Funding versus investing decisions

One of the more annoying examples of mismanagement is decision makers insistence of mixing funding decisions with investing decisions. This seriously erroneous practice is endemic throughout many organisations but festers most prominently in government. Take this article published in the Sydney Morning Herald . Aside from it being an hilarious example of an investment decision being woefully inadequate to meet the policy objective, the retort made by the leader of the opposition is even more humerous. How is retraining laid off employees and supporting business innovation a mutually exclusive decision to the original investment decision of providing a subsidy for relocation to regional areas? I guess one could hope that the statement to "use the money" from the axed programme could be a misquote but I doubt it.

The point here is not whether any of these investment decisions actually helps the policy objective of spreading the population across the state of NSW but that the investments described are not mutually exclusive and hence should be invested in based off their own merit and funded accordingly. By making the statement that you would scrap one investment so you can invest in another you are making the erroneous assumption that using the money saved from one justifies the investment in another. What about just not spending the money at all? The fact that you have money to spend is not an argument to spend it. Each investment should have its business case argued for, not subsidised by the fact that you're not going to spend the money on something equally moronic.

strategy execution

Over the years, this blog has been poorly maintained. One of the frustrating things is feeling constrained in being able to write the things I verbally comment on during the day. I'm a fairly argumentative person and have strong and passionate views. These views can land you in hot water if you don't think them through. When speaking, there's always the feedback loop from the listener in the form of them replying but also in terms of their body language that assists me to determine if I'm going too far. On the web, through a blog, this is much different. However, there is the opportunity to reach a far wider audience and obtain some validation or repudiation on thoughts and ideas. So, I am determined to make another attempt at regular blogging. On this occasion, my blogs will be less researchy "white papers" and more just random thoughts and observations about what happened during the day.

One of the more peculiar terms I've observed over the years is the management consultant's term "strategy execution". There's an American based management consultancy that differentiates their business via the tag line "strategy execution" and yet when you look at their services, they're much more about strategy formulation than strategy execution. To me, the only thing that "executes" strategy is the implementation of portfolios of projects aligned to that strategy with its associated change and resulting benefits based on the shareholder value created. It's not that I think their service offering wouldn't add value, its just that their whole proposition around strategy execution seems weird to me and undermines my trust in them actually knowing what makes a business hum.

Any thoughts?

examples of problems that need an end state

What I love about mbh and my role in the company is that we often get involved in developing cases for companies and governments to invest in potential solutions. What is frustrating, as per my previous post, is the lack of an overall guiding goal or end state to weigh up the worth of these investments. There are many large problems facing society that are being commented on in the mainstream press. What is often lacking from these commentaries is the end state or new world that we are trying to achieve.

The two main examples where we have been involved lately or where I have taken a personal interest is the current water and energy problems around the world. While both problems are world problems, their end state scenarios and solutions to reach said end states differ from region to region. At the moment, global warming and peak oil are being blamed for high energy prices and for problems countries are having with supplies of water. The amount of data in the marketplace on these two causes of problems (i.e. global warming and peak oil) is huge. As an example, check out this awesome website on energy http://peakenergy.blogspot.com/. Not only are the blog entries great, there are dozens of links to excellent and reputable websites for further information. It would be possible to write a business case on a variety of investment opportunities from the date linked within 6 degrees of separation from this one site. The problem would be distilling so much information.

It is almost impossible to distill information and analyse options if we don't know the end state of what it is we're proposing. However, once you put a stake in the ground, or define an end state, the options for investing are reduced to those that facilitate achieving the end state. As an example, this link to a video of a school friend of mine talks about a stake in the ground on CO2 emissions http://www.youtube.com/watch?v=wbwxF47x5ss. What Saul does is suggest an end state stabilisation of CO2 and then discusses how much demand needs to be reduced by as one option to achieving this end state CO2 figure.

I'd be interested to know societies expectations on these matters. It would certainly lead to better investment decisions if we debated what goal we were aiming for. Two answers I'd like are around water supply and energy use:

1. Is Sydney and most other Australian cities happy with permanent water restrictions or do we feel an end state of watering our concrete whenever we feel like it should be the goal or is it somewhere in between?
   
2. Is the industrialised world satisfied with Saul's reduction in consumption to meet global warming or the fact that we're going to lose various islands, flood parts of every coastal town in the world and have far more frequently dramatic weather events ok with is? Or again, is it somewhere in between and if so, what?
   

I know in a democracy that a definitive answer to these questions is impossible but gleanings as to general collective preferences would make government investment decision making a whole lot easier.

ramblings on investment decision making

I've been doing a lot of things around investment decision making lately. Reviewing business cases, teaching people how to complete feasibility analysis and compile business cases, actually compiling business cases for clients and assisting project teams to compile business cases. I've gotten to the point where I need to ramble for a few blog entries to get out of my system some thoughts that have been running around my head.

Real asset investment decision making has been a fascination of mine since University days. The process of discovering if an investment has potential is fascinating. The range of topics you get across is huge.

