have to split into three companies," everybody said, "Oh, wow, this is great. We've released all this value," so there's a bump.
The question is: Can you make the performance of each of the companies that much better? I think a short-term shareholder, if an activist comes in and forces them to divest something -- sell off their real estate assets or monetize some portfolio of assets -- they can have a bump in the stock.
But I think if you're actually a long-term shareholder -- let's say you're a pension fund or something that wants to hold a given stock for 30 years and an activist comes in -- I don't think it's particularly good for you because what they tend to do is make their money on a one-time bump.
As soon as we create the spinoff and we get a bump then we, the activist, can get out. It's a mixed blessing, depending on what your interest is as a shareholder.
Brendan: Warren Buffett in his recent letter to shareholders of Berkshire Hathaway said that CEOs should stop complaining about uncertainty. He said, "Things have been uncertain since 1776."
He might have stolen this idea from you, though, because you had a blog post where you talked about the "uncertainty excuse." What is the uncertainty excuse, and how can CEOs best deal with uncertainty?
Martin: It would be lovely if Warren did steal something from me. He's been very nice to me in the past.
Yeah, the uncertainty excuse is exactly what Warren is talking about, which is that companies say, "Well, things are too uncertain for us to make strategic choices, so we're just going to bob along and see what happens until such time as we've overcome this problem with uncertainty. Then we'll make choices."
What I like about Warren Buffett's thoughts there is, "Yeah, maybe in another couple hundred years it'll be less uncertain." "Oh, no. In America it's as uncertain as it was back then."
That's the problem. The uncertainty excuse is the way that executive CEOs convince themselves that they're doing the right thing by not making choices.
No, I think what you have to do is face up to uncertainty, recognize that there will always be uncertainty, that strategy is not ever about perfection, it's about shortening your odds and you've just got to make choices.
You've got to watch after you've made the choice and say, "Did it work out the way we thought? If not, what can we do to adjust that choice?" But you've got to make choices and not use uncertainty as an excuse not to make choices or, as Buffett said, not to invest.
Brendan: Let's switch gears a little bit. Let's talk about a case study you wrote that talks about "inventing in the dark." You said invention should be based around what the users want, essentially -- what you call "user-driven innovation."
Could you talk about what that means? What would that have meant for a Steve Jobs? When people talk about how Steve Jobs invented products -- the iPad, the iPhone -- that people didn't even know they wanted yet, how does that fit into that principle?
Martin: It very much does.
Any company that really wants to innovate, and innovate consistently, has to be close to their customers, has to be watching their customers carefully, understanding what the customers do with their product or service, because it's through understanding that and understanding frustrations they may have, things that they wish they could do, that you'll be able to come up with ideas that could help those consumers out.
But where Jobs is absolutely right, and my friend and coauthor on Playing the Game always says, "Consumer research of any sort never tells you the answer. It's only an aid to your judgment and creativity."
I think if Steve Jobs were with us today, he would probably say that. He's famous for saying, "We don't do consumer research," but he never said, "and I pay no attention whatsoever to what consumers think or want."
But he was wise enough to say, "They won't invent the next cool gadget. They'll just have needs and wants that we've got to get close enough to them to understand."
What's different about Jobs and Apple -- and this was pointed out to me by Tom Hulme, a really clever Ideo designer -- he said the explicit view at the top of Apple was, "We hire employees who are the best users of our product so we don't have to do as much consumer research as other companies, because we give all the prototypes to our internal people. They use them, and they are the great leading indicator for what people on the outside of Apple will want and use."
That had never occurred to me, but I think he's more right than wrong. You can have an advantage in understanding the consumer if the people in your company are prime consumers of the product that you sell.
Brendan: How important do you think it is to have a CEO or top management that are constantly innovating, to take Apple as an example? Are you of the opinion that they're in trouble now that Steve Jobs is gone and Tim Cook is in there -- more of an operator and less of an innovator? Is that how you see it, or do you think both can be successful?
Martin: I've never met Tim Cook, so I'm loath to make assessments of people I've never met, but to your fundamental question I do think, especially in the modern era of business, if you don't have a CEO that really believes that his or her company's life depends on innovation, I think it's bad for you.
