The real power of a well-crafted corporate theory becomes evident as companies go shopping for the assets to test their theories. Value creation through markets always comes down to prices paid, and a good corporate theory enables the acquirer to spot bargains that are uniquely discerned or uniquely available to it. Mittal Steel is a good example. From its origin in 1976 until 1989, Mittal Steel was a very small player in a global steel industry plagued by low profitability. Its operations consisted solely of a small mill in Indonesia. Mittal applied a then-new iron ore input technology (direct reduced iron, or DRI) to produce steel and afterward simply expanded with the economic growth of Indonesia.
Then in 1989, Mittal acquired a troubled steel operation owned by the government of Trinidad and Tobago—a mill that was operating at 25 percent capacity and losing $1 million per week. Mittal quickly and successfully turned around this business by transferring knowledge from Indonesia, deploying the DRI technology, and expanding sales. What followed was a succession of very significant acquisitions over the next fifteen years, primarily of assets in the former Soviet bloc. Each proved a gold mine.
Guiding this succession of acquisitions was a clear and simple corporate theory. To other steel firms, many of which were focused on improving their internal operations, the acquisition of state-owned steel operations in the former Soviet bloc was almost unthinkable. But Mittal believed it had the skills to create value from poorly understood and poorly managed state-owned steel operations in developing economies where demand for steel was predicted to escalate. Mittal’s theory possessed all three sights. Its foresight was an early recognition of the globalization of the steel industry, escalation in global demand, and the value of iron ore deposits. Its insight was recognizing the value of its DRI technology and its capability to turn around formerly state-owned enterprises. Its cross-sight was to recognize that most steel operations in place in emerging markets were uniquely complementary to Mittal’s capabilities. While other efficient steel mill operators focused on building and operating mini-mills dependent on scrap metal, Mittal’s iron ore–based DRI technology, its turnaround skills, and its willingness and competence in operating in emerging markets were unparalleled. To Mittal, these targeted assets were outright bargains.
By 2004, Mittal had emerged as the world’s largest and lowest-cost steel producer. Lakshmi Niwas Mittal, its key owner, became one of the world’s wealthiest individuals. Mittal’s success came from having a corporate theory that functioned as a remarkable treasure map, revealing assets uniquely valuable to it. Unfortunately, in 2006, Mittal pursued and acquired a very large and well run target—Arcelor, then the world’s largest steel producer by revenues and the second largest by tons shipped—paying a massive premium in the process. This move was quite inconsistent with its historic theory. The acquisition was also ill-timed: the financial crisis hit, followed by several years of falling steel prices as demand flattened and Chinese capacity came online. While all steel companies have struggled in this new era, Mittal’s deviation from its theory of buying troubled assets in emerging markets saddled it with large debt and the costs of integrating a massive asset inconsistent with its historic skills.
The mark of a well-crafted corporate theory is the uniqueness of the value-creating opportunities it reveals. This uniqueness may stem from the uniqueness of the foresight the theory reveals or from the uniqueness of the assets and capabilities a company already possesses. In this chapter, I’ll explain the market dynamics that make this uniqueness so necessary to value creation and discuss the pivotal role that a corporate theory plays in revealing this value.
It’s All about Auctions
Assets and capabilities are found in a bewildering array of places. Managers shop for skills and knowledge in labor markets. They shop for parts, services, and other inputs in supply markets. They shop for technology in patent and licensing markets. They solicit financial resources in financial markets. More broadly, they search for any critical complementary assets and resources in a range of markets, including the market for entire firms—the acquisitions and mergers market. This activity is staggering in scope, since the range of possible combinations to assemble through markets for people, technology, and assets is nearly infinite. The manager is essentially on a massive treasure hunt where the landscape, the value of hidden treasure, and the map to find it are all unique to a given firm.
The 2010 Nobel Prize in economics was awarded Peter Diamond, Dale Mortenson, and Christopher Pissarides for pioneering work on this type of problem. They argued that many of the markets in which managers participate are “matching markets.” For instance, in labor markets, employers place widely divergent value on the skill sets of particular individuals. Individual workers in turn place widely divergent value on working for different employers. An effective matching market optimally pairs employers to workers in a pattern that maximizes the total value generated.
