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How to develop a business strategy for an economic downturn

02 Apr 2020

Everything changes, everything is connected, pay attention.

I read this Zen quote whilst working in Japan during the recession of the 1990’s. It points directly to the need for current, reliable data and insights to ensure safe navigation through the dynamics of social and economic change. The Global economy has seen expansionary periods that last for eight to ten years at any point in time over the last 50 years. We were in one of the longest growth periods in economic history until Covid19 struck, recalibrating social and economic activity in ways not seen since the Second World War. Unfortunately, we cannot predict when recessions arrive. The running joke is that experts predicted seven of the last three economic downturns.

Strategies for a recession

What strategies can companies create to survive this recession so as to achieve sustainable growth once it has ended? Numerous studies suggest that companies that cut costs by focusing on operating efficiency even as they spend more than rivals on strategic insights, marketing, R&D, and assets are likely to be post-recession winners. Companies that only cut costs heavily during a downturn don’t flourish after it ends. According to a study by Ranjay Gulati, Nitin Nohria, and Franz Wohlgezogen published in Harvard Business Review during the last recession, the few businesses that only invest more than rivals during a recession also fail to flourish. Even companies that were doing well beforehand don’t retain their momentum- 85% of market leaders get dislodged during a recession.

Redirecting assets

Cutting costs while making investments is a challenging but rewarding task. Companies must be disciplined about costs, reducing those in non-performing areas whilst investing in those that are current and future based, such as digital. Successful companies use research and insights to reveal investment opportunities that offer good returns in payback periods that are sensible and manageable. If the mix is balanced, it helps them overcome short-term problems and develop medium term and long-sighted strategies that are customer focused; segmenting customers and prospects by their mindset as much as by their wallet. By categorising purchases as essentials, nice to have, and expendable, marketers can gain a rule of thumb over likely purchases. By having search data that provides insights into customers’ and prospects’ behaviour, marketers will be able to dive deeply into mindset and actions.

Prepare early

To understand what triggered growth or decline during recessions, McKinsey researched a number of companies that were successful in navigating macroeconomic crises, positioning themselves apart from their competitors during and post different downturns. They found those that prepared early emerged much stronger coming out of a recession and the advantage they gained was sustainable for a longer period.

(Exhibit 1)

While the downturn rate was severe, come companies flourished

McKinsey looked at 1,000 publicly traded companies in North America and Europe with more than $1 billion in revenue. They excluded financial institutions because total returns to shareholders (TRS)—the metric they used—looked different there, but they ran a similar analysis for them also and the key messages still held.

They then analysed how those companies performed relative to their industries. For the companies that they found had outperformed, they dug deeper to understand what they did differently—and, almost more importantly, when they did it.

Resilience Power Curve

The researchers then developed what they call the resilience power curve, which shows the Total Returns to Shareholders of all the companies in the sample, ordered from lowest to highest for the period of 2007 to 2011. The average TRS during that time was zero, and 45 percent of the companies had negative returns. But the top quintile actually did quite well. Their average annual TRS was 9 percent, and the median in that group was almost 20 percent which was a highly commendable performance in what was a really tough macroeconomic environment.

The researchers then looked at how companies performed relative to their sectors. For example, they analysed consumer packaged goods (CPG) companies and discovered those that achieved, on average, 10 percent TRS annually compared to the sector average of 4 percent. McKinsey call these companies the resilients.

For example, if you had a large CPG company with a $100 billion market capitalization in 2007, at the end of 2011 the value creation difference between that company and the average would be $30 billion. Over a ten- year lifecycle, that excess value creation is $130 billion—a big, big difference. What is more, this outperformance is sustainable: in those ten years, they outperformed the non-resilients by 150 percent. Also, they delivered essentially double the returns of the S&P 500. To underline the point of sustainable advantage, 70 percent of those resilient companies are still in the top quintile today.

What did these resilient companies do differently than their peers?

The first thing McKinsey found is that the resilients outperformed on earnings throughout, almost quarter by quarter. And they drove recovery much faster than others

(Exhibit 2)

Resilient companies did better at the outset of the downturn and after

On the revenue side, they wondered whether resilients’ outperformance was simply a function of their portfolio. If, for example, you happen to cater to a lower-income demographic in the CPG sector, you might see a bump in your business during a recession. McKinsey saw that there was some portfolio effect but, by and large, the biggest effect was around EBITDA [earnings before interest, taxes, depreciation, and amortization.

