Fluent Essays

Please go through all uploaded documents and read carefully the ASSIGNMENT GUIDELINES DOCUMENT. After reading if can do it then please text me. Thank You. TB0615 Bertrand Guillotin Berkshire Hathaway: COVID-19 and the Great Disconnect We simply attempt to be fearful when others are greedy and to be greedy only when others are fearful. Warren Buffet, 1986 Letter to Shareholders1 Synopsis This investment strategy had proven powerful for Berkshire Hathaway, Inc. It had transformed a bad textile company into a diversifed investment company, ranked as the 12th largest company in the world in 2019, right behind Apple.2 It had made Warren Bufet a billionaire and countless of his shareholders millionaires. At the end of 2019, Berkshire’s shareholders included Fidelity Investments and the central bank of Norway. The company’s stock was considered the number one retirement stock in America.3 Amid the 2020 coronavirus pandemic, U.S. fnancial markets crashed at record speed (–35\% between February 12 and March 20, 2020), including the biggest single-day drop ever of –12.9\% on March 16, 2020, eclipsing the record of October 28, 1929.4 Expected to be greedy when others are fearful, Bufet was a net seller of stocks and remained on the sideline during that period. His inaction, combined with an unusually cautionary tone at the annual shareholders’ meeting, triggered heavy criticisms. Some of his loyalists sold their stocks. As he was approaching his 90th birthday, many started to wonder whether Warren Bufet had changed his time-tested strategy. Was he disconnected from reality? Was he fearful himself? Berkshire Hathaway, Inc., During the 2020 Historic Crash On February 24, 2020, Warren Bufet, interviewed by CNBC’s anchor Becky Quick, made clear that, as the outbreak caused fears of a global economic slowdown, his long-term outlook remained unchanged.5 With US$128 billion6 in cash then, he had plenty of options. During this crash, Wall Street’s fear gauge or volatility index (VIX), invented by Dr. Bob Whaley, had gone from 13.74 on February 12 to 82.69 on March 16, 2020.7 With everyone fearful, Warren Bufet, who had experienced many fnancial crashes, was expected to be greedy; i.e., he was expected to buy vast amounts of stocks at a deep discount during the fastest bear market correction in history. However, he did nothing of the kind, especially by Berkshire’s standards, only buying a net amount of US$1.83 billion of stocks during the frst quarter8 and selling approximately US$6bn worth of, for example, airline stocks in April. His stock portfolio plummeted by 27\% from about US$242 billion to US$176 billion during the frst quarter of 2020. As the stock market recovered most of its losses in April, criticisms multiplied, some long-time shareholders sold their Berkshire Hathaway stocks,9,10 and the company’s stock (NYSE ticker BRK.A) price continued to slide (see Exhibit 1). On May 2, 2020, the tone at the annual shareholders’ meeting changed from typically cheerful to more serious; it was a rare history lesson, combined with risk management advice.11 Bufet did not try to convince shareholders that everything was going to be just fne; rather, he reassured them about what they could count on, amid this unprecedented uncertainty. Copyright © 2020 Tunderbird School of Global Management, a unit of the Arizona State University Knowledge Enterprise. Tis case was written by Professor Bertrand Guillotin for the sole purpose of providing material for class discussion. It is not intended to illustrate either efective or inefective handling of a managerial situation. Te author may have disguised certain names and other identifying information to protect confdentiality. Any reproduction, in any form, of the material This great disconnect between expectations and behaviors, both during the meltdown (buying opportunity of a lifetime; see Appendix A) and at the annual shareholders’ meeting, was raising many questions, such as what factors may have prevented Warren Bufet from buying heavily during this historic sell-of and when is it time for any CEO to reconsider a time-tested strategy? Warren Bufet Known as the “Oracle of Omaha,” Warren Edward Bufet was born on August 30, 1930, in Omaha, Nebraska, one of three children.12 His father was a stockbroker who became a member of the U.S. House of Representatives in 1942, and his mother was a homemaker. Gifted for mathematics, Warren Bufet started investing at age 11, enrolled at the University of Pennsylvania at age 16 to study business, and assumed control of Berkshire Hathaway in 1965. He was also known as one of the richest people in the world with an estimated net worth of US$68 billion as of May 2020, who had donated close to $28 billion between 2006 and 2017, according to USAToday .13 As Berkshire’s Chairman and CEO since 1970, Bufet remained the majority shareholder of the company. A very witty and folksy personage, Bufet was also known for his enduring personal habits; i.e., living in the same house since 1957 and earning the same salary of US$100,000 (very modest compared to other CEOs) since 2006. The following quotes, collected by M. Frankel, a Certifed Financial Planner,14 described some of his values, especially in regards to his disciplined and strategic approach to investing: On Money, Price, and Opportunities · “Rule No. 1 is, never lose money. Rule No. 2 is, never forget Rule No. 1.” (Warren Bufet’s golden rule). · “Price is what you pay. Value is what you get.” · “Opportunities come infrequently. When it rains gold, put out the bucket, not the thimble.” · “Widespread fear is your friend as an investor because it serves up bargain purchases.” · “The best thing that happens to us is when a great company gets into temporary trouble...We want to buy them when they’re on the operating table.” On Valuation and Long-Term Ownership, as Opposed to Frequent Trading · “It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price.” · “If you aren’t willing to own a stock for ten years, don’t even think about owning it for ten minutes.” · “When we own portions of outstanding businesses with outstanding managements, our favorite holding period is forever.” · “An investor should act as though he had a lifetime decision card with just twenty punches on it.” · “Since I know of no way to reliably predict market movements, I recommend that you purchase