Managers confront an array of highly complex matching markets as they search for value-creating bargains. These bargains reflect matches where buyers procure assets from sellers at market prices and yet still generate value. Exceptional financial returns in all settings are ultimately “rewards for scarcity”; in other words, value creation arising from finding a scarce and valuable match between your firm and available assets—a match that others cannot see or cannot access.1
This sounds obvious, but finding such matches is extremely difficult. Almost any business school lecture on M&A (a common way for firms to acquire assets and capabilities) begins with the empirical observation that the average corporate acquisition fails to deliver value for acquiring firms. More precisely, research suggests that on the day of an announced acquisition (or perhaps a few days before or after it), the capital market response is on average slightly negative—a response that suggests the market perceives on average slight overpayment.2
To understand why this happens, we need to step back and look at what all the resource markets have in common. Essentially, they are all variants of an auction process. Sellers submit assets for sale, while buyers submit purchase bids, and the auction process then matches the buyers to the sellers. Buyers create value when they obtain assets at a discount relative to their future, deployed use. Two impediments make discovering underpriced assets tremendously difficult. One, created by the uncertainty in calculating value, is known as “winner’s curse.” The other impediment is that firms can capture value in auctions only from the unique value they create when they acquire the target and not from any common value that other acquirers can also create. Because of the critical importance of these two impediments to value creation in corporate strategy, let’s look at the logic of each.
Most of us have at one time felt what’s called the winner’s curse, the dismaying realization, upon winning an auction, that no one else thinks the asset just acquired was worth the price you paid.3 You know this is true because if it were not, higher bids would have been placed.
The winner’s curse results from the simple fact that estimates of value in auctions are just that: estimates. As a consequence, those with the most wrong—or specifically those with the most upwardly wrong—estimates “win” auctions. The winners’ curse is pervasive in common value auctions—where the “true” value of an asset is identical for all bidders, but each bidder estimates this value with considerable error. Suppose five firms are competing for an acquisition target that is completely unrelated to their other assets. In this case, only the stand-alone assessments of value are relevant. But let’s assume that though their average estimate of value is accurate, the bids are randomly distributed around this average. In this case, the “successful” bidder—the firm with the highest (over)estimate of value—overpays by the difference between the overestimated value and the true value. Savvy bidders may seek to avoid the winner’s curse by shading their bids downward—submitting bids that are below their actual estimate of the value of the item. But unless all bidders are exceptionally disciplined and sufficiently self-aware so as to recognize the scope of their potential overvaluation, then winners overpay and the winner’s curse prevails.
What’s more, the severity of the winner’s curse is likely to increase with the number of bidders. The more bidders there are, the greater the likelihood that some will substantially overestimate the value of the item on auction. Consistent with this logic, empirical evidence suggests that as the number of bidders in an acquisition auction increases, the capital market’s response to an announced acquisition becomes more negative.4
What about synergies?
But, of course, in purchasing assets, firms seldom participate in common value auctions. Instead, bidders possess private values, which reflect their unique foresight and cross-sight into which assets are uniquely complementary to their core assets (as recognized by insight). Thus, an organization may place particular value on an asset that uniquely complements the firm’s own assets. Or, a firm’s unique theory may reveal value in a particular configuration of assets that others do not recognize. Under these circumstances, firms are able to provide differing bids, win auctions, and still retain value. By buying and selling assets in competitive markets while guided by unique corporate theories and uniquely complementary assets, they may continually discover value-creating targets at “bargain prices.”
However, under these circumstances, the path to value creation is narrower than might be expected. Consider the simple illustration of an auction for PlumCo, a small independent manufacturer of industrial products. The owners have determined it is time to sell. They retain an investment banker, who develops a sophisticated valuation model, which for purposes of illustration we’ll deem to be fully accurate in calculating the stand-alone value. Their model concludes that PlumCo’s stand-alone value is $14 million.
Of course, the investment banker and the owner are not very interested in this stand-alone value. They focus instead on the private values that various buyers may assign to to PlumCo as a target—values that reflect the respective buyers’ synergies. The investment banker markets PlumCo to companies that are particularly well matched—those with strong complementary assets and with the highest private values—and discovers five bidders with significant complementary assets: Alpha Industries, Beta Products, Gamma Systems, Delta Investors, and Epsilon Inc.
