Turning conventional wisdom on its head, a Senior Partner and an Innovation Specialist from McKinsey & Company debunk the myth that high-octane, built-to-last companies can continue to excel year after year and reveal the dynamic strategies ofdiscontinuityand creative destruction these corporationsmustadopt in order to maintain excellence and remain competitive. In striking contrast to such bibles of business literature asIn Search of ExcellenceandBuilt to Last,Richard N. Foster and Sarah Kaplan draw on research they conducted at McKinsey & Company of more than one thousand corporations in fifteen industries over a thirty-six-year period. The industries they examined included old-economy industries such as pulp and paper and chemicals, and new-economy industries like semiconductors and software. Using this enormous fact base, Foster and Kaplan show that even the best-run and most widely admired companies included in their sample are unable to sustain their market-beating levels of performance for more than ten to fifteen years. Foster and Kaplan's long-term studies of corporate birth, survival, and death in America show that the corporate equivalent of El Dorado, the golden company that continually outperforms the market, has neverexisted. It is a myth. Corporations operate with management philosophies based on the assumption of continuity; as a result, in the long term, they cannot change or create value at the pace and scale of the markets. Their control processes, the very processes that enable them to survive over the long haul, deaden them to the vital and constant need for change. Proposing a radical new business paradigm, Foster and Kaplan argue that redesigning the corporation to change at the pace and scale of the capital markets rather than merely operate well will require more than simple adjustments. They explain how companies like Johnson and Johnson , Enron, Corning, and GE are overcoming cultural "lock-in" bytransformingrather than incrementally improving their companies. They are doing this by creating new businesses, selling off or closing down businesses or divisions whose growth is slowing down, as well as abandoning outdated, ingrown structures and rules and adopting new decision-making processes, control systems, and mental models. Corporations, they argue, must learn to be as dynamic and responsive as the market itself if they are to sustain superior returns and thrive over the long term. In a book that is sure to shake the business world to its foundations,Creative Destruction, likeRe-Engineering the Corporationbefore it, offers a new paradigm that will change the way we think about business. From the Hardcover edition.

Richard Foster is a senior partner and director at McKinsey & Company and the author of the bestselling Innovation: The Attacker's Advantage, named one of the best business books of the year by The Wall Street Journal. Sarah Kaplan worked at McKinsey & Company for many years, specializing in innovation and technology management. Foster lives in New York City, and Kaplan in Boston.

Introduction: The Game of Creative Destruction

1

(7)

Survival and Performance in the Era of Discontinuity

7

(18)

How Creative Destruction Works: The Fate of the East River Savings Bank

25

(36)

Cultural Lock-In

61

(29)

Operating vs. Creating: The Case of Storage Technology Corporation

90

(35)

The Gales of Destruction

125

(18)

Balancing Destruction and Creation

143

(18)

Designed to Change

161

(20)

Leading Creative Destruction

181

(28)

Increasing Creation by Tenfold

209

(27)

Control, Permission, and Risk

236

(25)

Setting the Pace and Scale of Change

261

(27)

The Ubiquity of Creative Destruction

288

(9)

Appendix A: List of Companies

297

(14)

Appendix B: Managerial Approach of Principal Investors

311

(1)

Appendix C: Dynamic Performance Analysis (DPA)

312

(27)

Notes

339

(11)

Selected Sources

350

(3)

Index

353

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Survival and Performance in the Era of Discontinuity

This company will be going strong one hundred and even five hundred years from now.
- C. Jay Parkinson, President of Anaconda Mines, statement made three years in advance of Anaconda's bankruptcy

In 1917, shortly before the end of World War I, Bertie Charles (or B.C., as he was known) Forbes formed his first list of the one hundred largest American companies. The firms were ranked by assets, since sales data were not accurately compiled in those days. In 1987, Forbes republished its original "Forbes 100" list and compared it to its 1987 list of top companies. Of the original group, 61 had ceased to exist.

