WFA Musings - Spring 2023
Irrespective of the period of time, pundits will generally characterize the present period as one of “change.” By definition, we always need to refresh and amend our business strategies based on a frank assessment of future conditions. Some folks go so far as to say that developing a corporate strategy is a waste of time because current market conditions are too complicated and topsy-turvy. In their view, all one needs is a statement of values, purpose, and a set of short-term objectives. We would characterize this approach as “wishful thinking.”
What we are experiencing today is not simply “change,” but seismic shifts. After a prolonged period of very low interest rates and inflation which created a valuation bubble, we are returning to a more “normal” set of macroeconomic conditions. Unfortunately, many corporate leaders have never piloted their ships during a period of high interest rates and inflation. Given this “new” set of conditions, I called upon our Chief Economist, Dr. Roger Brinner, to provide his view:
The US is in the middle of an economic cycle with many useful precedents: fiscal policy over-heated the economy, followed by late Federal Reserve corrective action. In the late-1960’s, late-1970’s, mid-1980’s, early-1990’s, mid-2000’s, and the late-2010’s—in other words, about once per decade-- fiscal policies were legislated that were far too stimulative; eventually the Fed had to play the bad guy and produce an inflation-killing recession. This current cycle differs in two ways:
1) The fiscal stimulus during COVID was not only exceptionally massive but also included labor- market-wrecking excessive unemployment benefits which created exceptional wage inflation.
2) Confused by COVID and by Chairman Jerome Powell’s lack of economics expertise, the Fed watched core inflation (excluding food and energy) climb to a peak of 5% above their fed funds rate in 2021 and early 2022 with no action. Economic historians must look back to the failures of Arthur Burns and G. William Miller, Fed chairmen from 1970-1979, to find similar Fed policy failures (see chart below.)
The Historic Unemployment-Inflation Cycle and Federal Reserve Responses
Despite these COVID-based government policy nuances, the market cycle is likely to proceed in a familiar sequence:
1. Housing construction will weaken first, being the most interest-sensitive sector.
2. Consumer durables –also interest sensitive-will follow a couple quarters later once employment softens.
3. Producer durable equipment will fall several quarters later, given normal decision and delivery lags, and in this cycle a catch-up from COVID-related supply chain shortages.
4. Nonresidential construction will be the last sector to follow, in spite of its interest rate sensitivity, because the planning and permitting lags are so long.
5. Unemployment will begin to rise soon but unemployment typically peaks as much as two years after the Fed funds rate hits its peak! The stock market true bottom is often shortly before the peak in the unemployment rate.
6. The core inflation rate will start to recede 6-12 months after unemployment rises above 4%, with the disinflation pace thereafter correlating with the level of unemployment.
Bottom line: we will be in this economic downturn and/or likely mild recession through mid-2024, if not until the end of 2024.
Adding to the list of seismic shifts are four more:
First, we have significant and problematic geopolitical challenges such as the unwarranted Russian invasion of Ukraine and Putin’s plan to wage a war of attrition; the coronation of an emboldened autocrat in China, Xi Jinping, who is vigorously pursuing his “China Dream” vision to “rejuvenate the Chinese nation” in all respects economically and as a co-equal to the USA in military prowess and diplomatic standing; and, a fervent commitment by the Iranians to join the nuclear club. These are the major geopolitical risks but there are myriad “minor” ones in the queue. A “new” Cold War changes the global landscape significantly. Corporations cannot control these events but they would be wise to conduct scenario planning.
Second, the generational shift to the Millennials and Z’s has massive consequences and challenges. They are much more focused on work-life balance, equity, and sustainability than the Baby and Echo Boomers. They question the benefits of capitalism which has undergirded the economic systems of most of the world’s developed nation-states. They cannot be ignored. They must be listened to and we need to shape our thinking around the reality of their mindsets. This is one fundamental reason why ESG is not a fad. As flawed as the current ESG rating services are today, they will slowly improve and are here to stay, although they may consolidate. Additionally, the long arm of the SEC will ensure compliance on certain climate-related metrics. Many states are way ahead of the SEC.
Third, we live in a world where the political extremes seem to have disproportionate sway in political power circles, whether it is the USA, UK, EU, India, Brazil, Israel, or many other democracies. Gridlock and fractured bipartisan coalitions seem to be the order of the day. Finding a calm, charismatic, objective, and centrist voice is extremely difficult. The days of Ronald Reagan, George H.W. Bush, Bill Clinton, François Mitterrand, Helmut Kohl, Margaret Thatcher, Tony Blair, and Pierre Trudeau are distant memory.
