You Can Capitalize on Massive Opportunities: We’re going to see a harder landing than consensus expects, and it will create the best opportunities for your career as a senior leader if you prepare now. Shelter your shareholders in this downturn and reward them handsomely coming out of it.
Before we get to the proactive strategies, it’s critical to understand why we’re headed for a hard landing.
2 reasons to sharpen our risk management now
Terrible economic setup
After the Great Financial Crisis of 2008, we experienced nearly 15 years of easy money. Fed easing (QE), plunging interest rates, and soaring government spending fueled speculative behavior. Investors went further out on the risk curve. Due diligence and valuation discipline weakened, and leveraged loans and covenant-lite loans hit all-time highs.
With the Fed now tightening (QT) and quickly hiking rates over 500bps, many wonder why the economy has stayed hot.
The lag between when rate hikes begin and their economic impact can be quite long, sometimes several years after the first hike. The length has varied quite a bit across past cycles. So, no one can predict with certainty how long it will take for hikes to hit the economy. When I was at a hedge fund and trying to risk manage 2007-2008, I remember similar calls for a soft landing when the lag was long.
Unprecedented fiscal support has delayed the effects of Fed hikes and inflated consumer spending. This is significant since consumer spending makes up two-thirds of GDP. That fiscal support is starting to wane. Excess savings have recently run out, student loan repayments resumed in October, and credit card balances have reached record highs right as rates are soaring.
Leading indicators are ugly
No leading indicator can predict every recession, but we can form a mosaic from looking at several good ones. It is disturbing.
- The Conference Board Leading Economic Index has been in decline since April 2022.
- The housing market is freezing. Who is trading a 3% mortgage for an 8% one, especially when a new job in a remote-friendly world may not require moving? Housing activity contributes almost 20% to GDP.
- Manufacturing data is plummeting. The PMI has contracted for 12 straight months and new orders for 14.
- Oil prices have soared coming out of the pandemic.
- Credit is the lifeblood of the economy, and lending standards have tightened.
- The yield curve has been inverted since July 2022, and experiencing a bear steepening since July 2023.
Jobs are a lagging indicator, and we’re finally starting to see cracks in the labor market. The government continues to revise prior months’ non-farm payrolls lower. Job growth is largely coming from non-cyclical industries, multiple jobholders, and the birth-death adjustment. Employers are cutting hours.
All this suggests peak corporate profit margins will regress. We’ll see rising defaults and bankruptcies as maturities come due, and companies struggle with the availability and cost of financing.
3 WAYS TO PREPARE FOR GENERATIONAL OPPORTUNITIES
“Be fearful when others are greedy and greedy when others are fearful.” – Warren Buffett
I’ve spent an increasing part of my time in recent months working with CEO coaching clients on these 3 areas.
GET YOUR HOUSE IN ORDER
This is the ideal time to strengthen your balance sheet and prioritize cash. You can start by stress testing your financials for 20-30% shortfalls to projections or declines in net income. Having ample clearance to avoid tripping covenants is table stakes. You want to have enough balance sheet flexibility to take advantage of transformational M&A opportunities when there is blood in the streets and forced selling.
- Consider divesting unperforming or non-core assets while you can still get a reasonable price. If that asset hasn’t delivered solid profitability and returns on capital during a great economic backdrop, what are the odds it will turn things around as the environment worsens?
- Elevate the bar for acquisitions. You need an even higher ROIC to cost of capital spread given the heightened risk. The chances of integration problems and synergy shortfalls are greater when you’re distracted by economic pressures on your core business. You’re at risk of paying near-peak multiples on near-peak margins. Might some patience now give you more margin of safety when re-evaluating that asset 6-12 months into the downturn?
- Get ruthless on expenses. Consider pausing any discretionary capex that is neither maintenance nor imperative to longer-term growth prospects (such as R&D). Reduce every bit of fat in discretionary operating expenses while investing in technology and data to drive greater efficiency and productivity. Senior leadership can model the importance of expense cuts with their own skin in the game in the form of reduced salaries or bonuses.
- Cut labor to minimize firm-wide layoffs. When attrition occurs, can your group survive without replacing some of those positions? Are there any culture killers or underperformers to whom you’ve given many chances and hung on to for too long due to denial or sunk cost fallacy? Would any employees be a fit for a sabbatical, reduced hours, or a more flexible freelance role?
Imagine the degree of positive operating leverage you’ll inject into the business for when sales come back stronger.
PREPARE WITH A LONG-TERM VIEW
- Rank your desired acquisition targets and do early diligence. Which customers do you want to serve, in which markets, and with what services and products over the long-term? Which acquisitions would give you the best chance of fulfilling that vision with a strong moat? What diligence can you do now on those companies, markets, synergy potentials, financings, and valuations? With a fortified balance sheet and advance diligence completed, you’ll be in triple threat position to move fast and beat competitors in the M&A game.
- Plant seeds with “A” players in the industry. Your weaker positioned competitors may be forced into large-scale layoffs that include their most expensive employees. Talented leaders do not remain free agents very long. Identify a short list of “A” players you’d love to have and make sure they know you want their first phone call if they part ways.
- Double down on your top customers. Your customers may start struggling and look to cut back in a softer economic environment. Conduct an 80/20 analysis to determine your top customers. Spend time asking them about their top goals, challenges getting there, and how you can help them. You’ll become an even more trusted partner and gain market share during the downturn.
MASTER COGNITIVE BIASES
You’ll face some of the biggest decisions of your career in 2024 and 2025, and you’ll want to minimize the negative impact of cognitive biases on the quality of these decisions. Even world-class performers who are well aware of cognitive biases fall victim to them. Awareness is not enough.
Develop a document with a summary of common cognitive biases. For each one, write out an example of how you might be susceptible to it in your specific role/business. Before making any major decisions, review this checklist and ensure you’re not succumbing to any of them.
A few biases with example questions to ask yourself:
- Recency bias: In this M&A analysis, am I extrapolating recent peak margins and peak multiples rather than normalizing across the entire cycle? Or am I extrapolating recent trough margins and trough multiples and scaring myself away from a phenomenal long-term opportunity?
- Sunk cost fallacy: If I had the chance to start fresh with the decision today, would I still want to buy this underperforming asset or hire this struggling employee?
- Cognitive dissonance: Am I in denial about evidence that goes against what I want to believe? Am I making a mistake because of that?
BRINGING IT ALL TOGETHER
Could I be wrong about the hard landing? Of course!
Consistently nailing the economy’s trajectory is not easy, scores of highly trained Wall Street economists get it wrong every year, and there are a lot of political elements out of our control. Spending from some government programs (IRA/CHIPS) will continue to be supportive going forward. One move by the Fed or government could kick the can down the road. Defaults and bankruptcies could be delayed until the wall of maturities becomes larger in 2025 and 2026.
This is about process over outcome and risk versus reward. If the economy remains hot in 2024 and you’ve executed these otherwise sound business moves, are the downsides that big? How does that compare to the downsides of standing pat with business as usual into a hard landing? Please leave your own helpful strategies in the comments and write out your plan of action steps from reading this article.
Written by Ryan Renteria.
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