The Three Rules

Michael E. Raynor and Mumtaz Ahmed
From THE THREE RULES by Michael E. Raynor and Mumtaz Ahmed Copyright © Deloitte Development, LLC, 2013. Summarized by arrangement with Portfolio, a member of Penguin Group (USA) LLC, a Penguin Random House Company
getAbstract © 2013

Rating (10 is best)

Overall: 8
Applicability: 8
Innovation: 8
Style: 6

Take-Aways

To determine why some companies perform exceptionally over long timespans, researchers analyzed 45 years of data concerning more than 25,000 firms.
The study utilized return on assets (ROA) as its leading measure of business success.
Consistent top performers are “Miracle Workers”; firms with admirable extended records are “Long Runners”; and solid also-rans are “Average Joes.”
Most Miracle Workers follow three rules to achieve peak, long-term performance:
Rule No. 1: “Better before cheaper.”
Rule No. 2: “Revenue before cost.”
Rule No. 3: “There are no other rules.”
Exceptional business performance depends on smart decisions aided by simple “heuristics,” such as these three “decision rules.”
Consistent, superior achievement results from smart decisions you make over time.
As you apply the three rules to your operations, stay flexible and make decisions based on solid research data.

Relevance

What You Will Learn

In this summary, you will learn: 1) What the three “decision rules” of corporate strategy mandate, 2) How top-performing companies put the rules to work, 3) How your company can use them and 4) What research methods produced these rules.

Recommendation

How do some companies turn in exceptional performance year after year? Deloitte’s Michael E. Raynor and Mumtaz Ahmed apply a disciplined, statistically rigorous approach to determine what makes top companies great. The fruit of their impressive research is three pivotal rules any company can follow. To uncover this strategic knowledge, the authors worked as diligent “corporate paleontologists,” carefully analyzing the “fossil record” of high-performing companies to discover what makes them special. The authors back up their research with 110 pages of detailed appendices that reflect the meritorious rigor of their approach. Their intense research methods are solid and praiseworthy, but their opaque writing style is wearying, as is their criticism of other books that offer business advice based on anecdotes and one-off observations. getAbstract recommends their thorough analysis and practical findings to CEOs, COOs, business owners, organizational strategists, business professors, entrepreneurs, investors and avid students of the application of managerial theory to practical problems.

Summary

Research Methodology

To learn what makes certain companies extraordinary, most analysts focus on the organizations themselves. This logical approach has a major failing: A review of extraordinary companies often reveals little more than a “concatenation of unlikely and impossible-to-repeat events.”
The research that uncovered the three “decision rules” involved high-level analysis of Compustat data from upward of 25,000 companies. This information spanned a half-century, or “nearly 300,000 company-year observations from 1966 to 2010.” It focused on the “entire observable lifetime of each company” studied. Besides noting each firm’s long-range return on assets (ROA), researchers examined each one’s “annual ROA performance” to identify specific “elements of advantage.” Those factors might include selling, general and administrative expenses (SG&A), gross margin, and current and fixed asset turnover. The study used an “explicitly statistically driven method to separate signal from noise.” Its “powerful combination of large-scale data analysis and in-depth case studies” meets rigorous research requirements.

Superstar Firms

In each industry, the study identified a company (or sometimes more than one company) that performed exceptionally well for decades. Those “Miracle Workers” include Merck in pharmaceuticals, Family Dollar in discount retail, Heartland Express in trucking and Linear Technology in semiconductors. These firms faced challenges similar to those of their competitors, but over time they outperformed all the others. What made them special? What lessons could other firms derive from their success?
Consistent, superior achievement is the result of smart decisions these companies’ managers make over time. Each choice their strategists made became just one part of their successful “lifetime performance.” The best measure of corporate achievement – when viewed in the context of each industry, technological advances, globalization, relevant regulations, quality concerns and earnings – is ROA, the “ratio of income to assets.” This is the most accurate way “to capture and compare performance across a wide range of companies.” Return on assets also is a more indicative measurement of corporate performance than total shareholder return (TSR), because it factors in the contributions of management to overall performance. ROA also is a better performance measure than “revenue growth,” which is “a leading or lagging indicator of other performance of interest – often profitability or TSR.”

