Recessions are tough for most companies, especially midsize ones. Such companies lack the financial muscle that allows large companies to make brave moves during a recession. For mid-size companies, demand dries up, cash flows are blocked, credit is difficult to come by, and almost every financial metric turns red. What should such firms do during a recession, particularly as they rethink their strategy midway through it?
In our work with midsize companies, we usually find that the natural response is to play defense: Cut costs and preserve the remaining cash to last through the tough phase. But is playing defense the only strategy? Is it the best strategy? We provide data-based evidence of the optimal strategy for the midway point of a recession. What we found shows that playing offense could be a better choice for midsize firms than playing defense, provided they can pull it off.
We examined periods of three years before the recession (2004 to 2006), during the recession (2007 to 2009), and the period of recovery (2010 to 2012). We contrasted the changes in recovery-phase performance of the companies that increased investments during the recession with those that decreased them. Because financial numbers are not comparable across time, we adjusted them for inflation. We ignored companies with small changes in investments. We identified companies that were in the highest quartile (that is, the top 25%) in terms of percentage change in investments and compared them to those in the lowest quartile. Thus, we contrasted only those companies that made significant changes to their investment plans.
We examined three categories of investments:
Capital expenditures, such as land, buildings, machines, warehouses, equipment, and infrastructure
Economic competencies, such as in innovation, patents, brands, strategy, peer and supplier networks, customer acquisition and relationships, and training
Talent as measured by the number of people employed
We examined three measures of success: Improvements in return on equity, revenue growth, and market value of company stock. Since numbers may not be comparable across periods of recession and recovery and the sample of composition of firms changes over time, we converted our measures into percentile ranks. For example, a company was considered successful if its market value improved to 40th-percentile rank in the recovery phase from 55th-percentile rank during the recession.
Figures 1 through 3 show our findings, which are stark and instructive. The firms that increased investments during the recession showed improvement in return on equity, sales growth, and market values in the recovery phase. Companies that decreased investment showed deterioration on all three counts.
Clearly, playing offense dominates playing defense. What could be the reason? The principal reason is that recessions are inevitably followed by expansions, which typically last longer than the recessions. (The expansions after the 1980–1981 crisis and the 1990–1991 slowdown lasted eight years, the one after the 2000–2002 bust lasted six years, and the one after the great recession of 2007–2009 lasted 10 years.) Recessions are fertile ground for creative destruction and catapulting new winners.
So, despite the undeniable adversity, our prescription is that a CEO must consider recessions as opportunities. For some companies, they’re advantageous anyway. For example, Dollar Tree, Walmart, and Ross stores did very well during the 2008 recession when customers turned toward budget sellers. Similarly, 2020 has been a great year for Amazon. Yet even for industries battered by recession, it’s the best time to take advantage of the following opportunities for the forthcoming expansion:
Companies can attract ambitious employees who would thrive in a forward-looking, growth-oriented environment. Talent is not only available at a lower salary but is also more accessible. It’s an opportune time to conduct mergers and acquisitions and consolidate when valuations are low and competitors are willing to hive off divisions. It’s an ideal time to deploy new technologies, whose deployment during a boom phase would slow down the firm’s profit engine. There’s an opportunity to attract dissatisfied customers from competitors by offering superior products and services. To the extent that the government infuses liquidity into the economy and interest rates go down, it could be an advantageous time to lock in long-term financing.
A notable example of playing offense during a recession is Samsung. It increased its R&D and marketing expenses and hired the best brand managers during the 2008¬–2009 financial crisis and emerged as a formidable player in mobile phones market.
Why don’t most firms follow this strategy? Because their long-term vision gets fogged up by the day-to-day exigencies: Cancelled contracts, customer defaults, idled capacity, banks’ refusal to provide additional working capital, and cash-starved suppliers’ insistence on cash payments instead of extending credit. Firms come under intense pressure from investors to do something about deteriorating financial performance. CEOs cave and announce policies aimed atæ pleasing stock markets, such as reducing operating costs; shrinking discretionary expenditures like R&D, employee training, and advertising; eliminating frills such as offsite meetings and team-building exercises; delaying brand launches; rationalizing business portfolios; postponing buying assets like plants and machinery; firing contract workers; and lowering head count. They often resort to zero-based budgeting to start questioning every expenditure.
But restructuring and laying off workers might be the worst actions firms can take during recessions. According to Dave Cote of Honeywell, if you lay off employees when you’re halfway through a recession, you still have to pay six-month severance pay, which means you only realize those savings after six months. Suppose the recession lasts for another 12 months. In order to gear up production, you need to hire new workers six months ahead of time. So, by firing workers, you really don’t save much, but you do destroy morale and incur additional rehiring costs. Workers with low morale are unlikely to offer innovative solutions to problems, which causes product and service quality to suffer and leads to more unsatisfied customers. Notably, finance departments usually do “across-the-board” cuts, instead of a more judicious rationalizing of investments and saving at least a few future-oriented projects from the universal axe.
In sum, we believe that playing defense, particularly late in a recession, is not the optimal strategy for midsize companies. On the contrary, it could be the best time to prepare for a forthcoming expansion. And given the lower costs of forward-looking plans during a recession, such a strategy would provide better return on investments in capital, competencies, customers, and talent than it would during the expansionary phase.
By Vijay Gorindarajan, Anup Srivastava, and Aneel Iqbal
Extract from the Harvard Business Review