Big corporations must make sweeping organizational changes to get the best from their professionals.

Lowell L. Bryan and Claudia Joyce

2005 Number 3

About half a century ago, Peter Drucker coined the term "knowledge worker" to describe a new class of employee whose basic means of production was no longer capital, land, or labor but, rather, the productive use of knowledge. Today, these knowledge workers, who might better be called professionals, represent a large and growing percentage of the employees of the world's biggest corporations. In industries such as financial services, health care, high tech, pharmaceuticals, and media and entertainment, professionals now account for 25 percent or more of the workforce and, in some cases, undertake most typical key line activities. These talented people are the innovators of new business ideas. They make it possible for companies to deal with today's rapidly changing and uncertain business environment, and they produce and manage the intangible assets that are the primary way companies in a wide array of industries create value.

Productive professionals make big enterprises competitive, yet these employees now increasingly find their work obstructed. Creating and exchanging knowledge and intangibles through interaction with their professional peers is the very heart of what they do. Yet most of them squander endless hours searching for the knowledge they need—even if it resides in their own companies—and coordinating their work with others.

The inefficiency of these professionals has increased along with their prominence. Consider the act of collaboration. Each upsurge in the number of professionals who work in a company leads to an almost exponential—not linear—increase in the number of potential collaborators and unproductive interactions. Many leading companies now employ 10,000 or more professionals, who have some 50 million potential bilateral relationships. The same holds true for knowledge: searching for it means trying to find the person in whose head it resides, because most companies lack working "knowledge markets." One measure of the difficulty of this quest is the volume of global corporate e-mail, up from about 1.8 billion a day in 1998 to more than 17 billion a day in 2004. As finding people and knowledge becomes more difficult, social cohesion and trust among professional colleagues declines, further reducing productivity.

A flawed organizational design

Today's big companies do very little to enhance the productivity of their professionals. In fact, their vertically oriented organizational structures, retrofitted with ad hoc and matrix overlays, nearly always make professional work more complex and inefficient. These vertical structures—relics of the industrial age—are singularly ill suited to the professional work process. Professionals cooperate horizontally with one another throughout a company, yet vertical structures force such men and women to search across poorly connected organizational silos to find knowledge and collaborators and to gain their cooperation once they have been found.

Worse yet, matrix structures, designed to accommodate the "secondary" management axes that cut across vertical silos, frequently burden professionals with two bosses—one responsible for the sales force, say, and another for a product line. Professionals seeking to collaborate thus need to go up the organization before they can go across it. Effective collaboration often takes place only when the would-be collaborators enlist hierarchical line managers to resolve conflicts between competing organizational silos. Much time is lost reconciling divergent agendas and finding common solutions.

Other ad hoc organizational devices, such as internal joint ventures, co-heads of units, and proliferating task forces and study groups, serve only to complicate the organization further and to increase the amount of time required to coordinate work internally. The result is endless meetings, phone calls, and e-mail exchanges as talented professionals—line managers or members of shared utilities—waste valuable time grappling with the complexity of a deeply flawed organizational structure.

A new organizational model

To raise the productivity of professionals, big corporations must change their organizational structures dramatically, retaining the best of the traditional hierarchy while acknowledging the heightened value of the people who hatch ideas, innovate, and collaborate with peers to generate revenues and create value through intangible assets such as brands and networks. Companies can achieve these goals by modifying their vertical structures to let different groups of professionals focus on clearly defined tasks—line managers on earnings, for instance, and off-line teams on longer-term growth initiatives—with clear accountability. Then these companies should create new, overlaid networks and marketplaces that make it easier for professionals to interact collaboratively and to find the knowledge they need.

Companies can not only build this new kind of organization but also reduce the complexity of their interactions and improve the quality of internal collaboration by implementing four interrelated organizational-design principles:

1. Streamlining and simplifying vertical and line-management structures by discarding failed matrix and ad hoc approaches and narrowing the scope of the line manager's role to the creation of current earnings
2. Deploying off-line teams to discover new wealth-creating opportunities while using a dynamic management process to resolve short- and long-term trade-offs
3. Developing knowledge marketplaces, talent marketplaces, and formal networks to stimulate the creation and exchange of intangibles
4. Relying on measurements of performance rather than supervision to get the most from self-directed professionals

The ideas underlying each of these policies may not be entirely new, but we don't know of any company that applies all of them holistically—and this failure limits the ability to perform up to potential. A company that tries to simplify its vertical organizational structure without helping large numbers of self-directed professionals to collaborate more easily might increase its efficiency, for example. But that would be more than offset by a decrease in its effectiveness.

