Playing To Win
Balancing Exploration and Exploitation
This week, I am dedicating my 39th Playing to Win/Practitioner Insights (PTW/PI) to a critical tension in modern strategy that needs to be recognized, grasped, and tackled. To survive and prosper, every organization must succeed in Balancing Exploration and Exploitation. (Links for the rest of the PTW/PI series can be found here.)
The Original Insight
The original insight is courtesy of the late James March, a fascinating professor jointly appointed at the Stanford Graduate Schools of both Business and Education. I got to know him through one of his PhD students and collaborator of mine, Hilary Austen. While not widely known outside his field, March was an influential scholar. In an interesting article in Harvard Business Review back in 2003, the authors asked the 200 names on a prominent list of business gurus who their gurus were — i.e. the gurus’ gurus. Unsurprisingly, #1 was the greatest management thinker of all time, Peter Drucker, with 8 votes. But alone in second place was the much less famous March with 7 votes, only one vote behind Peter the Great! It is further notable that despite his eminence as a management thinker, his true passion was French poetry, of which he authored 11 books.
In 1991, he wrote an influential article in Organization Science, entitled Exploration and Exploitation in Organizational Learning. As with pretty much all great thinking contributions, it is obvious after it is pointed out. The article points out that all organizations operate in two contrasting modes. One is exploration, which is about doing new things at which we are not yet good — in March’s words “Exploration includes things captured by terms such as search, variation, risk taking, experimentation, play, flexibility, discovery, innovation.” The other is exploitation, which is about doing things at which we are already proficient more intensively and incrementally better than previously — in March’s words: “Exploitation includes such things as refinement, choice, production, efficiency, selection, implementation, execution.”
Others had talked about similar distinctions before. But his contribution that was new to me and helpful was to the organizational challenges that the existence of these two modes present.
The Organizational Implications
The organizational challenge is that exploitation is more straightforward, faster acting and the rewards come sooner. In March’s words: “Compared to returns from exploitation, returns from exploration are systematically less certain, more remote in time, and organizationally more distant from the locus of action and adaption.” The exploration path is fraught with twists and turns, is harder to predict and there is often a time gap between efforts and results. When a unit of resources, whether a dollar or a person-hour, devoted to exploitation is held up beside a similar unit of exploration, by most standard measures, the latter beats the former. At the time of investment, it just looks better. Again, to use the words of the master: “The essence of exploitation is the refinement and extension of existing competences, technologies, and paradigms. Its returns are positive, proximate, and predictable. The essence of exploration is experimentation with new alternatives. Its returns are uncertain, distant, and often negative.”
Pursuing exploitation makes sense: why not do more of and hone and refine what has a clearer and (apparently) higher likelihood of success? But the danger, of course, is if you keep dedicating incremental resources to exploitation, exploration will fade into the background — and potentially away entirely. It will always feel like the time for exploration is sometime in the future, a time that never seems to come!
But exploitation only works as long as the competitive environment is stable. The hidden downside of exploitation it that it works only until it stops working. That happens especially if a competitor or new entrant in exploration mode drives a meaningful change that obsoletes the exploitation. March is clear that “maintaining an appropriate balance between exploration and exploitation is a primary factor in system survival and prosperity.”
Less intuitive and critically important to the issue of strategy is March’s conclusion that exploration is more important if your goal is to win, and exploitation is more important if your goal is to avoid losing. That is, if you want to finish first against the relevant competitive set, that will only happen if you dedicate a healthy level of resources to exploration. But if you want to avoid finishing last in the competitive race, then focusing on exploitation is what will accomplish that job.
The Role of the Modern Equity Markets
The pervasive trap of overinvesting in exploitation and underinvesting in exploration is exacerbated by the modern public equity markets. While we might think romantically about the individual investors making decisions to invest their hard-earned capital in one stock versus another with the hope of earning a high return on the back of that company succeeding disproportionately, that isn’t the modern world of investing. It is dominated by fiduciaries: pension funds, like CalPERS, New York State Common Retirement Fund, Texas Teachers, IBM, Boeing, AT&T, and investment managers, like Black Rock, Fidelity, State Street and Vanguard. Because they are fiduciary institutions, the portfolio managers within them are much more worried about avoiding downside than achieving upside. While earning the highest returns for their clients would be nice, it pales in comparison to the ignominy of being in the lowest quartile. In fact, indexers like Vanguard institutionalize their avoidance of the downside by not picking at all. If the market is down; they will be down along with nearly everybody else.
