Ed Hess Explains Why 'Grow or Die' Is a Myth

Includes: BBY, COST
by: Wall St. Cheat Sheet

When I heard about Professor Ed Hess’s book Smart Growth: Building an Enduring Business by Managing the Risks of Growth (Columbia Business School Publishing),I figured he studied companies in another dimension. Given the Malcolm X spirited Wall Street axiom “grow or die,” I wasn’t sure if smart growth was still on the menu.

I caught up with Professor Hess to ask him a few questions regarding his excellent forthcoming book (which I read on my recent vacation).

Damien Hoffman: Ed, Wall Street obsesses over growth. However, in your book you say there are some important risks of growth. What are these major risks?

Ed Hess: The major risks of growth are the dilution of an organization’s culture, customer value proposition, brand and quality control, or financial control deviations that create material risks. These can result from either big growth initiatives or the cumulative effect of small changes made to drive top-line or bottom-line growth.

Damien: If companies must accept these risks to follow Wall Street’s desire for growth, it seems company execs are in a hard place if they believe death is the alternative. However, your book explains this is a myth. Can you explain why “grow or die” is a myth?

Ed: “Grow or die” is a myth because it has no empirical basis. The market generally measures growth by size — meaning, getting bigger.

Every business does not have to get bigger, it just has to continuously improve its customer value proposition to outcompete the competition. This “grow or die” myth can pressure companies to grow beyond their capabilities and management expertise.

Damien: What are some other corporate half-truths that get companies in a strategic trap?

Ed: The other key corporate half-truth I challenge is the belief that public company growth should be continuous and linear, as evidenced by ever increasing quarterly earnings. There is no empirical support for that position. It runs counter to what we know about how growth and innovation occur.

Growth is a complex learning process that is dependent on motivating and rewarding entrepreneurial growth behaviors. Growth is in most cases dependent upon the behaviors of many people — and people, just like markets, are not always rational actors or efficient processors of information.

Damien: Wall Street’s growth addiction is fed by managers willing to play the earnings game rather than act rationally. So, how can we alter what you call the Mental Model of Wall Street’s earnings game?

Ed: I propose 3 steps to lessen the dominance of systemic “short-termism”. First, the SEC, stock exchanges, or boards of directors should require every public company to disclose how it produces every penny of earnings so investors and the market can discriminate between what I call Authentic Earnings and non-authentic earnings.

Non-authentic earnings are generated by accounting elections, valuations, and judgments, and from, for example, related party transactions, channel stuffing, changing income recognition policies, liberalizing credit, investments, and financial engineering. They do not represent the same quality of information about the strength and sustainability of a company’s customer value proposition as Authentic Earnings.

Authentic Earnings are produced by selling more value-add goods and services in customary commercial transactions to more customers in arms length transactions. Using authentic earnings will make the earnings game transparent.

Second, change management compensation to reward the long-term creation of Authentic Earnings and penalize the creation of non-authentic earnings.

Third, use taxation to penalize the short-term “renting” of stock by institutions. Extend the holding period for long-term capital gains to three years and “tax” short-term gains of tax-exempt institutions to reduce the dominance of a short-term mentality that inhibits or delays real growth and innovation.

Damien: In your book you cite some case studies of smart growth. Why are Costco (NASDAQ:COST) and Best Buy (NYSE:BBY) models of smart growth companies?

Ed: Costco is a smart growth company because its management team understands its job is to build an enduring business. Management courageously stands up to pressure from Wall Street by refusing to take actions to generate more short-term revenue that it believes in the long-run will destroy its customer and employee value proposition.

Costco understands the inter-relationship between high employee engagement, high customer satisfaction, and profits. It understands that certain kinds of business decisions that produce short-term results may in the long-term destroy its differentiator and brand.

Best Buy is a smart growth company because it has built an internal Growth System that links, in a consistent self-reinforcing manner, its strategy, culture, execution processes, HR policies, leadership models, measurements and rewards to drive value-creating employee behaviors.

Best Buy understands that many growth ideas come from customers and line employees. Management is paranoid about the common growth sicknesses of complacency, arrogance, hubris, and executive elitism.

Damien: Sounds like we need more future leaders like those at Costco and Best Buy. As a professor, how do you keep business students focused on sustainable, healthy business thinking versus quick cash and promotions?

Ed: Ah, the big question for business schools. Speaking only for myself, it is hard with so many of the externalities emphasizing a short-term mentality with a narrow view of the purpose of a business.

It ultimately comes down to having engaging conversations with students about the higher purpose or the meaning of business in our society, values, and how you define success. Do the ends justify the means or is it how you play the game? What are you willing to do for money? What do you want your life to stand for?

Damien: Thanks, Ed. Those are great questions which shouldn’t be ignored. I greatly enjoyed your new book and wish you continued success with it.

Ed: Thanks, Damien.

Edward D. Hess is author of a forthcoming book, Smart Growth: Building an Enduring Business by Managing the Risks of Growth (Columbia Business School Publishing).He is also professor of business administration and Batten Executive-in-Residence at the Darden Graduate School of Business, University of Virginia.