Capital Punishment

Here is this month’s piece from Brand Velocity, an Atlanta-based consulting firm that is putting Peter Drucker’s ideas into practice at major corporations.

One of Peter Drucker’s most enduring concepts is the critical need for companies to define a “theory of the business”—basic assumptions about mission, markets, technology and core competencies.

The trouble is that even a good theory doesn’t last forever. “What underlies the malaise of so many large and powerful companies,” Drucker noted in his seminal 1994 Harvard Business Review article on the topic, “is that their theory of the business no longer works.”

It is with this in mind that my BV colleagues and I have been issuing a firm warning: A fundamental assumption that corporate executives have relied on for over 40 years is about to change radically.

Since the mid-1970s, companies have built strategies, invested money and shaped their operating models based on a stable or declining cost of capital. And it has worked. More than 65% of the gain in value of the S&P 500 since 1982 has been driven by the declining cost of capital—not inflation, not increased profits.

But suddenly, a broad range of global factors are poised to drive up the cost of capital significantly:

• Savings rates in developed economies are far less than the demand for replacement and growth capital.
• Savings rates in the developing world, which have supported much of the need for cheap capital, are declining while the demand for capital in these countries is rising rapidly.
• Governments in the developed world have massively increased their debt, with little or no real growth in GDP to support it.

In short, both debt and equity costs of capital are likely to rise soon as companies compete with each other for growth and replacement capital, as well as with governments that must refinance their deficit spending.

Yet few companies have adjusted their “theory of the business” to address this new operating environment. The old paradigm of aggressively investing low-cost capital in assets or acquisitions to quickly grow earnings is likely to deliver increasingly disappointing—or even negative—results.

Indeed, companies must shift their focus from income-statement-based strategies to investment-return strategies. Return of capital, calculated correctly, will be the critical driver of value going forward.

In addition, companies must:

• Target investments in high-capital-return business units.
• Strategically redeploy new and replacement capital into areas important to customers and future innovation.
• Explicitly align risks to the key drivers of value and growth.
• Invest early in known and needed asset restructurings and upgrades.

Once again, Drucker got it right when he wrote that successful executives “accept that a theory’s obsolescence is a degenerative and, indeed, life-threatening disease. And they know and accept the surgeon’s time tested principal, the oldest principal of effective decision making: A degenerative disease will not be cured by procrastination. It requires decisive action.”

What actions will you take in this new world?

—Wally Buran