Simplify the line structure

The first design principle is to clarify the reporting relationships, accountability, and responsibilities of the line managers, who make good on a company's earnings targets, for all other considerations will get short shrift until short-term expectations are met. To achieve this goal, a company must establish a clearly dominant axis of management—product, functional, geographic, or customer—and eliminate the matrix and ad hoc organizational structures that often muddle decision-making authority and accountability. Dynamic management and improved collaboration, as we show later, are better ways of accomplishing the purposes of these ad hoc structures.

A company that aims to streamline its line-management structures should create an effective enterprise-wide governance mechanism for decisions that cross them, such as the choices involved in managing shared IT costs. These mechanisms are typically created by defining and clarifying the decision-making authority of each member of the senior leadership team and establishing enterprise-wide governance committees as required. It may also be necessary to take important support functions, which demand focused management, out of the line structure, so that specialized professionals (rather than line managers, who are often, at best, gifted amateurs) can run these functions as shared utilities.

Finally, to promote the creation of enterprise-wide formal networks, parallel structures and parallel roles should be established across the whole extent of the company. Defining the role of the comptroller or the country manager consistently throughout it, for example, helps the people in those roles to interact and collaborate.

Manage dynamically

Once the newly simplified vertical structure allows line managers to limit their attention to meeting the near-term earnings expectations of the company, it has the luxury of focusing other professionals on the long-term creation of wealth. The advantages of such a separation are obvious. As one executive we know put it, you don't want people who are engaged in hand-to-hand combat to design a long-term weapons program.

Ongoing multiyear tasks such as launching new products, building new businesses, or fundamentally redesigning a company's technology platform usually call for small groups of full-time, focused professionals with the freedom "to wander in the woods," discovering new, winning value propositions by trial and error and deductive tinkering. Few down-the-line managers, who must live day to day in an intensely competitive marketplace, have the time or resources for such a discovery process.

Not that companies should forgo discipline while undertaking such a project. In fact, the portfolio-of-initiatives approach to strategy enables them to "plan on being lucky" by using the staged-investment processes of venture capital and principal investing firms, as well as the R&D processes of leading industrial corporations. ¹ Companies that take this approach devote a fixed part of their budgets (say, 2 to 4 percent of all spending) and some of their best talent to finding and developing longer-term strategic initiatives. Each major one usually has a senior manager as its sponsor to ensure that resources are well invested. Once an initiative is ready to be scaled up—when revenues and cost projections become clear enough to appear in the budget—it can be placed in the line structure.

Of course, at the enterprise level, companies must manage their short- and long-term earnings in a way that integrates their spending on strategic initiatives with the overall budget, so they will need to adopt a systemic, effective way of making the necessary trade-offs. What we call dynamic management can help: a combination of disciplined processes, decision-making protocols, rolling budgets, and calendar-management procedures makes it possible for companies to manage the portfolio of initiatives as part of an integrated senior-management approach to running the entire enterprise. Dynamic management forces companies to make resource allocation trade-offs, explicitly, at the top of the house rather than allowing them to be made, implicitly, by down-the-line managers struggling to make their budgets. This change further simplifies the line managers' role.

Develop organizational overlays

Having stripped away unproductive matrix and ad hoc structures from the vertical organization and clarified the line structure, a company must develop organizational overlays in the form of markets and networks that help its professionals work horizontally across its whole extent. These overlays make it easier for them to exchange knowledge, to find and collaborate with other professionals, and to develop communities that create intangible assets.

Because these market and network overlays help professionals to interact horizontally across the organization without having to go up or down the vertical chain of command, they boost rather than hinder productivity. Companies that establish such overlays are making investments not only to minimize the search and coordination costs of professionals who exchange knowledge and other valuable intangibles among themselves but also to maximize the opportunities for all sorts of cost-effective, productive interactions among them.

