The carnage underway in the financial sector reminds me of one those near-mass-extinction events that seem to strike industries and markets from time to time. What can a company do to maximize its chances of survival at such times?
Most everyone will agree that a strategy based on diversification is the best way to reduce risks in a very complex system, especially one whose components are interconnected and undergoing rapid changes, thus causing the overall system to be intrinsically unpredictable and emergent.
Nowhere are the benefits of diversification more apparent than in biology. Biodiversity is one of the best indicators of the health of a biological system. The biodiversity in our planet today is the result of a few billion years of evolution. It is evolution's way of improving the chances that as many forms of life as possible will continue to survive and thrive in spite of drastic changes in their environments, including periodic mass extinction events. It is estimated that 99% of the species that ever lived are now extinct. Thankfully, we are still among the 1%.
In dealing with your personal finances, a particularly timely subject, financial analysts generally advise that a diversified portfolio is the only reasonable strategy for managing your long-term investments - that is, a mixture of stocks, mutual funds and bonds spread across different industries, countries and risk levels. Given the impossibility of predicting the financial performance of any one item in the portfolio, diversification is the only prudent strategy to follow, so that losses in one area are offset by gains in others.
But along with diversification comes complexity, whether in biology or financial portfolios. Managing a pure-play portfolio with a small number of investments is a lot simpler than managing a mix of investments to try to achieve a well balanced portfolio. But the risks are much higher. If your pure-play investment does poorly, your portfolio could be essentially wiped out.
This link between diversification and management complexity raises some key strategic questions for companies. How diversified does a company need to be in order to survive major technological, market and geopolitical changes? And how diversified can a company get before it is too complex to manage effectively?
A new company is typically started around a new idea -- that is, a specific product or service offered to a specific set of customers. In its first few years, it needs to remain sharply focused on getting its offerings to market. Many do not make it. A recent study from the US Bureau of Labor Statistics found that 66% of establishments were still operating two years after they started, while only 44% were operating after four years.
Once successfully established, many of those companies will now begin to look for opportunities to diversify and grow by developing new products and services, as well as going after new customers and markets. This is usually the time when the management of the company needs to transition from a single focus to managing multiple tasks at once.
The company now has products and services, customer relationships, employees, business partners and financial obligations - all of which need lots of operational attention. But, at the same time, it needs to formulate a strategy for its future offerings, customers and markets. Standing still is not an option, as competitors - startups as well as established companies - will all want a slice of its hard-fought market share.
This tension between diversification and complexity is particularly pronounced with large, global companies that are leaders in their field. They achieved their leadership position by successfully managing this delicate balance between operational excellence for the present, and sound strategy for the years ahead. But day-in and day-out, these companies are constantly facing the challenges of managing the kind of diversified, complex business that has enabled them to survive and grow, while making sure that the business does not become too complex to manage effectively. Let me illustrate some of these challenges by talking about the company I am most familiar with - IBM.
IBM started doing business almost one hundred years ago. By the time the computer industry was born in the 1950s, IBM was already a successful company selling tabulating machines around the world. IBM then became the dominant vendor in the nascent computer industry, a position it solidified over the next few decades with the introduction of the highly successful System/360 family of mainframe computers. By the mid 1980s IBM was the most profitable company in the Fortune 500, as well as at the top of the most admired companies lists.
You would expect that a company like the IBM of the mid ‘80s, selling the most successful products in the computer industry to clients around the world, would be resilient enough to ride out just about any changes in its environment. But, as we know, that was nearly not the case. IBM's business model was too hardware-centric and too focused on a single family of products - its mainframe family. The principle of survival of the fittest applies just as dispassionately to companies and markets as it does in biology. You are never too strong or too big to be wiped out, whether you are a dinosaur or a powerful, global corporation.
Mainframe profits and market share started to decline sharply in the late ‘80s and early ‘90s with the advent of powerful, inexpensive microprocessors, as well as the distributed client/server computing model based on relatively inexpensive personal computers and small servers. This was a kind of marketplace mass extinction event that wiped out many industry leaders across IT.
IBM was nearly one of them. Because of its reliance on hardware and mainframes for the bulk of its profits, IBM came very close to disappearing in the early ‘90s. Plans were under way to split the company into a series of individual units. In "Who Says Elephants Can't Dance?", Lou Gerstner wrote ". . . keeping IBM together was the first strategic decision, and I believe, the most important decision I ever made - not just at IBM, but in my entire business career."
But he also wrote, "Keep in mind that all of this - hardware, software, sales, services - was dedicated and tied to System/360. Despite the fact that IBM, then and now, was regarded as a complex company with thousands of products, I'd argue that, until the mid-1980s, IBM was a one-product company - a mainframe company - with an array of multibillion-dollar businesses attached to that single franchise."
So, while reinventing the mainframe, it was critical to make IBM a truly diversified company. In 2007 IBM's income had a very different distribution from what it was in those days that Gerstner wrote about: 40% software, 37% services, and 23% hardware and financing, with 43% of its revenues coming from the Americas, 36% from Europe, the Middle East and Africa, and 21% from the Asia Pacific region. There is little doubt that the IBM of today is a significantly more diversified and robust company than the IBM of 1993.
In this regard, I had a strong sense of deja vu when I joined Citigroup earlier this year as a strategic consultant in innovation and technology. Citi is one of the most diversified global banks in the world. It is organized into four major segments - consumer banking, cards, wealth management and institutional clients. It does business in more than 100 countries.
Since being named CEO in December of 2007, Vikram Pandit had been under pressure to split the company. Some analysts have claimed that each part of Citi could do better as a pure play, independent business than as part of a diversified, integrated global bank. Pandit has consistently responded that Citi's diversification across products and regions is a strong source of stability, especially in these times of rapid change in the financial industry.
There are considerably fewer critics of Citigroup's business model these days. In the last few months we have seen bank after bank embrace Citi's diversified model as a way of weathering the ongoing financial crisis. Pure play banks have been the most vulnerable to failure.
We don't know how the present financial crisis will be resolved, let alone how banking will evolve into the future. But we know that fundamental principles continue to apply. Whether talking about biology, investment portfolios or large companies, diversification is the best, perhaps the only strategy to reduce risks and increase stability in a very complex system.