11/11/2014 06:04 am ET Updated Jan 11, 2015

The Best Thing Ever Written About Strategy

This weekend, I've been revisiting my misspent youth, by reading again the musings of Bruce Doolin Henderson and his colleagues from the Boston Consulting Group (BCG) in its early years. When BCG was an unknown, tiny company, Bruce spent his energy on just two things: inventing the concepts of "business strategy" from scratch; and writing very short "tracts" -- what today we would call blogs -- in the form of dark green Perspectives, each on one aspect of strategy, which he then mailed to CEOs. Amazingly, this ploy worked. Or perhaps it is not so amazing, because the quality of BCG "posts" was incredibly high, far higher than almost anything about business on the entire internet today.

And you know what? The early stuff was by far the best.

Today I've picked out two of these essays, one by Bruce and one by a colleague, and explain why they are so useful today.

The Product Portfolio (1970)

Yes, this is the famed "BCG Box", aka the Growth-Share Matrix. In this early version of the idea invented two years earlier, the "dogs" are called "pets" - these are the low market share businesses in low growth markets. What BCG soon was to call "cash cows" - after starting by calling them "gold mines", in many ways a better description - are shown on the 1970 chart as simply "cash flow": the high share businesses in low growth markets. The question mark was always called that - low share, but high growth market. And my beloved "star business" - with high market share and high market growth - was always called that.

I will focus just on the star business, as I did in my book The Star Principle. This is what Bruce had to say in 1970:

"The high-share, high-growth product is the star ... The payoff for leadership is very high indeed if it is achieved early and maintained until growth slows. Investment in market share during the growth phase can be very attractive if you have the cash. Growth in market is compounded by growth in share. Increases in share increase the margin. High margin permits higher leverage with equal safety. The resulting profitability permits higher payment of earnings after financing normal growth. The return on investment is enormous."

There we have, in a terse, tightly-argued single paragraph, about the most profound truth ever written about strategy.

Read it again and again, and you see the force of Bruce's micro-economic logic.

There is a virtuous circle that is generated by investing in a star business in the early, high-growth days of a new market. The star grows very fast - it becomes ten times, a hundred times, maybe several thousand times bigger than today. And while growing, it is also cash positive and highly profitable. It also increases its margins and competitive security over time, as it becomes bigger and bigger relative to its rivals, who are stuck with higher costs and usually negative cash flow.

It is a venture capitalist's wet dream.

It is also my investment philosophy, and I can tell you, hand on heart, that it really works.

Yes, we may cavil with one or two of Bruce's assertions and assumptions. With the benefit of decades of experience and thought, we can see the weakness in his qualifying statement in the second sentence, "if you have the cash".

Bruce made two dubious assumptions: that strategy was largely a financial game; and that the firm's product portfolio was a closed system, where cash had to come from other parts of the portfolio (the cash cows).

We know now that all the cash in the world may not allow a star business to remain successful if a rival comes up with a product that is easier to use, more useful, or more artful. Product innovation is a more powerful tool for seizing and keeping market leadership in a star business than having a big bank balance - look, for instance, at the fate of IBM in personal computers, or of Xerox when faced with competition in desktop copiers from Ricoh and Canon, or at what happened to Kodak. In the world of the star, cash is not king. If it were, no garage-shop boot-strapping entrepreneur would ever win against a large, cash-rich corporation.

And we also know that the idea of the product portfolio was flawed. Some of the most successful companies in the world in the last hundred years or so have been (or were when most successful) single product star-business companies - Coca-Cola and McDonald's for example. If a company just has a single star business, it can obtain funding from outside the firm (the venture capital industry was very small when Bruce wrote in 1970, but it was itself a very high growth market about to explode, and large companies could always tap their shareholders for more equity capital).

But hey - the insight that the most wonderful business in the world is a star business is priceless. If you know this one fact about business, and act on it, you are far better off than all the business school professors and alumni, and all the most highly paid consultants.

Praise be to Bruce!