We believe that moving simultaneously into knowledge marketplaces, talent marketplaces, and formal networks will make all three more effective. A knowledge marketplace, for example, helps members of a formal network to exchange knowledge, which in turn helps to strengthen the network. A talent marketplace works better if the people who offer and seek jobs in it belong to the same formally networked community. In combination, these techniques can make it possible for companies to work horizontally in a far more cost-effective way.

Knowledge marketplaces. For the better part of the past 15 years, knowledge management has generated a good deal of buzz. Despite heavy investment, the benefits have been limited. Real value comes less from managing knowledge and more—a lot more—from creating and exchanging it. And the key to meeting this goal is understanding that the most valuable knowledge of a company resides largely in the heads of its most talented employees: its professionals.

Exchanging knowledge on a company-wide basis in an effective way is much less a technological problem than an organizational one. As we have argued, to promote the exchange of knowledge, companies must remove structural barriers to the interaction of their professionals. These companies must also learn how to encourage people who may not know each other—after all, big corporations usually have large numbers of professionals—to work together for their mutual self-interest. What's the best way of encouraging strangers to exchange valuable things? The well-tested solution, of course, is markets, which the economy uses for just this purpose. The trick is to take the market inside the company.

How can companies create effective internal markets when the product is inherently intangible? Among other things, working markets need objects of value for trading, to say nothing of prices, exchange mechanisms, and competition among suppliers. In addition, standards, protocols, regulations, and market facilitators often help markets to work better.

These conditions don't exist naturally—a knowledge marketplace is an artificial, managed one—so companies must put them in place. ² In particular, the suppliers of knowledge must have the incentives and support to codify it (that is, to produce high-quality "knowledge objects"). "Buyers" must be able to gain access to content that is more insightful and relevant, as well as easier to find and assimilate, than alternative sources are.

Knowledge marketplaces are a relatively new concept, so they are rare. We have found that building an effective one in a large company requires significant investments to get the conditions in place—but that such a marketplace can indeed be built. A successful mechanism of this kind substantially improves the ability to create and exchange knowledge and dramatically cuts search and coordination costs.

Talent marketplaces. A company can create similar efficiencies by developing a talent marketplace that helps employees in a talent pool, either within a single organizational unit or across the enterprise, to explore alternative assignments varying from short-term projects to longer-term operating roles. Simultaneously, anyone with assignments to offer can review all of the people looking for new opportunities. As with marketplaces for knowledge, companies must invest in their talent markets to ensure that gifted men and women looking for new jobs hook up with managers seeking talent.

Companies must define the talent marketplace by specifying standardized roles, validating the qualifications of candidates, determining how managers receive the job seekers' performance evaluations, and so forth. The other requirements include pricing (the compensation for a particular role or assignment), an exchange mechanism to facilitate staffing transactions, and protocols and standards (how long assignments run, the mechanics of reassignment, the process of conveying decisions to reassign employees). Talent marketplaces do exist—particularly in professional organizations—but like knowledge marketplaces they are at an early stage of development.

Formal networks. People with common interests—such as similar work (industrial engineers, say), the same clientele (the automotive industry), or the same geography (China)—naturally form social networks. These networks lower the cost of interaction while increasing its value to all participants. A network often provides them with increasing returns to scale: the larger it is, the more chances they have to find opportunities for collaboration.

Social networks do face problems. They often have limited reach (for example, because they don't extend to many potential members in far-flung units and geographies). What's more, they sometimes operate inefficiently (several conversations might be required to reach the right person), may rely too much on the participants' goodwill, and, most particularly, can fail to attract enough investment to serve the common good of all members effectively.

The solution, for a company, is to boost the value of the network by investing in it and formalizing its role within the organization. One such move is the designation of a network "owner" to build common capabilities (for instance, by making investments to generate knowledge). Others include developing incentives for membership, defining separate territories (the existence of more than one social network may confuse would-be members), establishing standards and protocols, and providing for a shared infrastructure (say, a technology platform supporting the network's activities).

In fact, a formal network with specific areas of economic accountability can undertake many of the activities that have inspired companies to use matrix management structures. A formal network relies on self-directed people who work together out of self-interest, while a matrix uses a hierarchy to compel people to work together. In addition, a formal network enables people who share common interests to collaborate with relatively little ambiguity about decision-making authority—ambiguity that generates internal organizational complications and tension in matrixed structures.

