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 / Spring 2006 / Issue 42(originally published by Booz & Company)


Love Your "Dogs"

Behavioral economics can reveal the hidden value in the poor performers of a business unit portfolio.

Illustration by Marco Ventura

In the course of maximizing shareholder value, senior executives routinely face decisions about which of their companies’ businesses should be nurtured, which should be starved, and which should be sold. The typical strategy is to invest more heavily in the “stars” that are earning superior returns on capital, while starving or selling the underperforming “dogs.” This is the conventional approach in corporate finance and has become so ingrained in management practice that it is almost impossible to question it. But what if it is wrong? What if corporations would be better off shortchanging their stars and nurturing their dogs? What different decisions would managers make then?

There is, in fact, reason to believe that the conventional wisdom is wrong. Corporate managers often rely on accounting metrics to make business decisions. However, these metrics are based on past performance; the market is interested only in the future. And past performance is generally a poor predictor of the future. Thus, when performance is assessed over time, greater shareholder value can be created by improving the operations of the company’s worst-performing businesses. The way to thrive is to love your dogs.

Just as some fund managers earn superior returns by identifying and buying undervalued “market dogs” — better known as value stocks — corporate leadership can learn to identify “value assets,” hold and nurture them, and produce superior performance. This in turn will ultimately lead to an increase in shareholder value.

From a recent analysis that we conducted of 25 years of U.S. stock-price performance, three messages for corporate leaders became clear:

• Fixing your dogs can yield unexpected levels of shareholder value, even when their key financial indicators lag behind those of other business units. Business unit returns are not tracked like stock prices. But experience suggests that turning around an undervalued business unit can be analogous to turning around an undervalued company. In 1992, the Lowe’s home improvement retail chain was considered a “dog,” after five years of lackluster revenues. But then the chain’s executives conducted an operations turnaround — leading to total shareholder returns (TSR) of 37 percent annually over the next five years. During that time, Home Depot outpaced Lowe’s in revenue growth. However, a dollar invested in Lowe’s in 1992 would have yielded returns of $4.83 in 1997, compared with $2.93 if invested in its “star” rival. The same dynamic can be found in any number of business unit examples, from a specialized product in a manufacturing company to a moribund brand in a retail chain.

• Improving operations is an important management lever for adding shareholder value. Starving dogs is not a strategy for creating shareholder value; in aggregate, there is more potential value in helping the dogs thrive. Focus on fixing the business — in both sales and operations — in ways that allow business units to realize their potential. This may primarily involve investing time and attention, rather than more money.

• Buying and fixing someone else’s dogs will produce more shareholder value than buying stars. Adding value to an overvalued business is a tall feat, especially on top of the premium that acquirers typically pay for a controlling interest in an enterprise. It is no wonder that two-thirds of acquisitions fail to add value for the acquiring shareholder. The right dogs, on the other hand, could offer a company focused on operations wonderful acquisition opportunities.

Far too often, senior executives attempt to diversify out of their core businesses, selling underperforming business units and buying their way into businesses that appear to be more attractive. The beneficiaries tend to be the private equity firms that are usually the buyers of these “unattractive” businesses. Those companies that have done the opposite — concentrated on their underperforming core business units — have tended to perform much better.

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  1. Louis K.C. Chan and Josef Lakonishok, “Value and Growth Investing — Review and Update,” Financial Analysts Journal, vol. 60, no. 1, January–February 2004: Survey of the empirical literature concluding that value investing generates superior returns.
  2. Eugene Fama, “Market Efficiency, Long-Term Returns and Behavioral Finance,” Journal of Financial Economics, vol. 49, no. 3, 1998: Theoretical study of the “anomalies” caused by investor attitudes.
  3. Matthias Hild and Tim Laseter, “Reinhard Selten: The Thought Leader Interview,” s+b, Summer 2005: The Nobel Prize–winning theorist of the “winner’s curse.” Click here.
  4. Josef Lakonishok, Andrei Shleifer, and Robert Vishny, “Contrarian Investment, Extrapolation and Risk,” Journal of Finance, vol. 49, no. 5, 1994: Evidence that value strategies succeed because of the “suboptimal behavior of the typical investor.”
  5. James Montier, Behavioural Finance: A User’s Guide (John Wiley & Sons, 2002): Dense, informative overview by the director of global strategy at Dresdner Kleinwort Wasserstein in London.
  6. Michael Schrage, “Daniel Kahneman: The Thought Leader Interview,” s+b, Winter 2003: The Nobel Prize–winning theorist of the “law of small numbers.” Click here.
  7. Hersh Shefrin, Beyond Greed and Fear: Understanding Behavioral Finance and the Psychology of Investing (Harvard Business School Press, 2000): Practical introduction (with investment examples).
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