Managing Contraction

You will find very little work or training on the subject of managing a business to contract. Virtually all management training and experience assumes an environment that is growing; more people = more consumers = growing market in volume and value. Furthermore, virtually all management training assumes that the corporate objective is to grow the business within the market -- i.e. take greater market share. It is this ethos of trying to grow market share within a growing market that is the fixation of every management team.

What this means is that the infrastructure companies use to carry on their business must grow. Leaving aside technological changes and outsourcing, generally this means moving to larger premises, bigger plant, more HR, accountancy and other support staff, etc. As companies grow, they borrow (or raise from their investors) more capital to run the business. The justification to the investors (and lenders) is a bigger income, and a bigger profit.

Now, consider a market which is falling. At first sight you would think that you could contract a business in the reverse order -- like letting air out of a balloon -- but it isn't as easy as that. You can't reduce the size of the plant or premises by 10%. That's because companies tend to distribute functions between different sites or departments. If you sell off the plant that makes the ball bearings you need you will have NO ball bearings but all you wanted was a reduction of 10%. So you'd have to outsource the balls and you might not save the 10% which was your original requirement.

Those lenders and investors who had put money in your business because of your growth targets are going to want their money out.

You might have seen Sainsbury's little-publicised news this week that they are going ahead immediately with up to 100 new "convenience" stores? So they are planning to grow their business in this present market? A supermarket that has positioned itself over years to be at the premium end of the market? No. I think you are seeing a rare example of a management team trying to manage contraction. Once the convenience stores are online they can close down or mothball a hypermarket. The plan is no doubt to find funding to keep one step ahead of the game and keep investors in place while the turnover and profits fall. That's going to be the hardest part because the investors won't understand the game plan or the inevitability of the business contracting. Other, less enlightened management teams, are simply piling-in to the downmarket sections where, in some cases they have little experience. Like Northern Foods. You can't have all the players fighting for market share at the bottom of the market. It will be survival of the strongest balance sheet and most determined investors. That'll favour companies with old family money invested in them, not companies owned almost entirely by institutional investors.

Certain businesses seem to be at more risk than others. Large manufacturing plants such as automotive, aerospace and high volume manufacturing are at the gravest risk but consider also the financial services companies (and I include all insurers in that). Banks, health-care insurance, general and motor insurance and IFAs. Pension providers (and funds) are a unique nightmare; a disaster waiting to happen. How do banks contract and yet still provide a competitive service at a local level? If Bank A closes its branch in Little Rissington then the Little Rissington residents will probably go to Bank B, where there is still a branch. So cutting, say, 10% off the branch overhead could result in a much larger decline in business than 10%. Everything is easier when the overall market -- the number of consumers and what they are spending -- is growing.

The point that I am making here is don't expect an investment of £100 in a FTSE 100 tracker fund to track the market. If the market falls by, say, 10% (which is wildly optimistic, the contraction will be much larger, probably around 30% to 50% before this mess bottoms). Entire companies will go bust. The shares will be valueless. Any kind of chart analysis that suggests the DJIA will bottom at the 2002 lows, for example, is rubbish. There is no rational basis for such a prediction. It's like trying to predict the landing speed of a 747 that has lost its wings, based on previous landings. It's absurd. There will not be a soft landing.

That is not to say that we need to despair and run around like the proverbial headless chickens (although that is clearly what the US and UK administrations are doing this week) but you need to back teams that are showing they can manage contraction, survive and thrive in a contracting market. I don't think that all the management teams are going to share their thinking so you will need to be watching out for sensible moves, such as Sainsbury's.