Although social networks flourish at many companies, only a few have formalized them. That next step, though, is one of the most important things a company can do, because it removes unnecessary complexity from horizontal interactions among talented people across organizational silos.

Measure performance

The final set of ideas rounding out this new organizational model involves relinquishing some level of supervisory control and letting people direct themselves, guided by performance metrics, protocols, standards, values, and consequence-management systems.

To be sure, accountable leaders must control large companies even as many of their workers become more and more self-directed. But what's needed is inspired leadership, not more intrusive management. Of course, management will continue to be vital—particularly to get value from the many employees who will go on laboring in "industrially engineered" processes and to hold all of a company's workers and managers accountable for their performance.

But as the workforce increasingly comes to consist of self-directed professionals, leaders will have to manage them by setting aspirations and using performance metrics that motivate them to organize their work, both individual and collective, to meet those aspirations. One successful CEO once told us that to motivate behavior, measuring performance is more important than providing financial incentives to reward it. The challenge is that to measure it effectively, the metrics must be tailored to individual roles and people. Get the metrics wrong and unintended behavior is the result.

To motivate the collaborative behavior that makes this new organizational model work, companies must create metrics that hold employees individually accountable for their contribution to collective success—an idea we call holding people "mutually accountable." Such metrics are particularly important for senior and top managers but are required, more broadly, for all self-directed workers. People who are great at developing the abilities of other talented people or at contributing distinctive knowledge, for example, should be more highly valued than those who are equally good at doing their own work but not at developing talent or contributing knowledge.

A new organizational model for today's big corporations will not emerge spontaneously from the obsolete legacy structures of the industrial age. Rather, companies must design a new model holistically, using new principles that take into account the way professionals create value. Big companies that follow these principles will get more value, at less cost, from the managers and the professionals they employ. In the process, they can become fundamentally better at overcoming the challenges—and capturing the opportunities—of today's economy.

The largest corporations rarely sustain strong growth unless they compete in the right places at the right times.

Sven Smit, Caroline M. Thompson, and S. Patrick Viguerie

2005 Number 3

Growth is once again top of mind for business executives. As they turn their attention from improving the operational performance of their companies to making those companies grow again, many of them will follow the standard message: consistently strong, value-creating revenue growth lies within reach of major corporations that pursue best practice in strategy, marketing, operations, and organization.

Or does it? Execution and fundamentals are certainly vital, but growth, particularly for the largest companies, requires more than best practice. At the median annual revenue level of today's Fortune 100—about $30 billion—a corporation would in effect have to create a $2 billion company each year to sustain 6 percent top-line growth. Can investors and capital markets reasonably expect that kind of performance? How do some companies achieve it?

To explore the particular challenges of revenue growth in big corporations, we studied the performance of about 100 of the largest ones in the United States, in 17 sectors, over the two most recent business cycles. Almost a third of the companies managed to increase their revenues at a rate faster than the growth of GDP over the second cycle, from 1994 to 2003, while at the same time delivering shareholder returns above those of the S&P 500 index. The relatively large number of high performers here might indicate that the odds for companies aspiring to grow are decent, if not for a sobering fact: 90 percent of these companies were concentrated in just four sectors—financial services, health care, high tech, and retailing.

It isn't surprising that they are overrepresented. These sectors as a whole, or markets and segments within them, offer favorable growth environments supported by established trends: aging populations, rapid product or format innovation, deregulation, and consolidation. What's striking for large growth-minded corporations is just how crucial it is to have this kind of favorable wind at their backs when they try to achieve strong growth.

Looking across the two economic cycles also revealed the critical role of top-line growth. Large companies that trailed GDP for an entire business cycle were five times more likely to be acquired or otherwise go out of business than were faster growers. Eventually, companies that don't increase their revenues run out of ways to drive earnings and shareholder returns. Even if a company finds a way to create shareholder value, slow-growing companies remain attractive acquisition targets.

These findings have broad implications for management. The first is that large companies need to pay at least as much attention to top-line growth as to increasing the bottom line. While cost improvements can drive earnings and shareholder value in the near term, companies that raise their total returns to shareholders (TRS) without achieving top-line growth have the worst long-term odds of survival. Many companies that struggle to grow do indeed face a "grow-or-go" situation.

