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THE HYPOTHESIS IS EVERYTHING

The Huffington Post The Huffington Post 13/10/2015 Richard Koch

It has never been easier and cheaper to manipulate data. But it has also never been easier to miss the point. All science, all business insight, everything of value in life, originates not with data, but with a brilliant hypothesis. Without the hypothesis, you cannot know which data to crunch. With a great hypothesis, the data just act as confirmation. And as a matter of fact, the best scientists - particularly in earlier centuries - and the best intuitive business people, have often done without the data, and still reached precisely the right conclusion.
Yet we disposed to believe that the answers come from data. For example, the brilliant Perry Marshall has written:
Star Principle is what evolved after Richard Koch and the consultants at BCG had analyzed thousands of businesses.
They said, "All right, we have this giant spreadsheet of a million data points. What do all the successful ones have in common? What's the smallest number of common factors that all of them share?" And someone eventually figures out well, they're all number one in their market and they're all in a growing market. Wow. You could write that on a 3 x 5 card.
The Star Principle is indeed one of the simplest, most profound and most useful memes in the whole of business theory and practice. It says that nearly all cash and market value derive from businesses that become and remain "stars" - leaders in a market that grows by at least ten percent a year - for a decade or more. It's a principle that has made a fortune for me, and can do the same for you.
But here is the real point I'm trying to make. The Star Principle could have been derived the way Perry suggests - from running the numbers in a massive data crunch, and then trying to make sense of them - but it wasn't. In fact, the Star Principle was derived without any data crunching at all.
A Principle derived from Logic, not Data
The Star Principle came from simple logic, refracted through the simplifying mind of Bruce Henderson. He asked two questions:
•Which type of businesses, in any market, are likely to be the most profitable and cash positive?
•Which businesses are likely to grow the fastest?
He answered thus:
•The most profitable and cash positive businesses in any market are likely to be - and certainly should be - the market leaders. They are likely to have lower costs because of greater scale and experience.
•Businesses in a high growth market are likely to grow faster than those in a low or zero growth market. All they have to do is to hold market share and they are bound to grow fast. Over time, therefore, their value will be compounded.
In fact, Bruce went further. A leader with a cost advantage should be able to gain share from other, higher cost, rivals, either by offering a lower price, or by offering a better product, or spending more on marketing and selling. The rivals would still not have higher profits, because of the cost advantage of the leader.
Over time, the rivals should lose market share, which would increase the cost gap between the leader and other firms, leading to higher profits for the leader, and marginal profits or none at all for the higher-cost lower-market-share firms. Sooner or later, the latter would lose interest in the market, and might have to withdraw because of the cost of staying in it.
The ultimate result would be higher sales for the leader - not just from market growth, but from market share gain; much higher profitability from an ever-increasing cost advantage as a result of further gains in scale and experience; and a very large increase in absolute profits and return on capital, resulting from both sales and margin increases.
(Bruce did not connect the final dot, which is that higher growth and accelerating profits should lead to a higher multiple of market value being placed on the profits, so that you multiply together two numbers, each rapidly increasing, and get a massive annual increase in value. But that is how venture capitalists make a quick killing.)
All this was pure logic. At first, Bruce had no data to prove the idea. That came later, and actually was never a big selling point in BCG's pitch. To Bruce, the answer was axiomatic.
He didn't want clients to believe him because the data said so. He wanted them to believe because they had followed the logic and taken possession of the idea for themselves. Only in that visceral way could they be truly persuaded that one to five percent of their business portfolio had more than ninety-five percent of its true value.
Even then, he knew that it was most unlikely that the clients would do what logic dictated - throw all their money and best people behind that tiny proportion of their portfolio; and sell the rest, or manage it to maximize the cash it could throw off.
Your Hypothesis is Everything
What is the most important question you can ask about your business positions - the market segments, the arenas in which you compete?
There is only one vital question:
•Which of my businesses are likely to be most valuable in 5 to 100 years' time?
To answer this question sensibly, you need a hypothesis. Bruce's hypothesis, and mine, is that those are your star businesses.
Once you have this insight, verification is trivial. You then have to examine the
implications.
These are the most important ones:
•If you have one or more star businesses, put all your effort into it or them - maintaining and increasing their size relative to the corresponding businesses of your competitors; and increasing the size of the market as fast as possible, regardless of profit in the short and even medium term.
•Expand internationally before anyone else does, so you cement global leadership in your segment•Get as close to one hundred percent market share as humanly possible
•Be paranoid about rival firms that are smaller than you in your segment, yet growing faster. It doesn't matter how small they are - they key thing is their growth rate. Rub them out. If you can't do that, buy them
•If you don't have any genuine star businesses, start or buy them - however expensive this appears to be
•If you can't find any stand-alone star businesses to start or buy, sell everything you have and borrow as much as you can, and buy a firm that does have star businesses but doesn't realize their value. Then repeat the steps above.
If you have the right hypotheses, you can easily verify them. If they prove wrong, the verification process will lead you to change or refine the hypotheses. Keep going until you have hypotheses that are verified. Then bet the house on them.
If you want to read more about The Star Principle, read my eponymous book!

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