Berkshire shares only if you expect to hold them for at least fve years. Those who seek short-term profts should look elsewhere.” On Temperament and Patience · “The most important quality for an investor is temperament, not intellect. You need a temperament that neither derives great pleasure from being with the crowd or against the crowd.” · “The stock market is a no-called-strike game. You don’t have to swing at everything—you can wait for your pitch.” On Market Crashes and Prudence · “The years ahead will occasionally deliver major market declines—even panics—that will afect virtually all stocks. No one can tell you when these traumas will occur.” · “The best chance to deploy capital is when things are going down.” · “Predicting rain doesn’t count; building the ark does.” On Strategic and Sustainable Competitive Advantage · “The key to investing is not assessing how much an industry is going to afect society, or how much it will grow, but rather determining the competitive advantage of any given company and, above all, the durability of that advantage.” 2 A08-20-0020 This last quote, in particular, clearly indicated that Bufet was as much of a strategist as he was an investor. His strategy was to focus his research on a handful of industries and sectors, buying businesses that were well-managed and competitively dominant, enjoying the returns over time.15 It was this long-term view, holding stocks for an average of 7.5 years but sometimes for decades (e.g., Coca Cola, American Express) as compared to less than one year for retail (individual) investors, that played the biggest role in Bufett’s and Berkshire’s long-term success. Amid the typical bustle of activities and billions that changed hands within seconds among stock market participants on any given day, Bufet was known to act calmly. His buy-and-hold strategy enabled Berkshire to defer any capital tax payment until the company sold any shares.16 In addition, the fact that Berkshire did not pay dividends eliminated any tax liability on dividends earned by shareholders. His ability to think diferently about these important long-term implications had produced outstanding and unparalleled results since 1965. Results From the time he assumed control of Berkshire Hathaway, mathematical calculations indicated that “US$1,000 invested with Warren Bufett since 1965 would be worth more than $27 million today,” whereas the same amount invested with the S&P 500 would be approximately $200,000.17 Along the way, Warren Bufet and Berkshire Hathaway made several large acquisitions, especially during the 2008 global fnancial crisis (see Exhibit 2). Major Crises 2008 Whereas Warren Bufet had kept a relatively low profle throughout his career, he took center stage during the 2008 fnancial crisis, defending capitalism and America. A month after the implosion of Lehman Brothers, he published an article in the New York Times on October 16, 2008, titled “Buy American, I am.”18 However, the stock market, measured by the S&P 500 index, continued its downward spiral, tumbling from 946 on October 16, 2008 to 666 in intraday trading on March 6, 2009.19 For those dates, respectively, the VIX index (Wall Street’s fear gauge), had changed from 67.61 to 49.33.20 Called the Great Recession, the crisis of 2008 was addressed through several government bailouts and stimulus packages which totaled close to $1.5 trillion while unemployment reached 10\% in the U.S. in 2009.21 Considered a fnancial crisis that started with the 2006 subprime mortgage crisis, the 2008 crisis could have turned into a global depression if left unaddressed. Meanwhile, Bufet made an estimated US$10 billion during that crisis, fnancing diferent several billion-dollar deals and making strategic acquisitions (see Exhibit 2). Economic crises were known to happen from time to time in a capitalist system. However, the crisis of 2020 was triggered by a public health crisis and a planned shutdown of the economy as a result of the pandemic, caused by the novel coronavirus or COVID-19. COVID-19 As a consequence of the global pandemic that caused so many tragedies and casualties, the U.S. economy was shut down by governing authorities to stop the spread of the virus. Naturally, the stock market plunged in February– March 2020 with unprecedented magnitude and speed, as mentioned above. After years of low volatility, fear came back (see Exhibit 1) and unemployment numbers increased with the same unprecedented magnitude and speed that had caused the crash (see Exhibit 3). However, the swift and powerful rescue packages passed by Congress and the Federal Reserve system, led by FED Chairman Jerome Powell, injected US$3 trillion of liquidity22 into the economy and fueled renewed optimism. A08-20-0020 3 Right after the late March coronavirus sell-of, billionaire investor Bill Ackman acquired between US$219 million and US$255 million worth of Berkshire Hathaway.23 This move increased his US$5.7 billion hedge fund’s stake in the Oracle’s company from 11\% to 13\%, since he believed, as a longtime shareholder and seasoned investor, that “Berkshire will emerge from this crisis as a more valuable enterprise. ”In addition to this purchase of 1.4 million BRK.B-class24 shares, Vanguard Global Advisers, LLC, purchased fve million BRK.B shares on March 31, 2020.25 This LLC was part of the Vanguard Group, Inc., an investment company and the largest institutional investor of B-class shares in the world with a stake worth US$25.8 billion approximately. It was also important to keep in mind that more than 70\% of B-class shareholders were institutional investors, which are typically more conservative than individual shareholders. At the end of April, Brian Meredith, a respected analyst at Union des Banques Suisses, cut his estimate about Berkshire’s A-shares 12-month price target down to US$358,000 from US$393,000, due the impact of the coronavirus, using some-of-the-parts (SOTP) analysis to value the complex conglomerate.26 Bill Ackman added that he was “surprised they [Berkshire] haven’t done anything yet that’s visible, but my guess is they’ve been buying stocks, a lot” before concluding that “big opportunity for Berkshire is Berkshire itself,”27 a major buyback of shares. Interpreted as votes of confdence, buybacks (companies buying their own shares back, thus boosting their own stock price) had been instrumental