Profiting from Uncertainty: Strategies for Succeeding No Matter What the Future Brings - Hardcover

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Paul J. H. Schoemaker, PhD, a world-renowned authority on decision making and scenario-based strategic management, is chairman and CEO of Decision Strategies International, Inc. Formerly a strategic planner with Royal Dutch/Shell's scenario-planning group in London, Dr. Schoemaker has coauthored several books, including Decision Traps and Winning Decisions. In 2000, he co-edited Wharton on Managing Emerging Technologies and coauthored Peripheral Vision (both with George Day). His latest books are Chips, Clones and Living Beyond 100 and Brilliant Mistakes. Schoemaker is the author of a landmark 1995 article, "Scenario Planning," the second most requested reprint in the forty-one-year history of Sloan Management Review. In 2000, he was awarded the Best Paper prize by the Strategic Management Society, which publishes the leading academic journals in the field. Schoemaker also serves as Research Director of the Mack Center for Technological Innovation at the Wharton School, where he teaches decision making and strategy. For more than ten years he taught at the University of Chicago, and he has been a visiting professor with Cedep at Insead in France. Schoemaker is the founder and Executive Chairman of Decision Strategies International (DecisionStrat.com), which specializes in strategic decision making and leadership development, with offices in the US, Europe, and Asia.

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Chapter 1: Embracing Uncertainty

"The only 'risk' which leads to a profit is a unique uncertainty....Profits arise out of the inherent, absolute unpredictability of things."

-- FRANK KNIGHT, UNIVERSITY OF CHICAGO ECONOMIST, 1921

On March 17, 2000, a lightning bolt ignited a fire in Albuquerque, New Mexico, destroying a Philips semiconductor plant. Across the globe in Scandinavia, both Nokia and Ericsson depended on the factory for key chips in their cellular phones, and this chance disaster threatened to choke off their production. Nokia responded fast and flexibly, recognizing the problem thanks to its dynamic monitoring. Even before it was told of the plant shutdown, the company quickly patched together a solution. Ericsson, however, was less well prepared and moved slowly, losing an estimated $400 million in potential revenue, contributing to a corporate operating loss of about $1.86 billion in 2000 and ceding an increasing share of the global mobile phone market to Nokia. As Jan Ahrenbring, Ericsson's marketing director for consumer goods, told The Wall Street Journal, "We did not have a Plan B."

Ericsson lost some $400 million in sales -- a serious price to pay for not having a plan B. While it may be easy to understand how managers can be blindsided by a random lightning strike half a world away, this represents one of the simpler forms of uncertainty that managers face. It concerns a known risk with a very low probability and high potential cost -- against which managers can use insurance or contingency planning. The more challenging uncertainties that managers face are those they haven't a clue about -- when they wake up one day to find that the Berlin Wall has crashed to the ground or to recognize that the Internet has emerged or faded as a powerful new market space. Such uncertainties have the potential to create or destroy billions of dollars in market value:

• Cisco Systems very adroitly surfed the rising tide of the Internet to build one of the most successful information technology businesses in the world. Its market value skyrocketed for thirteen consecutive quarters and by April 2000 topped $550 billion, surpassing Microsoft and General Electric. Investors and managers began to believe it was a sure thing. Cisco, whose sophisticated Web-enabled accounting system allowed it to close its books hourly in a "virtual close," seemed to have the kind of tight rein on its business that would help avoid surprises. But then the tide of uncertainty turned against the company. In 2001 Cisco hit a downturn in the market that it had failed to anticipate. Its backward-looking accounting system turned out to be a highly polished rearview mirror that failed to keep the company from running off a cliff. It was also locked in to contracts and other commitments that made it hard to shift its strategy. Its revenues and share price plummeted over 70 percent, and worse, it had to take a $2.5 billion write-off for excess inventory. Cisco CEO John Chambers compared the slump to "a 100-year flood." He said, "It's something you don't expect to see in your lifetime. We never built models to anticipate something of this magnitude." But had the collapse of the Internet bubble and the ensuing recession really been that unpredictable? Or was the company so caught up in the euphoria of the moment that it had been slow to see the cross-currents swelling just below the surface?
  
  
• Even Nokia, the Finnish wireless equipment maker that grew to become the world's largest manufacturer of mobile phones by skillfully riding uncertain and turbulent market conditions -- and dodging occasional lightning strikes -- found itself blindsided by the ephemeral wireless market. In June 2001 it suddenly halved its forecasts for growth in handset sales, projecting lower second-quarter profits, and its share price fell by 23 percent. Is there any way it could have better prepared itself for this eventuality?
  
  
• The spectacular failure of Long-Term Capital Management (LTCM) in 1997 shows that even the brightest thinkers cannot fully anticipate the future. In this case, Nobel Prize-winning economists teamed up with savvy Wall Street traders using sophisticated computer models, but a future they did not bank on came to pass. They were blindsided by an unusual confluence of circumstances outside their mental frames. The failure of LTCM was also perhaps the result of sheer hubris, an unreasonable confidence in the team's ability to outsmart the market. As this elite team learned the hard way, the market can behave less rationally than their sophisticated models assumed. In the end, trading remains a very human business, fraught with the quirks and foibles that set us apart from machines.
  

So how do you come up with a plan B, and perhaps a plan C, when many uncertainties lurk around the corner? What will allow you to prepare for the lightning strikes or to capitalize on the gold strikes that occur with ever-increasing frequency in today's world? Uncertainty is ultimately the only source of superior profits, yet it entails a highly dangerous game. This game is where tremendous value is created -- and destroyed. How can you profit from the upside of uncertainty while managing the downside? How can you position yourself to win, no matter what the future holds?

The point of these examples is not to deride the companies involved for poor planning under uncertainty. It is easy to see the right path today, with twenty-twenty hindsight, when we know for certain what future came to pass; it is much harder to chart the right course in the midst of rapid change and high uncertainty. The point of these examples is first of all to show that the stakes are high. As economist Frank Knight points out in the quotation that opens this chapter, significant profit and loss are found in uncertain times. Cisco and Nokia, as well as other companies such as Microsoft and Amazon, all built tremendous wealth by charting a course across choppy seas that swamped many other boats. When more traditional players -- such as IBM, AT&T, and Sears -- struggled, the new kids on the block seized the opportunity. As 19th-century British banker Nathan Rothschild observed, "Great fortunes are made when the cannonballs are falling in the harbor, not when the violins play in the ballroom."

The second point of the examples above is to underscore that often the future that most rapidly undermines a business is the one that its managers fail to see or cannot imagine clearly enough to prepare for. It is well documented in behavioral decision research that we tend to become locked in our current frames, seeing what we are conditioned to see. Cisco may have seen things through rose-colored glasses long after the rest of the world had accepted that the U.S. economy was entering a downturn. As human beings, business leaders tend to be overconfident about their predictions of the future, especially if they have been successful in the recent past.

Why is it important to focus on uncertainty? First, it affects the part of the business that managers very often don't even try to manage -- the external environment -- and this is where much of the potential value of the business is created or destroyed. Second, the level of uncertainty in the business environment appears to be increasing significantly. And third, human beings have inherent limitations in dealing with uncertainty. To set the stage for the rest of the book, I'll explore each of these issues in more detail.

Leaving Half the Business to Fate

While managers concentrate most of their energies on the existing business, the management of external uncertainty may have far more potential for creating value. Studies across a wide variety of industries reveal that firm-specific actions account for just over half the value of a firm. About half...