The Yin and Yang of modern corporate leaders

“What is interesting to understand is that there is almost no interdisciplinary dialogue between the best academic research in Finance and Strategy. University institutes and academic conferences all around the world commonly identify with either of the two fields, and university courses offered to upcoming professionals also neatly separate along this divide with virtually no courses on financial Strategy or strategic Finance provided to students. But why is that and – more importantly - what can corporate leaders do to learn from it?”, asks Jakob Müllner, who is also Associate Professor at WU’s Institute for International Business

Finance vs. Strategy - why a look into corporate history helps

Finance and Strategy have developed along historically opposing aims and world views. The main focus of Finance, on the one hand, was to understand how "normal" companies function under "functioning markets." The aim was to understand the fundamentals that apply generalizable to all companies. To be able to make such generalizable statements, finance theory uses efficient market assumptions. These allowed finance scholars to boil down the inner workings of companies to the most reliable and valuable mechanisms that ensure profitable companies.

On the other hand, Strategy has always dedicated itself to understanding the outliers, exceptions to the rule, and the most competitive companies. Rather than studying how "normal" companies function, strategists have tried to explore what makes some companies better than average. “To get back to our analogy from medicine, Strategy can be compared to clinical medicine, which is not focused on understanding how the body (companies) work but on what exceptions there are to this functioning, like illnesses, for example”, Jakob Müllner adds.

Understanding the rules of the game

To study the exceptions, Strategy does not require assumptions about how the market is supposed to work (market efficiency). After all, market imperfections commonly confer a competitive advantage in the first place. For example, not all investors are fully diversified and interchangeable. Some strategic investors offer benefits that go beyond what is measurable by capital asset pricing. Similarly, not all companies are interchangeable with unique resources of strategic value. On a more macro-, market-level, the same applies. Markets do not efficiently price social and environmental consequences of business. These market imperfections have recently brought strategic opportunities for companies to light in the form of ESG. Having clear advantages when it comes to explaining deviations from the rule, strategy struggles to make generalizable recommendations. A strategy that might work for one company will easily fail for a different company.

Like Yin and Yang – balancing the best of both worlds

But what does this mean for corporate leaders in an increasingly complex and uncertain world? Just like doctors must understand the workings of the human body and exceptions to it, today's corporate leaders must understand both the fundamental mechanics of Finance and the exceptional value of Strategy. Though theoretically opposing forces like Yin and Yang, strategic foresight and financial diligence must be balanced. The key is to understand the nature of the decision as now both perspectives can offer insights. An interesting anecdotal example, therein is Nobel Laureate and originator of portfolio theory, Harry Markowitz. Tough Harry Markowitz, developed the formula to optimize financial portfolios of assets (in efficient markets), he recognized the limitations of his formula in a market where parameters change and, instead, applied a much simpler heuristic when investing himself. In other words, Harry Markowitz a true pioneer of quantitative methods knew about the limitations of financial models and included strategic aspects in his decision making.

Outbalancing the dilemma

Dogmatism and ideological silos on either side threaten to lead companies down one of two paths in an increasingly dynamic world:

• On the one hand, foregoing important strategic investments because of purely financial rationale will ultimately result in a loss of competitiveness.
• On the other hand, disregarding the financial health of the company will create costs of financial distress when exogenous events rattle the markets more frequently.

The key is to know the value each perspective offers in a particular context and build on the strengths of each domain. However, one question remains: How can leaders balance these opposing forces?

Here are a few practical guidelines for this:

• Think probabilistically, not deterministically.

Finance is good in numbers. But even if financial models are perfectly calculated, they are subject to many assumptions. They imply a certain status quo and disregard the dynamics of the future. Therefore, financial indicators like NPV should not be interpreted as true future realities but as ceteris paribus ("all things being equal") estimates with a probability distribution to the left and right.

• Analyze the nature of the decision first.

Decision makers should first assess the nature of the decision and the efficiency of the market. Where markets are efficient, financial metrics and reasoning offer very reliable tools. When decisions regard markets or assets that are unique, opaque or context specific, strategic reasoning is much more applicable. Applying financial metrics (e.g,, NPV) to such decisions might lead decision makers to ignore the strategic implications. There are ways to include strategic value in investment valuation (e.g, real options or simulation) but these approaches have limitations of their own, requiring solid strategic validation.

• Do not trust forecasts (your own or experts).

The same applies to forecasts. All forecasts are merely mathematical estimates from the status quo that is currently known. In a dynamic environment, forecasts are likely to fail. This, in turn, should advise the way you interpret valuations and investment decisions.

• Always consider both inside and outside views when making decisions.

Finance and Strategy have opposing world views. This can lead to biased assessments. One of these biases can be prevented by combining inside and outside views. When, for example, assessing the value of an investment, an inside view focused on the costs, revenues, and risks of the project at hand is essential but should always be complemented by external comparisons with similar projects. Generally, leaders are well-advised to combine such internal (financial) detail and external strategic comparisons when making decisions.

• Make contingency plans.

When the future is probabilistic, it is essential to make contingency plans for negative outcomes. In the event of positive outcomes, the return on investments can be maximized (in financial theory, this is sometimes referred to as “real options”). Ideally, companies have operational and financial flexibility. This flexibility increases the firm's value, especially when times are volatile.

Conclusion:

Following these simple rules of thumb will help CEOs be better financial experts and CFOs be better strategists.

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