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INSIDE TRACK: Exploding the built-to-last business model: CORPORATE PERFORMANCE: A new book suggests that to outperform the market in the long term, companies should buy and sell businesses rather than seek to control them writes Michael Skapinker:

Financial Times, Apr 12, 2001
By MICHAEL SKAPINKER

Run your finger down a listof large US companies. In 25 years, only one in three will still exist. And even the survivors will underperform the stock market. The longer companies survive, the worse their shares perform, according to a new book by two veteran McKinsey consultants.

After Tom Peters and Robert Waterman wrote their best-selling In Search of Excellence in the 1980s, business magazines had great fun reporting how many of their corporate paragons subsequently went off the rails.

"As soon as any company had been praised in the popular management literature as excellent or somehow super-durable, it began to deteriorate. Searching for excellent companies was like trying to catch light beams," say Richard Foster and Sarah Kaplan in their book, Creative Destruction.

But it is not the legacy of In Search of Excellence that this book seeks to shred. The authors' real target is hinted at in the first part of their book's subtitle: Why companies that are built to last underperform the market. This is an unmistakable reference to Built to Last, by James Collins and Jerry Porras. One of the most influential business books of the 1990s, Built to Last analysed the performance of 18 admired and venerable companies, including General Electric, Hewlett-Packard, Johnson & Johnson and 3M and claimed that they outperformed the stock market.

There are two odd things about Foster and Kaplan's apparent dig. The first is that Built to Last does not rate a mention in their book. It is not even listed in the bibliography. The second is that Mr Foster says he has nothing but admiration for Built to Last. "It is an absolute classic," he says. "It should be on everybody's shelf and mind."

In spite of this professed admiration, Foster and Kaplan set about destroying the premise on which Built to Last was based. Built to Last said their 18 admired companies vastly outperformed the stock market between 1926 and 1990. The companies did so by concentrating on a higher purpose than making money: preserving human life, in the case of Merck, or never killing a new idea, in the case of 3M.

There is just one flaw in Built to Last, Mr Foster says: there are not 18 companies that have consistently outperformed the stock market. There is only one that has done so: General Electric. Several others cited by Built to Last have stumbled since the book was published in 1994. Others look like consistent outperformers, he says, because they did so well in their earliest years and have not done so since.

There are only two types of company that outperform the market for some time, Mr Foster says: new companies and companies in new industries. But even they eventually slide into stock market mediocrity.

In reaching their conclusions, Foster and Kaplan looked at a far bigger group of companies than Built to Last. They built a database of 1,008 US companies in 15 industries and looked at their performance between 1962 and 1998. No company outperformed the stock market over this period, although General Electric, which was not included in the 1,008 companies, did.

Which book is right - Creative Destruction or Built to Last? Can outstanding companies outperform the market, or not? The two books are not comparing like with like. Creative Destruction examines a wide range of companies. Built to Last looked at a more selective group. The two books also compare different periods. Built to Last looks at companies' stock market performance over 64 years; Creative Destruction over 36 years. Mr Porras also rejects Mr Foster's assertion that the Built to Last companies' performance looks so good because they did so well in their earliest years. Some of his 18 outstanding companies did poorly in their early years, he says.

Does it matter which book is right? Both look at companies over very long periods - far longer than even the most patient investor is likely to stick with any particular stock. Both also make it clear that outperforming the market is extremely difficult.

But Creative Destruction's remedies for underperforming companies seem riskier than those of Built to Last. The authors of Built to Last say companies need to have a worthwhile mission. If they stick to their overriding purpose, profits and share price performance will follow. This has the advantage that even if the shares do under- perform the market, employees and society will probably still benefit.

It is not clear that the same benign consequences would flow from Creative Destruction's prescriptions. What its authors recommend is that, to match the stock market's performance, companies need to start behaving like the market. The stock market has no sentiment or loyalty. When companies no longer perform, their shares fall. When companies with new ideas and better performance emerge, the market rewards them.

Companies need to do the same. Rather than being controllers of businesses, they need to become traders in them. Like private equity firms, they should buy or launch businesses with the explicit intention of selling them.

Private equity firms manage to avoid what Foster and Kaplan call "cultural lock-in", which afflicts most companies as they age. Like people, companies become set in their ways and less alert to competitive dangers.

Which companies behave like private equity firms? GE does, the authors say. Within four years of taking over as chief executive, Jack Welch sold 117 businesses. In 1998 alone, he made 108 acquisitions.

But the most interesting section of this book is on Johnson & Johnson, a McKinsey client. J &J got out of businesses such as disposable nappies and into blood glucose monitoring and disposable contact lenses.

But J &J does more than just trade in companies. It has a values statement, its "Credo", which does not put stock market performance first. It puts mothers first, employees second, the community third and investors fourth - in the belief that if you look after the first three, the fourth will benefit too.

This sounds like the prescription in Built to Last and Foster and Kaplan are clearly enthusiastic about it. They point out that front-line employees are the best source of intelligence about what is happening at the periphery of their industries and companies need to make sure they talk to them.

But why should staff bother to gather ideas for an employer that has no long-term commitment to them and which plans, like a private equity firm, to sell their division as soon as it is no longer useful?

The real problem with Creative Destruction is that it never makes clear whether it thinks corporate longevity is a good thing and, if so, why. If no company other than GE can outperform the stock market, why not let the market do its business, allowing underperforming companies to be sold to those that can manage them better?

When this question is put to him, Mr Foster replies that it is distressing for chief executives and staff when their company is taken over. But then so is working for a company that constantly buys and sells its businesses, as Mr Foster advocates. What difference does it make to employees whether their division is sold at the behest of their chief executive or whether the entire company falls to a predator?

And are private equity firms really so good at what they do that chief executives of conventional companies should seek to emulate them? In a sustained economic downturn the private equity firms may not look as smart as they did in a bull market.

To order Creative Destruction: Why Companies That Are Built to Last Underperform the Market - and How to Successfully Transform Them, by Richard Foster and Sarah Kaplan, (rrp Dollars 27.50) for just Pounds 19.99 (+p&p), call the FT Bookshop on 020 8324 5511 or visit www.ftbookshop.com Copyright: The Financial Times Limited