Good Strategy / Bad Strategy — Richard Rumelt on the Difference and Why It Matters

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Richard Rumelt - Good Strategy / Bad Strategy

The kernels of good strategy

I’m somewhat wary of non-biographical business books these days. For every educational gem like Bruce Greenwald’s Competition Demystified, you’ll find a charlatan who promises the secret to riches. My interest in Good Strategy / Bad Strategy by Richard Rumelt piqued when Mervyn King described it as “the best book on business strategy written in the last decade”. Given the high praise from the former governor of the Bank of England, I decided to check it out.

Good Strategy / Bad Strategy doesn’t disappoint. It serves as a helpful reminder of the elements and pitfalls of strategy-making. While much of it is common sense, there’s value in reviewing sound principles, and seeing it in practice through case studies. Rumelt also draws on topics in engineering and physics, encouraging readers to think about business in ‘systems’, which I found enlightening. This post will summarise the key lessons that I took from Rumelt’s work.

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Dog food and blue skies

Before we get to the elements of good strategy, it helps to first consider the common tropes of bad strategy. Bad strategy glosses over the details of a company’s problem. It’s “long on goals and short on policy or action”, disguising the company’s failure to choose and focus. On one extreme, we have what Rumelt calls a ‘dog’s dinner’ – A messy laundry list of unprioritized actions. And on the other end, we have ‘blue-sky’ strategies that companies fill with vague aspirations and actions. Neither approaches offer companies a coherent and actionable direction.

Bad strategies, according to Rumelt, tend to contain four elements: (1) fluffiness; (2) the failure to identify the company’s challenge; (3) conflating aspirational goals with strategy; and (4) objectives that are unactionable and/or fail to address specified challenges.

While all of this is obvious stuff, companies and consultancies often fail to avoid these traps. Rumelt reminds readers of Lehman Brothers’ CEO Richard Fuld and the company’s strategy in 2006: to “gain market share by growing faster than the rest of industry”. It’s a bad sign when the company’s strategy is self-referential.

“Strategy cannot be a useful concept if it is a synonym for success. Nor can it be a useful tool if it is confused with ambition, determination, inspirational leadership, and innovation… Bad strategy is more than just the absence of good strategy. Bad Strategy has a life and logic of its own, a false edifice built on mistaken foundations.”

Richard Rumelt, Good Strategy / Bad Strategy, 2011

New age thinking

New age thinkers like to specify mental fortitude as the only necessary and sufficient condition for success in business. It’s reflects our desire to simplify the narrative of good business. And it helps to sell books.

But it’s a “radical distortion of history” if we attribute the success of companies to vision or individual talent alone. Such “acceptance displaces critical thinking and good strategy”. The author points out how Henry Ford’s vision was “hardly unique” for its time. His company’s “genius was in materials, industrial engineering, and promotion”.

“The amazing thing about New Thought is that it is always presented as if it were new!… These ritual recitations obviously tap into a deep human capacity to believe that intensely focused desire is magically rewarded”.

Richard Rumelt, Good Strategy / Bad Strategy, 2011

Path selection

Bad strategy is often a consequence of our tendency to avoid the hard work of thinking. Many organisations like to develop strategic plans – standardised templates that specify the company’s vision, mission, values, and so on. But many companies fail to use the document to understand their problems. As a result, these processes often become busy-work.

Here, the author reminds readers to distinguish between strategy and leadership. While the latter inspires, empowers and aligns employees towards a shared vision, the former involves path selection. Optimism can help companies to overcome setbacks in the same way charisma can help leaders to overcome institutional inertia. But all of this is to no avail if the game plan is poor.

Condorcet’s paradox

Furthermore, our inability to think and choose collectively can sometimes contribute to bad strategy. Rumelt uses the Condorcet’s paradox to illuminate this problem. The paradox describes how non-transitive collective preferences can, under certain conditions, emerge from individual groups with different ordered preferences. That is, the aggregation of individual preferences can sometimes lead a group to prefer option A to B, option B to C, but option C to A.

