Paper & Blocks

Thought experiment: If you took the corporate strategy departments of the Big Five banks in Canada and asked them to come up with a 5-year strategic plan calibrated to today’s environment, how much variance would exist in the five plans produced? How about if you did the same with the Big Four banks in Australia? Or maybe switching industries, the Big Four global accounting firms? Or the Big Three American auto manufacturers?

While purely hypothetical, of course, the variance in each of the peer groups would be quite low. That’s because there are a common set of inputs going into everyone’s strategic plans. Everyone examines the same observable trends in the macroenvironment, everyone pieces together the same competitive trends after watching the moves of their peers, and everyone likely leans on the same set of internal capabilities that have been built up over decades of stylistically similar decision making. Everyone is following logic and acting rationally, and what it produces is sameness.

Consequently, if everyone is following the same playbook, the results will be quite boring: no one will gain or lose market share and nothing innovative will be produced (because everyone will be producing the same thing).

As Rory Sutherland says in Alchemy, if we allow the world to be run by logical people, we will only discover logical things. And if logic is the only path, sameness is the only result.

This is true for picking ‘logical’ strategic paths. The similar 5-year plans above could be called the ‘rational strategic path’ in the industry (note that idea: it will come up again shortly).

Rory’s idea is also true when it comes to career-related decisions where the desire not to get blamed or fired for choosing the path forward is a powerful influence. Back to Alchemy: the best insurance against blame is to use conventional logic in every decision. After all, no one ever got fired for choosing IBM. So in risk-averse institutions like banks that attract a generally risk-averse employee base, logic is going to rule the day when it comes to strategic decision-making. The result: an obvious path forward and nearly identical strategic plans across the industry. To use an investing concept: this is Strategic Beta.

Strategic Alpha, Strategic Beta and the Rational Strategic Path Benchmark

I bet some of you can see where this is going already: strategy is a lot like investing. Put simply, investing is allocating financial capital to produce the best risk-adjusted returns. Strategy is allocating company resources to produce the best risk-adjusted outcomes.

It makes sense there are similarities: the two ideas derive from the same roots around making decisions in an environment of scarcity. Financial capital is scarce and can only be invested in so many opportunities—and if you subscribe to modern portfolio theory, those opportunities are only the ones that fall on the efficient frontier. Similarly, corporate resources are scarce and can only be allocated in pursuit of a limited number of initiatives.

Given that investing (a portfolio of financial securities) and corporate strategy (a portfolio of corporate initiatives) mirror one another in a number ways, so to must their performance equation.

In the investing world, straight off Investopedia, the evaluation of an investment breaks down into three components that link together in the equation below:

y = α + βx

Where:

• y is the performance of the stock or fund.
• α is alpha, which is the excess return of the stock or fund.
• β is beta, which is volatility relative to the benchmark.
• x is the performance of the benchmark, which is often the S&P 500 index.

Through an investment lens, there are two ways pursue higher returns:

• Increase the Beta of the investment. A beta of 1.0 follows the benchmark exactly. A beta of 2.0 will go up or down roughly twice the performance of the benchmark. Dialing up the beta also dials up the risk, but in times of positive benchmark performance, the 2.0 beta investment will outperform the 1.0 beta.
• Find Positive Alpha: Alpha is the excess return on an investment after adjusting for market-related volatility (beta). It is where ‘value’ is produced in investing and typically involves an information advantage – or in trader terms, an ‘edge’.

Given the similarities between investing and corporate strategy, we can also explain the performance of a Strategy through a similar lens.

y_S = α _S + β_Sx_S

In Strategy:

• y_s is the performance of the strategy measured by a basic KPI: revenue growth, market share, etc.
• α _s is Strategic Alpha, which is the excess return of the strategy, beyond that explained by the benchmark
• β_s is Strategic Beta, which is variance in outcomes relative to the strategic benchmark.
• x_s is the strategic benchmark, which, as above, is the Rational Strategic Path

Let’s break each of those down a bit further, starting at the back of the equation:

The Rational Strategic Path: This is the default path everyone in the industry could take. It is the obvious strategic choice. For an auto manufacturer, this could be the pursuit of electric vehicles. For a bank, this is digitizing your customer experience. For passive investment fund managers, this is investing through ETF structures rather than mutual funds. Throw five industry pundits in a room and this is the path they could all agree upon. Or, another way to derive the Rational Strategic Path is to obtain the corporate strategy decks or strategic plans of the largest industry incumbents and note the similarities and overlaps (which in financial services, we’ve established there will be many).

Not to overcomplicate, but the rational strategic path will also not just be a single thing, but rather the average of many. It will not be simply ‘to pursue electrification in the automotive sector’, but will also include things like diversifying distribution to include direct-to-consumer experiences and partnering with Apple or Android to embed and improve in-car entertainment options. As a rule of thumb, if an average Joe like me could spot the strategy without much study, it is likely on the rational strategic path.

