What Is in a Recession?

To prove that managing for a downturn matters, we analyzed the financial results of 850 of the largest companies in the United States. Using return on invested capital (ROIC), we separated companies into three groups: the winners — those that outperformed others in their industry for the six years following the recession of 1990-1991; the losers — those that underperformed others in their industry; and those that ended up in the middle. On average, the winners were able to improve their competitive trajectory beginning in 1990, the start of the recession, and maintained their rate of improvement over the following couple of years. During the same time period, the losers lost ground (see Figure 1).

Our Research

Our analysis used statistics from Value Line and Stern Stewart. To gauge performance, we analyzed a company’s ROIC before, during, and after the recession compared to the average in its industry. We then conducted in-depth interviews with 40 senior executives from 35 companies with a range of performance characteristics to understand the actions they took to create the results they achieved.

A company’s return on invested capital for the three-year period following this recession explains more than 60 percent of its return for the remainder of the decade. That is, companies that had the highest return coming out of the recession tended to maintain their lead despite other factors in the market. This correlation shows that companies that pull away from the competition during a downturn have lasting advantages, not just a fragile edge.

The New Contrarians

The companies that created substantial value relative to their competition after the downturn of 1990-1991 practiced a new brand of back-to-basics contrarianism. They refused to pursue growth for its own sake, opting instead for profitable growth, growth where their return on capital exceeded the cost of that capital. They insisted on getting value from their investments — from acquisitions to internal infrastructure. And they built solid franchises with fundamental, value-based principles instead of financial engineering or Wall Street wizardry.

These companies created the foundation for their lead in the good times and took advantage of it in the bad. A former vice president of a leading metals company explains his company’s posture in the late 1980s: “The rest of the industry was living in an up cycle, putting their feet up and relaxing. But we were moving to another level to be ready for the next downturn.”

Three factors distinguish these new contrarians:

Figure 1: Winners pull away from losers after a recession.

Focus On Generating Cash Flow

The new contrarians march to a different fiscal beat than most executives. Eighty-three percent describe their approach to financial management as conservative. In contrast, only 45 percent of the poorly performing companies take this stance. The winners build up war chests, limit debt, and focus on cash flow in good times in order to remain flexible and unencumbered. This gives them greater degrees of freedom and positions them to take advantage of opportunities that come up during a downturn.

Doug Rasor, vice president of strategic marketing for Texas Instruments, says his company has the ability to be aggressive in a downturn because of its strong cash position. “I think we have an advantage in our ability to do more aggressive things than our competitors are able to do, and we believe this will turn to a competitive advantage when things turn around.”

A metals company executive adds, “With the cash generated by running lean in the good times, we are now shopping around aggressively for growth. We have a balance sheet that allows us to do that.”

A strong cash position enables innovative companies to continue to invest in future growth. They fund research and development, sustain expansion programs, and continue marketing initiatives. The chief financial officer of a successful semiconductor company emphasizes, “We let research and development spending float above the model percentage in a downturn. As a result we outgrow the industry by a factor of two on the up side, and we lose only half as much on the down.”

Clever companies hold performing, semi-liquid assets in lieu of cash to give themselves both financial returns and a downside cushion at the same time. For example, one major retailer owns stores rather than leasing or franchising them. These could be converted to cash if the company needed capital.

The vice president of corporate strategy explains, “There are various theories on the best financial structure, but we always considered it a challenge to fund growth internally. Plus we have many company-owned stores, which are a potential source of cash if we ever want to increase growth.”

In contrast, Citibank was in a precarious situation in 1990 because it had pursued market share growth at the expense of cash flow and profitability. In the words of one senior executive, “You’re looking to grow so you lend aggressively. Credit control wasn’t as good as it should have been, and we were emphasizing market share.” To keep Citibank from teetering over the edge, the federal regulators stepped in for the next several years to supervise the company’s return to financial health.

Position Strategically in the Good Times

The successful executives in our study did not win by predicting when the next downturn would hit. They assumed that their industry would have ups and downs and positioned their companies well in the good times. How did they pull this off? They forged resilient strategies and stuck with them; they focused on managing fewer businesses well; and they emphasized organic growth over acquisitions unless they were in a position to consolidate their industry.