in the longest bull market since 2009, reaching US$1.8 trillion in 2018. Also in April, Ray Dalio, founder, Chairman, and Co-Chief Investment Ofcer of Bridgewater, the world’s largest hedge fund with more than US$160 billion under management, reiterated that he considered “cash as a bad investment even after the coronavirus sell-of,” especially relative to other investments that were expected to retain or increase their value in the long run.28 On May 2, 2020, at the annual shareholders’ meeting, which took place online instead of in person and with fewer than 10 people instead of the usual tens of thousands of attendees due to the pandemic, Bufet stated that today’s America was in better shape than it’s been at any other time in its history. He added that investors who invested in stocks for the long run would be amply rewarded.29 Known to collect dividends but not to pay any to Berkshire shareholders, Bufet preferred buybacks and had stated that “buybacks are so simple, it’s a way of distributing cash to shareholders. We will repurchase shares when it’s to the advantage of the continuing shareholder to have us do so.”30 However, he defended his position against any major buyback of the company’s stocks during the meltdown of March 2020. In fact, Bufett stopped the fexible and Board-approved but relatively limited buyback program (US$1.7 billion) on March 10, 2020, something that shocked Morningstar sector strategist Greggory Warren.31 At the May 2 meeting, called the Woodstock of capitalism, Bufet went further by cautioning shareholders not to necessarily expect Berkshire Hathaway to beat the S&P 500 going forward, concluding “in my opinion, the best thing to do is own the S&P 500 index fund.” These comments infuriated Bill Smead, chief investment ofcer of value-focused Smead Capital Management in Seattle, and a longtime Berkshire shareholder, who stated, “Does he work for State Street or BlackRock? If I was his Board. I’d fre him. This virus has got him scared.” Criticisms kept coming, pointing out that during the bull market that started in 2009, Berkshire Hathaway’s stock had underperformed the overall market by more than 100\%, still not paying any dividend that would have softened the blow for the past 11 years and accumulating more than US$130 billion in cash.32 According to Howard R. Gold, a MarketWatch columnist, this was the “end of the Warren Bufet era.” Bufet was not new to criticisms. During the 1990s tech boom, he had been chastised by analysts and in the press for missing out on the boom in technology stocks and focusing on unglamorous purchases instead, e.g., carpeting, paint, and roofng materials companies.33 When the tech stock bubble burst, Bufet had only this message for investors in March 2001: “I told you so.” In response to more recent criticisms, Warren Bufett said in 2019 that, despite Berkshire Hathaway’s lackluster performance, he and Charlie Munger “continue, nevertheless, to hope for an elephant-sized acquisition.”34 However, Bufett considered prices too high to justify such a big purchase then. Meanwhile, the optimism born from the April stock market rebound continued until early May when Jeremy Siegel, a professor at University of Pennsylvania’s Wharton School, asserted that the March coronavirus meltdown in stock prices was defnitely going to be the low and that “the massive monetary policy response from the Federal Reserve, along with additional progress on treatments and vaccines for COVID-19, could really boost stocks next year.”35 Opposed to that view, Jefrey Gundlach, also known as the Bond King, was betting against the stock market, arguing that “a retest of the low is very plausible. People don’t understand the magnitude of [...] the social unease at least that’s going to happen when [...] 26 million-plus people have lost their job.”36 In that context, the established valuation analysis using stock price and company earnings had become pointless since no one knew what earnings would be for the foreseeable future and “estimates have much further to go, at least for the second quarter,” according to Liz-Ann Sonders, Chief Investment Ofcer at Charles Schwab.37 This challenge and the fact that “we shut of air travel in this country,” as Warren Bufet explained, led his company to sell all of the U.S. airlines shares that they had accumulated since 2016,38 including the ones acquired during the February 2020 sell-of (US$45 million worth of Delta shares).39 Amid these challenges and diferent perceptions of reality and what the future might hold, one fact remained: Bufet still had not made his succession plan public. Due to COVID-19, his longtime partner and Berkshire Hathaway Vice Chairman, Charlie Munger, who was 96 years old, had not been able to make the trip to Omaha for the live-streamed shareholders’ meeting. His replacement on stage with Warren Bufet (at a safe distance) was another Vice Chairman, Greg Abel (57), a veteran of Berkshire Hathaway, responsible for non-insurance business, and seen as a potential successor to Bufet. As important as this was for the future of Berkshire Hathaway stock once he retires, this was speculation. Bufet said that he had chosen a successor and that this person already worked for the company.40 However, he was also known to “always leave the door slightly open for changing his mind.” This uncertainty added to the apparent disconnect between the expectations of Berkshire’s shareholders, Bufett’s behaviors, and the company’s subpar stock performance since 2009. On May 15, 2020, BRK.A was trading at US$253,500.41 With Bill Gates leaving Berkshire Hathaway’s Board of Directors and Ken Chenault, the former CEO of American Express, replacing him, the company had to decide what to do next: change the time-tested strategy, or stay the course? ( A08-20-0020 ) ( 5 ) ( Exhibit 2. Berkshire Hathaway’s 10 Largest Acquisitions Source: Compiled by the author from Ben Winck , “Warren Bufett Is Waiting to Deploy a $137 Billion Cash Pile for a Future Mega-Deal. Here Are Berkshire Hathaway’s 10 Biggest Acquisitions So Far,” Markets Insider , May 14, 2020. Accessed May 16, 2020. https://markets.businessinsider.com/news/stocks/warren-bufett-biggest-berkshire-hathaway - company-deals-takeovers-acquisitio ns-purchases-2020-5-1029204009. ) ( Exhibit 1. Berkshire Hathaway Stock Price vs. SP 500 and VIX Indexes *Weekly frequency, except