July 21, 2003

Competence, good governance in corporations


By Diana Drake

The scandals at Enron, WorldCom, Adelphia and other corporations have focused public attention on how companies can crash and burn when corporate governance goes wrong—but what about when corporate governance goes right? What role can good corporate governance play in helping successful companies to create a sustainable competitive advantage?

Stock analysts and financial advisors love companies with wide “economic moats.” Basically, these are companies with some kind of sustainable competitive advantage that keeps other similar businesses from encroaching on their profits.

Take Wal-Mart, for example. Its competitive advantage is that it is a low-cost producer in its industry, charging as much as 15 percent less for food products that traditional grocers. How about eBay? As one of the few online auction sites, its competitive advantage is known as the “network effect.” Buyers go there to find the sellers, and sellers go there to find the buyers. Where else would they be?

Extensive research exists about how companies benefit from an array of competitive advantages, but there’s not as much on how competitive advantages are created in the first place. That basic question has motivated Richard Makadok’s research for the past five years. Makadok, associate professor of organization and management in the Goizueta Business School, has written a series of papers about the creation and use of competitive advantages by companies.

In a paper forthcoming in a special issue of Strategic Management Journal, Makadok holds that corporate managers should be governed to serve the best interests of shareholders, and not their own.

“A lot of research has been done on manager capabilities and competence on the one hand, and a whole other body of research has been done on corporate governance, but very little at the intersection of those two,” Makadok said. “There is very little that looks at how competence and governance interact. That’s a big piece of the contribution of this paper. For the first time, we now have a reason to believe there should be a positive, synergistic interaction between the two.”

Wal-Mart, Makadok said, is a prime example: a top-performing company bursting with competitive advantage that historically stands out for both its competence and its governance. It has managed to generate a 200,000 percent return to shareholders in the 30 years since its initial public offering through amazing distribution efficiencies (competence) and outstanding opportunities for employee stock ownership and profit-sharing (governance). Makadok suggests that the extraordinary performance at Wal-Mart and other companies, like Microsoft, is “due to a synergy between governance and competence.”

He develops this hypothesis by analyzing certain scenarios that incorporate both competence and governance, and how they impact managers’ resource-investment decisions, otherwise known as the potential competitive advantage. Makadok writes that managers of firms with agency problems (basically having a CEO, or agent, whose interests differ from those of the shareholders), will on average tend to under-invest (below what shareholders would hope) in resources of uncertain value.

“This underinvestment will be most severe for those resources where managers’ information indicates a low expected value [a risky investment],” Makadok said, “and will actually be reversed [overinvestment will occur] for those resources where managers’ information indicates a high expected value [a safe bet].”

Two so-called levers can be used to reduce the degree of underinvestment: reducing the severity of the agency problems through better corporate governance, or improving the accuracy of managers’ expectations. These two levers, Makadok said, are more effective together than in isolation.

“There’s a synergy, if you will, between governance and competence—between having competent managers who know the right resources to acquire and having a system that governs those managers in a way that will use that knowledge for shareholders’ benefit, rather than their own benefit. The end result will be creation of a competitive advantage,” Makadok said. “Having managers who are motivated to do the right thing for shareholders is not much help if those managers don’t know what the right thing to do is. Conversely, having managers who know the right thing to do for shareholders is not much help if those managers aren’t motivated to do it.”