They forged strategies that worked in good times and bad, and they stayed the course during the downturns. Successful companies crafted solid business models and good cost positions. In other words, leaders understood the differentiating value drivers for their companies and molded their strategies accordingly. In many cases, this involved taking a different tack from competitors and withstanding criticism from Wall Street for their unconventional stance.

Across all the companies in this group, executives structured their companies to succeed in a recession before the recession arrived. “The strategy should be employed long before the downturn comes,” emphasized a senior executive in the retail industry. “In the late 1970s, we chose a different strategy from our competitors. We pursued that through the 1980s and kind of left them behind.”

His company managed to maintain a consistent ROIC during and after the recession of the early 1990s, while his closest competitors fell off the mark considerably over the same period (see Figure 2). The executive continues, “It starts with good strategy planning on the front end, making sure your company’s operating systems have robust detection tools and the right sort of levers to manage the business in the details.”

Figure 2: A major retailer sustains excellent performance while competitors fall off.

Figure 3: Northrop Grumman repositions itself.

High-technology winners concentrated on finding sweet spots in their industry that were more stable than commodity hardware. One semiconductor industry executive explains, “The memory and processor segments were volatile. We were well-situated in signal processing, the most stable part of the industry, which is really important when you get into challenging economic times.” A software supplier to the automotive industry dealt with cyclicality by building a base of recurring revenue. Its vice president of marketing says, “We structured our revenue model so we would see 40 to 50 percent of the price of the initial systems contract for each of the next five years. Our clients, the automobile dealerships, had done the same thing by focusing on service instead of sales. We were both more resilient to downturns as a result.”

Companies that repositioned in good times did better than those that waited for a downturn to rally the will for strategic change. For example, Northrop Grumman, a defense contractor, began its transition from airplanes to electronics systems in the early 1990s — an up cycle as the Gulf War boosted revenues for its annuity B-2 aircraft line (see Figure 3). The company had done its homework in the previous downturn with a far-reaching study on the future of war. “We concluded that it is human nature, and war will continue,” remarks one executive, “but the value will shift from the airplanes themselves to the electronics systems that are stuffed in them.” The market upturn gave it the operating runway to begin to move in the direction its strategists had outlined.

In the recent downturn, Harrah’s “outperformed the industry by a mile,” according to Chief Operating Officer Gary Loveman. The company came under criticism from analysts in the mid-1990s when it focused casino investments in places like Tunica, Mississippi, instead of Las Vegas, and targeted individual customers rather than large groups. Despite analysts’ complaints, Harrah’s stayed with its plan to build a solid business model that caters to individual gamblers rather than conventioneers. It uses a database of 25 million individuals to create demand in a few people at a time. Loveman continues, “To drive growth, we committed to a strategy that is robust through a wide range of situations. Our competitors are much more dependent on large groups that come and go en masse.”

Diverse companies narrowed their portfolio of businesses, shedding even profitable operations that did not contribute to a clear, advantaged position. Instead of counting on portfolio diversification to smooth out business cycle ups and downs, these companies took another tack. They concentrated their assets and efforts in areas in which they held a leadership position. Texas Instruments’ Rasor recalls, “We sold off $4 billion in profitable business when our total sales were $12 billion. By selling these divisions in the good times, though, we generated massive cash flows. We can now use that for research and development to solidify our position in digital signal processing.”

Robert Krebs, retired chairman of Burlington Northern Santa Fe Railroad, tells a similar story about his company. At the time he took over, the company was a conglomerate, including a railroad, a mining company, a leasing company, gas and oil pipelines, and a real estate development company. Krebs sold and swapped assets until he had pared the operating company back to its railroad core. Then he shrank the railroad and drove costs down to position the Santa Fe as the least cost producer.

Winning companies drove internal growth rather than acquiring, except when they were in a position to consolidate operations expertly. Despite the chance to pick up bargain assets, for example, one high-performing energy company moved prudently. The chief financial officer at the time explains, “A lot of companies in our industry were making acquisitions in the downturn, but we had core assets which we could develop and grow at better returns than we saw in the M&A arena. It certainly helped that our founder and majority owner kept saying, ‘Is this going to make me money?’” Only 8 percent of the winning companies ramped up acquisition programs in the downturn of 1990-1991, in contrast to 45 percent of the losers. The winners clearly understood what would drive the most value for their companies and acted accordingly.