Top Performers

This exhaustive study identified three populations with one of the following three types of performance profiles:

“Miracle Workers” – These “best of the best” companies achieved 90th percentile performance in annual ROA frequently enough, given their life spans, to be demonstrably more than just lucky. Think of them as “gold medal” winners.
“Long Runners” – These “silver medal” firms achieved annual ROA rankings in the 60th to 80th percentile with sufficient frequency to be statistically significant.
“Average Joes” – These companies have average life spans, average ROA achievement levels and average volatility.

“Every company’s financial performance arises from a combination of skill and luck.” Luck is random, but managers can build their skills to muster sound, proven, rational practices. The study identified the firms with that level of achievement, tallying “174 Miracle Workers and 170 Long Runners” that were more than lucky. Then researches set out to find the factors that distinguish Miracle Workers and Long Runners from each other and from Average Joes.
Detailed case studies and analysis indicate that most exceptional companies follow three basic rules:

Rule No. 1: “Better Before Cheaper”

Compete on quality, not price. For every purchase, consumers have a bias toward “non-price dimensions of performance” over price. “Price value” suggests that “the less you pay, the more price value you get.” “Non-price value” contains all aspects of “value that are not price,” for example, “durability, functionality, quality, convenience, ease of use, style, brand.” These factors define the superior value your company delivers to its customers in comparison with your competition.
The semiconductor industry encompasses many companies offering a variety of chips performing a number of functions. Linear Technology produces high-performance, analog integrated circuits. Its ability to compete successfully on “non-price dimensions of value” accounts for its remarkable success, including increasing its equity value by a factor of as much as 62 after its initial public offering. Linear invested its profits in R&D and capital expenditures. By investing this aggressively in its own corporate assets – both tangible and intellectual – Linear developed a line of superior products. It concentrated on “high-performance, mission-critical integrated circuits.” These circuits usually represented a small fraction of a product’s total cost to manufacturers.
Linear’s chips were “highly differentiated in ways their customers valued.” The low percentage of total cost that its chips accounted for in its customers’ products allowed it to charge relatively higher prices than its competitors.” This relatively small markup was no deterrent to manufacturers seeking superior performance. Linear fulfilled the first rule: Create products that are better, not cheaper.
From 1992 to 2010, Linear racked up an advantage of “25 pp [percentage points] of ROA advantage each year, on average, thanks to a higher gross margin than Micropac Industries,” a Long Runner. Linear’s superior performance correlates directly with its strong “non-price position” in the semiconductor industry. International Rectifier, an Average Joe in this sector, spent only 4% of its sales on R&D, compared with Linear’s R&D investment of 9%.

Rule No. 2: “Revenue Before Cost”

Most Miracle Workers’ profits derive from setting higher prices, achieving greater sales volume and generating more revenue through either higher unit prices or higher unit volumes. This formula gives firms that follow the second rule an edge. Exceptional companies achieve their ROA advantage by earning “higher relative revenue” rather than by pursuing “lower relative cost or lower relative assets.”
Heartland Express is a Miracle Worker in the trucking industry. Werner Enterprises is a Long Runner and PAM Transportation Service is an Average Joe. Each of these companies went public in 1986. From 1985 to 2010, Heartland’s average annual ROA was 14.6%, in comparison to 7.1% for Werner Enterprises and only 2% for PAM. During the same period, Heartland’s compounded annual TSR was 17.3%. Werner Enterprises achieved a 10.6% compounded annual TSR and PAM faced a disappointing -1.2% compounded annual TSR.
Heartland developed a strong non-price position that allowed it to charge premium prices for its trucking services. Werner and PAM competed by trying to achieve competitive pricing positions. Since Heartland could charge more “per ton-mile” for its specialized trucking services than either PAM or Werner, it developed a “relative revenue advantage.”
This fulfills the second rule: Prioritize revenue over cost. Heartland also controlled its costs by hiring the best owner-operator truckers and offering them benefits, including “university scholarships” for the children of long-serving drivers. Heartland reportedly paid its drivers the highest wages in the industry.