The Evils of Average Costing (1975)

This perspective, by the late Richard (Dick) Lochridge, discusses what happens when firms "average cost". This means that when they calculate the profitability of different products, they average the overhead costs, assigning the same percentage to each product. This is as common now as it was back in the 1970s.

Why is average costing a problem? Because high volume products typically have much lower overhead costs, so averaging the costs overstates the cost of these products, and understates the cost of the lower volume products. This encourages firms to introduce more and more products, believing erroneously that they are profitable.

"As a result," says Lochridge, "broad product lines tend to raise the manufacturing cost of all products. Cost averaging ignores this and therefore overstates the real and potential cost of the high-volume products ... The broader the product line and the larger the number and variety of the customers, the greater the use of overhead cost averaging. Since the leader typically has the largest product line and the biggest customer base, he tends to do the most cost averaging."

Therefore, cost averaging leads to loss of market share:

"The new entrant in the business is forced to focus because of his basic cost disadvantage ... he focuses on those sectors of the market that are being overcharged ... The overcharged customers tend to be the largest and most price-sensitive ... The leader abandons them to the new entrant because his average costing reports them as being less profitable."

The new entrant should therefore focus on the single biggest-volume product, and the big customers who are more profitable than they appear, and price to win this business.

The market leader should analyse its costs by customer group and by product, without averaging any costs. It should allocate overheads according to how much overhead is really necessary or used. This will normally result in big customers and high volume products being much more profitable than they appear to be under average costing. The prices of those products should then be cut, to ward off danger from new entrants.

Boring stuff? Maybe. But absolutely vital. Too often the market leader shoots itself in the foot by exaggerating the cost of providing its biggest volume products and the cost of serving its largest and best customers, opening the way for smaller rivals to make hay.

The Filofax Example

One of the oddities of the early BCG Perspectives is that they almost never give examples. So to make the two points above come alive, I'll give you my example - Filofax, my first serious foray into venture capital investing.

Around 1990 Filofax was a star business in trouble. It was about to lose its star status as a new entrant, Microfile, was taking business hand over fist from Filofax in its biggest market, the UK. Filofax, you may recall, was the iconic brand in non-electronic personal organizers, and had grown dramatically in sales and value in the early to mid-1980s. When I investigated it as a rescue investment in 1991-2, it was under pressure from Microfile, which provided a look-alike organizer at half the Filofax price. Sales at Filofax were plummeting as it lost market share and the company was in danger of going bust.

The problem was very simple. Microfile had focussed on a single product - its "filled organizer" with a diary, pages for contacts, a Tube map, and various other standard contents. By just making this product, it had been able to undercut Filofax's costs, despite not having Filofax's volume.

By contrast, the Filofax product range was out of control. It had a multiplicity of wallets and inserts available for everything under the sun - bird-watching, watch-collecting, esoteric sports and hobbies. The result was a huge overhang of worthless stock, and complete confusion amongst the Filofax retailers.

I organized a rescue bid for Filofax, changed the management, and focussed on producing a new version of the Filofax filled organizer. We cut costs dramatically, including almost the whole of the marketing budget! We cut the Filofax price so it was just above the Microfile price - the level of brand premium (10-15%) that our retailers said was sustainable. Within three years, Filofax volume had quadrupled and we were making money again. Filofax was again a clear star business, increasing its market share and leaving Microfile behind. When we sold the business - just as electronic organizers were getting their act together - we made seven times our money.

Thank you, BCG!

Concepts make money.

Next week I will reflect on a remarkably important and neglected piece by Bruce Henderson on Business Thinking - as fresh as when written in 1977. It contains insight that is as vital for our personal lives as for our business dealings.

If you want to read the BCG Perspectives for yourself, they are available in book form: Perspectives on Strategy, edited by Carl W Stern and George Stalk Jr. You might also want to read my book The Star Principle.

You may have noticed that I sometimes write about business theory and examples, and sometimes about psychological and philosophical issues that affect both business and the rest of our lives. Please let me know if you want more of one or the other, or whether I have the balance now about right.

If you find my blogs interesting or useful, please share them with a friend, leave a comment, or follow me on Twitter @RichardKoch8020