A Contrarian Bounce?

I previously asserted that corporate America teaches that firms that treat recessions as opportunities rather than threats could steal a march on their more conservative brethren and emerge into the post-recession recovery as more powerful competitors.

Today I'd like to back up that claim.

It's germane because even in the few days since I published my prior piece the cascade of bad economic news has intensified.   (For example, I said then that the stock market had opened the year with its worst performance in 30 years; it's now become its worst year-opening start since  1928.)   So what's a managing partner to do?

No fear.

Here's what McKinsey had to say, based on a study of about 1,000 mainly industrial US companies over the time span 1982—1999, which of course straddles the 1990—1991 recession.  In a nutshell, firms who exploited the opportunities inherent in recessions:

• pursued more M&A deals during recessions than during normal times (compared to their lagging and more conservative peers);
• spent more on "SG&A" (selling, general, and administrative expenses, for which you can roughly substitute "overhead" and be not far wrong) during downturns than their peers and more as a percentage of revenue than they themselves spent during flush times; and
• also followed the SG&A spending pattern with respect to R&D and advertising.

All of these behaviors are contrarian, even scary.  But I told you to have no fear, so let's explore this a bit more.

As for M&A, during normal times the contrarian firms did 63% fewer deals (measured by value of assets acquired vs. the median in their industry over the same time frame), but during recessions they closed the gap with their peers, not only pursuing more deals—their peers essentially exited the M&A business entirely during the recession—but pursuing larger deals, and devoting the management time needed to study, execute, and follow through on opportunities for acquisitions.  Does "buy low" come to mind?

But "the most dramatic" divergence between the aggressive leaders and the laggards was, as noted, in how they changed their operating spending mix.  Counterintuitively, they invested more in SG&A, in R&D, and in advertising.  And not just more than their batten-down-the-hatches peers, more than they themselves spent as a percentage of revenue during flush times—when they were among the most efficient and productive among their peer group in these "overhead" costs.

This represents how the more successful, aggressive firms changed their  spending across the three areas vis-a-vis the industry average, on a size-adjusted basis.   The story is simple:  The winning firms ramped up spending more than their peers during recessions and less than their peers during expansions.

What's  going on here?

Rather than tightening their belts, the aggressive firms apparently sensed opportunity and chose to invest in these areas in hopes  of a longer-run payoff, whereas during flush times they focused on operational efficiencies.  In other words—although they always invested more than their peers in R&D—their strategy was to sacrifice short-term profits in bad times for the sake of longer-term advantage:   And to more than make up  the sacrifice when good times returned.

And the market seemed to recognize this.  For industrial firms (which these primarily  were), a rough and ready proxy for how the market views firms' prospects is the "market to book" value ratio.  If you think about it, this makes some sense:  The book value is presumably about the least the firm would fetch if broken up for parts.  And to the higher the value the market places on the firm above that floor, the more the market evidently thinks the firm is excelling  vs. its competition.  Note in this chart how the winners accelerated away from the pack in the post-recession period:

Both during recession and expansion, you could say, in a sense, that they "spent smart."  But that's somewhat tautological.  The whole premise of the McKinsey study, after all, was to identify winners and losers. 

I think the key point is subtly different, and it is, as I said:  No fear.  Contrarian views can sometimes win.  Is it "risky" to increase operating expenses during a downturn?  So  it  would seem.  But the real risk may be in following the herd.