Second, where to compete is just as important as how. The choices a large company makes today about its portfolio mix and where to place its bets will shape its growth trajectory over the next five to ten years. Unless the company enjoys the advantages of fast-growing pools of revenues and profits or has ample opportunity to consolidate, growth that just keeps pace with GDP will be difficult to sustain, even if execution is great.

That vital top-line growth

Our research focused on 102 US public companies: the top 75 in 1994 revenues and the top 75 in 1994 market capitalization. We tracked these companies over the 1994–2003 business cycle and segmented their growth performance by revenues (including acquisitions and divestitures) and TRS, which encompasses both share prices and dividends. The median compound annual growth rate (CAGR) for revenues was around 5 percent, corresponding to nominal GDP growth over the period. At 11 percent, the median annual growth rate of TRS was roughly equal to that of TRS for the S&P 500 index.

We labeled companies whose top-line growth outpaced GDP and whose TRS outperformed the S&P 500 as growth giants and those that achieved above-average TRS growth but trailed in revenues as TRS performers . The unrewarded companies increased their revenues at a rate faster than the median but weren't rewarded with corresponding TRS growth. The challenged companies underperformed on both measures.

Thirty-two companies occupy our growth giants category, and most of them—20 percent of the overall sample—achieved double-digit revenue growth over the period while outperforming the S&P 500 on TRS (Exhibit 1). That accomplishment struck us as particularly impressive, even if more than half of these companies used acquisitions extensively ¹ to drive top-line growth.

Although we found a positive relationship between the growth of revenues and of TRS over the ten-year period, exceptions abounded. Companies that increased their revenues at a rate faster than the growth of GDP were 60 percent more likely to outperform the S&P 500 index. But nearly 20 percent outperformed it despite sluggish top-line growth. In fact, the median TRS performer increased its revenue by only 3 percent but, like the growth giants, boasted average TRS growth of 16 percent.

As might be expected, the TRS performers compete mostly in slower-growth industries, such as consumer goods, engineering and construction, and utilities. The keys to their ability to create value were good execution, cost controls, and savvy portfolio management—all of which generated strong earnings growth. Many of these companies sold or exited lower-margin businesses and bought or entered higher-margin ones. Half of the TRS performers increased their earnings at a rate at least twice that of their revenues, and 37 percent pursued major divestiture programs. ²

Next we asked what might happen over the longer term. How would the TRS performers and the growth giants cope in a subsequent business cycle? Could they maintain their momentum for an additional five or ten years? And what of the challenged and unrewarded companies—could they turn their TRS around, or did another outcome await them?

To find out, we chose a slightly different sample and a longer time horizon. With the same method we used for our first sample, we identified the 100 largest US public companies in 1984 and then followed their performance over the business cycles of 1984–93 and 1994–2003. When we segmented the performance of these companies during the earlier business cycle, only 20 percent made the grade as growth giants (Exhibit 2, part 1).

We then tracked the companies from each quadrant into the 1994–2003 cycle, examining patterns of survival and TRS performance. The correlation between the future survival of a company and its past revenue growth—but not its TRS—was striking. A company whose revenue increased more slowly than GDP did was five times more likely to succumb, usually through acquisition, than a company that expanded more rapidly (Exhibit 2, part 2). Past TRS performance, by contrast, was a surprisingly poor indicator of corporate survival.

Past revenue growth was also a superior predictor of future TRS performance. Almost half (45 percent) of the growth giants sustained their outperformance in both top-line growth and value creation through the 1994–2003 cycle, and nearly two-thirds continued creating value at a high rate. Even the unrewarded top-line growers from the previous decade had a better than even chance of surviving and outperforming during the 1994–2003 cycle (Exhibit 2, part 3). It was the challenged companies and, above all, the TRS performers that had the worst odds.

The reason is straightforward: most TRS performers from the 1984–93 cycle competed in slower-growth industries, such as utilities and telecommunications, which consolidated during the subsequent one. Most of those that weren't acquired continued to struggle with revenue and earnings growth. Unless these companies embarked on a successful acquisitions program or shifted their business mix, they couldn't capture enough gains from reducing costs or restructuring in their existing businesses to compensate for the lack of top-line growth.

