Understanding: The competitor with the greatest accurate information of both self and adversaries has a tremendous advantage over rivals because he is able to anticipate events and exploit the weaknesses of rivals while denying those same rivals an opportunity to exploit its own weaknesses. [1]
In The Big Short: Inside the Doomsday Machine, the author Michael Lewis relates how Steve Eisman, an analyst at Oppenheimer & Co. and later a Front Point Partners hedge funds manager, realized mortgage lenders were rapidly dropping their lending standards for subprime loans by analyzing a database sold by Moody’s that offered a general picture of the pools of loans underlying individual mortgage bonds. The database revealed the “manufactured housing” market [2] was experiencing unusually high pre-payment rates. One possible explanation for the high pre-payment rates was owners were refinancing their loans to gain a better interest rate. However, Eisman thought the high pre-payment rates were unusual because owners can not normally refinance because the value of a mobile home rapidly drops in value the moment they leave the store (like cars). The more likely explanation for the high pre-payment rates was that the buyers were defaulting on their loans at high rates and the lenders were receiving a fraction of the original loans when they repossessed the mobile homes.
Subprime lenders were maintaining their strong earnings by rapidly lowering lending standards to keep the flow of mortgages to Wall Street; since they would not be left “holding the bag” when the loans defaulted, they had every incentive to continue lending and passing the risk onto Wall Street’s clueless investors. Even worse, the rating agencies (e.g., Standard & Poors) were rating Mortgage-Backed Securities (MBSs) exclusively backed by subprime loans as AAA even though the underlying loans were increasingly given to borrowers with deteriorating ability to meet the terms of the loans. Steve Eisman later used his superior knowledge about the true state of the lending market to make spectacularly profitable multi-billion dollar bets against MBSs using Credit Default Swaps (CDSs). This illustrates the value of understanding.
Preparation: The competitor with the best and most thorough preparation has at least a two-fold advantage over rivals: superior analysis and speed. First, the more time you have to think about how to react to an event, the more likely the selected response will be better than that of rivals who must scramble at the last minute. [3] Second, since you have thought about and chosen the response ahead of time, when the event occurs, you can immediately react versus rivals who are paralyzed while a decision is made on how to react.
Bayerische Motoren Werke AG is a German automotive manufacturer of performance and luxury vehicles better known by its initials BMW than its full name. It is a global automotive company that competes successfully against much bigger rivals. During the Great Recession that began in December 2007, BMW managed to remain profitable even after demand in the automotive market collapsed and many of its much bigger rivals lost money. In the September 27-October 3 2010 issue, Bloomberg Businessweek reported how BMW managed such a feat. During a routine review of U.S. operations, CEO Norbert Reithofer met for lunch with the company’s top American car dealers to discuss the automotive company’s 2007 thus far record performance. The financial crises, which would begin in earnest after the sudden collapse of the investment bank Lehman Brothers on 15 September 2008, was a little more than a year in the future. Although woes in the housing market were roiling the economy, there was still widespread belief the problem would remain contained and might even quickly resolve itself. [4] During lunch, the conversation was positive given that year’s to-date performance but the Americans voiced serious concern the situation in housing could damage the wider credit markets and damage demand for luxury vehicles like those sold by BMW. Herr Reithofer could have ignored such concerns but instead choose a different path; upon returning to München he began preparing a crises response plan to be activated if the problems in housing spilled over into the wider credit markets and demand for vehicles stalled. As the economy deteriorated, U.S. automotive sales declined. In 2008, sales fell by 11% but the real crises became apparent in 2009 when sales declined a further 20% (figure 2). [5]
BMW’s preparation helped the company quickly respond after the collapse of Lehman Brothers by sharply reducing production to avoid a sudden buildup of inventory that would tie up cash and depress prices for its vehicles. BMW reduced its workforce by 11,000 workers through attrition and buyouts, and reduced hours for another 25,000 but did not need to resort to traumatic layoffs. As figure 3 illustrates, Herr Reithofer’s preparation succeeded in maintaining the company profitable during an unexpected collapse in U.S. demand. Much larger rivals such as Toyota and Ford experienced large losses in 2008 whereas BMW managed to earn a small profit. [6] This illustrates the value of preparation.
Flexibility: Strategy should be like water, which itself is formless but yet it can take any form. [7] Thus, although the basis of good strategy is understanding and preparation, since perfect knowledge is impossible and the future unknowable, flexibility is absolutely critical because the competitor that intelligently adjusts his response to incorporate new information about an event will be more likely to have the superior response versus rivals who slavishly apply a prepared response that may not fit well with the true facts of the event.
Leadership: Embedding within an organization the proper way of strategy requires constant vigilance and the active support of the leadership, who is responsible for removing obstacles and placing the right people at the right time in the right place with the needed tools to achieve success. Therefore, the competitor with the superior leadership, where superiority is defined by never ceasing encouragement to 1) seek an understanding of self, adversaries, and the environment; 2) calmly, carefully and constantly prepare ahead of time for all possible situations, and 3) maintain a flexible posture that avoids dogmatic application of preconceived beliefs not supported by the true situation, will triumph over rivals that lack such leadership.
Notes
[1] From The Art of War by Sun Tzu (544 BCE - 496 BCE): Hence the saying: If you know the enemy and know yourself, you need not fear the result of a hundred battles. If you know yourself but not the enemy, for every victory gained you will also suffer a defeat. If you know neither the enemy nor yourself, you will succumb in every battle.
[2] “It sounds better than ‘mobile homes.’” is one memorably quote from Lewis’ book.
[3] From the Hagakure by the samurai Yamamoto Tsunetomo (1659 - 1719): Among the maxims on Lord Naoshige's wall there was this one: “Matters of great concern should be treated lightly.” Master lttei commented, “Matters of small concern should be treated seriously.” Among one’s affairs there should not be more than two or three matters of what one could call great concern. If these are deliberated upon during ordinary times, they can be understood. Thinking about things previously and then handling them lightly when the time comes is what this is all about. To face an event anew solve it lightly is difficult if you are not resolved beforehand, and there will always be uncertainty in hitting your mark. However, if the foundation is laid previously, you can think of the saying, “Matters of great concern should be treated lightly,” as your own basis for action.
[4] On 11 September 2007 the influential stock market blog Seeking Alpha had one contributor (Alex Markels) write the following : “Yet for all the panic the credit crunch has caused, most housing experts aren't convinced that the current misery in the financial markets will lead to the sort of vicious economic cycle that resulted in the last big housing downturn in the early 1990s. Back then, prices in some areas fell by 20 percent and more in real terms before bottoming out. Economists point to continued strong employment, global economic growth, and a financial system far more sturdy than when the federal government had to bail out hundreds of savings and loans.”
[5] U.S. Bureau of Economic Analysis Auto and Truck Seasonal Adjustment (www.bea.gov/national/xls/gap_hist.xls)
[6] Data: Bloomberg Businessweek (net income) and Yahoo! Finance (currency conversion); currency conversion factor was closing price recorded prior to the market closing for New Years Eve.
[7] I believe this idea sounds more natural in Japanese: 水は形がないが全ての形になる事が出来る though my Japanese wife has commented this is not proper Japanese as it implies the water makes the decision itself but that precisely captures my thinking because the individual pouring the water into a container has no control over the shape of the water. The water adapts itself to the shape of the container per its inherently flexible nature; that is the essence of good strategy.
