What Is Productivity? What Is Efficiency?

Back in 1997, I wrote a 15-page white paper synthesizing concepts I'd read in various publications on economics, including some of Joseph Schumpeter's seminal papers from the 1920s. The short version of the paper enabled my mentor, Gerry Weiss, to get me a meeting with an influential, well-known former money center bank CEO to discuss the concepts and my resulting research as it applied to corporate performance, both internally for resource allocation, and externally for equity portfolio management.

I found that prior economic literature had, for the most part, failed to distinguish between productivity and efficiency. So I wrote, in part,

"The critical difference between efficiency measures (called “volume efficiencies” in this paper instead of the popular term “productivity”) and productivity measures (called “resource value productivities” in this paper) is that the numerator of the latter are value-denominated, whereas the former are unit-denominated. Thus, volume efficiency measures can’t provide any information regarding the value of what was done more or less efficiently. By splitting what has come to be misnamed productivity into two properly different concepts, some of the confusion regarding the modern behavior of volume efficiency can be better understood."

Imagine my surprise, therefore, that 12 years later, the Wall Street Journal published an editorial in last Wednesday's edition by two McKinsey consultants addressing some of the same concepts. Except that they still didn't get it quite right.

Here's what James Manyika and Vikram Malhotra wrote in their editorial Productivity and Growth: The Enduring Connection,

"Productivity can come either from efficiency gains (i.e., reducing inputs for given output) or by increasing the volume and value of outputs for any given input (for which innovation is a vital driver.)"

The McKinsey guys are close to getting it right, but they still fail to properly split volume efficiency phenomena from the very different notion of creating more value for a level of output.

Further, from reading their article, it's clear that they still mistakenly deal in averages across an economy. They also misleadingly connect productivity and growth, as if one will drive the other.

Truth is, as I found in my proprietary research over a decade ago, the highest resource productivity gains aren't typically associated with raw growth in value for shareholders.

The actual relationships are much more complicated, but I can't discuss them here. It's proprietary.

But I can tell you this. McKinsey's contention that productivity is some amorphous concept which can be grown or driven higher across an economy to spur economic growth is wrong. That's not how Schumpeterian dynamics works. It has more to do with higher value-added solutions displacing older ones in an economy, not simply flogging older competitors' operations to somehow run leaner and faster. Those activities won't create more consumer value.

You might be able to measure these concepts across an economy. But that doesn't mean they are managed or occur at that level.

However, I'm quite sure Manyika's and Malhotra's puff piece in the Journal is just the public facet of a well-orchestrated push, complete with Powerpoint presentations, that's being delivered to every potential client. It makes for good face time and high-spot meetings with CEOs to suggest some new project for, naturally, McKinsey, to measure various aspects of the firm's efficiency and productivity.

For those CEOs and senior executives who can't think for themselves, it will sound very seductive. It reminds me of something Bob Gach, a partner at Andersen Consulting years ago when I worked there, used to say. He didn't like Morgan Stanley, his lead client, very much. He said they were a bad client because they knew too much. Ideally, he contended, a client had to be smart enough to know they needed help, but, unlike the old Salomon, Goldman or Morgan Stanley, not so smart as to know they could do most of the job themselves. That probably also describes the ideal McKinsey client.

From that perspective, this new spin on productivity sounds good, doesn't it? Won't actually help the companies, but it should help the McKinsey partners.

The Sudden Emergence of Contentions of 'the End of Savings Glut'

I have read two separate articles in the past week concerning a contended coming 'end of savings glut.' One piece, by David Wessel, appeared in the Wall Street Journal, while the other was in a recent edition of The Economist. Both cite McKinsey & Co.'s McKinsey Global Institute as the source of their articles.

Seeing McKinsey's institute cited twice in a week on the same topic makes me suspicious that the consulting giant is once again gearing up its media machinery to stoke demand for projects based on yet another shocking 'finding' from its 'institute.'

I recall when McKinsey created its institute many years ago. At the time, I was with Andersen Consulting, now Accenture, which, belatedly, I believe, created their own allegedly-separate research arm, as well. Back then, it was relatively easy to identify McKinsey's 'institute' concept as simply a way to refashion certain publicly-releasable elements of their confidential client work, the better to get free media attention and put forth an image of doing independent research. I said as much to senior executives at Andersen at the time, but it took quite a few years for them to come around to the McKinsey concept.

Whether this latest shocker from the consulting firm is the result of its deliberate consideration of the question, or simply an agglomeration of various client work elements, is not clear. Or even if it's mostly some deductions made from combing through available OECD information. Reading the two derivative articles suggests it could easily be the latter.

Rereading those pieces, I find myself rather unsurprised by McKinsey's alleged 'findings.' It doesn't take a genius to see that wealthier developing nation consumers will both attract more investment to build infrastructure to serve their evolving needs, as well as provide some savings from their accelerating incomes.

Are the estimates of global investment, savings, and growth from McKinsey accurate? I don't know. Why should they be any more accurate than those of other pundits, researchers and observers?

Here's a sample of Wessel's interpretation of the McKinsey report,

"The global savings glut could easily become global savings dearth. And that would mean substantially higher interest rates.

