Every Decision Is about Capital Allocation

If you took an introduction to economics course in college, you likely encountered Gregory Mankiw’s Principles of Economics.³ This popular textbook opens with ten principles of economics, and the first is this: people face trade-offs. We are always up against a limited supply, whether of money, time, or attention. This is true in our personal lives, and it’s true in our professional lives. We don’t get to binge-watch TV and get in an extra three hours of work in the evening. We can’t afford a vacation in Paris and in Hong Kong this year. You can’t give every division the budget it asks for. Every decision prioritizes one thing over other things.

But we usually don’t think of ourselves this way—as allocators of precious resources. Instead, we use tricks to make it less mentally draining to make difficult decisions and assign priorities. We form habits, we do what other people are doing, we give in to the loudest voices, and so on.

But flying on autopilot isn’t reliable or advisable if you want to make the best decisions. Have you ever had one of those aha moments when you realized you were making bad allocation decisions out of habit? Perhaps you used to mow the lawn every Sunday, grumpily sweating in the summer sun and giving up precious weekend hours, until one day it occurred to you that you could pay someone else to do it. Or maybe it was something else. But we all have moments when we think, “What on earth took me so long to make this change?”

It happens in business, too, and the realization is often too little, too late. Kodak is a great example. In the 1990s, Kodak recognized the imminent transition to digital technology; in fact, it invented the digital camera. But rather than refocus its strategy on the next big thing, Kodak tried to slow the progress of digital technology and maintain its dominance in film through aggressive advertising. When Kodak finally entered the digital market with its Easy Share product line, it was too late; digital was already on the path to commoditization. In 2012, Kodak filed for Chapter 11 bankruptcy.

These situations happen because our mental models prevent us from seeing the need for change and, even when we see it, from acting on it. IBM probably could not have shed its PC business—once a jewel in its portfolio, representing innovation and daring, the ability to rapidly innovate, and an exciting success over Apple—if Sam Palmisano had not just come into the CEO role with a mandate to focus on high-margin, high-growth businesses. With this new perspective, Palmisano was able to push through the controversial sale to Lenovo in order to reallocate IBM’s time, talent, and money to more-fruitful ground.

Companies Are the Biggest Capital Allocators

If asked to describe themselves, most leaders of organizations would likely say they’re business operators rather than capital allocators. So you might be surprised to learn that companies with multiple businesses allocate about $640 billion annually, even more than capital markets allocate.⁴

What do corporations do with that $640 billion? Probably the same thing they did last year. McKinsey found that the average correlation between one year’s allocation and the previous year’s was 0.92 (a correlation of 1 is a perfect match). For one-third of companies, the capital allocation was almost exactly the same as the previous year—a 0.99 correlation.⁵

It’s astounding. A lot can change in a year. Externally, your industry may see new entrants, new technologies, and new customer preferences. Internally, you learn about business model performance, the capabilities of new leaders, and the performance of new assets. But despite all that new information, asset allocation changes very little year to year.

If that sounds like a problem to you, you’re right. It makes little sense, given new information, to do the same old thing, but that’s what most of us do. The same McKinsey study found that the most active reallocators, regardless of sector, delivered returns to shareholders 30 percent higher than the least active reallocators. And CEOs who reallocated less actively in the first three years of their term were more likely than their active peers to lose their position in years four through six. It makes a compelling case.

Principle 3, Strategy: From Operator to Allocator

The third principle we teach is to move from operator to allocator. On the left side of the spectrum, the leadership team focuses on operating the business effectively but doesn’t actively use the lever of reallocation to shift time, talent, or capital to adapt the company’s strategy and business model in real time. These companies usually keep doing what they’ve been doing, with the goal of improving gradually over time. For example, an automaker whose leaders are operators will build increasingly better cars. In contrast, an automaker whose leaders are allocators—another word might be investors—might shift its business model from automaker to transportation facilitator over some years through strategic reallocation.