When such conditions arise, as the result of different individual beliefs, groups may face difficulties in establishing a majority, consensus or coalition. Dysfunctional groups may find themselves unable to make cost-effective decisions under such conditions. “Put differently, universal buy-in usually signals the absence of choice”. (If you’re interested in the details and consequences of Condorcet’s paradox, you should also read about Arrow’s impossibility theorem)

The kernels of good strategy

Rumelt emphasises that good strategy should comprise of three elements: (1) diagnosis; (2) guiding policy; and (3) coherent action. Questions against these elements can help to expose our thinking errors. For example: What were the alternatives against each of the three elements? Did we diagnose the problem correctly? Are our guiding policies appropriate? Have we proposed the most appropriate actions?

The author observes how managers and consultants are often quick to diagnose their problems. They like to go straight to solutions-mode. Imagine if doctors or engineers glossed over the diagnosis phase. If a company cannot diagnose and articulate its problem correctly, then it cannot determine the quality of its strategic and capital allocation decisions.

Coherence

Good managers will recognise the “critical obstacles to forward progress and then develop a coherent approach to overcoming them”. It’s important to ask: “what’s going on here?” As Rumelt puts it:

“Good strategy requires leaders who are willing and able to say no to a wide variety of actions and interests. Strategy is at least as much about what an organisation does not do as it is about what it does.”

Richard Rumelt, Good Strategy / Bad Strategy, 2011

For example, we often remember Steve Jobs for his genius in product design. Rumelt says there’s a lot more to their success. Jobs, in his return to the company in 1997, helped to implement a coherent strategy and avoid bankruptcy. For example, customers at the time struggled to distinguish between Apple’s products. The product line was too complicated and burning too much cash. The response? Focus. Apple replaced their desktop computers with the singular Power Mac G3.

Similarly, in a 1998 interview, Rumelt asked Jobs how Apple could grow in the PC segment when the network effects and economies of scale of Wintel (Windows plus Intel) were so strong.  Jobs’ response: “I am going to wait for the next big thing”. He recognised the structural barriers and avoided pouring capital into what were probably insurmountable challenges for Apple at the time. The next big thing did come with the iPod’s arrival in 2001, and later the iPhone in 2007. To Rumelt’s point, what you don’t do is sometimes just as important as what you do and when.

Growth

“The proposition that growth itself creates value is so deeply entrenched in the rhetoric of business that it has become an article of almost unquestioned faith that growth is a good thing.”

Richard Rumelt, Good Strategy / Bad Strategy, 2011

Managers that prize market leadership above all else may stop at nothing to pursue everlasting growth. This focus is the result of long held but untested guiding policies. As we wrote in a previous post, growth-oriented managers may neglect the relationship between return on capital, reinvestment and growth, and its impact on per share value creation. Incentives that reward growth and size, as opposed to growth in value per share, serve only to fuel such desires.

On that note, I like the way Rumelt thinks about growth:

“Healthy growth is not engineered. It is the outcome of growing demand for special capabilities or of expanded or extended capabilities[, and/or] a firm having superior products and skills. It is the reward for successful innovation, cleverness, efficiency, and creativity. This kind of growth is not just an industry phenomenon. It normally shows up as a gain in market share that is simultaneous with a superior rate of profit.”

Richard Rumelt, Good Strategy / Bad Strategy, 2011

Competitive advantages

“The first step of making strategy real is figuring out the big ‘aha’ to gain sustainable competitive advantage—in other words, a significant, meaningful insight about how to win… If you don’t have a competitive advantage, don’t compete”.

Jack Welsh

No strategy book is complete without commentary on competitive advantages. Competitive advantages, according to Rumelt, are ‘isolating mechanisms’ that competitors cannot replicate. For example, a recognisable brand is not a competitive advantage if every competitor has one too. As Bruce Greenwald put it, competitive advantages must help the company to earn a return in excess of its cost of capital. Otherwise, is it really an advantage at all?

Citing Andy Marshall’s work on Strategy for Competing with the Soviets, Rumelt highlights that strategy also involves using “your relative advantages to impose out-of-proportion costs on the opposition and complicate his problem of competing with you”. It’s a subtle shift from a focus on absolute capability to one of asymmetric costs.

