Bruce Simpson is a director in McKinsey & Co.'s Toronto office. Sree Ramaswamy is a senior fellow at the McKinsey Global Institute.
The corporate world has entered a more volatile era of leaner profits and supercharged competition. Canadian companies have to adapt quickly to these new realities – and they can't simply play defence, by relying too much on the growing U.S. economy and a cheap loonie. The world is going through some monumental shifts, and while some create a tougher operating environment, others are creating outsized opportunities for companies that move decisively. Canada can win big by showing more "muscle" abroad, beefing up a "Team Canada" approach between the government and private sector, and being "leaner" and more productive at home.
We now face a shrinking global profit pool. Although they may not have always felt it, global corporations have enjoyed an unprecedented boom for the past three decades. Corporate earnings (before interest and taxes) more than tripled from 1980 to 2013, and large U.S., Canadian and Western European firms were the biggest beneficiaries. Despite recent gyrations in the resources sector, in 2015, the average after-tax profit margin for Canadian firms is at a nearly 30-year high.
That run seems to have ended. Recent research from the McKinsey Global Institute projects that the after-tax profit pool could drop from almost 10 per cent of global GDP today to about 7.9 per cent over the next decade, practically reverting to its pre-boom level. And, as profit growth slows, there will be many more companies fighting for a slice of the pie. Executives once knew their competitors and how they operated, but today new challengers are arriving from around the globe and, increasingly, from the technology sector. There are twice as many multinational firms active today as in 1990, and the majority of that growth has taken place since 2000.
Meanwhile, the ranks of Canadian multinationals have barely grown in 20 years, and 85 per cent of Canada's exports still go to the United States. Even 20 years after NAFTA, direct trade, investment and personal links between Canada and Mexico remain minimal.
Industrial giants from emerging economies are proving to be hard-charging competitors. Some of them rank among the world's largest firms, and they are now expanding globally, often through aggressive merger-and-acquisition strategies. Widely-held public companies in the West may be hamstrung by their shareholders' focus on the most current quarter's results. Because many of the new emerging-market competitors are state- or family-owned, they have flexibility to play the long game. They can prioritize revenue growth over short-term profits or engage in price wars for extended periods to build market-leading positions. Chinese firms, for example, have grown four to five times faster than Western firms in the past decade, yet their margins fell by more than five percentage points on average.
Technology firms represent another huge and even more unpredictable source of competition. By building powerful digital platforms and networks, the biggest tech giants have reached unprecedented scale in users, customers, revenue and profits. These platforms can drive marginal costs to almost zero, allowing the operators to add customers and new types of interactions at virtually no cost. Some digital disruptors are siphoning substantial value from industries and giving it away to consumers to build user bases. Technology-enabled firms are also expanding rapidly into adjacent sectors – and incumbents may be caught flat-footed. Consider the bookstores shuttered by Amazon, the video stores wiped out by Netflix, the travel agents rendered obsolete by Expedia.
Canada's share of Asia's expanding trade has fallen by half over the past decade. And yet Canada has many of the strengths needed to compete in a tougher global marketplace. Not only does Canada have an educated labour force, but it has built an excellent track record in fields that are in demand all over the world: natural resources, clean tech, financial services, infrastructure, health care.
Canada's strengths make it uniquely placed to take advantage of a massive and continuing wave of global growth. About 1.8 billion people are expected to join the ranks of global consumers by 2025, with nearly all of the growth coming from emerging economies. The expansion of the middle class worldwide represents a historic opportunity to capitalize on the ties that Canadian immigrants maintain with their former homelands in the developing world, to develop the export capabilities of small and medium-sized firms, and to better market Canadian expertise.
But there will be intense competition for these opportunities, and complacency could lead Canadian industries to miss out. In the new battle for corporate profits, business and government leaders face three challenges in particular. Companies and policy makers alike will need to take a more collaborative approach to tackling these challenges and build Canada's competitive muscle.
First, the firms that win in this new competitive landscape focus on high-growth markets. Canadian companies can expand their reach by targeting the hundreds of fast-growing megacities across Asia. Most Western leaders would be hard-pressed to point to these places on a map today, but they represent huge, untapped markets that are still up for grabs.
It's time for Canada to play "offence" and tilt decisively toward Asia. For example, Canada could create a minister for Asia, build a stronger "Team Canada" approach abroad and increase the quantity and frequency of well-targeted public/private-sector trade missions to the most promising markets.
The second challenge is to focus on competing in the knowledge economy. The highest profit margins are now in sectors such as finance, pharma, media and information technology – fields that revolve around talent, innovation, patents and brands. Western firms' share of profits in these sectors has nearly doubled in the past decade, but Canada has not benefited to the same degree as the United States or European countries. These sectors will be the source of future profit growth, and Canada has to compete on these playing fields. The public and private sectors will need to work closely on new strategies for developing and attracting the skills needed to compete.
Third, we must be leaner at home. The winning firms focus on productivity growth. Nearly one-third of Canada's mid-sized and large firms are in the mining, energy and metals sectors. They are not only exposed to gyrations in global commodity prices, but under increasing pressure as emerging-market giants drive down margins across entire industries.
Productivity is not just a matter of survival for firms in capital-intensive sectors; given Canada's aging work force, it is one of the most critical challenges facing the economy. Over the next 50 years, aging could slow Canada's GDP growth rate by 50 per cent – the steepest decline of any advanced economy in the G20. Every sector that hopes to be globally competitive has to continuously seek ways to become more efficient. And Canada does not currently lead the world on productivity in any sector.
In a hypercompetitive world, many companies (and countries, for that matter) instinctively throw their resources into protecting their current market niches. But with emerging-market companies and high-tech firms bringing a new aggressiveness to the game, there's no safety in inertia. Industry leaders could suddenly find themselves challenged by a startup, an unfamiliar foreign name, even a company from an entirely different industry that they never saw coming.
But if Canada can transform the way it does business, becoming leaner and more productive at home while aggressively pursuing growth opportunities abroad, there will be plenty of opportunity in this wave of disruption.