Learning to Love Recessions

Recession strikes different sectors in different ways, and at different times - but it is not always bad for everyone. Studies show that some companies emerge from recession stronger and more highly valued than they were before economy soured. By making strategic choices that defy conventional wisdom, these companies outperform their peers and doing so increase their market valuations. But if past is prologue, many companies would also lose their market leadership during this recession while others wouldn't last longer and fail.

McKinsey Quarterly studied the impact of last recession in 2000-01. Many companies weren’t prepared for the recession and nearly 40 % of leading US industrial companies toppled from the first quartile in their sectors during the recession, and a third of leading US banks met the same fate. At the same time, 15 % of companies that had not been industry leaders prior to the last recession vaulted into those positions during it.

So what distinguishes winners from losers? Are there certain attributes of successful companies, both during the recession and healthier economic times? Definitely, yes.
There are certain characteristics that successful companies have exhibited both prior to recession and during recession, which might help explain why they outperformed their peers.

Preparedness: Recessions strike different sectors in different ways and at different times. But the post-recession leaders across sectors had one characteristic in common - they were better prepare than others.

Pre-recession strategy: Successful companies enter downturn with a great degree of strategic flexibility which becomes even more valuable during the recession. Before the recession, these companies have made good decisions to:

• Maintain lower leverage on their balance sheets - lower Debt-to-Equity (D/E) ratios
• Control operating expenses better
• Diversify product portfolio and geographic presence.

By comparison, their unsuccessful peers leverage heavily as they try to expand through acquisition and alliances, before the recession. Not only that most companies would leverage to increase dividend payments or buy back share in good times.

Successful companies follow a conservative strategy in good times. These companies increase their asset-base through capital expenditures but with a different growth strategy - they rely more on organic growth rather than M&A, joint ventures etc. Also these post-recession leaders avoid excess capacity through restrained spending.

Recession strategy: Recession strategy is simply reverse of pre-recession strategy. Unlike their conservative peers in recession, successful firms are not afraid to spend their cash reserves. They leapfrog the competition by continuing to invest and grow inorganically through M&A - possibly buying cheaper assets from distressed sellers.

Also for most companies, selling, general and administrative (SG&A) costs are typically difficult to cut in the short term. However, successful firms are better positioned because of their increased operating flexibilty before the recession. It gives them immense advantage to cut spending selectively. Note that these post-recession leaders continue to focus spending on 3 key areas -even during recession: innovation (R&D), marketing programs and customer service for key customers.

Example (from McKinsey Quarterly): Starbucks used these tactics successfully in holding its market leadership before and after the recession. It maintained a low D/E ratio of 8% compared with average of 14% for restaurant sector, in 1996. The company consistently reduded its leverage every year until 1999 - to a low of 2% compared to industry average of 31%. Strategy was to grow by licensing outlets- expanded proportion of licensed outlets from 7% in 1998 to 23% in 2000. The company continued to build on its strategy of licensing and international expansion through alliances even during the recession (Exhibit). Currently, Starbucks' alliances contribute 14 % of the company’s revenues but account for 39 % of its profits.

When the recession struck, Starbucks avoided price cuts by offering innovative value-add services (WiFi internet access in Starbucks stores), Starbucks card and improved customer service.

If you have followed my previous posts, you might have noticed a consistent theme and common characteristics of successful companies. Their strategy defy conventional wisdom as they play conservative in good times and grow aggressively through acquisitions and product innovations-during recession. Such contrarian strategies have helped these companies beat their competition and in the process, create more wealth for its shareholders.

RECOMMENDED READING: Following books are recommended for further reading.