In a previous post, Deconstructing Strategy, I discussed some of the difficulties in developing a strategy. In this post I present a method that has worked well for me. The philosophy behind this method is based on the two ideas that the Pareto principle, also known as the 80/20 rule, applies to business strategy and that strategies must adapt to new information and changes to the business environment.

Starting with the Pareto principle it is rare that the full portfolio of products and services sold by a company contribute equally to the overall profit. As a starting point a ranking based on actual profit contribution should be assembled. This can then be adjusted for factors involving risk. Forecasting of the environment is of little use so products or services that are highly sensitive to changes to the environment should simply be given a higher risk weighting.

Next comes managing the uncertainty of the environment. The risk adjustments discussed above relate to the revenue side of the business. There is also an expense and investment side to the business that needs to be considered. The key issue is capital expenditure that is difficult to reverse. If the capital expenditure is large relative to total expenditure and the business environment changes to make such expenditure irrelevant then the company is going to face an extremely difficult future.

Large irreversible investments are a form of speculative betting. It also often takes place towards the end of a big trend, when executives feel the trend will never end and that they are being left behind. A toxic mix of fear and greed sets in and an entirely too large investment is made in an effort to catch up with the market and then maximise profits due to the most recent hot trend.

The problem with trying to maximise profits is that this only happens by maximising risk. It is much more sensible to optimise profits: focus on risk adjusted returns, consistency of returns and avoidance of ruin. This requires shareholders that back long term performance (see my post: Long Term Strategy in a Short Term World).

To do this the company needs an adaptive strategy, breaking up its capital expenditures into manageable chunks and staggering them over time. What this allows for is the capital of the company to be deployed using a wider spectrum of information as it becomes available over time. In the financial investment world we call this dollar cost averaging.

The adaptive part of the strategy construction creates a robust plan that has a greater immunity to changes in the business environment. In effect it decouples the accumulation of excess capital available for investment, which usually is concentrated during expansionary economic periods, from expenditure of this capital in long term investments, averaging it out over riskier expansion periods and cheaper contraction periods.

For a real example, see my post My Zawya Story: Deciding the Business Model.