Leveraging business cycle ups and downs.

• Author: Autry, Greg
• Position: COVER STORY

No financial executive should have been surprised by the 2007-2009 economic collapse. Indeed, by following just a few simple economic indicators, a crash could have been foreseen and appropriate defensive measures might have been taken. The following makes two bold assertions and presents a framework to fulfill them:

* Every executive can learn to forecast the business cycle; and

* Competitive advantage can be gained by combining this forecasting ability and business-cycle appropriate strategies.

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Many financial executives reacted to the severe recession like captains of a sailing ship caught in an unexpected storm at sea: Batten down the hatches, pull in the sails, ride it out.

In contrast, a few executives seemed to possess an uncanny ability to not only see the tempest coming, but to actually harness the recessionary winds to speed past their foundering competitors. Such captains of industry maintain robust profitability and enjoy higher share prices right through recessions--and their companies emerge stronger.

An extensive study into this phenomenon was conducted by the authors at the Paul Merage School of Business at the University of California, Irvine. The goal was to identify winning companies and isolate the strategies their executives employed.

Empirical results of market performance for firms using the forecasting framework were clear: They tend to enter downturns with more cash, lower overhead and a leaner payroll.

In the depths of a recession, these companies eagerly but up materials, suppliers, competitors and facilities on the cheap.

They use the pain of high unemployment to grab the best talent at the best price and actually expand their advertisting in the relatively uncongested ad market.

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They adroitly increase their capacity and seize market share in preparation for the inevitable upswing and take the opportunity to reinvest and reinvent when expectations are low and the pressure for short-term financial performance is lowest.

The Framework

The research-based framework involves three steps for achieving superior performance over the course of the business cycle:

1. Develop internal forecasting capabilities and communicate the results to executives;

2. Correctly apply counter-cyclical business cycle management strategies; and

3. Build a business culture that integrates business cycle management thinking.

Forecasting and the Most Critical Indicators

Though financial executives often take full-length courses on how to forecast the business cycle, some of the key points can be covered here. For starters, one of the most important incentives for every executive is that successful forecasting requires a continual reassessment of all the economic indicators under consideration. In other words: If the forecasting unit comes up with a projection for the quarter--or if it comes from an economic forecaster at a conference--don't bet the company on it.

While such forecasts are often very good, economic winds do change and three or six months later, that same forecaster would very possibly advise a new direction in order to accommodate the change. This point also underscores the importance of quickly communicating new economic information to all decision-makers within the company.

The central tool to becoming a successful economic forecaster is the famous "GDP equation," first set forth by the Depression-era economist John Maynard Keynes. The real, inflation-adjusted gross domestic product is used in every nation to measure the health and growth of the national economy. It is driven by four easy-to-follow components: consumption (C), business investment (I), government spending (G) and "net exports," which is the difference between exports (X) and imports (M).

Thus, the Keynesian equation may be written: GDP = C + I + (X-M) + G.

Exhibit 1 (above) provides an overview of the forecasting model and the 11 leading economic indicators and economic reports that may be used by you and your executive team to track movements of the GDP.

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