for 3/23 the lowest fgures for BRK.A and S&P 500 during that period. Source: Compiled by the author from Bloomberg on May 16, 2020. https://www.bloomberg.com/quote/BRK/A:US; https://www.bloomberg.com/quote/SPX:IND; and https://www.bloomberg.com/quote/VIX:IND. ) Date* Berkshire Hathaway in US$ (Ticker: BRK.A) S&P 500 Index (Ticker: SPX:IND) VIX Index (Ticker: VIX:IND) 2/12/2020 341,000 3,379 13.74 2/19/2020 344,000 3,386 14.38 2/26/2020 324,301 3,116 27.56 3/4/2020 326,125 3,130 31.99 3/11/2020 291,130 2,741 53.90 3/18/2020 256,300 2,398 76.45 3/23/2020 240,000 2,237 61.59 3/25/2020 270,759 2,475 63.95 4/1/2020 261,250 2,470 57.06 4/8/2020 286,999 2,749 43.35 4/15/2020 283,750 2,783 40.84 4/22/2020 279,660 2,799 41.98 4/29/2020 284,749 2,939 31.23 5/6/2020 259,100 2,848 34.12 5/13/2020 255,715 2,820 35.28 Year Company Name Industry Sector Price paid (in US$ bn) by Berkshire Hathaway 1998 General Reinsurance Insurance 22.0 2005 Pacifcorp Energy/Electricity 9.4 2006 ISCAR Metalworking (Israel) 4.0 2008 Marmon Holdings Holding company 4.5 2009 Burlington Northern Santa Fe Railroad 34.0 2011 Lubrizol Chemicals 9.7 2013 Kraft-Heinz Food 28.0 2013 NV Energy Energy/Electricity 5.6 2014 Duracell Batteries 4.7 2016 Precision Castpart Industrial goods/aerospace 37.0 ( 6 ) ( A08-20-0020 ) ( Exhibit 3. Monthly Number of Unemployed Persons in the U.S. from April 2019 to April 2020 (In Millions, Adjusted) *Monthly frequency Source: Erin Dufn , “Monthly Number of Unemployed Persons in the U.S. from April 2019 to April 2020 (in millions, adjusted),” Statista , May 12, 2020. Accessed May 15, 2020. https://www.statista.com/statistics/193280/seasonally-adjusted - monthly-number-of-unemployed-persons-in-the- usa /. ) Date* Number of Unemployed (in millions, adjusted) Change (in percent) April 2019 5.85 May 2019 5.89 0.68 June 2019 5.98 1.53 July 2019 6.06 1.34 August 2019 6.00 -0.99 September 2019 5.75 -4.17 October 2019 5.86 1.91 November 2019 5.81 -0.85 December 2019 5.75 -1.03 January 2020 5.89 2.43 February 2020 5.79 -1.70 March 2020 7.14 23.32 April 2020 23.08 223.25 ( A08-20-0020 ) ( 7 ) ( Appendix A. BRK.A vs. S&P 500 (^GSPC), January 1–May 15, 2020 Source: https://fnance.yahoo.com/ BRK.A vs. SP500 [ticker: ^GSPC] for the period January 1 - May 15, 2020, accessed on 10/15/2020. ) ( 8 ) ( A08-20-0020 ) Endnotes 1 Warren E. Bufett, “Chairman’s Letter—1986,” Berkshirehathaway.com , February 27, 1987. Accessed May 17, 2020. https://www.berkshirehathaway.com/letters/1986.html. 2 “Global 500”, 2019, Fortune . Accessed May 14, 2020. https://fortune.com/global500/2019/search/. 3 Shawn Langlois, “Warren Bufett’s Berkshire Hathaway Hailed as the ‘No. 1 Retirement Stock in America’ by Former Hedge-Fund Manager,” MarketWatch, February 26, 2020. Accessed May 16, 2020. https://www.marketwatch.com/story/ former-hedge-fund-manager-says-this-is-the-no-1-retirement-stock-in-america-2020-02-25. 4 Michael B. Sauter and Samuel Stebbins, “How the Current Stock Market Collapse Compares with Others in History,” March 21, 2020, USA Today . Accessed May 14 2020. https://www.usatoday.com/story/money/2020/03/21/stock-market- collapse-how-does-todays-compare-others/2890885001/. 5 Pippa Stevens, “Warren Bufett Interview Highlights: ‘Good’ When Stocks Fall, Likes Apple a Lot, Coronavirus Impact,” CNBC, February 24, 2020. Accessed May 14 2020. https://www.cnbc.com/2020/02/24/warren-bufet-interview-live- updates.html. 6 US$1 = US dollar; $1 = CAN $1.4091 on May 15, 2020. All currency amounts are in US$, unless otherwise specifed. Accessed on May 15, 2020. https://transferwise.com/us/currency-converter/usd-to-cad-rate. 7 Chicago Board Options Exchange Volatility Index (^VIX), chart for the period of February 12–March 20, 2020, May 14, 2020. Accessed May 14, 2020. https://fnance.yahoo.com/quote/\%5EVIX/history?p=\%5EVIX. 8 Sean Williams, “Warren Bufett’s $128 Billion Question, Answered,” Te Motley Fool , May 5, 2020 . Accessed May 18, 2020. https://www.fool.com/investing/2020/05/05/warren-bufetts-128-billion-question-answered.aspx. 9 Shawn Langlois, “Warren Bufett’s ‘Outdated View’: One Longtime Fan Is Considering Dumping His Entire Berkshire Stake,” Marketwatch , May 12, 2020. Accessed May 15, 2020. https://www.marketwatch.com/story/heres-why-one-longtime- warren-bufett-fan-is-considering-dumping-his-entire-stake-in-berkshire-hathaway-2020-05-12. 10 Andrew Bary, “Warren Bufett Needs to Get More Aggressive. Berkshire Needs an Activist,” Marketwatch , May 4, 2020. Accessed May 15, 2020. https://www.marketwatch.com/articles/warren-bufett-is-too-cautious-berkshire-needs-an-activist- investor-says-51588611940?mod=article_inline. 11 “Notes from the 2020 Berkshire Meeting,” Novel Investor , May 6, 2020. Accessed May 17, 2020. https://novelinvestor. com/notes-from-the-2020-berkshire-meeting/. 12 “Warren Bufett,” Biography.com , May 8, 2020. Accessed May 16, 2020. https://www.biography.com/business-fgure/ warren-bufett. 13 David Carrig, “Warren Bufett Gave Away this Much of His Wealth in the Past 10 Years,” USA Today , July 11, 2017. Accessed May 16, 2020. https://www.usatoday.com/story/money/2017/07/11/warren-bufett-charitable-contributions-bill- melinda-gates-foundation/468837001./ 14 Matthew Frankel, CFP, “The 100 Best Warren Bufett Quotes,” Te Motley Fool , August 30, 2019. Accessed May 16, 2020. https://www.fool.com/investing/best-warren-bufett-quotes.aspx. 15 Sean Williams, “3 Stocks Bufett Has Owned for at Least 25 Years,” Te Motley Fool , November 5, 2019. Accessed May 16, 2020. https://www.fool.com/investing/2019/11/05/3-stocks-bufett-has-owned-for-at-least-25-years.aspx 16 Shawn Allen, “Why Did Warren Bufett Buy Berkshire Hathaway in 1965?” Investorsfriend , January 4, 2014 (with minor edits to December 1, 2017)/ Accessed May 19, 2020. https://www.investorsfriend.com/why-warren-bufett-bought- berkshire-hathaway/. 17 Al Root, “Breaking Down the Bufett Formula: Berkshire Hathaway’s Returns by the Numbers,” Barrons.com , February 25, 2020. Accessed May 16, 2020. https://www.barrons.com/articles/berkshire-hathaways-investing-returns-a-breakdown- by-numbers-51582633800. 18 Warren E. Bufet, “Buy American,, I Am”, Nytimes.com , October 16, 2008. Accessed May 16, 2020. https://www.nytimes. com/2008/10/17/opinion/17bufett.html. 19 Kenneth Rapoza, “Here’s How Much the S&P 500 Needs to Fall to Match the ‘Great Recession,’ “ Forbes, February 12, 2018. Accessed May 16, 2020. https://www.forbes.com/sites/kenrapoza/2018/02/12/how-much-the-sp-500-needs-to-fall- to-match-the-great-recession/#585242457ca0. 