Competition demystified

Rumelt’s reflections reminded me also of Bruce Greenwald’s work in Competition Demystified. Greenwald likes to think about competitive advantages and barriers to entry across three layers. Firstly, there are demand advantages or sources of customer captivity. These include switching costs, network effects and habit formations. Secondly, there are supply advantages. This refers to production know-how that competitors struggle to replicate.

Thirdly, there are economies of scale. This refers to the fall in costs per unit as the volume of units sold rises. Some incumbents enjoy an operating efficiency advantage by virtue of their size and market share relative to the competition. Furthermore, companies that combine demand advantages with economies of scale are more likely to enjoy an enduring competitive advantage. Such chain-links are often difficult for competitors to copy.

Rumelt also recommends readers consider how advantages can deepen, broaden and degenerate over time. Managers and investors need to know what mechanisms enable (prevent) competitors from replicating or imitating their advantages. If this is not possible, then it is about how the company can stay marginally ahead of the game.

“A terrible industry looks like this: the product is an undifferentiated commodity; everyone has the same costs and access to the same technology; and buyers are price sensitive, knowledgeable, and willing to switch suppliers at a moment’s notice to get a better deal.”

Richard Rumelt, Good Strategy / Bad Strategy, 2011

Rumelt borrows several ideas from physics and engineering to help readers think about business and the dynamics of industry. They include: (1) chain-link systems; (2) inertia and (3) entropy. Let’s begin with chain-links first.

In engineering, weak links can sometimes compromise the integrity of an entire system. For example, we cannot allow bridges and space shuttles to have weak links in their design. While these issues exist in business as well, they’re often neglected because their costs are not easy to detect (and the price of failure is not as steep). That said, the identification of weak links, limiting factors or bottlenecks can help organisations to prioritise their diagnosis, guiding policies and coherent actions.

Here, the author points to IKEA’s success. The company’s business model is no secret. It designs ready-to-assemble furniture, outsources its manufacturing, and manages its global logistics in-house. However, traditional retailers, designers and manufactures have struggled with one or more these elements, making it difficult to replicate IKEA’s success in its entirety. Rumelt describes how IKEA’s chain-link strength, along with its first mover advantage and economies of scale, has supported its dominant position over time. As Rumelt puts it: “A well-managed chain-link system is difficult to replicate”.

Systems design

Continued success depends on the company’s ability to maintain and adapt the strength of its chain-links. Here, organisational design becomes important. Recalling his experience as a system engineer, Rumelt observed how the optimisation of one component would cause problems in other areas. He recommends managers pay attention to the subsystems and interactions of their organisation, and where bottlenecks, missed opportunities and waste might exist as a consequence.

With regards to systems design, I’m reminded of the quality circle that Dave Packard introduced in The HP Way. To improve productivity in Hewlett Packard’s production lines, Packard decided to co-locate assembling groups with the testing teams. Their proximity promoted informal communication and exchanges of ideas, while keeping bureaucracy low. Careful attention to the interactions of different groups and systems allowed HP to boost coordination, productivity and innovation. 

Coordination and centralisation

When thinking about chain-links, coordination and systems design, the role of centralisation becomes an important topic. Our prior posts on Berkshire Hathaway and Constellation Software described how successful decentralisation can support specialisation, increase responsiveness and lower overheads. In the Art of Stock Picking, Charlie Munger observed how companies face an ‘everlasting’ battle between the benefits of scale and centralisation, and the costs of bureaucracy.

And as Rumelt puts it:

“Coordination is costly, because it fights against the gains to specialisation, the most basic economies in organised activity… Thus, we should seek coordinated policies only when the gains are very large…[,] imposing only the essential amount of coordination”.

Richard Rumelt, Good Strategy / Bad Strategy, 2011

As an ex-management consultant myself, I sometimes wondered why my clients were attempting to decentralise their operations, when they centralised the very same functions just five or ten years ago. I guess its’ because companies are in a constant state of flux. The hunt for incremental improvement and the ‘sweet spot’ causes many to swing between varying degrees of centralisation and decentralisation. Some of it is busy work, change for the sake of change, or do-something-syndrome. At other times, it might lead to meaningful benefit.