Of the remaining thirty-nine, eighteen had managed to stay in the top one hundred. These eighteen companies--which included Kodak, DuPont, General Electric, Ford, General Motors, Procter & Gamble, and a dozen other corporations--had clearly earned the nation's respect. Skilled in the arts of survival, these enterprises had weathered the Great Depression, the Second World War, the Korean conflict, the roaring '60s, the oil and inflation shocks of the '70s, and unprecedented technological change in the chemicals, pharmaceuticals, computers, software, radio and television, and global telecommunications industries.

They survived. But they did not perform. As a group these great companies earned a long-term return for their investors during the 1917-1987 period 20% less than that of the overall market. Only two of them, General Electric and Eastman Kodak, performed better than the averages, and Kodak has since fallen on harder times.

One reaches the same conclusion from an examination of the S&P 500. Of the five hundred companies originally making up the S&P 500 in 1957, only seventy-four remained on the list through 1997. And of these seventy-four, only twelve outperformed the S&P 500 index itself over the 1957-1998 period. Moreover, the list included companies from two industries, pharmaceuticals and food, that were strong performers during this period. If today's S&P 500 today were made up of only those companies that were on the list when it was formed in 1957, the overall performance of the S&P 500 would have been about 20% less per year than it actually has been.

For the last several decades we have celebrated the big corporate survivors, praising their "excellence" and their longevity, their ability to last. These, we have assumed, are the bedrock companies of the American economy. These are the companies that "patient" investors pour their money into--investments that would certainly reward richly at the end of a lifetime. But our findings--based on the thirty-eight years of data compiled in the McKinsey Corporate Performance Database, discussed in the Introduction--have shown that they do not perform as we might suspect. An investor following the logic of patiently investing money in these survivors will do substantially less well than an investor who merely invests in market index funds.

McKinsey's long-term studies of corporate birth, survival, and death in America clearly show that the corporate equivalent of El Dorado, the golden company that continually performs better than the markets, has never existed. It is a myth. Managing for survival, even among the best and most revered corporations, does not guarantee strong long-term performance for shareholders. In fact, just the opposite is true. In the long run, markets always win.

The Assumption of Continuity

How could this be? How could a stock market index such as the Dow Jones Industrial average or the S&P 500 average--which, unlike companies, lack skilled managers, boards of experienced directors, carefully crafted organizational structures, the most advanced management methods, privileged assets, and special relationships with anyone of their choosing--perform better, over the long haul, than all but two of Forbes's strongest survivors, General Electric and Eastman Kodak? Are the capital markets, as represented by the stock market averages, "wiser" than managers who think about performance all the time?

The answer is that the capital markets, and the indices that reflect them, encourage the creation of corporations, permit their efficient operations (as long as they remain competitive), and then rapidly--and remorselessly--remove them when they lose their ability to perform. Corporations, which operate with management philosophies based on the assumption of continuity, are not able to change at the pace and scale of the markets. As a result, in the long term, they do not create value at the pace and scale of the markets.

It is among the relatively new entrants to the economy--for example, Intel, Amgen, and Cisco--where one finds superior performance, at least for a time. The structure and mechanisms of the capital markets enable these companies to produce results superior to even the best surviving corporations. Moreover, it is the corporations that have lost their ability to meet investor expectations (no matter how unreasonable these expectations might be) that consume the wealth of the economy. The capital markets remove these weaker performers at a greater rate than even the best-performing companies. Joseph Alois Schumpeter, the great Austrian-American economist of the 1930s and '40s, called this process of creation and removal "the gales of creative destruction." So great is the challenge of running the operations of a corporation today that few corporate leaders have the energy or time to manage the processes of creative destruction, especially at the pace and scale necessary to compete with the market. Yet that is precisely what is required to sustain market levels of long-term performance.

