What makes companies successful? It’s a very popular question that has been examined in a lot of academic papers and books already. The Three Rules looks examines exactly the same question but from a different angle: it’s a quantitative analysis of more than 25,000 companies over a period spanning decades. The companies that performed above industry average for such a long period of time were deemed to be exceptional.
Next, the authors looked at what these companies did differently, or what made them special. The result is the three rules that these exceptional companies tend to stick to: 1) Better before cheaper, 2) Revenue before cost, and 3) There are no other rules (meaning anything goes).
As with the other “success studies” The Three Rules doesn’t really provide a definitive prescription, but the authors are quite open on the strengths and weaknesses of their study. In any case, it does give some useful insight into what successful companies do that allows them to perform well on the long-term.
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Book Summary & Notes
All text between quotation marks is taken directly from the book.
Data and main results
The book presents the results of an analysis of 45 years of 25,000 companies (Compustat data). The authors identified 344 exceptional companies from that list – 174 of which they call “miracle workers” (best performance), and 170 “long runners” (good but not exceptional performance, and for a long period of time).
The three rules that they identified that drives better performance are:
1. Better before cheaper
Differentiation is based on two things: 1) price, or 2) non-price value. Exceptional companies tend to focus on non-price elements even if that means their prices are higher than the competition. While price-based competition can be a strategy, it is not linked with long-term superior performance.
2. Revenue before cost
While a competitive position determines how a company creates value, the profitability formula of a company shows how it captures this value. A company can create profit by increasing revenue, decreasing costs, or reducing the number of assets. In the sample, companies that capture profitability by increasing revenue had a superior, long-term performance (even if this means higher costs, or a higher asset base).
3. There are no other rules
The last rule is not a prescription of what to aim for, but what to avoid: that is, thinking that there are other systematic rules linked to superior performance. Some companies focus on core competencies – others don’t; some companies have larger-than-life CEOs, others don’t; some companies aim at disruption, others don’t; et cetera. The bottom line is that regardless of what a company has and what it wants to focus on, what drives performance on the long-term are the first two rules. For the rest: it all depends.
The important point here is that persisting with the rules pays off. If circumstances change, a company has two choices: it can stick with their positioning and profitability formula (which often leads to superior performance in the long run), or it can choose to abandon their positioning or profitability formula (which often means performance will be lower on the long-term). Persistence in positioning and using a profitability formula pays off.
“The three rules constitute useful advice because they define which of many plausible alternatives is systematically associated with exceptional performance. Better before cheaper does not mean price competition is irrelevant; it means that when you have a choice to make, and when the data are unclear, go with better. Revenue before cost does not mean keeping cost under control does not matter; it means increasing your revenue is more important. There are not other rules does not mean you can blindly follow the rules; it means you must apply all your creativity and insight to follow them in the face of all manner of other changes.”
Success studies – Signal vs. noise
The Three Rules is one of many ‘success’ studies, other famous titles are, for example, In Search of Excellence by Tom Peters and Robert Waterman and Good to Great by Jim Collins. But the authors of The Three Rules state that these books are based on flawed methodologies, and that the method they used remedies many of the previous issues in success studies.
A key problem is that of luck or randomness – what is attributable to the system and what to the company itself? So this study first looks at the variability of the system, and then looks at which companies perform better or worse based on the system parameters.
The way that’s done in this study is by using a quantile regression – every ROA (return on assets) also has a yearly decile rank. The impact of the industry, the specific year, survivorship bias, and other performance elements are stripped. The ROA numbers are put in decile ranks. This way a level playing field is created, and only performance beyond that is taking into account to determine exceptionalism. It also means that high absolute performance one year might not be exceptional relatively speaking (if the industry performed well as a whole, for example).
The authors looked at profitability (or ROA) as a sign of performance and not total shareholder return (TSR), as many other success studies do. They argue that TSR is a function of shareholder expectations rather than of superior management
Also in contrast to other success studies, this one does not take into account the “people and personalities” of the firms to avoid the halo effect (e.g., if the company is doing well the leadership is amazing, if it’s doing badly the leadership is arrogant and indecisive). Many other studies use journalistic records which means as one commentator says “many of the most famous success studies are not studies of what causes great behavior but studies of how great behavior is described.”
Rule 1: Better before cheaper
Positioning can be based on price and non-price values. Every product or service must be in a particular location on this competitive continuum, which requires trade-offs in some dimensions of value – this is how differentiated competitive positions are created.
These competitive positions relate to performance. In the sample it’s clear that companies with non-price positioning are “miracle workers”, companies with an in-the-middle positioning are “long runners”, and companies with price-based positioning are “average Joes”. And, also of importance, changing positioning is also associated with changes in performance.
“You cannot compensate for a poor position with great execution while poor execution can compromise even the most promising position. In short, position determines how fast you can go; execution determines how fast you actually go.”
There is one other thing, besides positioning and execution, that is of importance: the frame of reference. Or: the industry’s structural changes. All performance is relative to the frame of reference, and so if the industry and the company move in the same direction with the same velocity, then it’s basically standing still. Superior performance is based on differentiation, and if the choices you make are solely based on what’s happening in the industry then you tend to get an average performance.
When faced with difficult circumstances and trade-offs – such as cutting price or increasing value – choose to go for better rather than cheaper. Meaning: create or renew the non-price based position, rather than spending efforts to remain profitable at lower prices.
Rule 2: Revenue before cost
The profitability formula shows how a company balances the elements of costs, prices, and assets. Key to good profitability is not a single variable, but the connection of these elements. The second rule states that when faced with a trade-off of pursuing higher revenue or decreasing costs to increase profitability, go for increased revenue – even if this means higher costs or higher asset turnover.
Revenue before cost can manifest in a few different ways. If your competitive advantage is due to higher gross margins, it means you probably have higher prices (not lower costs). And if it’s driven by higher asset turnover, it means you probably have higher volume (not lower assets).
“To beat the odds, you want to focus on creating value using better before cheaper, and on capturing value with revenue before cost.”
Although the rules are generally presented as applicable to all, the authors have in their own sample some deviations as well. Including a company that had a clear price focus and that managed to become a “miracle worker”. An exception to the rule?
Overall the authors conclude that while “miracle workers” are not necessary wasting money, there comes a point when a company needs to make a trade-off: spend more and have higher costs or drive profitability through reducing costs and assets. The “miracle workers” of the sample tend to choose revenue above cost, while “long runners” focus more on cost leadership.
Rule 3: There are no other rules
The last rule, even though it’s a negative one, means two things: 1) that the authors were unable to find other meaningful patterns in their sample that could differentiate performance over the long run, and 2) that performance differences can be driven by many different strategies and adaptations. Meaning that companies within the sample, and the same companies over time, used different ways to reach the superior performance. (For example: some companies successfully used M&A to drive performance, others used M&A and failed.)
“No behaviors we studies suggested any significant association with performance. The only thing that seemed to matter was whether a given behavior contributed to better before cheaper or revenue before cost.”
While superior performance tends to get worse over time, or regress towards the mean due to various reasons (hubris, inertia, competitive pressure, regulation changes, et cetera), there are some company’s who for a (very) long period of time can keep performing well above the average. They are exceptional. And even though, on the long term, its questionable if they can keep up this superior performance, the authors state that abiding by the three rules will help companies do that. At least for some period of time.
Interested in The Three Rules? Get the book on Amazon.