I just think, with more global competition, especially with really legitimate players in so many sectors in the low-cost geographies -- whether it be Indian outsourcers in that business, or Chinese manufacturers in a whole bunch of businesses -- if you're not innovating, they're going to be able to replicate what you're doing now with a much lower cost structure and your advantage will be eroded that much faster.
You always have to be one step ahead, and I think you need a CEO who's comfortable with that, not uncomfortable, not wistfully thinking, "If we could only just keep things the way they are," or "If I could only go to the government and prevent those Chinese or Indian companies from entering our market."
If that's your CEO today, I just don't see good things for you.
Brendan: You've also done a lot of work on corporate responsibility. How important is that to shareholders of a company, and how do you think potential investors should look at the corporate responsibility of a company when they're considering an investment?
Martin: I think this is a really, really interesting issue which is still being very much sorted out.
I think there is now a rising tide of desire for corporate responsibility among consumers. Until such time as that happened, I just don't think that corporations were going to respond, but I think now consumers care more than they ever have before, so I think getting out ahead of sustainability issues and how you treat your employees is important.
Brendan: We talked about conscious capitalism last time. Companies like Whole Foods, Panera, Starbucks starting to do more of this and actually, if you look back at it over time, seeing better returns. Is that something that you think other companies will take notice and will start to take off and snowball like that?
Martin: I think they will, and I think what is cool about those examples that you've given are that the expression of their corporate responsibility is through what they actually do for consumers.
Starbucks saying, "You will get a cup of fair-trade coffee"; coffee is their business, so I like that better than -- even though I like corporate philanthropy -- than, say, giving money to something that doesn't relate at all to your business. Whole Foods would be a similar story. I think that's going to be the trend.
If I was an investor looking at that I'd say, "Boy, I'd rather invest in a company that's figured out through their business, in a way that supports and enhances their business -- those people drinking a cup of coffee from Starbucks and having confidence that it came from a farmer who's making a decent living -- I think those businesses will prosper."
As an investor I'd say the consumers will love them because they're expressing their responsibility through their product. I would look for that kind of corporate responsibility first and foremost.
Brendan: Taking it a little bit deeper, do you think corporate responsibility and growth, when a company is trying to manage those from a strategic perspective, can they do both? Can they balance both or do you think a corporation should always focus on corporate responsibility, or should always focus on growth for the shareholder? What do you think?
Martin: Both. I'm a "both" guy.
In my book way back when, The Opposable Mind, I wrote about that. The great CEOs, the great leaders, are the ones who when they're faced with what appears to be either/or, "I can either be responsible or I can make a buck for shareholders" -- making that choice is easy.
You can do one or the other; anybody can do that. The really great CEOs are the ones who say, "How can I make a good return for the shareholders while showing responsibility?" It's those companies and those CEOs that if I were an investor I'd be looking for.
I'd be looking for that attitude that says, "We've got to be clever. We've got to figure out how to do both."
Brendan: Executive compensation. You've said in the past that right now the executive compensation system is deeply flawed. What is wrong with it right now, and how has it evolved over time?
Martin: What's wrong with it now is it's so much based on stock-based compensation, and that has evolved since about 1980. Prior to 1980 there was actually almost no consequential amount of stock-based compensation in the American economy.
In 1976 less than 1% of CEO compensation was stock-based. By 2000 it had become 50%.
The deep flaw, I think, is if you really think about what a stock price is, a stock price is simply everybody in the market's view of how well the company is going to do in the future. It's not a real thing. It's just about expectations of the future.
Brendan: Another Warren Buffett; in the short term, it's a popularity contest.
Martin: That's absolutely right, so in essence when you give somebody stock-based compensation...
If you're the CEO of a company, I'm on the board and I give you a stock option at the current market price, and say, "This is your incentive compensation, Brendan. You should make the most of this," what they're actually saying to you is not, "Make the company perform better." They're saying, "Raise expectations about future performance by those people out there called 'investors.'"