The resilients were able to grow EBITDA consistently, no matter what the outside conditions were, without interruption.

By the time the depth of the recession came around, resilients had an astounding 25-point higher EBITDA than nonresilients. On the revenue side, resilients and nonresilients marched hand in hand until about 2009, butthere is a noticeable difference by the time the trough hits, and as you can see from the chart, divergence really kicks in during the recovery period.

Resilients do something different when it comes to EBITDA margins

What was driving this margin growth? During the downturn period from 2007 to 2009, resilients cut their operating costs by half a dollar for every dollar of revenue change, while nonresilients increased their operating costs in the same period.

When the recovery came, this allowed the resilients to build on the momentum they had secured and cut costs even faster for every unit of revenue change. Because of these actions, resilients were simply able to move faster, cut costs, and increase earnings.

Resilients sell and purchase businesses

Resilients divested more during the down cycle. Analysis showed that of all the deals the resilients did, 25% focused on divesting parts of their businesses versus about 18 % for nonresilients. Compare that with acquisitions during the recovery. Resilients acquired far more than nonresilients did during the recovery period- 96 percent of the total deal value for resilients was in acquisitions.

Resilient companies were able to free up resources to take advantage of acquisition opportunities and gave themselves the ability to react to changing circumstances.

The resilients focused on creating both operational and financial flexibility to enable them to thrive through the downturn by cutting about $1.20 for every dollar of capital while the nonresilients ended up growing their debt dramatically. During the recovery, the resilients turned contrarian and focused on increasing their leverage ratio while nonresilients continued to try to catch up and reduce their debt to capital. This is a lesson in speed and flexibility.

Will this downturn differ significantly from the previous one?

Most major recessions have been due to some form of credit crisis. The McKinsey analysis focused on the last recession before Covid19 sunk its teeth into the global economy. However, the lessons from the last recession will still apply but there will be a difference.

(Exhibit 3)

A new resilience playbook is emerging

Source: McKinsey

With self-isolation in force in many countries, most sectors are experiencing various forms of digital disruption, either as customers demand a frictionless mobile experience or as businesses discover new ways to drive efficiency through advanced analytics and digital techniques.

Coming into the last recession, there were far fewer digital natives dominating their sectors. Now, seven out of ten sector-dominant companies are digital natives. That gives them a pre-existing costs advantage.

Invest in technology

Amy Webb, the founder of the Future Today Institute and professor of strategic foresight at the New York University Stern School of Business, wrote that when faced with deep uncertainty, teams often develop a habit of controlling for internal, known variables and fail to track external factors as potential disrupters. That is a very important reason to employ technology and digital intelligence because it intersects with the outside sources of disruption. (Exhibit 3)

11 Macro sources of disruption

Source: MIT Sloan

Adopting technology costs less in a recession

Companies that play safe don’t emerge as winners through and after a downturn. Successful companies invest in technology during a recession because their opportunity cost is lower than it would be in good times. For that reason, adopting technology costs less, in a sense, during a recession.

That’s fine in theory, but other reasons may make more practical sense to managers. Technology can make your business more transparent, more flexible, and more efficient, according to Katy George, a senior partner at McKinsey. The first reason to prioritize digital transformation ahead of or during a downturn is that improved analytics can help management better understand the business, how the recession is affecting it, and where there’s potential for operational improvements.

George wrote that the second reason is that digital technology can help cut costs. Companies should prioritize “self-funding” transformation projects that pay off quickly, such as automating tasks or adopting data-driven decision making. The third reason is that IT investments make companies more agile and therefore better able to handle the uncertainty and rapid change that come with a recession.

Companies that fail to learn the lessons of the previous recessions and neglect digital transformation may find that this recession will create long-term issues that may be difficult to overcome.

During this testing period companies need to analyse their brands' opportunities, allocate resources for the long term, and reallocating budgets to reflect the new customer needs, whilst building long-term trust.

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