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Love Those Dogs

Love Those Dogs

Leading behavioural economists now believe that investing in your dogs, or poor performing units, could bring far better returns than investing in your stars, or best performing units. Will the same argument work for IT?

In their pursuit of maximum shareholder value, senior executives routinely consider which of their companies' businesses should be nurtured, which neglected and which sold. For most, that puts just one strategy in play: a heavy investment in the corporate "stars" (programs, business units, people and products that earn superior returns) and the starving or selling off of the underperforming "dogs".

In IT, much the same thinking can be seen at work as companies throw big dollars at enterprise and mission-critical systems while leaving the "shadow IT departments" kennelled within business units famished. The same dynamic is at play in companies that persist with delivery models that do not deliver full value, fail to leverage their data assets or leave much of their ERP capability untapped through poor configuration while they channel scarce resources into major systems.

In short, if companies were people, and underperforming resources were really dogs, the courts would be overwhelmed with prosecutions brought by the RSPCA for neglect and cruelty. And most executives would eventually be brought up on charges. After all, this conventional approach to maximizing value by grooming pedigreed lines while neglecting the mongrels is so ingrained in management practice as to make questioning it almost sacrilegious.

However, what if this conventional approach is so wrong as to be muddleheaded? What if corporations would be better off short-changing their stars and nurturing their dogs? That is a question a team of consultants from Booz Allen Hamilton thinks worth considering after applying the new field of behavioural economics to questions of value creation, and pondering its applicability to IT.

"The strategy of loving your dogs may be intuitively difficult to swallow for many, but it is supported by an economic field of study - behavioural finance - that has come into vogue over the last decade," note Harry Quarls, Thomas Pernsteiner and Kasturi Rangan in a recent paper called, fittingly enough, Love Your Dogs.

Clearly there will be plenty of cases where it is best to let sleeping dogs lie. But sometimes, rather than leaving the poor creature, ribs showing through its mange, chained all cowed and bedraggled to the Hills hoist, it might be better to bring it in from the cold. With a bit of care and attention, a thorough worming and an intensive bout of obedience training, some dogs might just have a chance to become man's best friend.

Why Smart Investors Make Dumb Mistakes

Behavioural economics is essentially about applying methods from social sciences like psychology to economics to illustrate how, and why, people make financial decisions. It rests on the precept, as put by economist James Montier, that "not only do investors make mistakes, but they do so in a predictable fashion". The theory seeks to explain why day traders, for instance, routinely display overconfidence by trading with high turn-over but low returns. And why, as noted by Nobel Prize-winning economists Amos Tversky and Daniel Kahneman, people are likely to overestimate the similarities between a small group they know and the larger population, and hence make faulty predictions of the behaviour of markets and prices. Irrationality occurs even with highly trained specialists, such as professional investors or, as Kahneman puts it, when "people who are explicitly trained to bring [rational] thinking to problems don't do so, even when they know they should".

"There are many different flavours of it but I think the main flavour is that fundamentally, people are myopic," Quarls says. "You know, when somebody looks at something they probably use past history as a guide to the future, and so therefore if things are doing very badly, they assume that it will continue that way, and if things are doing very well, same assumption, they assume that things will continue that way. What happens is that if things are doing badly, usually there is some intervention, but people don't build things to their expectation. Then secondly on the top side, gravity usually takes hold: you can't maintain those high levels forever and so therefore you tend to underperform relative to expectations."

Love Your Dogs uses the theory to demonstrate how corporate managers typically rely on accounting metrics to inform business decisions even though such metrics are based on past performance, which is generally a poor predictor of the future. "Thus, when performance is assessed over time, greater shareholder value can be created by improving the operations of the company's worst-performing businesses. The way to thrive is to love your dogs," the authors insist.

In the way fund managers can earn superior returns by identifying and buying undervalued "market dogs" (in this case value stocks), corporate leadership can learn to identify "value assets", hold and nurture them, and produce superior performance. This in turn will ultimately lead to an increase in shareholder value, they say.

Their analysis of 25 years of US stock price performance produced three simple rules for corporate leaders:

1. Fixing your dogs can yield unexpected levels of shareholder value, even when their key financial indicators lag behind those of other business units.

2. Improving operations is an important management lever for adding shareholder value. Starving dogs is not a strategy for creating shareholder value; in aggregate, there is more potential value in helping the dogs thrive.

3. Buying and fixing someone else's dogs will produce more shareholder value than buying stars.

"Adding value to an overvalued business is a tall feat, especially on top of the premium that acquirers typically pay for a controlling interest in an enterprise. It is no wonder that two-thirds of acquisitions fail to add value for the acquiring shareholder. The right dogs, on the other hand, could offer a company focused on operations wonderful acquisition opportunities," the consultants write.

"Although behavioural finance is used by a growing number of fund managers to guide their purchases, another potential application has largely gone unnoticed: its use as a guide to corporate strategy decisions. The same kind of behavioural analysis can help corporate executives better understand and manage their own 'portfolios' - the businesses or business units that make up their companies. Executives who understand behavioural finance will capture more shareholder value from businesses that have previously been regarded as unworthy of much attention," the authors say.

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