Over the years I've also discovered the massive political and emotional aspects to decision making too. I've experienced the political and emotional responses through observation rather than participation. Most of my experience in observing the emotive and political response to a problem has been through the review of business cases or cabinet submissions that have been written to get a certain decision up rather than testing and proposing the best option for decision makers. Other observed phenomena is the retrospective business case. This is where a document called a business case is written to cover for the fact that a decision has already been made. What I find interesting in these cases is discovering what was the business case that caused the actual decision to be made. Was it a conversation, a presentation, a site visit or something else. There is always something that is the catalyst for a decision maker or person in power to decide to act. Sadly, it is often some small, quick comment or observation rather than as a result of a sound and well developed business case.

The most frustrating thing for me has been the difficulty in understanding the overall thread or long term goal to investment decisions. They are so often made in isolation with the dependancy and impact on other initiatives rarely considered. Yes, the investment aligns to strategy but does it contribute to an overall plan that leads to some end state that the organisation, community or society finds desirable.

Many new management theories are being explored around complexity theory and the uselessness of trying to predict the future (e.g. through forecasting and modelling). However, I find it impossible to be motivated and commit to investing money in a project that has no clear purpose and cannot be defined as part of some overall goal or end state.

I understand that it is extremely difficult to define an end state, but without one, all common principles of strategic planning and business management are useless and the complexity theorists become 100% correct in their description of organisations as self forming organisms that bumble along much the same way life always has since that first single cell split and became two.

machiavellian nature of the real decision maker

My last two blog entries have described the theory of economics being an abstract method of measuring both society and the environment. Investment time horizons should be extended to reflect the long term nature of an investment's impact and that when this is done, economic evaluations can be used as the sole tool for decision making.

Unfortunately, this is a normative theory; it describes how I think things should be done. As a consultant, it is my role to spend too much of my time contemplating how to make things more effective. This is the way we compete with other consulting organisations. While the rest of the world gets on with the doing, we contemplate how the doing can be more effective.

The other thing we do is contemplate how we can incorporate this normative theory into the real world. In essence we contemplate how we make it a positive theory.

To do this, we have to develop positive theories of our own for current practice. Positive theories are theories that describe the way things are actually done rather than those that describe how they should be done. This blog entry aims to describe how investment decisions are currently executed. It is based on observations over 14 years across dozens of industries in 10 countries.

The common thread between my normative argument and the positive theory is the importance of time horizons. In our positive theory, people are motivated by improving their own lot. Altruism does not exist. In this light, a decision maker makes decisions that suit his or her motivation to improve their own position. Sometimes, this will be an improvement to their financial position. In this instance people will make the decision that will increase the chance of financial reward. In other instances it will be power, a lasting legacy etc.

The time horizon of the decision maker looking to increase their own financial wealth will be extremely short. Even a non-fraudulent decision maker with these motivations will focus on projects that "payback" quickly instead of long lead time projects that "payback" 10 times the amount in present day terms.

If the decision maker wants to leave a legacy behind, then they will focus on longer term decisions. Their tenure in the organisation will be longer and their succession planning will be detailed and targeted. It is important for the information providers to understand the motivations of the individual making the decision. These motivations will drive the tools being employed by that organisation to assist them to make a decision.

Here's some observations to assist in determining what drives your decision makers:
Financially motivated

• Payback used as assessment method
• Subjective overlay applied to financial analysis (e.g. 2+2 = whatever you want it to be)
  
• Focus is on short term (e.g. quarterly) results
• Reward structure is financially based.
• Analysis is retrofitted to a decision
  

Legacy motivated

• Cost/benefit analysis is used over the life of the investment
• Focus is on long term vision of the organisation
• Vision has meaning to everyone in the organisation
• Rewards are a mix of financial and non-financial
• Financial analysis has forecast error only not bias error
• An analysis is never retrofitted to a decision

Of course, even positive theories are falsely formulated. I'd be very surprised if this theory wasn't shot down in a ball of flames. Please feel free to do so. Let the evolution begin.

investment time horizons

This blog entry will put forward a case for a radical redesign of investment time horizons.

What are investment time horizons? Investment time horizons are time periods applied to the assessment of the potential of an investment in terms of its economic impact. As per my previous blog entry, economic impacts are results or consequences of social and environmental change caused by an investment. Some examples; many people in society now walk around with headphones or ear pieces on, listening to music emanating from a device that has been called an iPod or MP3 player - if we are not being brand specific. The original investment by apple in product development, production and marketing of the iPod has had significant economic consequences for a subset of society that this investment has impacted on. This can be measured by the net overall increase in market value attributable to the companies that are impacted. I say net, because some companies, like Sony, have lost market value even though they have brought out their own MP3 devices. Suppliers of component parts, and retailers like Harvey Norman have gained market value as consumers decide to spend their hard earned money in these retail outlets rather than on clothes, drink or food. Clothing and food outlets have lost for the same reason. However, the net result is probably positive as the device has created a feel good effect that makes people spend money.

If there is a net increase in wealth from the release of the iPod, which I suspect there is, then the increase is societies way of rewarding the innovation. The increase represents societies view of the higher standard of living the device has given them.