Alpha Industries examines PlumCo and recognizes that exceptional value could be gained by distributing its products through Alpha’s distribution channels. Alpha conducts its own sophisticated valuation and concludes that the present value of this enhanced performance is worth an additional $2 million, for a total value of $16 million. Beta Products assesses its own internal assets and sees a valuable distribution channel comparable to Alpha, but additionally recognizes valuable technology by which PlumCo’s products can be significantly enhanced. Beta performs its valuation and concludes that the combined value of these two synergies is worth an additional $3 million, or $17 million total. Gamma Systems assesses its complementary assets and recognizes that in addition to having assets similar to those possessed by Beta Products, it has marketing skills uniquely suited to PlumCo’s product portfolio. Sigma estimates the total value of these synergies at $4 million, for a total value of $18 million. Delta Investors turns out to have all of Sigma’s synergies, but also valuable R&D technology that it believes will enhance PlumCo’s product portfolio, and its estimates place the total value generated by these synergies at $6 million, for a total value of $20 million. Finally, Epsilon Inc., in addition to commanding the same synergies with PlumCo as Delta Investors, additionally possesses some idle production capacity that will lower PlumCo’s production costs. Epsilon estimates that the total value of its synergies is worth $7 million, for a total value of $21 million.
In an ensuing auction, Epsilon Inc. presumably obtains the target for a price above $20 million, but below $21 million. At any price below $20 million, Delta Investors will be willing to bid more, but at prices above $20 million, Delta drops out. What portion of the $7 million in synergies between Epsilon and PlumCo does Epsilon capture? At best, it retains somewhere between zero and $1 million. All of the remaining $6 million-plus in synergies—the value of all synergies that are non-unique—accrue to PlumCo’s shareholders.
The moral of the tale is that even in these “private value” auctions, where bidders’ valuations of the target reflect their unique theories and assets, the winning bidder captures at most the privately held unique value it possesses with the target (as illustrated in figure 2-1).
Of course, the example above is extremely simplified. In a real auction, the synergies that bidders possess with the target are not as nicely additive. Rather, each would-be acquirer has a unique composition of synergies. Some will have better distribution assets, others better technology, and others more valuable brands. However, the fundamental principle remains: the maximum value retained by the winning bidder is the difference between the value of that bidder’s synergies with the target and the synergy valuation of the bidder with the next-highest valuation. Again, the maximum appropriation by the buyer is the portion of synergies that are unique. The value of the remaining shared synergies flows to the target shareholders.
FIGURE 2-1
Asset auctions with synergies
What happens if each bidder also estimates the value of synergies with considerable error? Many firms are prone to substantially overbid for the real synergies that they possess, especially because confidence—the belief that they can pull off a difficult challenge or that they know their business better than others—is a key attribute of effective leaders. But confident leaders are prone to exaggerate the value they can generate with targets. Clearly, in these circumstances, discovering value-creating acquisitions is highly problematic.
So what was it that set Mittal’s apart? How did it, for so long, consistently avoid overpaying for new assets? The answer is simple. Mittal developed a corporate theory that revealed target assets with which it uniquely possessed synergies. Other companies did not have those synergies. Consequently, Mittal could participate in the auction markets, win assets in these auctions, and still appropriate tremendous value.
The Importance of Being Unique
Of course, many theories prove to be misguided and value-destroying. They reveal flawed foresight, skewed insight about existing assets, or cross-sight that overestimates synergies. In most cases, however, these faults stem from a single cause: the theory has not identified anything unique.
Consider the saga of General Mills as it aggressively pursued an array of acquisitions in the 1970s and 1980s. In the early 1970s, General Mills discarded its flour-milling assets and developed a new theory of value creation prompted in part by a senior faculty retreat entitled “Good to Great.” The result was a plan to diversify through acquisition into new businesses, businesses not only beyond packaged foods, but businesses with a bit more flair and excitement than Bisquick and Cheerios. The companies it acquired fell largely into five broad categories: toys, fashion, restaurants, catalog retailing, and packaged foods.
