Brilliant managers are bargain shoppers. As they shop for skills and knowledge in labor markets, parts, services, and other inputs in supply markets, and technology in patent and licensing markets, they seek to secure assets at prices below their value in an envisioned future use. A corporate theory guides this bargain hunter, revealing unique and valuable matches between the firm and assets available in markets.
In 2010, Peter Diamond, Dale Mortenson, and Christopher Pissarides were awarded a Nobel Prize in economics for their pioneering work on this subject. They argued that many of the markets in which managers participate are “matching markets.”
For instance, in labor markets, employers place widely divergent value on the skill sets of particular individuals. Individual workers, in turn, place widely divergent value on working for different employers. An effective matching market optimally pairs employers to workers in a pattern that maximizes the total value generated.
Managers confront an array of highly complex matching markets as they search for value-creating bargains. These bargains reflect matches where buyers procure assets from sellers at market prices and yet still generate value. Exceptional financial returns in all settings are ultimately “rewards for scarcity;” in other words, value creation arising from finding a scarce and valuable match between your firm and available assets — a match that others cannot see or cannot access.
This point will sound obvious, but finding these matches remains extremely difficult to do one time, let alone repeat multiple times. Consider the case of Mittal Steel. From 1976 to 1989, Mittal remained a very small player in global steel industry plagued by low profitability. But in one small mill in Indonesia, Mittal implemented direct reduced iron (DRI), a then-new iron ore input technology, to produce steel. Expansion followed with the economic growth of Indonesia.
Mittal acquired a troubled steel operation in 1989 from the government of Trinidad and Tobago. The mill operated at 25 percent capacity and lost $1 million per week. Mittal lead a quick and successful turnaround by taking the DRI knowledge from Indonesia and increasing sales. Over the next 15 years, they acquires other similar mills, primarily assets in the former Soviet bloc. Each addition proved a gold mine.
Mittal’s theory seemed almost unthinkable to other steel firms at a time when they were focused on improving their internal operations. But Mittal believed it had the skills to create value from poorly understood and managed state-own steel operations in developing economies where demand for steel was predicted to escalate.
By 2004, Mittal emerged as the world largest and lowest-cost steel producer. But Mittal’s ability to match with new opportunities went off the tracks in 2006 with the purchase of Arcelor. This producer was very large and well run — the exact opposite of Mittal’s prior acquisitions. The ill-timing of the deal didn’t help as the financial crisis hit soon after, followed by several years of falling steel prices as demand flattened and Chinese capacity cam online. While Mittal wasn’t the only steel company to struggle during this time, its deviation from the theory of buying troubled assets in emerging markets saddled it with large debt and the costs of integrating a massive asset inconsistent with its historic skills.
The mark of a well-crafted corporate theory is the uniqueness of the value-creating opportunities it reveals. Mittal found a way to identify perfect matches and value-creating opportunities. But as its later misstep makes clear, even the companies who figure it out once need to remember the importance of holding on to the uniqueness that’s so necessary for value creation and understand the pivotal role that corporate theory plays in revealing this value.
This excerpt comes from Beyond Competitive Advantage. Published June 14, 2016, by Harvard Business Review, enter your email below to download the first chapter.