The traditional measures of business performance, the financial results that find their way into annual reports, are all lagging indicators. They tell you where the company was last year, but they no longer—in a world of constant change and seemingly infinite choices—provide a reliable guide to where a company will be a year from now, far less five or ten years down the road.
But leading indicators have proved difficult to define, and even more difficult to measure. This publication has frequently made the case that the best guide to the future performance of an organization is the quality of its relationships with key stakeholders. But we have also acknowledges the absence of any convincing methodology for measuring these relationships.
Now, along come Jonathan Low and Pam Cohen Kalafut of the Cap Gemini Ernst & Young Center for Business Innovation with a book that makes the case for a broader set of intangibles that drive corporate success, and some suggestions for managing and measuring those intangibles. Invisible Advantage: How Intangibles are Driving Business Performance won’t be the last word on the subject, but it does present a provocative and ultimately convincing thesis.
Low and Kalafut point to a dozen different intangibles that have a major impact on corporate performance: leadership, strategy, communications, brand, reputation, alliances and networks, technology, human capital, workplace culture, innovation, intellectual capital, and adaptability.
Public relations professionals have a direct involvement in managing communications, brand, and reputation, but they play an equally vital role in several other areas: effective communication is a key factor in leadership; reputation is important in attracting human capital and by extension intellectual capital; and employee communication is a primary contributor to building a healthy workplace culture. As intangibles become more important, the role of public relations within an organization will be greatly enhanced—and its practice more challenging.
Intangibles are becoming more important, the authors say, because of the increasingly competitive environment in which companies operate, and also because of the increasing transparency that comes with an unprecedented degree of scrutiny. Traditional differentiators are no longer enough to sustain competitive advantage.
“The increase in the level of competition has increased the strategic importance of intangibles,” say the authors. “If a company faces constant competition, after all, what does it have to fall back on? Size alone isn’t enough. Physical assets—factories, stores, equipment—can help, but only until someone changes the rules of the game. Financial strength is always a plus, but it doesn’t necessarily translate into competitive advantage.
“What companies can fall back on are precisely those assets and competencies that are hardest for competitors to emulate: an ability to innovate; adaptability, or the ability to turn on a dime as market conditions change; dedicated, loyal, well-trained employees; a powerful brand; a sterling reputation; and systems—information systems, production systems, service-delivery systems—that can provide customers what they want, when they want it.”
Low and Kalafut are not the first to insist on the importance of non-financial measures—New York University’s Baruch Lev has been undertaking some fascinating research into the same subject—but they do offer some important research, demonstrating that even hard-nosed financial executives factor “soft issues” into their decisions. And they present some useful guidelines for measuring and thus managing intangibles.
They acknowledge that measurement has been a stumbling block for many of those who believe in the importance of intangibles.
“An economy in which intangibles loom so large presents a puzzle,” the authors acknowledge. “Economists don’t really know what’s going on, because the measurements they rely on capture only a portion of economic activity. Accountants can give only a partial picture of a company’s health, because they haven’t yet developed tools to track and value assets that can’t be touched or spent.
“Investors are operating in the twilight. We have found in our research that the savviest among them rely heavily on intangibles in evaluating a company’s performance and prospects, which all by itself should be enough to make a CEO sit up and take notice. But they don’t do so systematically—and most companies haven’t yet figured out how to tell investors what they really need to know.”
It’s clear from the authors’ research that others are giving serious consideration to the issue of intangibles. They quote former SEC chairman Arthur Levitt, who told the Economic Club of New York, “As intangible assets grow in size and scope, more and more people are questioning whether true value—and the drivers of that value—are being reflected in a timely manner in publicly available disclosure.” And they point to the work of a task force appointed by the U.S. Securities & Exchange Commission, which suggested companies should be encouraged to provide more information on intangible assets.
And Low and Kalafut have done some research of their own, surveying buy-side investors who manage portfolios for pension and mutual funds, banks, insurance company, and other large financial institutions. The authors gave each respondent a fund to allocate to any of several different unnamed companies, and provided information on those companies: financial data including P/E ratio, sales growth, and earnings per share; and information on intangibles.
When the researchers analyzed how professional investors spread their wealth around, they found that on average 35 percent of professional investors’ allocation decisions were driven by non-financial data or intangibles. Say the authors: “More than one third of the information used to justify these large-scale investment decisions is non-financial.”
Among the various intangibles, information about strategy, management credibility and innovation tended to carry more weight that information about customer complaints, employee training programs, or environmental policy.
The conclusion has interesting implications for the corporate governance debate. According to the authors, “While the people who run companies are busy beefing up their balance sheets and managing their earnings, the people who invest in companies are looking at indicators such as what’s in the R&D pipeline, whether the company has the talent it needs, and whether it does what it says it’s going to do.”
If managers invested half the energy that currently goes into smoothing quarterly earnings into building better stakeholder relationships, not only would their companies be better run, they’d also be better rewarded in the marketplace.
A similar return, the authors say, awaits companies that open their books to internal and external stakeholders.
