The more I think and discuss about risk management, the more convinced I am about the importance of strategic risks. I have seen several companies with well developed hedging practices for their FX or interest rates exposures facing serious problems (i.e. going out of business) because of some unexpected changes in consumer preferences, the appearance of a new competitor or a new technology, etc…
Risk management is about managing risks and uncertainty in order to make a profit as a reward for assuming certain risks. The point is that if we do not consider all the potential risks faced by the firm (the risk map), we might be controlling all about some risks, leaving large exposures to some unforeseen risks (some might be more comfortable using the term uncertainty rather than risk in this case, I do not think the difference is important at this point). We usually classify risks in Strategic, Operational, Financial and Political Risks. Strategic Risks are, among the hardest to manage (i.e. identify, measure and hedge). This is due to several reasons: (i) there is no such thing as an accepted list of strategic risks, (ii) whoever poses the threat (or generates the opportunity) for our company might very well be somebody who is not an established player in the industry, (iii) there are no financial markets trading these risks, therefore there are no derivatives or financial counterparties that can help us hedging them, and (iv) there is no culture in analyzing strategic risks; nobody discusses them, and no regulator cares about them. This post is willing to, at least partially, alleviate this problem, by proposing a first discussion on Strategic Risks.
As we mentioned above, risk management is about managing situations that might be different from what originally expected. It is about being able to make a profit when the outcome is better than the original expectation without going bankrupt if the outcome happens to be bad. I like to simplify the analysis of strategic risks in two main trends that generate uncertainty and might affect a firm’s ability to compete, posing, at the same time, opportunities for growth and threats of bankruptcy: (i) demographic trends, (ii) disruptive technologies.
Demographic Trends. Population is growing older, more urban, more educated (also more digital), etc. Additionally, it is growing faster in less developed countries, and the share of population in stable economies is expected to further decrease in the next decades.
Disruptive Technologies. New technologies can happen in almost every bit of the industry; they can affect production, supply chain (both upstream or downstream), marketing, administration, human resources, finance, etc… and have the potential to entirely reshape it up to the point of dramatically redefining its boundaries.
Both, the demographic trends and the disruptive innovations, have the potential to generate important changes that, if not anticipated properly, might generate problems and opportunities for firms, especially when both trends interact. Additionally, it is likely that the same threat might be, at the same time, a problem for the incumbent companies in an industry and an opportunity for an outsider willing to enter. Just to characterize a simple example of how this combination of forces can operate in an industry consider the following situation. Younger, and more technologically oriented consumers decided to take advantage of the innovation that allowed music to be downloaded and played in portable devices. Outsiders, companies that were not in the industry (Apple for example), captured this opportunity, generating hefty profits and substantial growth, but, at the same time, this same event literally disintegrated the market for the incumbent companies. More specifically, manufacturers of music players and digital media (CDs and DVDs), music studios, retailers selling music, artists and some other established players in the market witnessed a dramatic change in their business model. Some of these firms tried to reinvent themselves; artists started going on tours offering shows that are far more complex than a simple concert, music studios are now event organizers, and some retailers started selling other products taking advantage of their brand name and location. Some other organizations disappeared; CD and DVD manufacturers went out of business, some retailers sold their real estate and closed, while some of the equipment manufacturers are still struggling between reengineering and vanishing. Similar stories can be told about companies in the book, newspaper and printing sector in general, other retailers, cell phone manufacturers, firms in the computer industry, etc…
Who will be the next industry affected by these trends? Obviously we do not know yet, I will only list, and shortly describe, some trends that have the potential of reshaping entire industries in the (near) future, with the only objective of fostering an internal discussion.
3D printing, a manufacturing innovation that allows the printing of any scanned, or computer-designed, object is likely to severely shake several industries by allowing the decentralized small-scale production of customized goods at a cheap price. This technology (already a reality) will have large implications for logistics, inventories, retail, and also tax collection. YouTube is plagued with videos showing its endless possibilities. An interesting development is the 3D printing of entire houses; a TED talk on this matter can be seen here. Less known, but potentially equally disruptive, examples include the ability of using any glass surface as a computer screen and a virtual keyboard, (interested readers can see a very good example in this link to the video by Corning). How will this change the discussion on personal computers/tablets future evolution? It might very well be that in the (near) future, our computers will be composed of a chip, embedded in some other device, interacting with external screens on demand. Are we (and the manufacturers) prepared for this?