Another example is the increase in property values delivered to houses or land that surrounds new infrastructure development. This increase in value is reflecting the greater standard of living provided to those impacted by the investment through faster travel times, better health, safer living etc. This example illustrates the full process of investment decision making. A government makes a decision to build public transport in an area, the affected area now has faster commuter times; be they by car, rail or bus. Housing prices increase due to this higher living standard. More people are attracted to the area because of the higher living standard. The wealth increase is the result of the social change.

However, all of these examples are transient. The iPod will be superseded by some other piece of technology in the future. Alternatively, people may start to suffer hearing loss from playing them too loud or cancer from magnetic radiation. When these events occur, the economic value will erode, and if Apple hasn't innovated with something new, it's market value will deteriorate.

With this in mind, to what time horizon should we be looking to when assessing the potential benefits of the investment? Obviously, this will vary depending on the investment, but typically, the time horizon used in practice is too short. In the iPod example, did Apple assess the risk of being sued for causing deafness or cancer? If this effect is large enough, it could threaten the very existence of the organisation (e.g. tobacco companies and their short term assessment on the effects of lung cancer on their businesses and asbestos companies and their short term assessment of the effect of asbestos on their companies). Eventually, the social consequences will impact the business.

The question is, should these long term consequences be included in the assessment when making the decision to invest? It should be noted here that I am not asserting that iPods will make people deaf or will cause cancer. What I am asserting is that these possibilities should have been reviewed when making the decision to launch the product. If the risks were high, then mitigating steps should be taken immediately, and the overall economic value of the product reduced accordingly.

In the public infrastructure example, over time, the roads will become blocked again, pollution will increase and the value society places on the area impacted will reduce. Should this be taken into consideration when making the decision to invest?

My belief and answer to these questions are yes. Time lines must be lengthened. Even though forecasting the effects will be difficult and the variance of our estimates high, we must start modelling these consequences if we are to make better investment decisions. The long term will always, one day, be the short term. Asbestos companies are now paying for what they once thought was a long term problem. It is now their current problem. If they were to include the negative consequences back when they made the decision, would the decision have been the same?

Sometimes we will not know or be aware of these consequences, but investment decisions are not a buy and hold proposition. Decision makers have the capacity to change their mind at any moment. By constantly re-evaluating the investment decision and by keeping the time horizon long, we should be able to adjust quicker to negative consequences and hence reduce the negativity.

It is my belief that in using this longer term model, economics becomes the sole measure for assessing an investment decision, but the drivers for that assessment, social and environmental change, are being properly incorporated into that assessment.

triple bottom line reporting

This blog entry will put forward a case against triple bottom line reporting.

Much of my life lately has returned to capital investment decision making. This area resides with me way back in my roots. I was always drawn to the methods and processes that assisted decision makers in making the decisions that one way or another will alter the course of the organisation. Lately, the focus has moved to assessing investment decisions on a triple bottom line basis. Firstly to jargon. What is triple bottom line? Triple bottom line refers to the observation that any entity, be they an individual or an organisation, has an effect on the human world in three ways; the human world itself (i.e. the society), the natural environment that surrounds that society, and the measure of wealth that exists in that society. With this observation made, it as asserted that each investment decision should be made balancing these three elements. Triple bottom line reporting refers to a report that will measure either qualitatively or quantitatively the effects a decision will have on these three elements. Sometimes it will be referred to as Economic, Social and Environmental reporting. These terms are synonymous in my opinion.

There are many methods of measuring the 3 aspects of the triple bottom line. The most important element to define first, before choosing your method, is time. What time horizon are we looking at in making our decision? If a decision maker's time horizon is very short, then the economic factors will outweigh all else. However, the paradox here is that the decisions made for short term economic effect will have significant medium term and catastrophic long term economic effects (i.e. The measure of wealth will fall). The drivers of this catastrophic economic consequences are the resulting deterioration in society and the environment over the longer term.

If the time horizon of the decision maker is medium term, then the economic effects will still outweigh the social and the environmental. In this instance, the long term economic effects will still be negative and considerable. This time, the main driver initially will be environmental and then this will drive social responses that will then drive economic consequences.

If the time horizon is longer term, then the primary focus of the triple bottom line will be environmental. All things will stem from this. The current measure of this is the economic wealth that is valued in the long term.

There are many definitional issues with the statement above, and like all theories I need to create observations and experiments to prove it. However, if my analysis is correct, then triple bottom line returns to being bottom line reporting and bottom line reporting currently is the measure of wealth. My point is that people misunderstand the purpose of economics. Economics is an abstraction of reality. Wealth is an abstraction of reality. Society and the environment is the reality that economics is describing. By combining the three we are mixing the drivers with the result. Society and the environment are the drivers and economic wealth is the result, or at least one result. Economics provides us with a measure to assist us in making a decision and in tracking performance to that decision. The measure it uses, money, is based on the society and the environment. In essence, triple bottom line is double counting and sometimes triple counting.

Why does it exist? It exists because economics, in its abstraction, does not describe the world effectively enough. In my opinion, either economics has to evolve to better describe the world or a new method of describing the world needs to be developed. The intermediary process of triple bottom line is only confusing the measurement and decision making framework rather than improving it.