In making these acquisitions, General Mills appeared to have a reasonably clear theory of its path to value creation—one they believed would enable the purchase of assets at prices below their future value as deployed within General Mills. The implicit theory was that General Mills had a deep understanding of household consumers, including what direction their tastes and preferences were taking, and a broadly applicable skill in consumer goods marketing, which it could use to infuse value into a wide range of consumer goods businesses. Perhaps equally important, there was an idea that combining or collecting related assets under these five platforms was value-creating.
At first glance, this theory was not lacking in merit. General Mills was a reasonably good marketer, and the assets it had purchased indicated that it had a good sense of trending consumer tastes and preferences. In terms of cross-sight, it was possible to see some modest potential synergies between consumer goods and restaurants, or even between toys and packaged foods.
The trouble is, none of these sights was unique. They revealed neither internal uniqueness that General Mills could leverage nor unique value-creating opportunities it could pursue. General Mills did not have any skills or assets that competing acquirers did not, and other firms shared its views on where consumer tastes were heading. While some of their investments in toys (e.g., Kenner’s Star Wars products) or fashion (Izod and the emerging preppy look in the late 1970’s) proved clairvoyant, General Mills seemed as surprised by these successes as anyone.
Nor did General Mills have any unique complementarity to the assets it acquired. Other bidders for the acquired assets likely possessed equal if not greater knowledge, capabilities, or even physical assets with greater synergies with these targets. Toy firms, specialty catalog retailers, or even restaurant chains were arguably better positioned to give ongoing strategic guidance to fashion companies than executives in the food product industry.
Consequently, aggregate purchase prices paid by General Mills very likely exceeded the anticipated value of cash flows, which probably explains General Mills’ unimpressive stock price performance between 1974 and 1984, a period in which it significantly underperformed the S&P 500. The clear lesson is that buying assets at prices below their deployed value requires having a theory that reveals more than generic synergies. It requires a unique theory.
But to fully understand the challenges faced in creating value through acquisitions and the central role of uniqueness, we need to look at the process from the seller’s perspective.
The Virtues of Selling and the Challenges of Buying
When corporate theories are common—when they reveal only commonly held foresight and identify synergies easily accessed by other firms, then selling assets has clear advantages, while buying has a much more limited upside. Consider the events that played out in the US defense industry as the Cold War came to a close. In 1989, the Soviet-backed regimes in Hungary, East Germany, Bulgaria, Romania, and Czechoslovakia all fell. In November 1990, presidents George H. W. Bush and Mikhail Gorbachev announced the official end of the Cold War. Almost instantly, expectations regarding defense spending collapsed—the 1991 and 1992 US defense budgets declined 25 percent from 1990 levels. The market value for all defense contractors also collapsed as they confronted a very different strategic landscape—one in which organic sales growth afforded little opportunity for value creation. Suddenly, consolidation became the clear path to value creation (or at least the path to reducing further value erosion). However, this same theory was rather clear to every defense contractor and the key question was whether your theory was to buy or sell.
The value-creating benefits of selling were compelling. As noted above, in common value auctions, buyers have great difficulty creating any value and may substantially overbid, thereby generating a winners’ curse. In private value auctions, buyers retain only the unique value they can derive from the assets they purchase—that is, they capture at most the value of any unique synergies, while the value of the remaining or common synergies flows to the seller. Although there were certainly firms in the defense industry with differing assets and thus potentially unique synergies, there was also much commonality and overlap. Indeed, over the years, to encourage competition, the government explicitly supported multiple firms in areas such as missiles, aircraft, space systems, and defense electronics. Consequently, there were multiple bidders with potentially significant synergies with any given asset or acquisition on offer.
In 1989, William Anders became chairman and CEO of General Dynamics, which at the time was the second-largest US defense contractor. His contract included an incentive package that strongly rewarded share price appreciation. Along with others in the industry, he quickly saw the need for consolidation, but he was rather alone among the larger defense contractors in recognizing (or at least recognizing and acting upon) the fact that selling afforded much greater returns than buying. From late 1991 to late 1993, General Dynamics sold its data systems, small commercial aircraft (Cessna), missiles, electronics, military aircraft, and space systems divisions. For the most part, all of these sales were made to strategic buyers in the defense industry with similar assets, or in the case of data systems, to a large IT consulting firm. Consequently, General Dynamics was positioned as a seller to nearly fully capture the synergies buyers possessed, as these substantial synergies available to buyers were rather non-unique.
