What comes first – Strategy or Structure?

The former US Secretary of Defence, Donald Rumsfeld, famously said, “You go to war with the army you have, not the army you might want or wish to have at a later time.” A robust military structure built on the foundations of unswerving training and a disciplined approach is one that is believed to win wars. This school of thought is supported by the military strategy of ‘attrition warfare’ whereby an army wins a battle by wearing down the enemy to the point of collapse through continuous losses in personnel and material. In such a scenario, the war is more often than not won by the side with more resources, the side with the bigger and stronger army so to say. The larger, more solid military structure triumphs. In other words, structure determines strategy.

This approach has given way to a modern school of thought called ‘manoeuvre warfare’ wherein readiness and flexibility are imbibed in military approach. Manoeuvre warfare implies defeating the enemy by tactically limiting the enemy’s movement. Napoleon used a combination of cavalry and fast infantry movement to defeat superior forces while they still moved to their intended place of battle. Shivaji, was another proponent of manoeuvre warfare, his army would use out of the box strategies and essentially the element of surprise to defeat the opponent. Manoeuvre warfare strategies are based on the premise that a fluid structure driven by a smart strategy and out of box thinking triumph over a disciplined structure, i.e. strategy determines structure.

The age-old debate of what comes first – strategy or structure is not limited to military warfare but extends to businesses as well. A study of the cause and effect relationship of these two interdependent concepts leads to interesting results.

The Structure-Conduct-Performance (SCP) framework which used to be famously used in industrial organization studies until about 20 years ago can be likened to attritional warfare. It posits that an industry’s structure dictates how firms in the industry behave and the behaviour of the company in turn drives its performance. Michael Porter’s five forces framework drew from the SCP framework and made it widely popular. Porter and industrial organization economists therefore believe that structure determines strategy (and the two together determine performance).

On the other hand, for ages, management theory has taught us that an organization’s strategy should determine its structure. The company’s vision and mission should drive all business decisions – capital structure, supply chain, reporting structure, employee policies, and so on. However, this implies that the management needs to mould the status quo to suit its objectives and attempt to alter external variables. Given the difficulty of the task ahead of them, most management teams opt for the easier way out – they change their strategy and vision to adapt to the existing industry and organization structure. Companies often fall prey to the “this is how things are done in this industry”, “this is our way of functioning”, leading to a gradual shift in strategy and alignment of all functions to the organization’s way of doing things. By trying to improve the way in which existing structures operate, and then gaining efficiencies in that structure, managers become creatures of the structure and succumb to the comforts of the known and trespassed. Unknown territories are looked at with doubt and not ventured upon for fear of the unknown. Creators of structure knowingly or unknowingly become creatures of that structure. While implementing any strategy, competitive forces and the industry structure often act as invisible barriers which an ordinary management cannot think beyond. This often serves as a deterrent to any kind of disruption or innovation and the company is caught up in its own narrow pond of thought. This results in a conundrum wherein all future strategy is drawn up within the four walls of the organization’s existing structure. Charles Ellis aptly summarizes this in his book Capital: The Story of Long-Term Investment Excellence (2004), “The more successfully a corporation perfects the efficiency of its structure, the more surely that structure will eventually strangulate the effectiveness of its strategy.” His namesake Charles Darwin’s statement is as relevant to the field of business as to the field of evolution “It is not the strongest of the species that survives, nor the most intelligent that survives. It is the one that is most adaptable to change.”

Investment implications:
Large, market leading organizations are generally associated with bureaucracy and processes that are difficult to change while younger, smaller organizations are associated with nimble footedness and agility. As a result, at Marcellus we often face the paradox of looking for dominant, market leading franchises that are also extremely fluid, which is why we end up investing from a small universe of stocks that portray this unique combination of market leadership and agility. We typically look for organizations that ideate like entrepreneurs and execute like MNCs. One of our portfolio companies, Bajaj Finance is a fitting example. Every year, the company zero bases its vital processes and starts from scratch to counteract the anchoring bias. This lends the company the freshness of a new venture even while sustaining as a large organization. Whether it is Asian Paints rethinking the structure of the paints industry (read Chapter 2 of the ‘Unusual Billionaires’ (2016)) or Bajaj Finance rethinking its processes every year, it is rare to find companies which have the courage and conviction to give strategy precedence over structure. It is this approach of completely altering the status quo rather than focusing on incremental innovation that leads to disproportionate benefits over long periods of time. Businesses which behave like Napolean and Shivaji show the limitations of the Porter and SCP frameworks. Our framework of identifying firms with long track records of outstanding results and then seeking to understand how their strategy drives structure upend the Porter and SCP frameworks.

Apart from looking for new companies that possess this unique characteristic, fluidity is an important conduit through which we also test our existing portfolio companies. In our analysis of portfolio companies, we conduct the ‘lethargy test’ wherein we constantly ask questions such as is the company nimble-footed, is it constantly innovating, is it only reacting to changes or is it being proactive and anticipating changes and so on.

Fluidity and flexibility in structure would imply true liberation of an organization’s strategy. Much like warfare, running successful companies is an art more than a science and much like in war, only the nimble-footed stand the test of time. Apart from ensuring that our portfolio companies keep demonstrating an ability to alter the status quo for their benefit, it is our continuous endeavour to discover clean companies which have the courage and clarity of thought to prioritise strategy over structure.

Tej Shah is a Portfolio Counsellor at Marcellus Investment Managers.

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