Corporate inertia and entropy

Now, onto inertia and entropy, two fundamental ideas in physics that Rumelt believes make useful analogies for business. First is the law of inertia, which describes the tendency of objects to resist change in its motion. Put another way, it’s the tendency of objects to maintain its state of motion unless a force act upon it.

In business, the inertia of routine and culture is common. These are the processes, attitudes and habits that companies find hard to change. There is also inertia by proxy. A classic example of this is when companies fail to adapt to changing consumer preferences because the cash flows on aging products remain lucrative.

Then there is the second law of classical thermodynamics. The law states that the total entropy, or the degree of disorder, of an isolated macroscopic system never decreases in time. Rumelt parallels entropy in physics to the erosion of company chain-links. Without attention, maintenance and reinvestment, there is a “tendency [for] unmanaged human structures to become less ordered [and] less focused” over time.

Rumelt’s garden

With corporate inertia and entropy in mind, Rumelt likens healthy companies to a healthy garden. While new plantings are nice, gardeners must make time for weed removal as well. The author cites the story of Chevrolet, and how its out-of-control decentralisation led to unintended competition and cannibalisation internally. Corporate inertia and entropy is a major cost to companies (and the ‘jackpot’ for management consultants). Often, the way strategic way forward is clear, but companies find themselves unable to overcome their institutional forces.

Buffett’s tide

Warren Buffett shared the aphorism that “it’s only when the tide goes out that you learn who has been swimming naked”. It was a warning about the dangers of leverage and excessive risk. But it applies as well I think to companies that rest on their laurels during periods of stability and prosperity.

Rumelt points out that resources and integration are imperfect substitutes in business. It’s easy to over rely on the former when cash flows, market cycles or related endowments are in our favour. Management’s capacity to maintain excellence and focus when times are good is as important as their ability to navigate the company through tough times.

Grandmasters of chess

We cannot evaluate the quality of our choices in an isolated and static system. Whether we like it or not, good strategy and coherent actions require some degree of premeditation and anticipation, and path selection amongst the sea of possibilities.

On this topic, Rumelt believes we can learn a little from the Grandmasters of chess. Citing Herbet Goldhamer, grandmasters don’t twenty or fifty moves ahead. Instead, they draw on experience and guiding policies to move pieces in ways that can “improve [their] position”, “increase their mobility” and create “stable patterns… that induce enduring strength for oneself and enduring weakness for the opponent”. Grandmasters will look to check mate “if and when sufficient positional advantages have been accumulated”. (For more on this topic, I recommend Garry Kasparov’s Deep Thinking)

Where was the competition?

Rumelt observes that many MBA students often fail to recognise the role of competition when discussing strategy. He describes how Kmart had made a similar error in their response (or lack of response) to Walmart in the 70s and 80s. As Wal-Mart focused on “innovations in logistics and its growing dominance of small-town discounting”, Kmart focused instead on global expansion. The retailer soon found itself unable to replicate the localised advantages of Wal-Mart. As in chess, neglecting your competitor’s positioning can spell disaster. Strategic analysis must always account for the choices and responses of the competition as well. 

Industry dynamics

“It is hard to show your skill as a sailor when there is no wind”.

Richard Rumelt, Good Strategy / Bad Strategy, 2011

Unfortunately, there’s no single or simple theory to describe the dynamics of industry change. But it can’t hurt to pay attention to the happenings of industry, and the responses of incumbents. Some companies and industries might exhibit ‘attractor states’. These are the tendencies of the system if no new or unexpected factors were to influence its development.

Rumelt observes that it’s usually during periods of transition or disruption that the power structure of industry shifts. For example, rising fixed costs may trigger a wave of consolidation and innovation, where only the largest or most innovative survive. Similarly, sudden deregulation may introduce intense competition and eliminate sluggish incumbents. By contrast, it’s often difficult for laggards to close the gap when industry conditions remain relatively stable.

Rumelt’s description reminded me of Peter Lynch’s approach to investing in One Up on Wall Street. Lynch liked to classify the company he was studying into one or more of six categories: (1) slow growers; (2) stalwarts; (3) fast growers; (4) cyclicals; (5) turnarounds; and (6) asset plays. This helped him to think about the company’s path to value creation, and how they might / might not meet this narrative. In a way, he is also thinking about their tendencies and attractor states.