As a result of these strategic sales and other cost-cutting moves, between 1991 and 1993 General Dynamics shareholders received a 553 percent return, or $4.5 billion in additional value on a base of about $1 billion in 1991. Quite a remarkable return—and one largely based on simply capturing the non-unique synergies that bidders had with the General Dynamics assets.
I am not advocating that simply selling assets is the optimal path to sustained value creation for most corporations. After all, at some point a company will run out of assets to sell. And success with such a path was in some ways unique to the opportunity landscape that confronted defense contractors in 1991. However, this illustration does provide a cautionary tale about the challenges that firms face in asset procurement. As noted, firms pursuing acquisitions will distribute all non-unique synergies to acquirers. Therefore, it is essential that acquirers have a unique and ultimately accurate theory that enables them to identify underpriced assets—assets with which they possess unique complements. Without these, a firm has no path to value creation other than selling assets to others and essentially capturing the non-unique complementarity that others can gain from the assets it possesses. However, as the General Dynamics example shows, this path can be an enormously value-creating one. Managers should not wed themselves to growth as the sole path to value creation.
Lessons from Empirics
How difficult it is to find bargains while assembling assets and resources is easily highlighted by empirical work on acquisition outcomes. One metric for assessing whether a firm has discovered a “bargain” is to examine how capital markets respond to the announcement of an acquisition, which typically includes the purchase price. We can think of this market reaction as a crowdsourced assessment of the price paid relative to the value that investors anticipate will be created. A drop in share price signals that the market perceives overpayment, while a positive response essentially signals a bargain. Here is what we know from research of this type:5
• Averaged out, market reactions are not dramatic. Overall, the market’s reaction to announced acquisitions is slightly negative, suggesting that acquiring firms only slightly overpay for the value obtained. While this suggests the acquisition game is difficult, the result is not surprising. If the average market response were widely positive, this would only encourage more acquisitions, perhaps more marginal or questionable acquisitions that would lower returns. Similarly, a significantly negative response on average would strongly discourage acquisitions, and as acquisition behavior changed, returns would elevate.
• The variation is wide. Although the average market reaction is slightly negative, firms don’t pursue the “average acquisition.” Many acquisitions trigger a strongly positive market reaction, while others create a strongly negative one. While the average is slightly negative, the variance is tremendous. A recent study suggests that nearly 45 percent of firms saw their stock prices move more than 10 percent positively or negatively in response to an announced acquisition.6 The result merely highlights the critical role of a corporate theory in ensuring value creation through acquisitions.
• The lower the premium paid, the more positive the reaction. In the case of acquisitions of publicly traded firms, when the market’s reaction is positive, the average price premium paid was 30.7 percent. When the market’s reaction is negative, the average price premium paid was 38.4 percent.7 Higher premiums are likely to occur in common value auctions where bidders possess synergies with the target that many others bidders also possess. Lower premiums are likely to result from private value auctions where unique corporate theories reveal private value to the acquiring firm.
• Private information helps. Research also suggests that the market reacts more positively to the announcement of acquisitions when the targets are privately held firms (or divisions of public firms) rather than publicly traded firms.8 Because less information is available about privately held firms, there is more opportunity for foresighted and insightful corporate theories to identify valuable acquisitions that others cannot see or access. Scarce information means those with equally complementary assets are less likely to also spot them and bid away the opportunity for value creation.
• Firms pursuing more “unique” corporate strategies pay less for their acquisition targets. My own research with Lubomir Litov shows that having a unique corporate theory (and presumably the unique foresight or cross-sight that such a theory provides) enables firms to pay discounted prices for the assets that they purchase.9 We find that as firms move from the tenth to the ninetieth percentile in terms of our strategic uniqueness measure, the price declines from an average premium of 34 percent to an average premium of 20 percent. As discussed above, lower premiums increase the probability that the market will perceive an acquisition as value creating.