20 Yahoo Finance, “^VIX”, period October 16, 2008–March 6, 2009. Accessed May 16, 2020. https://fnance.yahoo.com/ quote/\%5EVIX/history?p=\%5EVIX. 21 Kimberly Amadeo, “The Great Recession of 2008: What Happened, and When?” Te Balance , March 30, 2020. Accessed May 16, 2020. https://www.thebalance.com/the-great-recession-of-2008-explanation-with-dates-4056832. 22 Jef Cox, “Powell Says GDP Could Shrink More than 30\%, But He Doesn’t See Another Depression,” CNBC , May 17, 2020. Accessed May 18, 2020. https://www.cnbc.com/2020/05/17/powell-says-jobless-rate-could-top-30percent-but-he- doesnt-see-another-depression.html. 23 Theron Mohamed, “Billionaire Bill Ackman Plowed More than $200 Million into Warren Bufett’s Berkshire Hathaway after the Coronavirus Sell-Of,” Markets.Businessinsider.com , April 7, 2020. Accessed May 16, 2020. https://markets.businessinsider. com/news/stocks/bill-ackman-put-200-million-warren-bufett-berkshire-hathaway-coronavirus-2020-4-1029071562. 24 B class shares were 1/1500th of the A-class shares. More afordable, they were also considered more liquid. 25 “BRK.B—Berkshire Hathaway, Inc. Shareholders,” Cnnmoney.com , May 18, 2020. Accessed May 19, 2020. https:// money.cnn.com/quote/shareholders/shareholders.html?symb=BRKB&subView=institutional. ( A08-20-0020 ) ( 9 ) 26 Julia La Roche, “Berkshire Hathaway Price Target Cut by UBS Due to Coronavirus Impact,” Finance.Yahoo.com , April 24, 2020. Accessed May 16, 2020. https://fnance.yahoo.com/news/berkshire-hathaway-coronavirus-ubs-price-target- cut-184604435.html. 27 Theron Mohamed, “Warren Bufett’s Berkshire Hathaway Has Likely Plowed Billions into Stocks and Buybacks, Investor Bill Ackman Predicts,” Markets.Businessinsider.com , April 29, 2020. Accessed May 16, 2020. https://markets.businessinsider. com/news/stocks/warren-bufett-berkshire-hathaway-bought-stocks-investor-bill-ackman-says-2020-4-1029144240. 28 Theron Mohamed, “ ‘I Still Think Cash Is Trash’: Ray Dalio Doubled Down on Dollar Doubts in Reddit ‘Ask Me Anything,’ ” … SPRING 2009 VOL. 50 NO. 3 SMR309 Pankaj Ghemawat The Risk of Not Investing in a Recession Please note that gray areas reflect artwork that has been intentionally removed. The substantive content of the ar- ticle appears as originally published. REPRINT NUMBER 50309 D O WNTURN: STR ATEGIC INVESTMENT The Risk of Not Investing in a Recession The challenge for managers during a downturn is to find the balance between pursuing too many unprofitable investment opportunities and passing up too many potentially profitable ones. BY PANKAJ GHEMAWAT Editor’s note: In 1993, Pankaj Ghemawat wrote the classic article “The Risk of Not Investing in a Recession,” which addresses a question that every organization now confronts with fresh urgency. But which classic man- agement insights still apply in the new, crisis environment? Do Ghemawat’s? Recently, we asked him. His answers are published here, as commentary annotating the original text. TWO VERY DIFFERENT WAYS of thinking about investment and risk are headed for a show- down. One emphasizes the financial risk of investing; the other concerns the competitive risk of not investing. In normal times, the bearishness of the former tends to (or is supposed to) complement the bullishness of the latter. But the balance between the two seems to break down at business-cycle ex- tremes. Specifically, at the bottom of the business cycle, companies seem to overemphasize the financial risk of investing at the expense of the competitive risk of not investing. Once-in-a-cycle errors of this sort can create a lasting competitive disadvantage, which is reason enough to write (and THE LEADING QUESTION During an economic downturn, how can managers balance the financial risk of investing with the competitive risk of not investing? FINDINGS €The competitive risk of not invest- ing can be higher than managers think. €Knee-jerk cutbacks can do more harm than good. €Downturns can provide opportuni- ties to buy assets at bargain prices. D O WNTURN: STR ATEGIC INVESTMENT read) an article on the risk of not investing while the economy is still weak. ( DOESTHE ‘CLASSIC’ WISDOM STILL HOLD? Looking back over 15 years, I am struck by the extent to which the logic presented in the article still holds up. Thinking long term, fo - cusing on competitive position, and recogniz - ing the moving competitive baseline still seem to make sense as antidotes to the bias toward excessively large cutbacks in capital investment during downturns, such as the one we are now experi - encing.This should not be too surprising, since they are grounded in a basic framework for strategic choice that is meant to apply in good times and bad. Still, I would place more em - phasis on a few things if I were writing this article now.The most impor - tant question managers should ask is, What’s your company’s strategy for dealing with the re- cession, or are you simply trying to hold your breath until it ends? Specifically, I would give more weight to actions related to peop le, globalization and innovation. )Risk — Financial and Competitive By risk, I mean what managers mean: failure to achieve satis- factory performance along some dimension. The financial risk of investing is the failure to achieve sat- isfactory financial returns from an investment. And the competitive risk of not investing is the failure to retain a satisfactory competitive position for lack of investment. Of course, it doesn’t make sense to stamp out either type of risk, even though financial risk could be eliminated by not investing at all and com- petitive risk could be eliminated by investing indiscriminately. Instead, a balance must be struck between the error of pursuing too many unprofitable investment opportunities as opposed to the error of passing up too many potentially profitable ones. As one might expect, companies have devised ar- rangements for dealing with both financial and competitive risks. These arrangements can be associ- ated, respectively, with their capital budgeting and strategic planning processes. Capital budgeting tends to be a bottom-up process in which investment pro- posals are filtered through screens that are intended to limit financial risk. Robert