I would argue there are a lot easier ways to do that, especially in the short term, than actually work really hard to build better products and be more efficient and effective and a better company.
Brendan: Let's talk about those ways. How do you do it better? Do you look at a model like maybe Jeff Bezos at Amazon and say, "He's focused on the long term, that's what we need more of?"
Martin: Yes, I think so. I really think companies have to -- and Paul Polman at Unilever when he took over in January 2009, the Google guys who said when they went public, "We will never give quarterly guidance" -- I think you have to establish that early on, that you're interested in growing the company for the long run.
You can't have it both ways. I'm not as sympathetic to the CEOs who complain about the capital markets as some people are. The minute you wander down to Wall Street and say, "We just had a great blowout quarter. You should really all be excited and push our stock price up" -- you're now in bed with those same people.
Brendan: You can't have it both ways.
Martin: You do not have it both ways. I think the ones who just are really clear, Jeff Bezos, Paul Polman, the Google guys, and then stick with that for the long run are absolutely doing the best thing for their company because it enables them to actually invest in creating real performance.
As Warren Buffett would say, in due course the stock market does reflect underlying values. But boy, in the meantime there can be massive fluctuation.
Brendan: What's an example of executive compensation done the wrong way?
Martin: I really think the banks in the 2000s. They were highly stock-based in their compensation practices, and if you looked at the CEOs of the too-big-to-fail banks, those 14 banks, and ask what happened to them, lots of people say, "Oh, well, their incentives were aligned and they all suffered terrible downturns in their personal portfolio in 2008."
But if you look at the numbers, they made so much money in realized stock gains between 2000 and 2008 and still had so much left even after the crash, it's an example of complete disalignment.
There was massive, massive, massive destruction of shareholder value and they all came out with hundreds of millions of dollars of compensation, despite the performance of their banks. There just isn't alignment.
Brendan: Why not take on that extra risk lever up if I'm going to leave with a golden parachute and say, "See you later."
Martin: Absolutely. It's even probably more serious than that.
If you have stock-based compensation -- again, I've just hired you to be my CEO and I give you a stock grant and I tell you, "Every year, you're going to get half in stock and half in compensation, like everybody else."
It turns out if you really are bloody-minded about this and say, "I'm in this to make my compensation the highest possible," the smartest thing you could possibly do is immediately upon becoming CEO say, "I've looked at the books and it's so much worse than I've ever imagined. It's just horrible. I don't know what the previous guys were doing, but it's horrible. We're going to have to do a massive retrenchment and restructuring and everything."
Brendan: Bring all the expectations down.
Martin: Down, right, then let them stay there for a year. They're not going to fire you because they just hired you. You get your next big stock package January 1 of the next year. In the meantime, start working on a bunch of things that start to show up.
Brendan: Start blowing out earnings on low expectations.
Martin: You came in at, let's say $100 a share. You drive the stock down to $50 a share then you work it back up over a couple of years to $100 a share. Shareholders got what? Zippo. What did you get? Rich. Massively rich.
Stock-based compensation, even though we believe in our heart of hearts -- there's this deep, deep belief that it actually aligns the interests and gets you to do the right thing -- it does not. It is an incentive to create volatility in your stock, and it is an incentive to take huge advantage of the shareholders in order to make money.
Brendan: Should CEOs not get any stock-based compensation?
Martin: I think the world would work a lot better if they didn't. We have this now romantic attachment to stock-based compensation. If people feel that they have to use stock-based compensation, I think they have to do two things.
One is, in the case when I hired you, I'd say, "Brendan, this is your only grant of stock-based compensation you are ever going to get as CEO. It's a really big one, but we're not going to give you one annually."
And, "These are restricted. They're restricted until three years after you retire."
If that was the case, then you wouldn't try to drive things down to drive them back up because you're not going to get some more stock at a low value, and you won't try and time it right to the end and do all sorts of extravagant, crazy things at the end -- gigantic acquisitions, massive cost-cutting of all R&D and everything -- to get the stock as high as possible when you retire, because it's going to have to perform well for several years until you leave. That's what I would do.
