By Gary Hamel
January 22, 2004

Finding a convincing logic for J.P. Morgan's acquisition of Bank One isn't easy. It certainly isn't the illusory benefits of size. Although any CEO with an imperial instinct can be counted on to trumpet the benefits of scope and scale, my research across more than 20 industries suggests there is little or no correlation between size and profitability.

The auto industry is a perfect example. Over the last decade, Ford and General Motors bought a clutch of minor marques, such as Saab and Jaguar, with the hope of bestowing the benefits of global scale on these niche brands. Similarly, it was the pursuit of scale economies that drove Daimler Benz and Chrysler together. How odd, then, that two relative half-pints, BMW and Porsche, are two of the world's most consistently profitable car companies.

* * *

Whatever the rationale for corporate coupling, a spate of academic research has demonstrated that mega-mergers are as likely to destroy shareholder wealth as to create it. In most cases, the costs of integration, both direct and indirect, overwhelm the anticipated economies. As management's attention turns inward, customers lose out and market share wanes. While a newsworthy deal may temporarily distract shareholders from a company's otherwise lackluster performance, it doesn't do anything to make a company more dynamic, more innovative or more customer-centric. Put simply, you don't get a gazelle by breeding dinosaurs.

Despite these contra-indications, CEOs seem all too easily seduced by the allure of an outsized deal. Why should this be so? Perhaps, with the economy bounding forward, prudence and steady progress seem so, well, last year. Perhaps the attraction lies in the fact that it is so much easier to put together a deal than it is to reinvent a company's decrepit business model or re-energize its dispirited employees. Unlike a program of root-and-branch transformation, an acquisition can be brought to fruition within the ever-shrinking timescale of a typical CEO's tenure. Or maybe CEOs naively hope that shareholders will view a bold gambit as evidence of a truly prescient strategy-and boost the share price accordingly.

While all these things may fuel a CEO's appetite for a big acquisition, there is often an even simpler, though equally suspect, rationale: A major acquisition is the fastest way to compensate for a company's failure to grow organically. Although an acquisition may well destroy shareholder wealth over the medium term, in the short term -- the time frame relevant to most CEOs -- it always increases the top line and usually adds at least something to the acquirer's bottom line.

To a large degree, jumbo-sized acquisitions are simply a response to the pressure CEOs feel to deliver above-average growth in revenue and earnings -- a pressure that is more easily relieved via deal-making than through the arduous task of developing strategies that might rev up internal growth. This pressure is particularly acute when a company feels it has lost ground to a larger rival.

But while an uninspired or impatient CEO may have a penchant for a big acquisition, investors should be highly skeptical of any growth strategy that relies on aggregation. Peer-beating growth, when achieved organically and free of accounting trickery, is an undeniable testament to the quality of a company's underlying strategy and the competence of its management. Think of Southwest Airlines, Best Buy, Dell Computer or Wal-Mart. Aggregation via acquisition carries with it no such implicit warranty. A company that expands via acquisition grows not because it's good (although it may be), but because its investment bankers are good. Sometimes the strategy is sound, as in the case of Clear Channel's roll-up of radio stations across the U.S.; more often, it is not -- a fact born out by the travails of Vivendi, Tyco, HealthSouth and several dozen other acquisition addicts.

Shareholders have paid a heavy price for ill-conceived or poorly executed deals. Between 1998 and 2002, a span that includes several years in which the value of global M&A exceeded $3 trillion, companies in the S&P 500 recorded more than $470 billion in exceptional charges against earnings, net of gains -- a figure 400% greater than that for the previous five years. Although it's impossible to say exactly how much of this nearly half-trillion dollars can be chalked up to failed or flawed acquisitions, my analysis suggests that as much as half is the product of acquisition-related write-downs and restructuring costs. While, on average, the deals have been getting bigger, they haven't been getting any smarter.

But shareholders are as much culprits as they are victims. It is their expectations, along with the compensation plans they approve, that induce CEOs into imprudent deal-making. It's a fair bet that every CEO feels he or she is expected to deliver above-average growth in revenue and earnings -- the only exceptions being hopelessly crippled companies where sheer survival is an accomplishment. While it's impossible for every company to outperform the average, it nevertheless seems reasonable to expect every CEO to at least strive for that outcome. But is it? When one realizes just how hard it is to deliver peer-beating growth for more than a few years at a time, the expectation of sustained, superior growth suddenly appears quite unreasonable.

Consider the following. If one divides the 10-year span from 1993 to 2002 into two five-year periods, one finds that less than 7% of the S&P 500 managed to achieve top quartile average annual earnings growth in both periods. Those are long odds. Indeed, a CEO is about as likely to get a coin to come up heads on six consecutive throws as he or she is to deliver two consecutive demi-decades of top quartile earnings growth.

Producing a decade's worth of top quartile revenue growth isn't much easier. Of those companies that were in the S&P 500 continuously from 1993 through 2002, only one in six delivered top quartile revenue growth in more than five years out of ten. An equal proportion failed to turn in top quartile sales growth in even a single year. And only one in 27 companies achieved top quartile sales growth in eight or more years out of 10.

* * *

Any CEO of a large incumbent company who's still tempted to shoot the moon should consider the following. The few companies that did manage to deliver consistent, top quartile earnings growth over the last decade were either small (it's easier to grow earnings fast when you start from a small base), were pursuing a consolidation strategy in an industry that was highly fragmented (like waste disposal), were the beneficiaries of powerful environment forces (like the run-up in IT spending or mortgage refinancing), or had a killer business model (like Starbucks, Kohl's or Dell). In the absence of these relatively unique circumstances, a bold growth strategy is likely to end in tears.

So can an incumbent like J.P. Morgan outgrow its mostly mediocre peers? Sure. But, like Toyota, it's best done the old fashioned way -- by building market share one happy customer at a time. That takes inspired innovation and relentless improvement. This isn't as sexy as a big deal, but it's a much surer bet for shareholders.

Mr. Hamel is chairman of Strategos and director of the Woodside Institute.