Best Buy took on the giants of consumer electronics stores in the late 1980s and focused on internal growth. The company grew 40 percent in 1991, increasing its number of stores by 30 percent. While the recession affected its bottom line — profits rose just 1 percent that year — the company has recently overtaken Circuit City in profitability (see Figure 4). Al Lenzmeier, Best Buy’s president and chief operating officer, explains, “In 1989, we were not in a position to compete with the leaders in our industry; we just did not have the volume. The company conducted focus groups and found out that customers wanted a nonpressure sales environment. We developed a self-service format that focused on efficiency, speed, and low price. Then we continued to grow aggressively to amass market share, which allowed us to have the lowest SG&A expense in the universe. Then we kept our foot on the pedal. When Federated went out of business, we picked up their stores. Otherwise, all our growth has been organic.”

A global metals company did not focus on internal growth. It scooped up its competition instead. But it aggressively consolidated its acquisitions and applied its own efficient processes across the expanding domain (see Figure 5). Because the company drove itself to achieve superior process performance all the time (not just in a downturn), it was able to achieve significant operating savings as it brought acquired companies under its management. One senior executive explains, “We drove to have top quadrant performance in every process and practice in our company. And we compared ourselves to the best companies in the world, not just in our industry. As we got thinner, leaner, and meaner, we were able to acquire our competitors and immediately do to them what we had done to ourselves.”

In contrast, a large agricultural chemicals company also merged with its competition, but the resulting company did not rush to exploit the operating synergies it created. According to one executive, “Egos got in the way, so it took us a long time to pull the companies together.” This company’s results lagged those of others in its industry.

Figure 4: Over time, Best Buy closed the performance gap with Circuit City.

Figure 5: A global metals firm drove performance.

Execute Distinctively

Winners and losers make some of the same moves during the downturn. They also do some things differently. Let us first look at the most visible tactics — the ones that do not separate the good from the poor performers:

Figure 6: A financial services firm underperforms its competition.

High-Performing Organizations

These recession tactics are important, but they are not the drivers of competitive value; they do not separate the winners from the losers. However, winning companies do take some actions that losers do not. These strengthen their strategic position.

Act Decisively When There’s Trouble

Executives in more poorly performing companies accept that their industries are slowing down, but hold their breath in the hope that things will get better before any hard actions are necessary. A railroad chief financial officer speaks from the experience of the early 1990s, “We waited to respond to the downturn until we saw the impact on the operating line. By then it was just too late.” The best performers watch for downturns and take action quickly.

Explaining how Best Buy dealt with its profitability nosedive in 1997, COO Lenzmeier says, “PC prices dropped, and we were caught with a lot of product. ... It was the wakeup call that told us we had to change how we operated internally. ... That was the first time we ever went outside for expertise, but we needed it.”

Ensure That All Employees Understand

Companies do not just cut costs, they cut the right costs. And they divert resources to activities that actually create value. How did these companies make the right calls? Unlike most executives, the leaders and everyone else in these companies know explicitly how they make money. They know how their products and services stack up against those of the competition, why customers prefer doing business with them, and exactly what they have to do to turn a profit.

Susan Kaminski, a former executive in the semiconductor industry, emphasizes, “It’s not just the finance people who must understand the financial and operational measures. Anyone in the company, from human resources to research and development, should be able to talk you through the details.”

In contrast, a vice president at one financial services company explained that the company did not put much stake in extensive business measures. He asserted that the organization outperformed the competition because it had the best operating margins in the industry. When we looked, we found that the company’s overall performance actually lagged that of others in its industry (see Figure 6). The implication? The executives in this company did not really know whether or not they were creating value relative to the competition.

Leverage Unique Information Systems

The high-performing companies invest in information systems designed to give them the ability to manage their key value drivers, and, more importantly, they use the output. The poorly performing companies do not have the same responsive systems. Bank of Montreal’s vice president of strategic planning, David McVay, along with his counterpart at a major retailer, both point to computer-based modeling systems that give their companies an edge, the former for risk management and the latter for real estate site selection. The retail executive explains, “Before we decided to develop our own models, we and everyone else in the industry used data provided by supermarket developers to locate new stores. Now we independently prospect for new sites based on numerical trading potential. It’s been very important for us.”