Strategic Beta: This is the degree of relative exposure a company has to the Rational Strategic Path. It is still a pursuit of the obvious choice, just an amplifier of the outcome. In an example, if we simplify the rational strategic path of the auto industry down to the electrification of vehicle fleets, Tesla is very exposed to the strategic path [mostly because they paved that path]. It has a high strategic beta. But what strategic beta do the big three American manufacturers have:

• GM says it plans to stop selling gas and diesel vehicles by 2035. GM’s carbon neutrality is planned by 2040. (High Beta, maybe a 2.0)
• Ford is investing $22 billion through 2025 to deliver battery EVs, and plans to be carbon neutral by 2050. (Medium Beta, maybe a 1.0)
• Stellantis (the old Fiat Chrysler Automobiles) plans to invest $35.5 billion in EVs through 2025, but hasn’t given a date for its planned carbon neutrality. (Low-ish Beta, maybe an 0.8)

Admittedly, what makes beta an elegant measure in the investing world is its quantifiability. In the strategy world, that won’t be the case. Although we’ll have to work with qualitative inputs, and subjectivity and judgement will come into play, the concept still holds.

Strategic Alpha: Strategic Alpha is the fun stuff. It is the excess return of a strategy beyond exposure to the Rational Strategic Path. By definition, then, strategic alpha is created by exploring paths off of those that are initially obvious and rational (Rory would be getting excited because we’re going to start throwing logic out the window). Following through on the example, this is Tesla’s pursuit of building an autonomous self-driving fleet in addition to electrification. The company still has exposure to industry strategic beta AND has a way to create excess value beyond.

How do you create strategic alpha? Well generating alpha is also known as ‘beating the market’, earning returns in excess of those that can be explained away by general market exposure. In Strategy, to beat the market, you must do something that the market is not. To generate Strategic Alpha, one must take a contrarian approach enabled by an information advantage driven out of customer insight. Breaking that down one-by-one:

• Contrarian Approach: By definition, strategic alpha will be contrarian in nature since things that are already consensus will be part of the Rational Strategic Path. You must be willing to have others think that you are wrong in order to generate beyond-market returns.
• Information Advantage (Seeing Around Corners): True to investing alpha, those with an edge in their investment strategy often have an information advantage. This could be from a unique information source, a unique way of analyzing data, or a combination of both. The ability to obtain data which better enables you to forecast future outcomes (ie. consumer behaviour, competitive responses, regulatory changes, etc.) is an information edge in Strategy. So to is the ability to interpret that information better than your competitors. Colloquially, this is the skill of ‘seeing around corners’ and it can be a source of information advantage as well as alpha.
• Customer Insight (Problem Solving): Seeing around corners is only useful if it can be translated into economic value for customers and the business. Any information advantage must also be tied to a customer insight, typically one associated with the root of purchase decisions: the problem the product/service/business solves for the customer.

Adding together a company’s pursuit of the rational strategic path (x_s), their degree of exposure to it (β_s), and the things they are doing to create excess value beyond (α _s) produces the company’s performance. This completes the loop on the similarities between investing and corporate strategy.

An Example: The Rational Strategic Path in Retail Financial Services

When trying to scope out the rational strategic path in any industry, it helps to first define the industry. While this can be done in any of number of ways, the most basic is to observe a group of companies that are related based on their primary business activities. That is, an industry peer group is often the best place to start.

In financial services, there are many different sub-industries: banking, insurance, payments, wealth management, and so on. There are firms that specialize in each of those verticals, but what we’ll focus the discussion on here are financial services generalists. They are big conglomerates that have grown to sit at the top of the current market share pile. This is JP Morgan Chase in the U.S., it is RBC in Canada, and it is HSBC in the U.K. We’ll also focus specifically on their primary retail businesses, leaving commercial banking and capital markets for another time.

When it comes to defining the rational strategic path in retail financial services, the path would currently include:

• Digitization or omnichannel enhancement of the customer experience
• Reorganizing the business and the user experience around customers and their problems and/or key life stages
• Expanding product shelf breadth to become a one-stop shop for all financial services needs
• Anchoring customer relationships with financial advice
• Modernizing data infrastructure to compete more effectively on personalization
• …

The list ends with a “…” to signify that there are many other things that can be added. This list is also likely a greatest hits version of industry conference topics from the past several years. This is the middle of the market. This is how to keep pace with average consumer expectations. This is how to apply logic to decision-making and “not get fired” for choosing IBM.

The rational strategic path is also enflamed by certain types of industry consultants, who productize strategy and resell the same ideas to multiple parties. This has the effect of keeping more companies headed in the same direction.