Monocultures

Predictable biases and feedback loops can create monoculture strategies in industry. For example, in his brief recount of financial history, Rumelt identifies the common elements of booms, busts and manias: (1) engineering overreach; (2) smooth-sailing fallacy (i.e., treating the absence of bad events as the absence of risk); (3) risk-seeking incentives; (4) social herding; and (5) the inside view (the belief that this time is different). Books like Robert Shiller’s Irrational Exuberance, Howard Mark’s Mastering the Market Cycle and Carmen Reinhart’s This Time Is Different have touched on this too.

Market delusions

If I could add upon Rumelt’s observations, it’s the of problem market delusions and twin strategies. A new venture, investment or strategy might seem profitable in isolation. But what happens when everybody shares the same view and behaves in the same way? In public equity for example, the self-reinforcing effect results in a bubble. A rise in the stock price leads to a rise in optimism and expectations, further raising demand, prices and so on.

By contrast, a promising niche in venture capital might attract hordes of start-ups and intense competition, driving out the likelihood of success. What appears sensible in isolation can become untenable in the aggregate. (For more on this, see Aswath Damodaran’s The Big Market Delusion)

If your strategy is not reflexive to the behaviours of others, you might find yourself at the cliff’s edge along with everyone else. I’m reminded of Robert Axelrod’s work on the iterated Prisonner’s Dilemma in The Evolution of Cooperation. One test of a strategy’s viability is its ability to compete with its twin (i.e., how good is your strategy when everyone else is doing the same?).

Thinking strategically

Rumelt observed a common problem amongst the MBA students he taught: their tendency to stop at the very first solution that comes to their mind. He describes how very few students could explain their rationale, let alone explore alternatives to their diagnosis, guiding policies or coherent actions.

The author offers several suggestions to combat such myopia. Firstly, we need to develop a variety of mental models or tools to combat against strategic myopia. Secondly, we shouldn’t forget the kernels of strategy – our diagnosis, guiding policies and coherent actions. Thirdly, we have to record our judgements in ways that allow us to reflect and improve. Fourthly, take advantage of thinking tools like proximate objectives, imaginary panels and checklists.

Proximate objectives

Managers may set proximate objectives to resolve ambiguities and enable employees to proceed. Rumelt recalls Phyllis Buwalda’s work at NASA to land the unmanned Surveyor on the moon. At the time, NASA did not know the features of the lunar terrain, but the engineers needed a specification to work. To proceed, Phyllis directed her team to work under the assumption that it was “like the Southwestern desert”.

Good leaders will “absorb a large part of that complexity and ambiguity, passing on to the organisation a simpler problem – one that is solvable”. Rumelt believes that many leaders “fail badly at this responsibility”. This quality is “more than a willingness to accept blame”. It requires leaders to specify proximate objectives and coherent problems for their employees.

The more complex or uncertain a situation is, the poorer our forecasts will be and the more proximate our strategies must become. Like the grandmasters of chess, the goal is to make incremental moves that improve our relative position. Mervyn King and John Kay share a similar and more extensive view in Radical Uncertainty.

Imaginary panels

Imagine that you have to communicate your diagnosis, policies and actions to an imaginary panel of experts. In investing, this panel might consist of Warren Buffett and Charlie Munger. In technology, this might consist of Steve Jobs and Bill Gates. What would they say? What feedback would they give you? This form of questioning encourages you to incorporate their personality into your evaluation. It’s a simple yet effective thinking tool I think.

Checklists

Finally, Rumelt recommends people make better use of checklists. Atul Gawande shared a similar view in Complications and The Checklist Manifesto. (Practically every author we review on this website recommend the use of checklists)

It’s a red flag when management cannot identify their company’s top three challenges and actions to address them. Checklists can help with that. They’re simple tools to manage our biases, forgetfulness and short sightedness. We don’t need fancy PowerPoint presentations, expensive MBAs or sophisticated softwares to strategise and prioritise.

Further reading

References