Companies that don't increase the top line eventually hit a TRS wall and often become targets for acquisition. Even the largest companies may therefore find themselves grappling with fundamental grow-or-go decisions.

Where to compete

How does a large company achieve and maintain strong growth? Our analysis of the 32 growth giants in the 1994–2003 sample reveals a sobering reality: good execution is required, but being in the right business at the right time is almost always a prerequisite as well.

The tailwind factor

Four sectors—financial services, health care, high tech, and retailing—collectively accounted for half of all large companies in our sample but for nearly 90 percent of all growth giants in the 1994–2003 cycle (Exhibit 3). The overall economy grew at a rate of 5 percent during those years. Meanwhile, financial services, supported by deregulation, increased borrowing, and the trend toward broader participation in equity markets, grew by 7 percent. So did high tech, propelled by the innovation and information revolution of the 1990s; high-tech services grew even more robustly, at 9 percent.

Health care expenditures grew by 7 percent as a result of innovation and an aging population. Most of the health care growth giants, such as Johnson & Johnson, Eli Lilly, and Pfizer, were concentrated in pharmaceuticals, which expanded even more quickly—by a 12.5 percent CAGR from 1994 to 2003. A similar story unfolded in retailing, which expanded by only 4.5 percent as a whole but much faster in segments where growth giants competed. Wal-Mart Stores' format innovations in the late 1980s, for instance, boosted growth in the overall discount-store segment, to the benefit of followers like Target. In the home-improvement segment, Lowe's, another growth giant, revamped its store format and capitalized on the do-it-yourself craze that The Home Depot created in the 1980s.

Good execution is needed for strong growth, but so is competing in the right business at the right time

Since most growth giants had the benefit of a favorable growth environment, more than 70 percent of them (23 in all) succeeded in generating impressive financial results by exploiting opportunities in their existing businesses. Most of these companies focused on incremental product innovations or consolidation or on the geographic expansion of a business model or a series of products within the United States. For the 3 growth giants lacking a tailwind, consolidation in the core business was the preferred strategy. ³

Breakthrough innovations—new products, retail formats, supply chain models, and so forth that change the competitive game or produce a distinct competitive advantage—were unusual for large companies. We found only four growth giants that developed such innovations during the 1994–2003 cycle and used them as the primary driver of growth. All of them were new products from R&D-intensive industries that experienced a tailwind: technology and health care. None of the growth giants owed their achievements to reinventing the business model. While radical innovations of this kind have propelled companies (such as Dell) from relative obscurity to the Fortune 100, they are rarely pursued or executed successfully after companies become large.

Not all growth giants stuck to their knitting; the other 30 percent (nine in all) extended the scope of their portfolios by building or acquiring new businesses or expanding into global markets. ⁴ Except for the diversified conglomerate Berkshire Hathaway, all of the growth giants entered adjacent customer or product markets or focused on internationalizing a successful business model or series of products. Seven of the nine companies used acquisitions to enter new markets.

But success in building businesses was about more than acquisitions or customer and product strategies. The companies that excelled at it had either truly distinctive capabilities or operational assets that created a real competitive advantage in the new arena. Johnson & Johnson and Medtronic, for example, use acquisitions to enter new product spaces but drive organic growth by leveraging excellent product development and commercialization capabilities and superior relationships with doctors, hospitals, and other customers. Of the nine business builders, eight took advantage of industry momentum by building or acquiring new operations in health care, financial services, or technology.

Only one growth giant built a big new business without the backdrop of a rapidly growing market: Wal-Mart, which used its network of stores, its brand, its supply chain expertise, and a format innovation to enter the relatively slow-growing US market for perishable grocery products. The other business builders may or may not have been looking for the next favorable business environment. Creating a new business, however, not only gave them opportunities to behave and grow like an attacker but also provided moderate diversification if the prevailing favorable winds were to shift in the core business. ⁵

The experience of the large companies that we followed across the 1984–93 and 1994–2003 business cycles shows how difficult it is to grow without a tailwind. Although almost half of these companies maintained their status as growth giants through the two cycles, all except Wal-Mart had or built new businesses in health care or financial services—sectors that were hot in both cycles. Similarly, most companies in the challenged category from 1984 to 1993 lumbered along in industries that were then growing slowly: automotive, defense, oil, and utilities. Twenty percent of the challenged companies (7 of 37) managed to become growth giants during the next cycle, but a favorable environment was important: five of the seven growth turnarounds took place in industries whose conditions improved dramatically. Only 2 companies moved from our challenged category to become growth giants without substantial growth in demand. Both were grocery chains that relied heavily on consolidation, investing at least 80 percent of their 2003 market cap in acquisitions over the period.

