The strategic yardstick you can’t afford to ignore

StrategicYardstickHere is an excerpt from an article by Chris Bradley, Angus Dawson, and Sven Smit for the McKinsey Quarterly, published by McKinsey & Company. In it, they discuss a systematic scan of the economic-profit performance of nearly 3,000 global companies that yields fresh insight about where and how to compete.

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At first blush, “beating the market” might sound like an expression better suited to investing or financial management than to business strategy. When you think about it, though, overcoming the profit-depleting effects of market forces is the essence of good strategy—what separates winners from losers, headline makers from also-rans.1 A focus on the presence, absence, or possibility of market-beating value creation should therefore help transform any discussion of strategy from something vague and conceptual into something specific and concrete.

While there are many indicators of market-beating strategies, in our experience economic profit (EP)—what’s left over after subtracting the cost of capital from net operating profit—is highly revealing. Using this lens, individual companies can take a hard-boiled look at the effectiveness of their strategies. Recently, we undertook a large-scale analysis of economic profit for nearly 3,000 large nonfinancial companies in McKinsey’s proprietary corporate-performance database.2 That effort enabled us to test some deeply held truths and distill generalizable lessons about what it takes to win consistently.

For example, we saw that the corporate world, like the world beyond it, has a relatively small number of elites and that, just as society grapples with the contemporary challenge of limited social mobility, many companies seem stuck in their strategic “class.” Escaping the gravity of the corporate middle class, indeed, requires businesses to expand or reinvent themselves unusually rapidly, often in the context of an industry whose overall performance is improving.

This article focuses on eight analyses emerging from our economic-profit exercise.

Strategy is rife with inequality

Economic profit is distributed in a far from democratic way (Exhibit 1). The 60 percent of companies in the middle three quintiles generate a little over $29 billion in economic profit, or around $17 million each—only 10 percent of the total pie. This share is dwarfed by the $677 billion generated in the top quintile, where each company creates almost 70 times more economic profit than do companies in the middle three, and by the nearly $411 billion destroyed in the bottom quintile.

For companies in the majority group, at least, market forces appear to be a very powerful constraint to creating value.

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So, what are the implications for CEOs and strategists?

o If you’re in the elite, “use it or lose it.” You have a privileged ability to mobilize capital. Really know the formula that got you there and vigilantly watch for signs of change. You can’t rest on your laurels, as the odds are almost 50–50 that you will slide down into the middle class—or lower.

o If you’re in the middle, you mostly face a battle of inches. A fortunate few companies will ride a favorable industry trend. But for the most part, it will take substantial strategic or operational shifts to escape the gravity of market forces. The odds are against you, which elevates the importance of looking at strategy with a high degree of rigor.

o If you’re at the bottom, growth without better performance will be the equivalent of throwing good money after bad. You will probably need a new trend to get out of the basement, but in the meantime focus on improving ROIC, which often requires improving asset turns.

Our research offers a yardstick on the empirical reality of strategy and can help create better rules of thumb for considering and assessing it. Individual companies should start by measuring whether they beat the market and by digging into the timeless strategic question of why they make money.

Coauthor Chris Bradley narrates a slideshow of this article’s exhibits in “Are you beating the market?”

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To read the complete article, please click here.

Chris Bradley is a principal in McKinsey’s Sydney office, where Angus Dawson is a director; Sven Smit is a director in the Amsterdam office.

The authors would like to acknowledge the contributions of Alex Harper, Taichi Hoshino, Bin Jiang, Pia Mortensen, and the team at the McKinsey Strategy and Trends Analytics Centre (STAC) to the development of this article.

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