The essential difference between corporations and capital markets is in the way they enable, manage, and control the processes of creative destruction. Corporations are built on the assumption of continuity; their focus is on operations. Capital markets are built on the assumption of discontinuity; their focus is on creation and destruction. The market encourages rapid and extensive creation, and hence greater wealth-building. It is less tolerant than the corporation is of long-term underperformance. Outstanding corporations do win the right to survive, but not the ability to earn above-average or even average shareholder returns over the long term. Why? Because their control processes--the very processes that help them to survive over the long haul--deaden them to the need for change.

The Reality of Discontinuity

This distinction between the way corporations and markets approach the processes of creative destruction is not an artifact of our times or an outgrowth of the "dot.com" generation. It has been smoldering for decades, like a fire in a wall, ready to erupt at any moment. The market turmoil we see today is a logical extension of trends that began decades ago.

The origins of modern managerial philosophy can be traced to the eighteenth century, when Adam Smith argued for specialization of tasks and division of labor in order to cut waste. By the late nineteenth century these ideas had culminated in an age of American trusts, European holding companies, and Japanese zaibatsus. These complex giants were designed to convert natural resources into food, energy, clothing, and shelter in the most asset-efficient way--to maximize output and to minimize waste.

By the 1920s, Smith's simple idea had enabled huge enterprises, exploiting the potential of mass production, to flourish. Peter Drucker wrote the seminal guidebook for these corporations in 1946, The Concept of the Corporation. The book laid out the precepts of the then-modern corporation, based on the specialization of labor, mass production, and the efficient use of physical assets.

This approach was in deep harmony with the times. Change came slowly in the '20s, when the first Standard and Poor's index of ninety important U.S. companies was formed. In the '20s and '30s the turnover rate in the S&P 90 averaged about 1.5% per year. A new member of the S&P 90 at that time could expect to remain on the list, on average, for more than sixty-five years. The corporations of these times were built on the assumption of continuity--perpetual continuity, the essence of which Drucker explored in his book. Change was a minor factor. Companies were in business to transform raw materials into final products, to avoid the high costs of interaction between independent companies in the marketplace. This required them to operate at great scale and to control their costs carefully. These vertically integrated configurations were protected from all but incremental change.

We argue that this period of corporate development, lasting for more than seventy years, has come to an end. In 1998, the turnover rate in the S&P 500 was close to 10%, implying an average lifetime on the list of ten years, not sixty-five! Drucker predicted the turning point with his 1969 book The Age of Discontinuity, but his persuasive arguments could not overcome the zeitgeist of the '70s. The '70s were, for many managers, the modern equivalent of the 1930s. Inflation raged, interest rates were at the highest levels since before World War II, and the stock market was languishing. Few entrants dared risk capital or career on the founding of a new company based on Drucker's insights. It was a fallow time for corporate start-ups. As the long-term demands of survival took over, Drucker's advice fell on deaf years.

The pace of change has been accelerating continuously since the '20s. There have been three great waves. The timing and extent of these waves match the rise and fall of the generative and absorptive capabilities of the nation. The first wave came shortly after World War II, when the nation's military buildup gave way to the need to rebuild the consumer infrastructure. Many new companies entered the economy at this time, then rose to economic prominence during the 1940s and 1950s, among them Owens-Corning, Textron, and Seagram.

The second wave began in the 1960s. The rate of turnover in the S&P 90 began to accelerate as the federal defense and aerospace programs once again stimulated the economy, providing funds for the development of logic and memory chips, and later the microprocessor. They were heady days--"bubble days," in the eyes of some. The hot stocks were called "one-decision" stocks: Buy them once and never sell them, and your future fortune was assured.

The bubble burst in 1968. The New York Stock Exchange, which had risen to almost 1000, did not return to that level again until the early 1980s. During this absorptive, or slack, period, when the country was beset with rising oil prices and inflation, and when bonds earned returns substantially greater than equities, few new companies joined--or left--the S&P 500. Interestingly enough, though, despite the worst economic conditions the nation had endured since the Depression, the minimum rate of corporate turnover did not drop to the low rate of turnover seen in the 1950s. The base rate of change in the economy had permanently risen.

