From Good to Great … to Below Average?

Steven Levitt on what used to be one of my favorite business books:

Last week, ... I picked up Good to Great by Jim Collins. This book is an absolute phenomenon in the publishing world. Since it came out in 2001, it has sold millions of copies.

The book focuses on eleven companies that were just okay, and then transformed themselves into greatness — where greatness is defined as a sustained period over which the stock dramatically outperformed the market and its competitors. Not only did these companies make the transition from good to great, but they also had the sorts of characteristics which made them “built to last” (which is the title of Collins’s earlier book).

Ironically, I began reading the book on the very same day that one of the eleven “good to great” companies, Fannie Mae, made the headlines of the business pages. It looks like Fannie Mae is going to need to be bailed out by the federal government. If you had bought Fannie Mae stock around the time Good to Great was published, you would have lost over 80 percent of your initial investment.

Another one of the “good to great” companies is Circuit City. You would have lost your shirt investing in Circuit City as well, which is also down 80 percent or more. Best Buy has cleaned Circuit City’s clock for the last seven or eight years.

Nine of the eleven companies remain more or less intact. Of these, Nucor is the only one that has dramatically outperformed the stock market since the book came out. Abbott Labs and Wells Fargo have done okay. Overall, a portfolio of the “good to great” companies looks like it would have underperformed the S&P 500.

I seem to remember that someone did an analysis of the companies highlighted in Peters and Waterman’s 1980’s classic book In Search of Excellence and found the same thing.

What does this all mean? In one sense, not much.

These business books are mostly backward-looking: what have companies done that has made them successful? The future is always hard to predict, and understanding the past is valuable; on the other hand, the implicit message of these business books is that the principles that these companies use not only have made them good in the past, but position them for continued success.

To the extent that this doesn’t actually turn out to be true, it calls into question the basic premise of these books, doesn’t it?

Indeed it does. The problem with books like Good to Great is that they are entirely backwards looking and try to extrapolate past performance of companies into the future. there is simply no way to isolate the performances of these businesses down to key traits they each posses. Granted, they may have commonalities, but if you randomly select any 11 businesses and look close enough, you'll find find attributes that are common to all of them.

The problem with Good to Great in particular is that Collins claims his findings are very scientific, backing up his claims with a lot of statistical analysis. To be true science, he would have hypothesized what attributes would lead to a great company, find companies that posses those attributes, and then track them over a period of time to see if his prediction was correct. Finding trends in past data is much easier to do than predicting future performance. That's the trouble with a lot of econometrics.

If you want to read a business book that will really challenge the way you think about business, forecasting, and the validity (invalidity?) of these types of studies, I cannot recommend The Halo Effect by Phil Rosenzweig highly enough. If you like business books, it is a must read.