“In the past, companies tried to control the flow of information that reached the outside world,” say Low and Kalafut. “They talked only to a few favored analysts. They guarded company secrets. They changed course without much explanation. As organizations they were opaque rather than transparent. Plenty of companies would still like to operate in this manner, no doubt, but it’s getting harder, maybe even impossible…. There’s a growing clamor for more and more disclosure of more and more information.
“This is one bandwagon that business people would be well advised to climb on, and the sooner the better. In the intangibles economy, transparency provides an invisible advantage… The more information you provide (within reason), the more intelligent will be the response of those you hope will lend you money, invest in your equities, seek you out as a customer, or accept you as a supplier.”
There are chapters dealing with each of the 12 intangibles, including reputation. While the authors are not experts, they have done their research, and they draw heavily on studies conducted by Burson-Marsteller, as well as by Charles Fombrun and the Reputation Institute. They back up their case with a handful of illuminating examples.
Low and Kalafut point to what happened in 1999, after Coca-Cola was accused of selling a tainted product in Belgium. The company “lost $34 billion in market value; profits of its European subsidiary fell by $205 million; Coke’s proposed acquisition of European soft drink giant Orangina was rejected by the European Commission; and the CEO lost his job soon after.
“All this stemmed from an episode in which the facts were in dispute. The market reaction was so severe because the damage was to intangibles: The company’s reputation for unimpeachable leadership, for sterling brand management, for effective communications, and for sensitivity to the nuances of alliance and network management.”
By contrast, Low and Kalafut point to Singapore International Airlines as a company that was able to enhance its reputation in a crisis, after experiencing the first deadly crash in its history in October 2000. The day after the crash, the airline offered $25,000 to the families of those who had died to help cover immediate expenses. When it was determined that the crash was caused by pilot error, SIA offered each family another $400,000, five times the amount required by law.
According to the authors: “SIA was acting to protect what it perceived to be its most valuable assets: the intangibles of brand, reputation, and leadership based on treatment of its customers.”
Finally, they get into a valuable discussion of how to measure—and manage—intangibles, discussing some of the approaches taken by companies on the leading edge, and offering their own ideas.
Several companies have attempted to measure the impact of intangibles. The authors cite Sears Roebuck, which has tracked the relationship between employee satisfaction, customer satisfaction, and financial performance; Alcoa, which measured the impact of worker safer on morale, productivity, and financial success; and Southwest Airlines, which has seen a significant return on its investment in hiring and developing people who fit its unique culture.
Their own methodology has five phases.
First, they say, determine the critical intangibles for your business. Every industry has three or four intangibles that wind up being the most important. “We studied half a dozen different industries, and we rarely found consistency in the rankings,” they say. In manufacturing, for example, innovation, quality of management, and employee relations were most important, while in financial services the key intangibles are management quality, technology, brand and customer relations. In the airline industry, the most important intangible is employee quality.
Second, companies need to decide on metrics for their key intangibles. They should ask what they already measure—often they will find someone somewhere in the organization is already gathering the data they need. Other metrics are easily established: customer and employee turnover, and turnover, for example. Other qualities, like leadership, are tougher to measure, but the company can ask itself several questions: are departing leaders sought for top-level jobs elsewhere; are specific management training programs held up as industry benchmarks?
Third, create a baseline and then benchmark it against your competition. “The purpose of managing intangibles isn’t simply to get better scores, it’s to outflank your competitors with moves that are difficult or impossible to copy,” say the authors. “So you need to know where your competitors’ strengths and weaknesses are, and to gauge them against your own.” This involves a substantial amount of research, they say, and often requires the use of an outside consultant.
Fourth, undertake initiatives to improve your performance on key intangibles. According to Low and Kalafut, “Intangibles can be managed. Your performance can be improved.” Innovation, for example, can be measured by the number of new products in the pipeline; by the number of new patents; by the proportion of revenues and profits that derive from products or services that are less than three years old. It’s not enough to focus on the R&D department, however. “Intangibles such as innovation permeate a company…. So every business unit and department should be expected to come up with initiatives.”
Finally, communicate what you’re doing. Citing Enron as an example of an opaque company, the authors argue that companies need open systems to make intangibles work to their full potential. “Share your insights into intangibles with employees, customers, suppliers, industry groups, investors and Wall Street analysts,” Low and Kalafut urge. “Share your metrics and your targets; let them know what you expect to achieve and why it’s important.”
Invisible Advantage offers considerable encouragement to the public relations industry, especially since its authors don’t come at the issue from a public relations perspective.
It’s easy to see how public relations will benefit from an increased emphasis on intangibles, since so many of the important intangible drivers of business success are dependent on the strength of an organization’s relationships with its key stakeholders.
But just as important, public relations and investor relations people need to start telling the story of their companies’ intangible assets, explaining to stakeholders—including shareholders—what the company is doing to manage invisible assets and why.
Invisible Advantage by Jonathan Low and Pam Cohen Kalafut is published by Perseus Publishing.