Paul Volcker, chairman of the Federal Reserve Bank, finally led the charge that broke the back of inflation, and the number of new companies climbing onto the S&P 500 accelerated. In the 1980s, once again the S&P began substituting new high-growth and high-market-cap companies for the slower-growing and even shrinking-market-cap older companies. The change in the S&P index mix also reflected changes in the economic mix of business in the United States. When the markets collapsed in the late '80s and a short-lived recession hit the American economy in the early '90s, the rate of substitution in the S&P 500 fell off. But again, even at its lowest point, the rate of turnover was higher than it was during the 1970s decline. The minimum level of change in the economy had been quietly building, and was increasing again. This was even more evident as the technology-charged 1990s kicked into gear, accelerating the rate of the S&P Index turnover to levels never seen before. By the end of the 1990s, we were well into what Peter Drucker calls the "Age of Discontinuity." Extrapolating from past patterns, we calculate that by the end of the year 2020, the average lifetime of a corporation on the S&P will have been shortened to about ten years, as fewer and fewer companies fall into the category of "survivors."

The Gales of Discontinuity

The Age of Discontinuity did not arrive in the 1990s by happenstance. It arose from fundamental economic forces. Among these are:

The increasing efficiency of business, due to dramatic declines in capital costs. As industry shifted from goods to services, there was a concurrent decline in interaction and transaction costs. These costs declined because of the advent of information technology and the steady rise in labor productivity due to advances in technology and management methods.

The increasing efficiency of capital markets, due to the increasing accuracy (and transparency) of corporate performance data.

The rise in national liquidity, due to the improved profitability of U.S. corporations, and a favorable bias, unparalleled anywhere else in the world, toward U.S. equities.

Strengthened fiscal management by the federal government, including an effective Federal Reserve, and reduced corporate taxes.

These forces have helped to create the likes of Microsoft, with a market capitalization greater than all but the top ten nations of the world (Microsoft's real assets make up about 1% of its market value). Computer maker Dell has virtually no assets at all. Internet start-up companies begin with almost no capital. For these companies, returns on capital are unimaginably large by previous standards. Productivity is soaring. The pipeline of new technology is robust. There are more than 10,000 Internet business proposals alone waiting for evaluation at venture capital firms, even after the Nasdaq collapse in March and April of 2000. By all reports, the number (if not the quality) of these proposals is increasing all the time. Information technology is not nearing its limits. The effectiveness of software programming continues to grow; communications technology is just beginning. The global GDP will double in the next twenty years, creating approximately $20?$40 trillion in new sales. If, through the productivity improvements the Internet enables, the world can save 2% of the $25 trillion now produced, the market value of those savings will run into the trillions.

Incumbent companies have an unprecedented opportunity to take advantage of these times. But if history is a guide, no more than a third of today's major corporations will survive in an economically important way over the next twenty-five years. Those that do not survive will die a Hindu death of transformation, as they are acquired or merged with part of a larger, stronger organization, rather than a Judeo-Christian death, but it will be death nonetheless. And the demise of these companies will come from a lack of competitive adaptiveness. To be blunt, most of these companies will die or be bought out and absorbed because they are too damn slow to keep pace with change in the market. By 2020, more than three quarters of the S&P 500 will consist of companies we don't know today--new companies drawn into the maelstrom of economic activity from the periphery, springing from insights unrecognized today.

The assumption of continuity, on which most of our leading corporations have been based for years, no longer holds. Discontinuity dominates. The one hundred or so companies in the current S&P 500 that survive into the 2020s will be unlike the corporate survivors today. They will have to be masters of creative destruction--built for discontinuity, remade like the market. Schumpeter anticipated this transformation over a half century ago when he observed: "The problem that is usually being visualized is how capitalism administers existing structures, whereas the relevant problem is how it creates and destroys them."

Excerpted from Creative Destruction: Why Companies That Are Built to Last Underperform the Market - And How to Successfully Transform Them by Richard Foster, Sarah R. Kaplan
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