If long-term rates, adjusted for inflation, returned to the 40-year average, McKinsey estimates, they would be 1.5 percentage points higher, a big jump from the current 3% or so yield on 10-year Treasurys. And rates could go up more if emerging markets try to step up infrastructure and other investments faster than U.S. and other rich countries increase their overall saving, which could be an unwelcome brake on global growth."

Funny, I thought the US is dissaving to the tune of a trillion dollars of federal deficits per year, plus various municipal pension funding gaps in the tens of billions.

The fuzzy forecasts for various constructs- savings, investment, economic growth- combined with whether various rates rise, or fall, makes the whole notion of declaring a savings shortages a joke.

I'm not saying their won't be an 'end of savings glut,' nor that their won't be a rise in rates. But so much depends upon the movement of many inter-related factors that it's really just impossible to know, isn't it?

But, then, that's probably McKinsey's objective. To create some newly-imagined risks of uncertainty, the better, well, to go hire those supposedly-smart folks who wrote that study. Just in case there's new uncertainty.

This is classic consultant marketing. I can well-imagine the hours of conference-room sessions at McKinsey dreaming this one up. Corral a bunch of publicly-available statistics, use a lot of beach-time among under-employed junior staffers, and demonstrate the possibility of some shocking headline. Doesn't really matter what the headline is, so long as it's a shocking departure to something current. Change is news, change brings risk, and perceived new risk just might bring in some new assignments to assess various companies' risks to these new, possibly-changing facets of the global economy.

And McKinsey is doubtless counting on getting their share, or more, of those assignments. Regardless of whether there is going to be a dearth, or glut, of global savings on the horizon.

"Target-Proofing" Corporate Performance- How Probable Is It?

Friday's Wall Street Journal carried an editorial entitled, "Target-Proof Your Company," by Robert Pozen. Pozen is chairman of MFS Investment Management, and evidently adapted this piece from one he wrote for the Harvard Business Review.

Ironically, explaining that last part goes a long way toward explaining the rather ho-hum nature of his recommendations for how public companies may avoid becoming targets of private equity firms.

As I recall from many years reading HBR, it frequently would feature 'so-what' sorts of corporate pablum that espoused laudable, if largely unattainable goals.

For instance, Pozen's five questions for target-proofing a company are:

Is there too much cash on the balance sheet?

Is the capital structure optimal?

Does the operating plan significantly increase shareholder value?

Is executive compensation tied closely enough to shareholder value?

Do directors devote enough time and have enough incentive to increase shareholder value?

The first two questions are truly inane, at this point in modern corporate development. Any firm significant enough to merit private equity attention can afford a decent CFO who can make sure these tactical matters are appropriately managed.

The third question is, frankly, probably the toughest, hardest to achieve of any single question for modern corporate CEOs.

My proprietary research shows that, at best, only 10-20% of the S&P500 CEOs can figure out what to do in terms of fundamental, operating peformance, that leads to consistently superior shareholder returns.

Jeff Immelt's never done it. Chuck Prince never did, either. Nor most of the CEOs of large-cap companies. The best way to increase the odds of such shareholder return performance is, according to my findings, deceptively simple, and requiring of exceptional management talent and discipline.

Thus, Pozen's question, while useful, is, for all practical purposes, unanswerable by most CEOs and their boards. They simply have no clue.

If they did? They'd be doing it!

Questions four and five have elicited a myriad of posts from me over the past two years. Read my posts under labels such as 'corporate governance,' 'private equity,' 'executive compensation,' or 'Immelt.' Suffice to say, I've written about these topics prior to Pozen.

Don't pay CEOs for failure. Give them about $250-300K per year in cash, and the rest subject to a 3-5 year return performance that beats the S&P500. Lag that incentive compensation to force the CEO to focus on sustained outperformance of the S&P.

As for boards, I wrote this piece which pre-dated and anticipated Pozen's recommendations. I wrote,

"Here's another insight. If, as I wrote last summer as a solution to America's corporate governance problems, board members were required to "run" for the post, and invest significant assets of their own in the company, thus clearly aligning their financial interests with those of shareholders, it might improve corporate board oversight and involvement in the operation of companies.

Suppose private equity firm partners offered their services to a publicly-held company. Would they not, in effect, take board positions, in exchange for options to own much of the firm, or be paid a percentage of the value they created over, say, a function of the firm's prior total returns, relative to the S&P500? In effect, like my idea, they'd commit their financial fortunes to, and align them with those of the firm's. But what mechanism exists for shareholders to do this? None."

Pozen's ideas,

"Directors of private equity companies hold substantial equity in them, and share in the performance fees of the private equity funds -- typically, 20%-30% of the returns realized by these funds.

Such small boards may be particularly effective in smaller public companies, which have trouble recruiting outside directors,"

are precisely for what I have been arguing in this blog for years. They are not new.

Nor are they likely to happen. It's one thing to observe better practices. It's another to expect a set of wealthy, and growing wealthier, mediocre CEOs who sit on each other's boards to really care about their shareholders.

That's why, per this post, I forsook consulting with my research findings many, many years ago. Rather than try to change the culture of large-cap American businesses, it's easier just to invest in the ones that do what Pozen suggests, and leave the rest to muddle along on their own.