Computers are easier to use (and cheaper to buy), and allow more and more interconnection to large databases and between people. In the last few years, computers have been replacing white collar jobs; managing incoming and outgoing phone calls, typing letters, translating texts, etc. are just a few examples of tasks in which human labor is being replaced by computers. Additionally, we are learning to efficiently manage large amounts of data. This ability combined with the increased computing power is allowing us to learn a lot about, for example, consumer habits. We also know, thanks to the smartphone today and other devices like Google Glass (and other wearable computers) in the future, were everybody is located at any moment in time. The combination of these technologies allows us to reach potential customers with targeted push marketing actions exactly at the right moment in which purchase probability is high. Nanotechnology, combined with the trends just described, is likely to generate an impact in other industries, like for example health care. I have recently read an article about a small blood test that, inserted in the patient skin, continuously scans its blood in search for a molecule that appears three to four hours in advance of a heart attack. In the presence of the molecule, the patient is alerted and directed to a nearby hospital, and at the same time the doctor is notified (follow this link to the article).
The whole idea of crowd collaboration is also generating interesting changes. Students and researchers post questions in collaborative platforms to get answers and discuss ideas, entrepreneurs seek financing in crowd-funding platforms, and even classic office tasks are offered over the net in a collaborative scheme. The whole financial intermediation industry is likely to be severely affected by several new trends. Cash, used to be stored and managed by banks and financial institutions. Crowd funding platforms are diminishing the banking primacy in financial intermediation, direct payment methods (pay by phone is growing fast) are threatening credit card dominance in payments, and digital currencies like bitcoins, pose an even more extreme threat to the whole monetary system by creating currencies that are not backed by any central bank or government.
Education is not spared of the effects of innovation. Massive Online Open Courses, labeled MOOC, but also referred to, as the tsunami in education or education 2.0 are bringing top level education to almost everybody in the world for free, by posting online courses taught by the best professors in the world, and making them available to students with an internet access. Not only, the cost of education will reflect the changes brought by this innovation for sure in the near future, but also the relative importance of certain skills in the workplace will reflect it as well, some skills will likely become common place, while some others will be increasingly important.
Interestingly, companies affected by the outcome of these kinds of risks did not notice, at the moment, that some of their decisions were taking them to a dead end. At the time the decision was made, and according to the prevailing paradigms, the decisions always looked right. A good example is what happened with Nokia, cell phones market leader. When Nokia decided to focus on regular phones instead of going to smartphones, the prevailing paradigm was that size was an important value, and as reflection of that, cell phones were getting smaller. At the same time, computers were completely portable; i.e., everybody could easily access its computer on the road. Therefore, not launching a suboptimal phone combined with a suboptimal computer (i.e. a smartphone) seemed like the smart thing to do… well; now we know they were wrong! The market changed and the appearance of mobile applications dramatically reshaped consumers’ habits. All of a sudden, having a mobile handheld computer with the ability to make phone calls was more important than having a small cell phone. When Nokia realized this it was already too late (the sad part of the story is that the first prototypes of smartphones where done by… Nokia, back in 1996!). We can tell similar stories for the video stores, music and film studios, publishers, and many others. In almost every case, sticking to their paradigms, the ones that apparently had taken the firm to the market leadership, was the main problem. Those who took their markets were usually younger firms, fearless to break the established paradigms, willing to try new ideas and take a few risks.
These were only just a few examples of how strategic risks can affect a company. Isn’t this much worse than having an unexpected 10% volatility in the FX rate or a fluctuation in commodity prices? On the other hand, doesn’t these types of issues bring a much stronger opportunity for firms to make a dramatic change in the market dynamics? Think of how Amazon, Google, Apple and many others companies that dramatically changed the market rules, leaving the incumbent market leaders, most of the times powerful companies, with a fistful of nothing, and sometimes, facing their dead. Managing strategic risks is the answer for survival, growth, ability to compete and profitability. Some old paradigms will need to be reconsidered… top management has the obligation to stand up and face these threats and opportunities for the benefit of their stakeholders.
