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Weekly Thoughts: Productivity Differentials

Here is something that caught our eye this week:

Productivity Differentials

One of the things we love about our work is seeing how academic theory translates into business reality in real-time.  For example, several researchers have sought to explain differing operational and financial performance across businesses in the same industry or of the same size. As research conducted in 2004 by University of Chicago Professor Chad Syverson explains:

“…’within 4-digit SIC [Standard Industrial Classification] industries in the U.S. manufacturing sector, the average difference in logged total factor productivity (TFP) between an industry’s 90th and 10th percentile plants is 0.651 … [meaning that] the plant at the 90th percentile of the productivity distribution makes almost twice as much output with the same measured inputs as the 10th percentile plant.’”

Academic work on this topic further shows that these productivity differentials tend to persist over time, across industries and geographies, which is to say, the good firms tend to remain good.  The question then becomes, what is driving this productivity gap?  On that point, we stumbled across a 2010 piece in the Journal of Economic Perspectives by Nicholas Bloom and John Van Reenen, whose research found strong positive correlations between companies with more developed management practices (i.e., monitoring processes, development targets, and incentive programs) and high performance (i.e., productivity, growth, survival rates).  Basically, it’s the people, stupid.

In academia, however, the persistence of bad management explaining productivity differentials is an unsatisfying answer.  Bloom and Van Reenen argue, for instance, that a management change is a “relatively straightforward process” (their words, not ours), and therefore, a highly irrational reason for persistent under-performance.  In theory, it is that simple, but our experience would suggest that sub-optimal management practices are far more prevalent than one might assume and that changing these practices can be extraordinarily difficult.  Interestingly, Bloom and Van Reenen also note that firm size can help compound the effect of good management since larger companies have more resources to devote towards the effort. From the paper:

“When we plotted average management score against the number of employees in a firm (as a measure of firm size) we found that firms with 100–200 employees had average management scores of about 2.7. The management score then rose steadily with firm size, so that firms with 2000–5000 employees—the largest firms in our sample—had average management scores of about 3.2.” 

For Chenmark, these findings are quite exciting (we know, we need to get out more).  First and foremost, they provide an academic underpinning for one of our core operating principles, which is that high-quality leadership teams can drive outsized, sustainable success.  Furthermore, our strategy centers around providing bigger company resources to smaller companies, thereby putting them in a position to unlock additional productivity gains.  If we can execute well, companies in the Chenmark portfolio should be able to gain a significant edge against their local competitors, creating a compounding effect to their success.  We are still closer to the top of the proverbial mountain than the bottom, but the snowball is gaining speed.

Correction from last week’s Weekly Thoughts: While we’re sure Adam Levine could provide some fantastic commentary on Alphabet’s reporting policies, in fact Matt Levine is the author of Bloomberg’s Money Stuff.

Have a great week,

Your Chenmark Capital Team

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