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There is no new normal – business principles
Times of exuberance and despair pass. Times where capital or labour is scarce also pass. The constant through all of this is that individually, all humans seek to maximise their utility. For some it’s money, others it’s power, knowledge, connections, belonging, or spirituality. The individual utility that humans seek is very diverse (microeconomic imperatives).
However, the microeconomic imperative when aggregated boils down to creation, growth, security, and sustainability. And this gets reported as national wealth, production, income, and growth (macroeconomic perspective).
How is this relevant to business, and investment?
Business competes for labour and capital in a marketplace. But what’s important is understanding the supply and demand for each key commodity and the emotional cycles of exuberance or despair – which are the cycles of greed (bull markets) or fear (bear markets), and then identifying the inflexion points.
Business and investment are inextricably intertwined, and investment and business imperatives are closely correlated. Unsurprisingly, this aligns with the micro and macroeconomics of maximisation of utility.
In the brave new world of triple bottom lines, social responsibility, SaaS (software as a service), innovation and science investing, and the power being exerted by the young, in both labour and consumer markets, increasing further still the ‘diversity’ of perceptions of utility – it is easy to get sucked into the belief that there is a new normal. When all that is changing, is that what we value as utility is getting re-weighted between utility now (microeconomic behaviour) or in the future (macroeconomic behaviour) and risk now, or in the future.
It is easy to succumb to customers and people’s current noise exerted in the marketplace. Business adapts and trades in the present, and if they don’t, customers and talent won’t engage, and their businesses become unsustainable. People and businesses adapt to the environment they live in today, but what they care about long term doesn’t change much. We all, of course, choose to say we care, and many do from the privileged position of being able to afford to care.
The cycles listed below, change the focus of investment and business from the mid and long term to the short term, and of course, without some constancy of purpose, vision, and focus, resources are wasted pursuing the current fad.
- Future risks and profits are the prerogatives of those with enough profit now.
- The economics of a future driven by undefinable fear is fundamentally a redistribution of resources now.
- The economics of future profits are driven by the hope-greed cycle and are the economics of creation and growth. Which is good, and sustainable is both a belief and political structure.
- The create-redistribute sentiment is just another cycle of collective human beliefs and behaviour. We are currently in a fear-redistribute cycle like none we have seen before. It will pass, it always does, eventually. In the meantime, business adapts but don’t mistake that for ‘adopts’.
Warning signs of cycle change and when most waste occurs
You can tell when a long cycle is changing because jargon is thrown at you. Someone says this business or business model is special and defies traditional thought processes – this is when you know that you are being spun a line. But these storylines change perceptions in some and create short term opportunities and sometimes bubbles before the cycles change. The acceleration to the top and bottom is fastest near its end.
If there are enough out there buying the storyline, it surely will result in the mispricing of one asset class over another. But this article is not intended to be about macro or microeconomics, investment theories or approaches. I intended it to be a simple article on business principles unclouded by the adaption process to cyclical changes.
Fundamental goals of the business, unchanged since cavemen accumulated food for winter
Businesses and investors seek sustainable returns on their investments. This is the prime focus of all collective activity. For simplicity, I will focus this analysis just on money and economic profits. It is more topical anyway because, without profits, you don’t have the resources to think about slavery, the planet, or poverty, as you are seeking to avoid your own the latter.
There are two key elements within the return. The first is simple, earn a dollar, spend less (i.e. free cash flow). The second is growth in free cash flow over time. The value of the business to its owners is the sustainably of each. Sustainable growth has a higher value than existing cash flow due to compounding. Historic cash flows can be measured, and the risks attached to their sustainably can be identified easily and mitigated. It is also more predictable, therefore rated as having lower risk and absent exceptionally high growth rates a higher value than growth.
In understanding your business, your first question should be, “Is most of its value in its existing cash flow, or is most of its value in its growth?” Understanding this to maximise value will drive your strategy.
Risk to each
The efficient frontier and the law of diminishing returns impact both your ability to optimise cash flow and growth. There is a point when you can’t grow anymore, nor can you extract more cash from your existing business.
The larger the scale of your business, the more opportunity you have to improve cash flow. The larger your addressable market, the longer you have before diminishing growth emerges.
