One Year Later: Lessons for business leaders

Anyone who's lived through the last several decades or studied recent economic history knows that capitalism is inherently unstable. More specifically, the system goes through periods of economic expansion and contraction, which generally last eight to 10 years from peak to trough. Business leaders have a choice about how they react to these expanding, then popping economic bubbles. And the key lesson is that it's better to be a leader in responding to these cycles than a follower.

Before getting into the lessons of these cycles for business leaders, it's worth pointing out that the Great Recession -- or whatever it is that we're in now -- is an extreme example of one of these cycles. For example, it wiped out $30 trillion in market value, led to nearly $2 trillion in bank write-downs, and drove the elimination of almost 7 million jobs.

Such cycles happen because of changes in lenders' willingness to extend credit to business. When lenders are afraid of losing market share to competitors who are giving away money cheaply, the economy expands. And when lenders are gripped with fear of not getting paid back, they call in their loans and the economy contracts. After a while, bankers will only make loans to people who can actually pay them back. But when they run out of credit-worthy borrowers, they take greater risks so they can grow. And the cycle begins anew.

Business leaders wear two "hats." One is as a business strategist -- deciding which markets in which to compete for share and how to win in the selected market. The other is as a financial strategist -- deciding how much, if any, the business should borrow and whether to use that capital to expand or to prepare for a downturn.

As business strategists, company heads have two basic choices. They can pursue a low cost producer (LCP) strategy, which implies charging a below-industry-average price for their product and keep their costs low. An example is Wal-Mart Stores (WMT) with its everyday low-pricing strategy. Or they can follow a differentiation strategy -- in which they charge above-industry-average prices because they give customers more value -- think Neiman Marcus.

During periods of economic growth, often a business pursuing a low cost producer strategy may find more customers who feel like living large so they lose some revenue growth to the competitors pursuing a differentiation strategy. Wal-Mart tried to chase those customers during the "boom years" by trying to add design skills so it could appeal to more upscale clothing buyers.

But it didn't work. Meanwhile, Neiman Marcus, which grew when times were good, must be hurting along with its customers. An important lesson for business leaders is that it's difficult to change your strategy once it's been working. The best you can do is to use financial strategy to bolster the business strategy throughout the cycle.

How so? Business strategists can use their financial strategies to prepare for these periods of contraction. When times are good, they ought to sell equity and pay down their debt so that when the economy collapses, they are in a position to expand by buying up their debt-laden competitors out of bankruptcy.

If they can, they should even consider taking on debt when their competitors are de-leveraging. The best time to expand is when competitors are contracting. The reason? The prices of assets and of acquisitions are lower when everyone is desperate to raise cash.

And once the excess capacity is wrung out of the market, the leader of the consolidation process will get the biggest share of any growth that follows.

Peter Cohan is amanagement consultant, Babson professor and author of eight books including, You Can't Order Change. Follow him on Twitter. He has no financial interest in the securities mentioned.

Read Full Story