Hayes and David Garvin pointed out in their landmark article, “Managing as if Tomorrow Mattered,” that the capital budgeting pro- cesses at U.S. companies discounted competitive risk as well as cash flows.1 That bias persists and seems likely to do so well into the 21st century. To address competitive risk, managers have turned, instead, to strategic planning. Strategic plan- ning is more of a top-down process than capital budgeting: It influences how investment proposals are (or aren’t) defined, evaluated and implemented. The focus of strategic planning has shifted since the late 1970s from basic forecasting to an external ori- entation that is more responsive to competitive pressures and that is intended, in part, to countervail the financial emphasis of capital budgeting. IN THIS ARTICLE, I emphasize the importance of maintaining a balance between financial and com- petitive risk by discussing business-cycle downturns, when the balance is especially likely to break down. Investment During Downturns Some insight into the balance that is actually struck be- tween financial and competitive risk can be obtained by tracking investment over time. Investment turns out to be very volatile over the business cycle. For the sake of concreteness, I will illustrate this point using U.S. investment in physical capital during the last few decades, although other countries and other forms of investment (training, research and development, ad- vertising, and other marketing communications) could also be used. During general business down- turns, such investment has historically declined two to four times as fast as output. Business economics suggests several explanations for the macroeconomic volatility of investment. Lags in adjusting capital stocks to desired levels create an incentive to stretch out investment projects during slow periods. The heightened ambiguity about fu- ture economic prospects that often accompanies downturns may reinforce that incentive by increas- ing the (flexibility) value of the option of waiting to see where the economy is headed. And downturns may combine with debt service and other obliga- tions to create liquidity crunches that rule out even desired investments. Although such effects contribute to the volatil- ity of investment over the business cycle, quite a few economists think that that volatility is excessive rather than efficient and, to a significant extent, self-imposed. John Maynard Keynes emphasized as much in his original discussion of the investment process and managers’ “animal spirits.” Keynes fell back on a general drop in business confidence as the major reason managers might voluntarily cut investment too much during business downturns. Several less arbitrary sets of reasons have since been identified. They can be classified as operating on the individual, group or organizational levels. At an individual level, financial risk, which in- volves out-of-pocket costs and the prospect of red ink, may loom larger than competitive risk, which involves “only” opportunity costs. Any such per- ceptual mismatch is likely to loom largest at business-cycle downturns. At the group level, there are several additional reasons for underinvestment during downturns. A herd mentality is a plausible psychological afflic- tion. It can also be a rational response to the receipt of common information (such as a credible forecast that the economy is headed downward). Economic theory indicates, in addition, that herd behavior can be induced by information asymmetries among competitors or between managers and their em- ployers. Whatever its sources, herd behavior implies boom-and-bust investment cycles, with the busts tending to coincide with business-cycle downturns. Finally, at the organizational level, research by Gordon Donaldson and Jay Lorsch, among others, indicates that historically many U.S. companies chose to finance investment from internal cash flow even when external funds were available.2 Such a self- imposed constraint has the awkward effect of choking off or delaying investment during downturns as in- ternal cash flow falls off or moves into the red. All of these reasons for underinvestment during downturns show an excessive concern with the fi- nancial risk of investing at the expense of careful consideration of the competitive risk of not invest- ing. A case study will illustrate that this emphasis is misplaced — that although the financial risk of in- vesting during a downturn may be high, the competitive risk of not investing can be even higher. Competitive Risk During Downturns: A Case Study Consider the loss of leadership by the United States in semiconductors, which it dominated from the in- dustry’s inception through the mid-1970s. The U.S. semiconductor industry benefited from access to leading edge research at universities, Bell Labs and other institutions; governmental support (from the Department of Defense and the National Aeronau- tics and Space Agency); the largest and most sophisticated home market in the world; a strong supporting cast of industries (particularly semicon- ductor manufacturing equipment); and vigorous rivalry, funded by venture capitalists. As a result, U.S. merchant suppliers outsold their Japanese rivals more than two-to-one through the early 1970s. But by the end of the 1980s, U.S. merchant suppli- ers’ revenues had dwindled to two-thirds of the Japanese level. Although many overlapping elements caused this decline, the one I wish to focus on is the one that leaps out from a comparison of revenue shares and investment shares of Japanese and U.S. merchant suppliers from 1973 to 1989. These data suggest that in the aftermath of the 1974-1975 recession, U.S. com- petitors in semiconductors took their collective foot off the investment pedal while Japanese competitors didn’t. So striking is the pattern that it has led some to stereotype Japanese semiconductor competitors’ (rela- tive) steadiness in investing during downturns as the archetypal Japanese competitive strategy. The data are, of course, highly aggregated. Does the pattern make sense in more specific terms? Consider dynamic random access memories (DRAMs), the dis- crete memory chips that constituted the single largest segment of the overall market for semiconductors. Texas Instruments Inc. and other U.S. companies in- troduced DRAMs with 64-component memories