Business cycles: looking beyond the downside for competitive advantages

Describing a business as cyclical isn’t usually a compliment.

Investors prefer to hear about stable, structural growth, and typically discount projected future cash flows less harshly than they do for a cyclical business. It’s natural, therefore, that managers have a tendency to downplay cyclicality in their communications. More dangerously, this can lead to their downplaying cyclicality in their planning as well. However, the ability to take advantage of cyclicality in a business represents a huge opportunity for managers. In times of flux great opportunities arise to act decisively to fundamentally improve the competitive position of the firm. In some businesses, coping with cyclicality has been part of best practice for a long time. But many other industries are exposed to cyclicality as well.

Ensuring that managers and organizations are truly prepared to take advantage of business cycles requires consistent, objective discipline. This article lays out the five main steps of this process:

1. Which parts of the business are cyclical?

It is rare for all elements of the business to be the same: sales of a capital product could be highly cyclical, whereas service and maintenance sales could be very stable.

Where can innovation create new businesses that have stability, driven by stronger, fundamental factors than those driving the cycles?

2. How big is the financial impact of cycles on the business?

Generally, the scenarios managers use for strategic planning tend to understate potential variability.

Furthermore, because the scenarios are often too narrowly defined, assumptions and estimates of fixed and variable costs can be inaccurate. Labor and plant costs are neither fully fixed nor variable, but are one or the other within a band.

Finally, the scope of scenarios on the impact of cycles tends to be too limited. For example, in a big downturn, making assumptions about working capital and credit quality based on better times is a major mistake.

3. Understanding cyclicality gives the company an execution edge

Diversification across multiple cycles works for investors, but individual diversified companies typically lose out against focused competitors who put all their effort into understanding the supply and demand drivers of their specific segment. Human cognitive limits for handling complexity should not be underestimated.

Companies must be ruthless about defining their edge – what investors often refer to as ‘‘alpha.’’ For instance, it is common to hear general managers express strong opinions about the levels and direction of foreign exchange rates, energy, or commodity pricing. However, it is rare for their companies to have the ability to beat specialist investors in these fields. Companies must think hard and objectively about the competition. Can they beat the market in every area? Or would it be better to focus resources on a single area or a few key areas of edge?

 4. Does the company have the tools (timing, reserves, optionality) to exploit a business cycle?

Timing: 

Not only buy low/sell high, but also in/out and short-term versus long-term are crucial decisions that require equal diligence.

Reserves: 

Cash, debt capacity, inventories, production capacity, etc.; when to build them and how much is required.

Optionality: 

How can the company create cheap options, so that it can take advantage of upsides without incurring downsides, if the world develops differently? These are generally operational ‘‘real options’’ and contractual terms with suppliers and customers, rather than pure financial options.

5.  Do  the  company’s  organization  and  compensation  systems  reflect  the  cyclicality  of  its business?

Optimizing the stable elements of a business can often improve efficiency at the expense of flexibility and speed of decision-making. Cyclical inflexion points require rapid, clear, top-down calls that can be lost in a typical large, bottom-up, more bureaucratic organizational structure.

Companies should match compensation to the reality of their business cycle. If cycles are typically over five years it makes no sense to judge a manager over 1-2 years. Companies should keep incentives aligned.

 

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