Strategy in cyclical industries

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The world’s biggest basic materials firms are suffering along with others as the world economy collapses, and the Economist points out that taking on loads of debt to grow and acquire others did not help. But these industries have always suffered cyclicality, even when not buffeted by extreme market conditions. Pity is that we have known how to steer away from these dangers for many years. Seems to me the same principles would have been useful to a great many other firms over the last 5-6 years. Here’s the essentials and an article that explains more …

Cyclicality afflicts many industries, not just basic materials like steel, paper-pulp and chemicals, but other sectors including shipping, insurance and office space. They suffer far worse cyclicality in price-levels and profitability than can be explained by variability in the markets they serve – why?

How these industries behave

What these industries have in common is that capacity increases come in large lumps and take a long time from any decision to raise capacity and that increase coming on-stream. So, any growth in demand leads to tightening supply and rising prices and profitability. Many firms respond by announcing new capacity, and during the delay while shortages persist, prices and profits sky-rocket, leading to still more plans for new capacity. Eventually, that capacity all comes on-stream, grossly exceeding demand levels, and prices collapse for as long as it takes for demand to grow to match – often many years.

A further mechanism is that during the up-turn, investors take some time to be persuaded that higher prices and profits are real, adding a still further delay and exaggerating the boom and bust still further.

How to manage strategy in cyclical industries

Dealing with these circumstances was certainly documented as long ago as 1996, though experienced executives in many of the industries affected by cyclicality had long known intuitively what to do:

  • first, do not spend money on building new capacity when demand exceeds supply and prices and profits are strongest – every else will be doing the same
  • instead, take all the excess margin and build up cash reserves
  • when excess capacity comes on-stream and prices and profits collapse, competitors will be in trouble, and you can use the capital war-chest to buy fire-sale assets or entire companies
  • take the opportunity to shut down inefficient capacity, either amongst what you had before or acquired, to shorten the time when supply exceeds demand
  • if underlying demand looks healthy, invest in new capacity before prices and profitability recover, so that it will come on-stream in time to take most of the share of any increased demand.
[BEWARE – as with all strategy principles, this one should be checked carefully to make sure it’s right for you under the circumstances you face.]

The Economist article implies that many of the big firms in basic industries ignored these principles, bet the farm on demand growth going on for ever, and made matters worse by borrowing heavily – resulting in still greater excess capacity than would otherwise have been the case. Were they really not aware of age-old wisdom, had never read this or other articles on the issue, or did they just hope that gravity had been abolished?

The interesting extension of this story is that the naive strategy of ‘build-capacity-when-demand-is-exploding’ seems to have infected many, many industries that would not normally have been susceptible to the problems in 2005-07, just as it did between 97-99.

We are still waiting to hear where the consultants were who should have been advising caution .. and did the strategy academics have anything to say on the subject? If you were a consultant or strategy professor who urged caution, or a business who received that advice, do let us know.

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Comments

  1. J. McLane  May 22, 2009

    The data center industry may be in the middle of just such a situation. Massive overbuild in the late ’90s, collapse in 2001-2003, assets bought at fire-sale prices now fully utilized, and an investment boom in new capacity underway.

    Is anything different this time?

    Senior management claim to have learned their lessons. Capacity is increasingly added in small increments, and signaling via public announcements of new projects includes the total potential capacity as well as size and timing of first phase. Some even announce their explicit decision rule: only spend for next phase when existing plant is at 70% capacity.

    However, the data is not so simple. Forecasters (cheerleaders) all predict 20% demand CAGR vs. 6-10% capacity CAGR over next 5 years, leading to very tight capacity and outstanding operator returns. But forecasters use an easy capacity measure, square footage, when actual capacity is driven more by power and cooling availability, seldom published. In addition, demand is served by many competing technologies, some of which are far more power-efficient than others, and the crystal ball is very unreliable in forecasting their future success.

    The credit crunch is widely cited as holding back investments in this space at present, perhaps forcing some players into the cash-accumulation stance you cite, or at a minimum driving some deleveraging and balance sheet cleanup.

    But for an investor considering getting into this space, it is both a promising time and a scary one.

    reply

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