Note that companies still need good operators to run a business well. But those operators need to be focused on the right business model, and that’s why capital allocation is essential.

Acting like an allocator doesn’t necessarily mean that you will automatically be a network orchestrator, but you won’t be able to shift your asset allocation, and therefore your business model, without taking on an investor mentality. Further, maintaining an investment or allocation mindset will help you stay current, no matter where technology or business models go in the future.

Consider your own organization, and your leadership team, and determine where you fall on the spectrum from operator to allocator. Ponder the following questions and mark on the scale where your team falls from operator (1) to allocator (10).

• Does your organization react to annual budgeting as a chore to be completed, or as an opportunity to create a brilliant future?
• Do you begin the budgeting process with a draft of last year’s budget? How far do you move from it? Or do you instead use a zero-based budgeting process?
• What factors influence your team to be conservative on reallocation? Fear? Politics? Time constraints? Market pressure?
• Does your team have the capability, skills, and insights needed to keep up with market shifts and potential alternative investments?

As McKinsey’s research indicates, most companies fall on the left side of the spectrum, but you have the opportunity every day to actively reallocate by making new decisions.

What Do the Best Allocators Do?

From our experience working with leaders and organizations, we’ve observed some best practices that active allocators use to keep their capital allocation fresh. Here’s what we recommend.

SET ALLOCATION GOALS. We’re sure that your organization has many goals, and often specific and measurable ones. But do you have targets for capital allocation? Has your leadership team agreed that a certain percentage should be spent in high-growth, transformational areas? We recommend 10 to 20 percent to begin a business model transformation.

MAKE PRUNING A PART OF YOUR PROCESS. The hard part isn’t saying yes; it’s saying no. In any pool of assets, there are usually a few laggards or underperformers. Selling or closing these projects will clear space for more-valuable ones. Create guidelines that will help you commit to making difficult decisions, such as the goal of eliminating the bottom 10 percent of performers.

USE DIFFERENT ANCHORS. It’s easy and understandable to use last year’s budget as a starting point, but doing so anchors your teams to these numbers and makes active reallocation much more difficult. Courageous zero-based budgeting helps, but you can also use another approach to help shake up perspectives. For example, you could review what the budget would be if it were allocated based on percentage of revenue generated. Or on last year’s growth. Or on expected growth. Or on customer satisfaction. We don’t recommend making a budget based on any of these alone, but together these data points can help the team see perspectives other than last year’s numbers.

SET THE EXAMPLE. Keep in mind that as a leader you set the example for your peers and teams. You’re not going to hold hands down the chain and review each allocation, so you want to demonstrate the right behavior for everyone else. Use this as motivation when the going gets tough.

A Little Inspiration

Starbucks and Nike have tangible, non-digital core products: coffee and sneakers, respectively. They’re asset builders, and, based on our analysis, we would expect them to have price-to-revenue ratios in the 2× range. Instead, as of this writing, Nike was at 3.26, and Starbucks sat at 4.80. Those are strong numbers for thing-based companies.

The two companies’ higher market values are driven by their willingness to innovate and invest beyond their historical business models. Nike has partnered with Apple, developed hardware and software, and expanded its social media presence with the Nike+ ecosystem. Starbucks has developed a wildly popular app that is now a mobile payment system. It took guts to invest the time, talent, and technology to make these initiatives, but there is a reason these companies are market leaders.

They haven’t achieved the 8× multipliers of network orchestrators (yet), but that is because only a fraction of their businesses is in the more valuable business model. But that fraction affects the value and trajectory of the entire company. Moreover, it differentiates them in the market and has the potential to grow into new core businesses.

Just as in our personal financial portfolios, it’s smart to diversify as a buffer against risk. Of course, it’s risky to take your organization outside historical areas of expertise. It’s also risky, as Blockbuster and Kodak have eloquently proven, to remain in your historical areas of expertise when their value is diminishing.

Challenge yourself and your team to allocate with the same focus that you operate, and create a business with greater profit, growth, and value.