Investing with a Theory
Acquisitions are, of course, only one of the vehicles through which firms pursue theory-guided strategic investments. More broadly, firms pursue investments such as hiring talent, building factories, investing in R&D, and acquiring licenses to technology. Making effective choices from among a vast array of investment options is vital to sustaining value creation.
In most firms, the process of comparatively evaluating investments can feel very much like a beauty contest. The details may vary, but the basic process is this: Contestants from disparate groups and subunits of the firm put together investment ideas, forecast their value, and draft compelling proposals to lure the attention of those judging them. Proposals are then filtered and distilled down to a set that is passed up to the corporate level for review. What follows are often culminating events in which these groups or individuals parade in front of senior managers or the board to make their pitch. Senior management must then comparatively assess the merits of what amount to strategic experiments with often very uncertain outcomes.
To guide that assessment, decision makers are generally advised to apply a rather straightforward rule for evaluating investments of any type: say yes to projects that have a positive net present value (NPV). The math to calculate NPV is likely familiar: estimate a project’s future cash flows net of investment (both positive and negative), “discount” these cash flows to the present, using the current cost of accessing capital, and sum them. If the calculation is positive, invest. If not, pass. Given such a straightforward decision rule, why bother with a corporate theory?
Part of the answer is that although the math to calculate NPV is simple, generating the inputs for calculation—the forecasts of future returns is not. In fact, all such forecasts are necessarily business fiction, and there are no limits on imagination or on the cognitive and behavioral distortions that may fuel it. One large company I advised discovered from a post mortem analysis that its aggregate return on newly invested capital from 2008 to 2013, all of which were positive NPV, was significantly negative. Its investments had destroyed rather than created value.
This is not unusual. All too often, projections of future returns are upwardly biased. Partly this reflects proposers’ optimism about their capacity to create value from the investments they propose. While such confidence is perhaps an attribute essential to putting together a strong proposal in the first place, proposers may also have incentives to deliberately inflate projections: the battle for resources has personal implications—the success of a proposal shapes personal credibility, remuneration, and career prospects. In fact, competing proposals often lead to an arms race of exaggerated claims and projections. The only tempering effect is the hit that failure to deliver has on proposers’ future capacity to obtain funds. Therefore, given the necessarily fictional nature of proposals, those evaluating them must make a subjective decision about whose fiction they prefer—whose narrative of the future they find most compelling.
This is where a good corporate theory becomes particularly vital as a tool for selecting the right alternative hypotheses or fictions. As with acquisitions, theory-guided investment may enable the purchase, formation, and structuring of valuable activities and assets at discounted prices—for instance, hiring talent, designing activities and routines, and contracting for others—before rising demand for these investments escalates prices, as your foresighted corporate theory predicts it should. Theory-guided investment may also grant a firm a temporary advantage—for instance, a technological position that is difficult for others to quickly replicate, and leaves them to play a costly game of catch-up.
Monsanto’s investment history is illustrative. In 1983 Richard Mahoney took over as CEO of what is now the agricultural biotechnology giant. At the time Mahoney became CEO, Monsanto was a chemical company and, under his predecessor, had only dabbled in biotechnology. Mahoney had a theory that biotech was the future in both pharmaceuticals and agriculture, and he decided to transition into these sectors. The approach was to generate cash by selling most of the petrochemicals businesses and squeezing additional cash from other businesses, thereby enabling heavy investment in biotechnology and industries that could utilize it. Mahoney’s vision was a “life sciences” company that could explore the health and healing of humans, the genetic functioning of plants, and the composition of food. The theory projected foresight about the value of biotechnology, insight into the value (or lack thereof) of existing assets and capabilities, and articulated clear cross-sight concerning investments in talent, technology, and assets to access or acquire.