in the mid-1960s. They outpaced non-U.S. competitors over the next decade, introducing a new product gen- eration (with components half the size of the previous one and with four times as much memory) every three years.When the downturn hit, U.S. competitors mostly deferred their investment in capacity to produce 16K chips, but their Japanese rivals didn’t. When the upturn came, IBM Corp. and other U.S. cus- tomers, unable to source 16K DRAMs from domestic suppliers, began to turn to Japanese suppliers for the first time. By 1979, the Japanese had captured 43\% of the U.S. market for 16K DRAMs. They never looked back. Fail- ure to invest in time proved fatal in this segment for three related reasons: its very fast growth, the opportunities that it afforded for rapid yet relatively cumulative technological progress, and customers’ willingness to switch vendors if that was necessary to secure improved (next generation) chips. Note, by the way, that the critical failure occurred after the economy had bottomed out, that is, during a general recovery. What would have happened if U.S. manufacturers had invested more aggressively in 16K DRAMs in 1975 and 1976? Although we can never be certain, one industry expert (the only one I have been able to draw out on this point) guesses that U.S. DRAM manufac- turers would have managed to hang on to 95\% of their customer base if they had invested in time. Even a 95\% customer retention rate probably wouldn’t have let them hang on to 95\% of their initial market share: The demand for memory chips was growing more quickly in Japan than in the United States. But such a rate might well have sustained U.S. leadership in the single most important industry segment. Why did events take the turn they did? U.S. pro- ducers seemed, for the most part, to have adopted D O WNTURN: STR ATEGIC INVESTMENT “balanced” capacity expansion strategies that limited investment during downturns in order to staunch losses (and push profits up during upturns). Al- though most U.S. producers could have invested during the 1975-1976 downturn, they stuck to those “balanced” strategies, even though they realized that their Japanese competitors were maintaining or in- creasing investment levels. Sadly, concern about the ( PEOPLE My 1993 article was written at a time when my own research was centered on strategic investment decisions.That functional focus got even more play back then, because there was much debate going on at the time about the invest- ment horizons of American management. Today, I would place greater emphasis on the inter face between strategy and human resources. Why? Because this recession already seems to have led to all the familiar kinds of questionable behavior in dealing with people during downturns. In addition to some clear cases of exaggerated cutbacks, one still notes many uniform across-the-board reductions in head counts or in benefits, untar - geted employee buyout plans, blanket cancellations of training and development programs, and nickel-and-dime mandates that can do more harm than good (e.g., one comp any’s centrally mandated restrictions on air conditioning, which left a lot of people hotter under their collars than made sense). We seem to have slipped very fast from assertions by companies that their peo - ple are “their greatest assets in the knowledge economy” to a situation in which companies need to be reminded that people are assets at all. As with any long-term asset, decisions about what to do need to be based on a deep look into the future — one that recognizes that there is likely to be a future after the current recession is over — rather than on knee-jerk reactions to current conditions.That deep look is necessarily industry- and company-specific and can, in some cases, imply head count additions (e.g., for a solvent financ ial services organization that still has the ability and appetite to target rapid growth). And even when head count reductions are indicated, it is better to treat the exercise as one of becoming more selective about the kinds of people employed than simply adjusting numbers to conform to desired targets.The difference is subtle — but potentially significant. The other people-related point worth making is that, given the ambiguities and anxieties that a recession induces, it is a t ime for more rather than less communica - tion about what the company plans to do. Of course, such communication is eased by actually having a plan that goes beyond holding one’s breath and waiting for the end of the recession, i.e., having a strategy for responding to the recession (rather than just one tool, cutbacks). Some ideas in this regard are discussed below. ) financial risk of investing had crowded out consider- ation of the competitive risk of not investing. What managers need, in good times as well as bad ones, are not exhortations to invest or not invest but ways to separate good investment opportunities from bad ones. The rest of this section discusses how invest- ments ought to be analyzed at cyclical extremes.3 Think Long Term It is important to retain a long- term perspective on investment because of the lags in implementing major investment programs. Consider some cross-industry averages. As a rule of thumb, two years are required to build the average plant. Casual evidence suggests that building a new distribution system or reforming an existing one may take even longer. The mean lag in returns for R&D expendi- tures tends to be four to six years.4 Major changes in HUMAN RESOURCE PRACTICES (as opposed to policies) may, it has been suggested, require as many as seven years.5 And the restructuring of a corporate portfolio may take a decade or longer to implement.6 Adding the economic lives of assets to these in- vestment implementation lags often pushes the appropriate investment planning horizon 10 or more years into the future. However, the typical business cycle is often shorter, and the typical mac- roeconomic model’s effective forecasting horizon is shorter still. These figures strongly suggest the im- portance of maintaining a long-term perspective on investment. I should emphasize that this long-term perspec- tive is not meant to exclude consideration of cyclical fluctuations. The more cyclical the industry, the more important it is to distinguish booms from busts in- stead of aggregating them into an “average