Brendan: And maybe you would focus more on grooming a successor.
Martin: Oh, you sure would. You sure would.
Brendan: Waiting three years afterwards.
Martin: Yeah, because that person, you really depend on them. Again, back to P&G and A.G. Lafley, he went to the board and said, "You know all my stock-based compensation? I think you should make it vest in 10% increments in each year after I retire." He did that, not the board.
He said, "This would be better for P&G and P&G shareholders." That means he's going to leave a company in the best shape possible with the best management team there, because he doesn't cash out until that last 10% comes 10 years after he retired: 2019. That's the kind of thing you would want, but that was A.G. saying it to the board, not vice versa.
Brendan: The stock-based compensation system is pretty entrenched right now. Do you have any faith that it can change, going forward?
Martin: I guess I do. I see that large changes in these things are made on the basis of theories and ideas. This all came into being because of one article written in 1976 by Jensen and Meckling, who posited that we needed to create this alignment through stock-based compensation.
I think in due course people will just say, "You know what? This is bad theory." Mike Jensen says it's a bad theory, interestingly enough. He said, "It's been misinterpreted, and what's happening is not consistent with my article."
But these things tend to take awhile. There's such an infrastructure built up around it, including all the proxy voting services. They give advice to the pension funds that say, "You need to make sure there's big stock-based compensation," so the pension funds say, "OK, I guess I'll vote for more stock-based compensation rather than less."
You've got compensation consultants out there who say, "Oh, stock is a really important part of your compensation package." When you have all of that infrastructure around, it takes longer to break out of that.
Brendan: As an investor, from your perspective, you have an inside view of quite a few companies. What do you think investors should look for, from the outside, at companies that are maybe doing things the right way from a strategic point of view?
Martin: Boy, it's a really hard question. Lots of people say, "You're a strategy guy, Roger, so what's your investment advice?"
I say you have to be careful. There are two things that are completely different. One is the real operations of a company, and then there's the expectations surrounding those. I have no experience, no insight, no nothing, on evaluating the expectations.
I could say to the person, "Here's what I would do. If I wanted to understand whether that company was going to perform well over time I'd ask myself the question, 'Do they have a very clear Where to Play?' Can you tell from the outside that they want to play here and not there, and they're sticking to this?
"Then they have a How to Win. Here's an offer that they have to their customer base there. If you can see that, and you can see that clearly, that company has got a better likelihood of performing well over the long term."
Now, it may just be that everybody else looking at that says, "They're unbelievable. They're even better than you think they are, or better than reality," in which case buying that stock would be a bad idea.
I often point to Microsoft. Microsoft, I sometimes feel sorry for them. I probably shouldn't, but you know what their stock price has done for the last 10 years?
Brendan: Just about nothing.
Martin: Nothing. Nothing. During those 10 years, has Microsoft done badly? No. They've doubled in sales and tripled in profit. But nothing.
Why? It's because 10 years ago, even after the big dot-com crash, even after that, people had these huge expectations for how wonderful Microsoft was going to do. They've done wonderfully and everybody said, "Yeah, that's kind of what we thought."
Look at Apple now. At $700, everybody was saying, "This is the best company. They're doing so fantastically," but they were saying "They're going to keep on doing that forever," and it's $427 today. Is that because Apple's a bad company? Heck, no. It's one of the best companies on the planet.
That's where there's two skill sets, Brendan, that are completely different. One is running and understanding the real operations of a company, and then the other is understanding market sentiment.
The reason why Warren Buffett is worth whatever it is, around $50 billion, is he's one of the few guys that I know of in the world who has profound understanding of both. That's why he can do two things. He can take companies private and make lots of money on them, and invest with an unbelievable track record.
There aren't many people who can do that. There are either people who can invest and have a fantastic track record, or people who can really run companies fantastically, and the intersection is just a tiny, tiny, tiny little number.
Brendan: They're on Warren Buffett's free float from the insurance companies.
Martin: Right. Yes.
Brendan: Roger Martin, very interesting. Thanks again, good to see you.
Martin: My pleasure to be here.