*As a reminder, these are strategic decisions, not operational ones. Operational decisions required to keep the lights on and the wheels turning are excluded from this type of analysis.

Dialing up Strategic Beta in Financial Services

Following the rational strategic path is not necessarily a bad direction to take, it is simply one that is undifferentiated. There can still be winners and losers on that path depending on how much strategic beta a firm is willing to take on.

Dialing up strategic beta means over indexing to some of the industry defaults. For example, most industry strategists would have the insight that banking customer interaction preferences are becoming increasingly digital based on general societal and technological trends. Most banks are acting on this insight, pursuing some form of digitization of their customer experiences today. There are, however, some banks who have doubled down on investing in their digital experiences by allocating more resources than average to modernize systems architecture on the back end, clearing out as much technical debt as possible in the middle, and building out new digital capabilities and tools for their customers on the front end.

The Royal Bank of Canada is an example:

• Back-end: For RBC, a major revamp of their back-end began in 2013 with the hiring of Bruce Ross away from IBM and tasking him with responsibility for global technology and operations for RBC. While much of the bank still runs its core applications on mainframe computers, the company is working on shifting its stack to more modern platforms, including private cloud, and has built out an API platform to provide connectivity between the two. All of this is to ultimately enable and improve capabilities on the layers above.

• Middle: In the middle, RBC is developing the connectivity necessary to build modern digital experiences, from launching a data sharing portal for app developers to building direct integrations with account aggregators like Plaid.

• Front-end: For its customers, in addition to streamlining the interface and adding capabilities to the RBC online banking platform and mobile app, the bank is also building a variety of tools to add value to their banking transactions (NOMI, MyAdvisor, Home Value Estimation, etc.).

They have dialed up the strategic beta associated with the ‘digitization of the customer experience’ and have become more heavily leveraged to that element of the path. If that strategy proves to be successful in the industry as a whole—that is, if the insight that customer interaction preferences are indeed shifting toward digital channels—those that have invested most heavily (a strategic beta > 1.0) will reap the benefits.

If that strategy proves to be unsuccessful in the industry, that is, if for some unexpected reason the internet became an untrusted and unusable channel of interaction [obviously a highly unlikely outcome], then those that invested most heavily will fall behind.

All of the elements of the rational strategic path are opportunities to dial up or dial down strategic beta. Hence, the strategic return profiles of all industry participants will vary, despite the fact that they are all pursuing the same general direction, just to different degrees.

Seeking Strategic Alpha in Financial Services

This is the fun part. It is also the speculative part. In seeking strategic alpha, the question to ask is: what ideas are not found on the rational strategic path today?

Given that pursuing an idea off of the rational strategic path involves a higher degree of risk, most ideas for strategic alpha are NOT going to be tested in the heavily regulated and risk-averse environments of industry incumbents. They are more likely to emerge from the start-up ecosystem.

A couple examples from recent memory:

Social Money: Payment is a form of communication, a way of transmitting information that produces shared meaning [as paraphrased from Lana Swartz’s thought-provoking book New Money]. That form of communication ties us together in shared transactional communities and underlies the basis for strategies that put the social aspect of money at their center. This idea was most prominently tested in the start-up world by Venmo, whose business model evolved around not just peer-to-peer payments, but the social exhaust that they created. Venmo’s social feed was incredibly novel at the time, described by PayPal CEO Dan Schulman as Venmo’s ‘secret sauce’. The social element of the service created engagement, entertainment, accountability in group payment settings, and many other unforeseen value-adds. It was also a poster child for powerful network effects. With each user, Venmo grew stronger. The social element also became a prominent feature in the company’s customer acquisition strategies. Of course, this idea is beginning to emerge in other forms across the financial services world, from the incumbent response in Zelle to the rise of social investing and copytrading. Yet, in my opinion, there is still a lot of strategic alpha yet to be uncovered here.

Self-driving Money: Google’s mission is to organize the world’s information. That has driven its search bar to become a verb in the Oxford Dictionary. Early in the search bar’s history, the results it returned to users were not very useful because they lacked the context of the user. Links to maps of the London Underground are not a helpful search result for “London Subway” if I’m wandering around London, Ontario in Canada searching for a sandwich shop. By incorporating more and more context, the Google search bar now almost seems to know what you’re searching before you search for it. While a bit creepy to some, others think that their money should also work this way. Money, and the advice institutions provide around it, should have as much user-context baked in as possible. Wealthfront’s self-driving money concept is an early application of this idea, experimenting with a way to automate financial decision-making for customers by making money-advice context-aware. If your financial life could be as simple and predictive as the Google search bar, it might also have some strategic alpha opportunities present alongside.