As a consequence, the most powerful players in modern public equity markets all ask the same thing of public companies: achieve above average growth and profitability with below average risk. It is, of course, delusional, as with much of the goings on in the modern public capital markets. It isn’t Lake Woebegone for those companies. They all can’t be above average, especially while making sure to not engage in any risky activity. But the consequence is a greater push on exploitation than March would have noted as of 1991. And if you don’t focus enough on exploitation, the activist hedge funds will enter the picture and force adherence to it.
Meanwhile, there is another pool of equity capital centered in the Bay Area. It both understands and seeks exploration. It fully appreciates that many of the entities in which it invests will expire worthless. But the successful explorers will provide 10X, 100X and even 1000X returns. And that pool of capital just keeps getting bigger and bigger.
In the modern capital markets, widely held public companies are pushed aggressively to exploitation and venture-backed companies only get funded if they are dedicated to exploration. This is and will continue to be bad news for the exploiters. They are being held to a different standard — growth without risk. At the same time, another class of competitor is being funded explicitly to disrupt them by exploring writ large. The irony, of course, is that some of those pension funds are investing capital into private equity pools whose goal is to invest in startups in fintech, med-tech, ed-tech, auto-tech, etc. that are aimed at destroying the companies in the public equity portfolios of those same pension funds. It is turning those exploiters into sitting ducks for those funded to explore. Even though 90% of the explorers will fail ignominiously, it only takes the 1-in-10 success to devastate the exploiter.
The most common exploiter response has been to outsource exploration. The big legacy public companies let someone else explore and then pay gigantic acquisition prices for the few that succeed. And their equity investors don’t mind them paying huge prices for companies that they see as being already finished with their risky exploration. It is pathetic, but it is the modern way.
Regardless of how high or low you sit in an organization; you need to recognize these two modes and know when you are engaging in each. What you should do and how you should think about the two are different.
If you are engaging in exploitation, analyzing the past to cost-reduce and more deeply penetrate the current Where-to-Play using the current How-to-Win, talk about your work openly. Be enthusiastic about it. You will be embraced and supported.
If you are engaging in exploration, be careful talking about it. It is better to do it as secretly as possible with the least disclosure of the costs. Most importantly, don’t overpromise results or timeframes thereof. That is what got Steve Jobs fired. He promised huge volumes for the frame breaking MacIntosh and they didn’t arrive on the promised schedule. And if Steve Jobs can be fired for exploration, I can promise you that you can be too!
If you are in a public company, try to find allies on the board that will let you experiment and will defend what you are doing when you will need the support — and you will. If you are in a private company, you are in better shape. But you still need allies.
One of the most fascinating assertions in the March article — which I buy at a visceral and experiential level — concerns the individual level. He first observes that the pace of learning in the exploration mode is slower than in the exploitation mode. So, for successful exploration, you need people who are willing to accept a slow learning journey. The second thing he observes is that the benefits of the slow learning are asymmetric. The slow learners engaging in exploration get almost no benefits from the fast-learning exploiters in their organization, while the fast-learning exploiters get huge benefits from exploiting the successful explorations of the slow learners.
My Monitor Company experience mirrored this to perfection. During my entire time there, I was the #1 explorer, and it wasn’t even close. I received zero benefit of my exploration from Monitor but the toolbox I created out of the exploration is still being exploited profitably by the firm even though I left it 23 years ago. I am not complaining by the way. I have gotten plenty of rewards outside of Monitor for my efforts in exploration. But it does reinforce March’s point. At the individual level, exploration will have to be much more intrinsically than extrinsically motivated.
But the secret at the individual level is to maintain a balance. I got away with my exploration efforts by being one of the most successful Directors in the firm measured by exploitation metrics. It meant lots of extra work to explore, but I achieved a sustainable balance. And that balance, I believe, is what made the second coming of Steve Jobs a hero. When he came back, I believe that the track record shows that he dedicated energy to both exploration and exploitation and created a trillion dollars of value. It is a path that everyone should aspire to follow.