Catch the wind

When large companies face slow-growing markets and have few options for consolidation in their existing businesses, opportunities to change the growth trajectory are limited. The best approach is to reposition the portfolio of businesses, customers, products, and geographies to create a mix with a higher potential for growth.

In 1994, for example, ITT Industries was a diversified conglomerate with holdings ranging from hotels to defense electronics. It then decided to concentrate on two segments—defense electronics and fluid technologies (pumps, mixers, and valves)—that seemed likely to grow and were well aligned with ITT's capabilities. The rest of the portfolio was spun off, and these divestitures not only created substantial value for shareholders but also gave the remaining parts of ITT a strong operational focus in segments with favorable growth conditions. In 2003, the company's revenue had reached only 70 percent of its 1994 level, so ITT wasn't a growth giant by our criteria. It did, however, increase its annual TRS by 18 percent during this portfolio transition, and the remaining businesses are growing rapidly, by an average of 18 percent over the past three years.

IBM's turnaround strategy also focused on the portfolio, although the company did less pruning and put greater emphasis on building new businesses. Management believed that IBM's brand, customer relationships, and engineering skills could propel growth in the emerging IT services market. From 1994 to 2003, the company's largely organic growth in services ranged from 15 to 20 percent, and the proportion of its corporate revenue from services, starting out at 25 percent, rose to almost 50 percent. ⁶ These strong growth prospects have been a major driver of the company's TRS—almost 22 percent a year during the sample period.

Viewed over the course of ten years, the top-line growth performance of ITT, IBM, and other companies that transformed their portfolios was characterized by divestitures or strategic decisions to exit businesses with relatively low growth potential. These transformations created considerable shareholder value and gave such companies a better position to increase their revenues and TRS in the next cycle.

Grow or go?

When a large company faces a headwind in its existing businesses, consolidation and efforts to transform the portfolio are its most plausible ways to grow. Even so, these are not without risk.

Consolidation strategies have a better chance for success when a company can show that it has "earned the right to buy." Do its operating margins and returns on invested capital (ROIC) compare favorably with those of its industry peers? Has it created value through mergers and acquisitions in the past? The answers to these questions—as well as the industry's readiness for consolidation—have a direct bearing on whether buying makes more sense than selling.

M&A skills and sound operations are part of the picture for any company that considers transforming its portfolio. But it is even more important to place the right bets on where to compete. A company must not only figure out which markets are likely to be attractive but also have a realistic view of its own capabilities. Are any of them powerful enough to confer a competitive advantage in a new geography, product, or customer segment—or even a different sector? The importance of having a real competitive advantage holds whether an entry strategy calls for organic growth or acquisitions.

The bar for distinctive capabilities is high. A company may believe that it has them in logistics or the supply chain, for example. But are they so strong that customers of other companies will switch? Will these capabilities support a price premium or allow the company to maintain operating margins that competitors can't match? If the answer to all of these questions is no, the capabilities don't provide a true competitive advantage; they are merely things the company does well.

For companies struggling to increase their revenues, a high bar to investments in new capabilities, markets, and growth seems particularly well justified. One-third of the 37 challenged companies from the 1980s chose to sell before 2003. As a group, the sellers performed well, realizing median compound annual TRS growth of 19 percent from 1994 to the time of sale, as compared with only 11 percent for the median survivor in the challenged category. In other words, unless your company has a reasonable chance of turning itself around, don't dismiss the "sell" option too quickly.

As a company becomes larger, the question of where it should compete becomes more critical. Choosing the right battlegrounds means matching its distinctive capabilities to the businesses, customers, products, and geographies where profitable growth is most likely to occur and acting on those insights before it's too late. A company that struggles with growth may have few distinctive capabilities. Building or acquiring new ones that can stimulate growth surely ought to be explored—as should the possibility of selling.