The start-up world is a potential gold mine of strategic alpha opportunities. This is where an information edge, a unique and actionable insight, can drive strong strategic returns. Information edges also exist on the corporate strategy front as well, although they typically have less to do with ‘product’ or ‘customer’ insights and more to do with decisions about ‘where to play’. This is how larger firms with well established market positions can still maneuver to create strategic alpha.

Information edges, however, have a downside. Just like in the investing world, after an information edge that creates strategic alpha is discovered by the industry, it can be quickly ‘arbitraged’ away as more and more incumbents also pursue the same direction.

Two examples of this today are:

Acquiring Acquisition Funnels: Question: Why did Intuit, a 100+ million user platform for managing personal, business and tax finances, acquire marketing automation platform Mailchimp? Answer: to engage with small businesses earlier in their formation before they have made decisions about who their accounting (Intuit QuickBooks) and tax (Intuit TurboTax) providers will be. This is an example of vertically integrating up customer acquisition funnels through strategic M&A. While Intuit acquired Mailchimp to indirectly feed their tax filing and accounting software, in another example, Wealthsimple went further down the funnel, acquiring tax filing software SimpleTax to feed their online investment services (you have to deposit those tax refund dollars somewhere!). Similarly, Morgan Stanley’s 2019 acquisition of equity administration platform Solium Financial had similar vibes. This strategy is both novel and opportunistic and builds immediate advantages for the acquiror and acquiree. BUT, it is also slowly shifting into the world of strategic beta as more and more firms look at the approach.

Beyond Banking: Expanding beyond banking means vertically integrating up and down the customer journey that eventually leads to a financial product. In an example of integrating up the journey, putting the spotlight on RBC again, the firm launched RBC Ventures in 2018 as a way to ‘lure clients using unconventional means’. One venture, OWNR, was created to help small businesses get off the ground, offering services to help them register, incorporate, and create legal agreements [and eventually direct them to an RBC small business banking offer]. Another venture, Arrive, was designed to help newcomers to Canada get settled after landing in the country, offering advice and information around finding a job, obtaining healthcare, dealing with the immigration process, and of course, getting set up with banking services. In an example of integrating down the journey, Santander UK just launched a feature, ‘My Home Manager’, in their mobile app. My Home Manager is the bank’s first step toward delivering customer value after a mortgage transaction has taken place by assisting mortgage customers with all aspects of managing their home. Home valuation, free quotes from local tradespeople, telecom provider deals, and even home décor advice. In the insurance arena, integration down the customer experience is also starting to take place. Manulife, for example, works with South Africa-based Vitality to offer its members a healthy-living rewards program. Through rewards which include gift cards, half priced Expedia travel, free Amazon Prime Membership, free Apple Watches, and beyond, Manulife has developed touchpoints and value adds with their customers beyond the initial insurance transaction. The fact that there is so much to write about here suggest that this idea too is starting to shift from strategic alpha to strategic beta.

Beyond the start-up and corporate realms, where else might strategic alpha be found today? Well, also like in the investment world, if there was an information edge to be gleaned, it is typically best kept to oneself to keep the forces of arbitrage at bay. There are two areas, however, that are worth exploring in the retail financial services domain that are off the rational strategic path of financial generalist platforms today.

Open Finance: Open ecosystems tend to out-innovate closed ecosystems over time. As the canonical example: Apple could not have matched the value of all the third-party apps created on the app store. What creates a strong open ecosystem? As argued by Peter Diamandis in BOLD, it is the creation of a simple and elegant user interface that gives developers and entrepreneurs the ability to solve problems, start businesses, and most importantly, experiment. In banking, this is often associated with banking-as-a-service, which has produced a powerful yet fragmented ecosystem of providers. Most of these providers have also tended to be smaller or regional financial institutions, or firms who are less at risk of disrupting themselves by ‘arming the rebels’ (to steal Shopify’s quote from the retail realm). No large incumbent has figured out a viable approach that harnesses the power of open ecosystems. Not yet, at least.

Crypto: Speaking of open ecosystems, one of the best examples of ‘open’ out-innovating ‘closed’ is in crypto. Most attempts at creating a digital money system by private or centralized actors had failed until the birth of bitcoin and its decentralized structure in 2008. For many reasons, financial services generalists have yet to step into this arena. There are too many risks: regulation, accounting, fraud, reputation, and so on. But as the crypto ecosystem expands and the public acceptance around it shifts, the bank that can harness the unique value being created in crypto and web3 will certainly be well positioned to generate strategic alpha in the years ahead. But hey, there is no strategic reward without first taking strategic risk.

Summary

The aim of this article was to provide a framework for thinking about sameness versus differentiation in strategy, and hopefully, encourage firms to explore roads less travelled, away from the well worn rational strategic path.

Rehashing a line from the introduction: if logic is the only path, sameness is the only result, and in a world where others are pursuing strategic alpha and strategic beta, there is no reward for playing it safe. To win, you must escape the obvious.