A global metals company executive says they also managed successfully through downturns because of the wealth of actionable information available to them. “We had every one of the numbers in front of us constantly. We knew where every fraction of a body was in the company.” Competitors were not so well-equipped. This executive talks about inviting a competitor into his plant for a tour: “They were a family company — not lean and ruthless enough — and the tour convinced them that their plants could never match our efficiency. That’s how they decided to get out of the business.”

Collaborate With Customers

The winners reach out to customers to better understand the pressures they are facing. This allows them to provide new products and services that meet customers’ needs and cement relationships. Companies that took this approach improved performance in both good times and bad.

“Downturns are a great time to be involved with your customers, to work with them and find ways to reduce your costs as well as theirs,” says Kaminski. “Some of the best products and services evolve out of downturns.” Bank of Montreal’s McVay adds, “We elevated our role from a source of credit to a personal adviser to our clients during the recession.”

Some organizations do not just tweak their value propositions, they design new offerings that appeal specifically to customers who want to save money in the recession. The founder and former CEO of a health insurance company saw the 1990-1991 recession as a huge opportunity for growth. “We knew people were going to be more price-sensitive than ever,” he explains, “so we designed the first managed care health plan to help them tighten their belts. Over the next five years, the company grew at an enormous rate and went from break-even to highly profitable in the process.”

Price for Profitability

Winners work themselves into an advantaged cost position during good times, then use their pricing flexibility to pick up market share in a downturn. Says one transportation executive, “We lowered our prices to gain market share. We took some business from the truckers and some from the railroads. We won it on price.”

A veteran executive from Motorola added, “Our competition is smaller companies that do not have our scale or manufacturing flexibility. We pick up market share by booking four- or five-year contracts at prices they cannot match.” However, in the downturn, winning companies walk away from bad business, and losers do not.

The companies that perform poorly accept unprofitable sales in an attempt to hold onto market share. An insurance company executive lamented, “We had conflicting goals. We wanted to grow, but we had to meet the competition in price. As a result we put business on the books that was underpriced. ” A high-performing bank took the opposite road. Says a senior executive, “We aim for consistent growth, not spectacular growth. That means, for some risky opportunities, we just decline to participate.”

The Reckoning

By cultivating financial flexibility, making smart strategic moves, developing an intimate understanding of the real drivers of value and executing accordingly, companies can and do shape recessions into opportunities. They gain market share, forge new customer relations, and strengthen product and service positions to provide them with a platform for profitable growth into the next expansion.

However, making the most of a downturn is as much about what a company does in the good times as the tactics it takes when a recession hits. What matters most is managing for value consistently, relentlessly, and continually. Successful executives infuse their companies with an innate sense of urgency that compels action even without the stimulus of a foundering economy.

“That is the toughest challenge, to maintain the discipline necessary to be prepared for a downturn during the good times,” says former PepsiCo Division President Lloyd Ward.

Companies that wait for the downturn to worry about the fundamentals are often too late. Especially in challenging industries, they choke on the excesses of the previous up cycle — undigested acquisitions made possible through encumbering debt, distracting diversifications that do not strengthen the company’s position, and loose decision processes that allow investments without returns that pay the cost of capital. Tightening costs and reining in decentralized decision-making surely helps performance. It just does not create advantage.

What does create advantage? The superior strategic positions, operating capabilities, and superb execution of well-managed companies. Good companies exhibit these traits in good times as well as bad, but prosperity masks performance. In an expansion, even astute observers cannot easily tell the difference between a business model that creates value and one that destroys it. But things change in a downturn. Companies with poor fundamentals falter, and the consequences show up quickly in their results. Economic downturns, then, shine a spotlight on able leadership.

What should companies do in the current uncertain economy? Companies that are not well-positioned can still turn the downturn to their advantage. During a downturn, companies can get unvarnished answers to vital questions. Executives have the chance to learn what is important to customers, what is essential for delivering value, and what actually distinguishes their company from its competition. Companies can ask these questions any time, but the pressure of a difficult economic environment puts a much finer point on the responses.

Organizations that seek and apply these answers can ready themselves to take advantage of the next inflection point.