Improving cash flow
The lever is this: increase prices. This is only achievable if you have market power or a unique product in high demand. Simply put, demand exceeds supply. Key questions for your business:
- What is your product or service’s unique selling proposition?
- What is its value to a customer?
- What is the pain point you are solving?
- What is your competition? If you believe you have not got competition you are probably wrong, so think about it some more.
Screw your suppliers
Reduce your buy-in costs – i.e., force price reductions on your suppliers, or other more favourable terms. Again, you can only do this if you have market power. Do your suppliers deal with you because they must? You normally only get away with this if you have scale. Have a look at the Woolworths and Foodstuffs procurement models – an example of this taken to extremes. The efficient frontier of this approach is a market or regulator backlash, or supply chain collapse.
Reduce your cost of delivery
This either makes people work harder for less or deploys better systems and processes. You must understand how you deliver stuff to systemise all the basics so that your labour is deployed where it matters – at the high value and margin edge of customer engagement.
The 80/20 rule
80% of your profit will come from 20% of your customers or products. Likewise, 80% of your aggravation will come from 20% of your customers and products. You may have heard the line in retail, ‘reduce your SKU (stock units) to increase profit and reduce inventory lock up.’ Profit and free cash flow improvement can come from reducing your customer numbers. Do you understand your profit by service and customer?
The first step is to understand the size of your market. Usually described as your ‘addressable market’.
The second step is to understand how far you have penetrated that market. The market is divided into a perfect bell curve, divided into simple standard deviations from the mean. The first minor segment and the easiest to sell, are innovators, then the early adopters, then the early majority. By the time you are selling to the late majority, you are in a well-established marketplace. The law of diminishing returns from growth will cut in at this stage as the cost of acquiring growth will rise.
The third thing to understand is the interplay between a transactional business model and a relationship business model. All businesses have both in play. What you need to get a handle on, is which is dominant in your business and why? Often the two models compete. Maximising transactional value can damage relationship value.
The fourth step is to understand the lifetime value of a relationship relative to the cost of acquiring that relationship. It is a good clue to the economics of growth and a lead indicator of where you are in the penetration of your addressable market.
An accepted measure of this is customer churn, which drives the lifetime value. The cost of acquisition, however, is often fudged. Most choose to ignore product and feature costs in an existing business, and consequentially product activity is rarely economically tested. In growth businesses, the moving bits are cost to service, research and development, new products or services, and marketing and selling costs.
Over time, the costs associated with marketing and brand, rise. Whereas development and research, (product lead marketing activity), decline. Understanding the components is important to manage capital efficiency and ensure growth is profitable.
To summarise, growth is about increasing your margin on your service, increasing your customer numbers, not losing them, and getting repeat business.
As the business grows, its focus changes from an emphasis on transactional value creation to relationship lead growth. This creates the option of projecting your brand from one declining market into another that is growing. Baked beans are a product and Watties is a brand – when everyone is bloated on baked beans, make spaghetti. Then when multiple products from the one brand source have wowed the customer, introduce them to frozen veg and canned fruit, etc. Taken to extremes, this is Nestlé. The objective of such expenditure is to overcome the law of diminishing returns as it applies to growth, by making your addressable market infinite.
Beware the marketing and brand spend on this sort of activity as most cannot achieve this objective. And without the support of great people and customer-centric culture, the expenditure will be wasted. Hence the emphasis on growing people and culture early. It is not that most employers care, most only care because it is essential for sustainable growth.
Such businesses can get to extreme volumes on skinny margins. Eventually, however, the 80/20 rule will surely cut in. Growth in revenue without a line of sight to return will send you broke faster than anything else. Margin strength is the best measure of resilience and sustainably.
2022 the year of adjustment seems to be coming to a pass
So, as we head into difficult times, ‘a year of adjustment’, financial data and operational data, is more important than ever. Cash or access to it is essential. Understanding your business and being very clear on what your strategy to provide a return is and how is fundamental.
So, final thoughts
Focus, know your numbers, never run cash low, and be clear on your strategy to achieve more back from your activities than the cost of initiating them. Return on investment and internal rate of return are the age-old normal.
Old fashioned and basic, everyone parts with a dollar to get it back, plus some.
There is no new normal.