Finally, we need to recognize the power of innovations in bioscience and artificial intelligence (AI). The advancements on both fronts and the consequences for society are breathtaking. How many of you had heard of “gain-of-function” research before COVID? How many of you focused on Chat-GPT before it became a tool for students to cheat in writing their essays? These are transformative innovations on the order of Thomas Edison and Alexander Graham Bell. Some of these innovations will generate positive change and some will be devastating. But, like stem cell research a few decades ago, the train has left the station and there is no stopping it.
All of these seismic shifts impinge in varying degrees on a corporation’s strategy. While CEOs cannot control them, they need to establish a base case for each seismic shift in addition to an upside and downside case. This exercise, coupled with the corporation’s view of its future performance, will form the basis for a robust Monte Carlo analysis. I am reminded that only a few decades ago, the common wisdom for multinationals was to invest in China and many did so. Now, they are faced with a much different calculation. Will China remain a growth engine or will it be an albatross? Most importantly, how will they mitigate the risk? It also raises the question about the economic potential in India if it continues to remain an ally of Russia.
We distinguish ourselves as a firm of pragmatic strategic advisors. I have been fortunate enough to attract three exceptionally talented and thoughtful partners to Acropolis: Peter Gates, Bob Goad, and Jill Kravetz. We are intentionally structured as an inverted pyramid with a small number of consultants and analysts supporting us. We act as a “kitchen cabinet” to our clients so they receive the full benefit of our experience and wisdom. Consequently, we only work on helping our CEOs solve their most vexing strategic issues and will not advise their competitors. As disciples of Professor Porter, we are riveted on competitive advantage and want our clients to “win” versus “place.”
To become a superlative company, we believe there are Five Truisms:
A CEO must be a “steadfast realist.” They must establish trusted links to customers, employees, suppliers, communities in which they operate, and investors, as well as seeking a constant flow of information from each constituency. In addition, they must have regular intelligence on current competition and potentially future competitors. As an example, a company like CVS Health needs to know what is happening at their emerging competitors in Amazon and Walmart, along with their traditional competitors at Walgreens and UnitedHealthcare, if they are going to be successful.
Our co-founder and strategy icon HBS Professor Michael Porter’s timeless principles of achieving “competitive advantage” and creating “shared value” opportunities are foundational and must be a focus for every CEO.
Notwithstanding the recent focus and frenzy on ESG and stakeholder capitalism, investors remain riveted on “growth and action.” Growth must be grounded in generating cash flow within a reasonable timeframe. The DotCom and SPAC graveyards are full, and the tech unicorn graveyard is filling up. We do not discriminate between organic and inorganic growth and we do not believe investors do if a company is a proven acquirer. Look at Danaher and ThermoFisher Scientific. Both have been savvy serial acquirers. The median P/E for the S&P 500 is 20.3X and Danaher’s and Thermo’s P/E are 25X and 32X, respectively. Action is a function of innovation or acquisition. Both are important and equally valued if they have the same return on capital. My long-time mentor, Bill Bain, used to lament that corporations that practice “satisfactory underperformance” are destined to be bought or go bankrupt. Complacency has no footing at a superlative company. Superlative companies know how to generate loyalty amongst their key non-shareholder constituencies while prioritizing providing above per average total shareholder returns. Capitalism remains the most advanced and beneficial economic system in the world.
Talent acquisition and retention are essential. To become a magnet for great folks, the corporation must live its values and purpose while being a winner in the marketplace(s) in which it competes. There is never an oversupply of A-team players. We once pointed out to the Goldman Sachs management committee that it was folly to stop recruiting the best and the brightest analysts even when business was soft. You must always deal from the top of the deck while removing the underperformers at the bottom of the deck.
Strategy is as much about STOP as it is about GO. Dartmouth’s Tuck Business School strategy deacon, Professor Vijay Govindarajan, published in 2016 a very simple but insightful book called The Three Box Solution. It posited that CEOs must constantly 1) Manage the Present; 2) Selectively Forget the Past; and 3) Prepare for the Future. He effectively argues that too many CEOs spend disproportionate time on Box 1, Manage the Present, and do not dedicate substantial and necessary time on either Boxes 2 & 3.
Our shingle is out and we are open for business. We appreciate any references and referrals. I can assure you that we can help CEOs accelerate their growth and profit aspirations. Collectively, we have helped our clients generate hundreds of billions of dollars of market value. Recently, we have found that just as some patients seek a “second opinion” on a medical diagnosis, we can help provide CEOs a “second opinion” on their strategy. As seasoned practitioners, we can usually conduct a review in less than three months.
Onwards,
P.S. This marks the first of the WFA Musings which I will release quarterly. Please use this link to answer two simple questions: Did you find this piece valuable to you and would you like to receive it on a quarterly basis? Thank you.