Rule No. 3: “There Are No Other Rules”

Quality and revenue are the only two systematic, significant and specific guidelines identified in the study. When you honor these rules, you keep your other strategic options open. For example, opting to compete based on price or on non-price factors depends on which choice is likeliest to lead to exceptional performance and, therefore, best aligns with the first two rules. Your decision whether to hire a driven, charismatic CEO or a humble servant-leader CEO depends on which executive will focus more on quality and earnings. Stick to these priorities, and all other options will become viable, assuming that you make smart, careful decisions.
The three rules favor a non-price competitive position and they point companies in the right direction. The simplicity of these three rules – or “heuristics” – makes them easy to put into action. These rules also help strategists separate their true, pivotal priorities from the “noise” generated by lesser concerns.
Your company can change its strategy and operations and still perform exceptionally well – if it maintains a “non-price position and a revenue-driven profitability formula.” During the course of this study, some high-performing companies reorganized major areas of their operations and activities, but they maintained their market positions and profitability formulas based on prioritizing performance and putting increasing revenue ahead of reducing cost.

Strategic Suggestions

Additional insights for corporate planners and strategists include:

When superior-achievement firms forego their “non-price position[s],” their financial performance tends to suffer. Stick to your strategy.
Exceptional firms have to continuously earn their “non-price value.” Companies should always have a bias toward “increasing the non-price dimensions of their competitive differentiation.”
Corporate planners have to sort through many equally viable alternatives. Use the three rules to narrow your focus so you can then cut through the confusion that plagues most corporate decision-making.
If you follow your competitors’ strategies, you are unlikely to move past them.
Top-performing companies invest and spend, while Average Joes usually work from “price positions.”
To follow the three rules, your firm must remain flexible and adaptable.

Swimming Upstream

The study also identified companies that defy the rules. Weis Markets, a supermarket corporation, was the primary outlier – the “Miracle Worker that swam upstream.” Weis Markets attained Miracle Worker status with a “price-based position and cost-based profitability formula.” Of course, the exception proves the rule – or in this case, actually the three rules.
One warning: “The only certainty for any company [that is] doing well is that eventually it will be doing worse.” Apply the three decision rules to help your firm defy gravity for as long as possible and to reorient its strategy to prioritize performance and earnings after tough periods.

About the Authors

Michael E. Raynor, a director at Deloitte Services LP, is the author of The Strategy Paradox and The Innovator’s Manifesto.Mumtaz Ahmed is chief strategy officer at Deloitte Consulting LLP.

Quotes

“Adherence to the three rules does not mean becoming a corporate barnacle, gluing oneself to a spot and then eating one’s own brain.”
“Our intuitions seem programmed to see patterns in randomness, leading us systematically to make far worse decisions than we need to.”
“If you want to say anything about the performance of any company, you have to look at all the data available for it.”
“Diversification, however limited its scope, can be dangerously dilutive of management time, one of the most valuable resources in any corporation.”
“You cannot compensate for a poor position with great execution, while poor execution can compromise even the most promising position.”
“When exceptional companies abandoned a non-price position, their performance subsequently suffered.”
“When you depend on low price and low cost, you are far more vulnerable to competitive imitation.”
“Short-run pressure to improve profitability through cost cutting is very often a double-edged sword, and the wrong edge is sharpest.”
“Exceptional profitability demands, beyond a point, making trade-offs, accepting higher costs as the price of being truly exceptional.”
“Experimental design, data collection and analysis are absolutely critical to making an informed choice.”
“Making choices dominated by industry-level considerations makes you average.”
“It takes an awful lot of adaptability to stick with the same position and profitability formula.”
“Although you might not be able to predict precisely what will bring down any given high flyer, it is a sure thing that something will.”

Summary of "The Three Rules"