The CEO walks in, trailed by his entourage. They are deferential and wait for him to take a seat across from us. Their firm’s hierarchical culture surrounds them like a desert dust cloud. He wastes little time with small talk before launching into the PowerPoint pitch: why our big asset management firm should sink billions into his stock. The pitch is about two things really. They mostly all are.
The two things are certainty and the waterfall chart.
Certainty is what we money managers demand. We promise our clients a secure retirement. Our bonuses are (sort of) on the hook for this promise. To deliver it, we want secure investments. Secure means no surprises. No surprises mean…out comes the waterfall chart slide.
The CEO explains. His firm has identified three major initiatives: cost cutting, better pricing through brand investment, and expansion into emerging markets. Each one will generate x amount of earnings growth. Add them all and you get to his target earnings. This is the ‘guidance’ they tell the Street they are committed to meeting. Analysis and iron execution is all it takes. The CEO is all about iron execution. We nod our heads. We can depend on it.
The waterfall chart, though, has an Achilles Heel. For a while there, through much of the past 20 years, the chart seemed invulnerable: all shield, sword and muscle. When pierced in this particular spot, though, the waterfall chart collapses. This seems to be happening more and more lately, leaving scores of corporate Achilles prone on the battlefield.
The heel is complexity.
The waterfall chart is about as static and reductionist as you can get. It pretty much screams “…assuming nothing else is going on at the time,” nothing like, for example, interdependence and feedback, the stock characteristics of networked ecosystems.
Ecosystems produce an effect familiar to anyone that has read Alice in Wonderland. It is a key concept in ecology, first developed in the 1970s by a scientist named Leigh Van Valen. Van Valen looked at the extinction rates of shellfish species in a fossil record. What he found was that the species disappeared at a uniform rate. It was almost like a conveyor belt was launching them off the planet, and the best their adaptations could do was keep them running in place for awhile. Van Valen, riffing on Lewis Carroll, dubbed it the Red Queen Effect.
When you think about it, the Red Queen doesn’t just exist because of interspecies arms races. One species’ fantastic adaptation could be offset by maladapted prey. The shellfish were often only as successful as their food sources.
Out there, in that ancient shallow sea, it was ecosystem vs. ecosystem.
The waterfall chart’s casual, “all else equal” optimism reflects a stable time, one in which corporate profits were rising for pretty much everyone. That stability is not a feature of ecosystems. It is a transient phase, one whose lifespan, in evolutionary terms, is like that of a well-liked character on Game of Thrones.
Ecosystem dynamics emerge. They can have tipping points and cascades, positive feedback loops and, occasionally, seas of tranquility. The waterfall chart assumes all that away. It only has room for linear, piecemeal causality: if the company just does x and y, earnings of z will result. The chart has all the self-awareness of a grounded teenager!
Out there, in that modern corporate landscape, it’s ecosystem vs. ecosystem.
Strategy is best when it leaves room for, anticipates, and even shapes ecosystem emergence. To take the first step down that path is to throw out the waterfall chart. No matter how useful it seems, how tight one wants to hold to it, the truth is that the chart obscures network dynamics from view. It is more than a pitch slide. It is a frame, a mindset, a way of seeing the world, a way that needs to change as stability ebbs.
That waterfall chart has got to go.
Diego Espinosa is a former BCG strategy consultant, hedge fund manager and Wall Street Director of Research.