9 October, 2017

The Best and the Rest Lessons for SMEs.

A recent study of returns in SMEs (Small and Medium sized Enterprises) came to some astonishing conclusions, which I would like to share with you. In one of the largest studies of its kind, Magdalena Pollok, of the University of Bremen, Germany examined the return profiles of 1,400 SMEs in the north west of Germany over a five year period from 2008 – 2012, grouped by sectors and then subdivided into specific industry codes. Looking at returns (EBIT) as a percentage of revenue, she then compared the average returns of each sector with the returns generated by the best in each sector, defined as the top 10%. The results are displayed in the graph below:

Across all the sectors, the average profit margin before financing costs and taxes is 2.7%, with surprisingly little variance. Equally, the results of the Top 10 average out at around 17.2%, a factor of approximately six times the average, although with much larger variance. Six times! And that is just the average. That average contains a 10% weighting of the Top 10%, which means, that if you strip out their oversized contribution to the average (which comes out at 1.72% points) then that leaves the other 90% sharing a meagre 1.1% of the average returns.

Whilst this research study is the most recent and also the most detailed one covering Small and Medium sized businesses, that I have seen, it ties in with results I have come across from studies in other countries, most notably the US and the UK. In most advanced economies, SMEs and small owner-managed businesses, defined as businesses with less than 250 employees and with less than 50 million in annual revenue, make up the vast majority of business entities. Somewhere between 93 and 99% of all companies in most large economies – and all european ones – are small or medium sized.

So how are we to interpret these dramatic numbers? What story are the statistics telling us?

Well, firstly, I suppose the really good news is, that there are extraordinary returns to be made in almost every industry and service sector, even in sectors thought to have horrible, commodity-type economic profiles and reputations. The second bit of good news is, that there is obviously a right way of going about capturing those returns and, by definition, a wrong way, probably lots of wrong ways. Thirdly, the rewards for getting it right are disproportionately high.

The frightening aspect of the research is the sheer volume of companies delivering subpar performance. If in a sample of 1,400 companies, 140 are taking the lion’s share of the returns (64% or two thirds of the average), then, by definition, 1,260 are having to make do with substantially less and my guess is, that the top 35% probably account for almost all of the positive returns generated, with a substantial number breaking even and a not insignificant bottom section actually losing money.

Again, this analysis is bourne out by evidence from international studies and from anecdotal evidence from the global SME sector. Most small and medium sized companies are doing an awful lot worse than they could or should be.

In his excellent book the E-Myth, Michael Gerber points out that “in the US people who own small businesses work far more than they should for the return they’re getting” and notes “that 40% of businesses fail in the first year and 80% will have failed after five years.” Of the 20% that make it through the first five years, another 80% will have failed before they can celebrate their 10th anniversary. A 20% survival rate on the 20% that made it to year five is 4% of the total.

Leaving aside for the moment the question of why anyone would want to embark on a venture with such miserable odds of success and with such a high cost of failure, the real questions are: What are the best doing, that is so much better than the rest and how, given their limited resources, could the odds be changed to give the rest a better shot of achieving significantly higher sustainable returns?

My friend and sponsor of the research report, Lutz Penzel, himself a keen student of SMEs and an investor in distressed businesses, is quite clear on the causes of this underperformance. He says “The fastest route to higher returns is in a concentrated and relentless focus on serving the needs of a well-defined target client or customer group – in a word ‘strategy’.” My business partner Dr. Kerstin Friedrich, a lifelong observer of SMEs and their struggle with strategy, is adamant that the spoils go to the specialist and that superior returns are only available to those who understand and embrace a strategy of laser-focused specialisation. She says “In a world in which everything is in oversupply, healthy survival and growth is only possible by creating rich seams of demand, which we do by evolving into specialists and focusing on the problems of others. Securing the rewards of specialisation whilst avoiding the risks, is the key to sustainable success and, strange as it might seem, smaller businesses are today at a significant advantage to larger ones.”

So, strategy and specialisation appear to be the keys to unlocking the door to lasting success. Unfortunately the word “strategy” has become almost meaningless through over- and misuse in the business context. It has come to mean whatever the speaker wants it mean. But if strategy is crucial and specialisation the key to evolving from the rest to the best, then we, the entrepreneurs, SME business owners and leaders and their trusted advisors need to recapture the term and fill it with meaning that matters.

So here is my definition: Strategy is the deliberate organisation and direction of available resources most effectively to achieve a stated objective.

And here is Tim Ferriss’: “Imagine if for every person you met, you thought of some way to help them, something you could do for them? And you looked at it in a way that entirely benefited them and not you? The cumulative effect of this would have over time would be profound: You’d learn a great deal by solving diverse problems. You’d develop a reputation for being indispensable. You would have countless new relationships. You would have an enormous bank of favours to call upon down the road. That is what [..] strategy is all about – helping yourself by helping others.” Tim Ferriss, Tools of Titans (p. 338)

Combine the two and you have a clear set of instructions:

  1. It’s not about you – it’s about putting yourself and your resources in service of others. If this means changing your attitude, then work on it.
  2. Define the problem** you are seeking to solve and articulate it. If you can’t, then you’re not focused.
  3. Define the specific target clients** for whom the problem is real and urgent. If you can’t, then you’re not focused.
  4. Be aware of the resources at your disposal** (hint: they include intangible, as well as tangible resources. Another hint: your time, enthusiasm and expertise are amongst your most valuable resources. How are you directing them?). If you are unsure, then you how can you focus them effectively?
  5. Define the innovative product/process/service** through which you are solving their problem / meeting their need. Answer the question: How can you better solve the problem / meet the need than it is currently being solved or met?

I call this process “enlightened altruism”. It is altruistic, because it is about serving others. It is enlightened, because it derives from a belief that, to quote Benjamin Franklin, “we do well by doing good.”

The top 10% of companies securing the largest share of the returns available in any industry are doing this. They are focusing their efforts entirely on serving the needs and solving the problems of their tightly defined target customers. They are strategically clear and highly specialised. Isn’t it time you were as well?