In his first year as CEO, Mahoney sold off Monsanto’s commodity chemical, paper, and polystyrene divisions, which accounted for about $4 billion in sales. Between 1985 and 1990, he sold off an additional eighteen business units and made several acquisitions, most notably a pharmaceutical firm, the Searle Corporation, which included Nutrasweet. Monsanto then invested heavily in specialty chemicals, agricultural products, pharmaceuticals, and biotechnology. Central to investment in these latter three businesses was the formation of a central lab focused on biotechnology and the hiring of an army of post-docs charged with doing research in areas such as the genetic structure of plants, the molecular science of taste, and the functioning of the stomach. While the broad vision of a life sciences company was composed centrally, the specific projects and investment paths were locally proposed and reviewed for their consistency with this theory.
In other words, it wasn’t that Monsanto avoided the need for a beauty contest, it was merely that the set of acceptable proposals was filtered by the theory. Accordingly, Monsanto began heavily investing in both pharma with the purchase of Searle and agricultural biotech R&D. By the mid-1980s, Monsanto had developed several important breakthroughs critical to modifying the genetic structure of plants. These tools were then used to develop products of enormous value to farmers, such as seeds that produced plants resistant to the herbicide glyphosate (or Roundup) or plants that were resistant to destructive insects. Both technologies dramatically reshaped the economics of farming and reduced the need for environmentally unfriendly herbicides and insecticides.
Although this unique theory of heavily investing in biotech, particularly agricultural biotech, was controversial at the time and actively resisted by many analysts (and environmentalists), Mahoney’s investment decisions were remarkably foresighted. Monsanto’s investments in pharmaceuticals and the purchase of Searle paid off quickly. In 1993, Searle filed patents for the first selective COX-2 inhibitor that became the blockbuster drug Celebrex (the drug that prompted Pharmacia to purchase Monsanto in 1999). Recognition of the agricultural biotech investments took longer. Despite the development of both Roundup-ready corn and soy, Mahoney’s large investment in agricultural biotechnology was initially seen as a waste of money. But fifteen years later, these initial large investments in ag biotech and those that followed had generated enormous value for investors. Of course, competitors like DuPont and Ciba-Geigy eventually recognized ag biotech’s potential, but by that point Monsanto’s technological lead was formidable. Competitors were left to play a very costly game of catch-up, and none have competed particularly well.
One of the real advantages of a corporate theory is its capacity to help senior managers overcome their own inherent biases in evaluating investments. Senior managers are all too often inclined toward divvying resources up more evenly than is optimal or simply carrying last year’s investment pattern forward. Alternatively, they may go entirely hands off and allow business units to retain and invest whatever excess cash they generate. Or, they may adopt a simplifying, but rather ill-conceived portfolio model that preclassifies businesses into investment categories that shapes the types of investments that will be considered by each. All of these are a poor substitute for the critical task of composing a corporate theory and then evaluating the merits of the strategic experiments that it reveals.
Well-crafted theories help managers identify unique, underpriced opportunities for creating value through investment, pinpointing which combination of new and existing assets will create value not yet built into the share price. As illustrated by the case of Monsanto and many other companies, managers must be prepared to stick with their theories until performance proves or disproves the accuracy of their theories and their ability to implement them. Following a theory can also reduce, though it may not eliminate, many of the cognitive and behavioral distortions that plague conventional investment processes. Finally, patterns of investment are a key vehicle through which theories are tested, and through which investors evaluate these theories for their own portfolios.
LESSONS LEARNED
Whether you are acquiring whole corporations or specific assets—or even hiring people—in order to create value, you need to acquire these assets at prices that are less than the value you can create with them. A well-thought-out corporate theory makes spotting such bargains more likely.
The capacity to spot bargains comes from one of two sources. Either cross-sight and foresight reveal complementarity among assets that others cannot see, or insight reveals complements to available assets that you uniquely possess. Either path is entirely about uniqueness. Without this uniqueness in your corporate theory, other firms may well be better at implementing your theory than you are.
However, it is not enough to craft a well-sighted theory that reveals unique complementarities. As the difficulties experienced by Steve Jobs illustrate, the financial markets may not be convinced by a firm’s theory, which means that it may never get the chance to test its theory. As we will see in chapter 3, this problem arises precisely because the value in your theory’s three unique sights are not obvious or easy to verify, and financial markets are almost structurally conditioned to discount them. Overcoming this problem to successfully sell the theory to investors is the next challenge facing the corporate theory builder.
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