It was unimaginable almost two years ago – when Davos was last in Davos – that the Dow, then at 10,730 would crash 32 percent to 7,286 on October 9 of 2002, the largest sustained slide since the '70s or maybe even the '30s. While everyone had come to expect the cyclical ups and downs of the U.S. markets, none of the pundits was predicting the damage that would be visited on companies, investors, employees and management.

Corporations must evolve with the market
Today, we are more aware than ever that aspiring to perform at unrealistic levels can trigger collapse – either because of loss of control of the corporation due to its rapidly expanding scope and scale, or because it has assumed too much debt, or because of a decline in the corporation's moral health. The clear message of the McKinsey Long Term Performance Database and our book, Creative Destruction is, "If a corporation aspires to perform as well as the market indexes over the long term, it will have to change at the pace and scale of the market, but without losing control." Companies, of course, do not have to change at the pace and scale of the market, but if they do not, then the research from McKinsey's Long Term Performance Database shows that they are more than likely to underperform for their investors.

Understanding market conditions
Our investigations supporting the analysis in Creative Destruction show that about 30 percent of the long-term increases (or, more technically correct, changes) in stock prices are due to the overall changes in the capital markets themselves, that is the general economic conditions that push markets ahead or retard their progress – interest rates, global economic climate, consumer spending. Another 50 percent is due to the industry in which a company participates. The steel and the airline industries have been under pressure for long periods of time, while the pharmaceutical industry has been enjoying success for two decades now. The remaining 20 percent of stock price change is due to actions that a company takes, beyond deciding when to enter and leave the markets, and which industries to join. Once these key decisions are made, it is up to management to perform well but very, very few of them other than new entrants are able to outperform the markets for any long period of time.

Balancing change and risk
What does this say about the role of management? Our analysis shows that, in the long term, management does make a critical difference. And the primary lesson of the last two years is that companies which attempt to perform at well above the rates of the markets are implicitly, at least, taking on increasing levels of risk. At very high levels of change, these risk levels can become fatal. There is no ideal balance of permission and control, only the right balance for the times.

Top management's task is to anticipate the needed balance sufficiently far in advance of market changes so that it can either capitalize on the opportunities or protect itself from the risks of the markets. Those companies that accept the challenge of performing at market levels will have to find ways to change at the pace and scale of the market without either jeopardizing operational effectiveness, for losing control of their companies.

The crucial tasks
Four tasks are crucial: First, a corporation has to refresh its portfolio of businesses and processes at the pace and scale of the market, such as GE did under Jack Welch. This requires not only increasing the number of opportunities to pursue – whether they be internally developed or externally purchased – but also increasing divestiture of businesses and/or business processes. In our experience, while it is hard to create new businesses, it is even harder to rid the company of legacy businesses and processes that have gained the economic equivalent of tenure in a university.

Second, these higher rates of change have to be achieved without exposing the corporation to unacceptably greater risks, specifically the risk of loss of operational excellence. This requires rethinking control systems ("Control what you must, not what you can; control when you must, not when you can") and risk ("Price for risk, don't avoid it").

Third, top executives must further decentralize corporate decision making to allow them to focus on getting the balance right between change and control. Private equity firms have done this by decentralizing the balance sheet as well as the income statement. They also tailor the capital structure of their businesses to the prospects for the business, rather than applying the same leverage to all businesses, independent of their prospects.

Lastly, top management needs to rethink its contribution to the corporation. The core of management's time should be spent setting the pace and scale of change, while ensuring that the control systems work efficiently, and that operations continue to perform at world-class levels.

This is what Johnson & Johnson has done in providing investors an annual return of more than 20 percent over the past decade.

Painful lessons
The millennial market collapse has been painful, but there are two lessons that stand out clearly for us.

First, for survivors, it is possible that CEOs have become risk managers rather than performance managers. Their most fundamental duty, as they see it, is to keep the corporation going, rather than to maximize its performance. This is a reasonable goal for many leaders, although it does imply some underperformance for their investors. Setting the right balance between longevity, which is in the best interest of the employees and perhaps management, and performance, which is in the best interest of the investors, should be the focus of discussions between management and the board.

Second, the increasing pace of change in ever more turbulent markets, along with the increasing complexity of our society, will confound our ability to accurately forecast the future. A common assumption of capitalism is that the future can be accurately forecast. If that were possible, "efficient markets" would always be the result. But we have mastered this black art only for the simplest and slowest-moving of industries. Any industry of substantial complexity is beyond the range of today's practical market-based forecasting systems. Both equity analysts and the debt rating agencies have forecast the future as a straight-line extension of the recent past.

Problems and opportunities are new
Markets are dynamic. They cater to the masters of creative destruction because problems and opportunities rarely present themselves in the same way a second time. The all-important problems are almost always new problems, just as all-important opportunities are new opportunities (as any venture capitalist can attest). Moreover, change comes from the periphery (for example, consider the drug industry). New companies will bring new ideas to the marketplace, and with those new ventures will come the inevitable reversal of fortunes that first attracted them. This process is not about "creation" alone, but creation and "destruction" or divestiture of assets (including business processes) which can be replaced by better performing investments.

The pull of economic gravity
In a similar way, the spectacular long-term performances we have seen in some companies, e.g., The Limited, TCI, Wal-Mart, GAP, Amgen, Microsoft, Berkshire Hathaway, have all come from entrants, rather than survivors, with the singular exception of Leucadia National Insurance company. The strong performance of these companies is not evidence that they had learned the lessons of perpetual exceptional performance, but rather that they had found a formula that lasted for a while, but not forever. None has escaped the pull of economic gravity. As Tennyson wrote in "The Passing of Arthur": "And slowly answered Arthur from the barge: The old order changeth, yielding place to new; And God fulfills himself in many ways, Lest one good custom should corrupt the world."

Creative Destruction was based on the analysis of 1,008 companies in 15 industries from 1962–1998. All companies in these industries with more than 50 percent of their sales in the industry category as judged by S&P, and with a market capitalization above the bottom 20 percent of U.S. companies (a number that in 1998 meant that companies had to have market capitalization in the top 80 percent of U.S. market capitalizations which is about $400 million in 2002) were included in the McKinsey Long Term Performance Database, for as long as they met these conditions. We now have about 1,500 additional companies in the database. Many of these companies were in the original 15 industries, but 17 new industry groups are now incorporated including financial industries (e.g., asset managers, broker dealers, commercial banks and insurance companies). We also extended the time covered by the database by four years up to and including much of 2002.