year.” That is why Delta Air Lines Inc., which operates closer to the macroeconomic edge than most manufacturing companies, builds two sharp recessions into its 10- year plan. The purpose of this planning exercise is apparently to keep debt low enough to allow expan- sion during a general downturn. Nor does the long-term perspective imply that temporary bargains (and other short-term phenom- ena) should be ignored. It may sometimes be possible to acquire assets for less than their true value during downturns. The paper industry is a case in point. Of the bargain hunters that have scored spectacular coups during slumps, [Chicago-based] Stone Container Corp. is perhaps the most notable. Stone became the world’s biggest manufacturer of brown paper bags and corrugated boxes by spending $1.7 billion be- tween 1983 and 1987 to purchase assets from companies that were disenchanted with the brown paper business, strapped for cash or poorly managed. Stone thereby quintupled its capacity for perhaps one- fifth of what it would have cost to build new plants. Investors were delighted: The market-to-book value ratio of the company’s stock exceeded two, and even three, through much of 1987 and 1988. Stone’s subsequent fall from grace is a reminder, though, that one can easily overestimate one’s own bargain-hunting ability. In 1989, Stone borrowed heavily to buy a leading Canadian competitor in European pulp and paper markets. It purchased the assets toward the peak of the industry cycles and paid more than double what it paid (relative to re- placement cost) in previous acquisitions. Focus on Competitive Position To the extent that there are pitfalls in presuming superior long-term forecasting ability, how should companies assess the long-term profitability of their investments? It is useful, in this regard, to focus on (long-term) COMPETITIVE POSITION, for three reasons. First, com- parisons with competitors will foster an external orientation by forcing the organization to keep its eyes on its environment instead of on its navel. Second, even apparently minor operating differentials relative to competitors can have major effects on financial performance. Third, competitive benchmarking fa- cilitates the long-term analysis of investment opportunities because the margin available to the or- ganization will equal the margin of the benchmark competitor plus the organization’s competitive ad- vantage (or minus its disadvantage). I will draw on my own consulting experience to illustrate the logic of competitive benchmarking at cyclical extremes. In 1988, I was retained as a consul- tant by a chemical company that was considering spending several hundred million dollars on a new plant for making ethylene, a commodity chemical that serves as the building block for many other or- ganic chemicals. The market for ethylene had been depressed through much of the 1970s and the 1980s, but its price had more than doubled in the previous 12 months as the supply-demand balance had tight- ened. One early mover had already parlayed this tightening into a billion-dollar gain by buying seven ethylene plants for $1.1 billion (most of it borrowed) in 1987 and reselling them less than a year later for $2.2 billion. But by 1988, it was clear that new U.S. capacity was needed. It was unclear, though, who would actually add capacity and by how much. It would take four years to bring a new ethylene plant on stream. Given this lead time and the ex- treme volatility of ethylene prices, the study group agreed that we would not try to make a case for or GLOBALIZATION My 1993 article essentially took a domestic perspective on strategy (despite the global semiconductor and diamond examples, each of which was treated as one global market, to which theories about the domestic market could presumably be easily transposed).The fact that many companies do (or could) participate in multiple mar- kets, whose cycles, growth and other economic parameters are only imperfectly correlated, opens up a number of interesting strategic possibilities. First, for many multinationals from advanced countries, the recession is likely to amplify — or should amplify — a refocusing of interest on emerging markets that was already under way. I remember the CEO of one of the largest companies in the United States telling me in March 2008 that the future for his company was about China, India and other emerging markets: that “evenTur- key” looked better than the United States. I also remember asking him what would happen if China and other emerging markets went into a downturn as well. He shrugged and said, “Then we’re toast.” Well, Chinese and Indian growth forecasts have fallen sharply. What should companies do? In a number of sectors, given the downward revision in Western growth forecasts from low to zero and those of key emerging markets from high to medium, emerging markets may actually assume proportionately more im- portance in terms of post-crisis projections of long-run growth! In beer, for example, medium-term growth forecasts were less than 1\% for advanced mar- kets even before the downturn; now it looks as if all growth (not just most of it) will be accounted for by emerging markets, particularly China, which is already the world’s largest beer market by volume. Of course, the opportunities are not limited just to emerging markets. Ryanair Ltd., the Dublin-based low-priced airline, bought more than 100 planes fromThe Boeing Co. at deeply discounted prices after the last downturn in early 2002, and it is thinking of investing in 300-400 short-haul aircraft. And Fiat S.p.A. recently agreed to buy 35\% of Chrysler LLC for nothing more than promises to share small car technology and its global dealer network. Fiat’s price was much less than the $7.2 billion that Cerberus Capital Management L.P. paid for its 80.1\% stake in the company less than two years ago, not to mention the tens of billions of dollars that Daimler-Benz AG paid for control of Chrysler in 1998. More broadly, don’t be surprised to see more hostile takeover bids during this downturn. Obviously, a downturn can create pressures to restructure as well as opportu- nities to build. Decisions by companies such as HSBC Holdings plc, the world’s largest bank by market capitalization, and Unilever PLC, the world’s second- largest consumer products company, to begin pulling out of the U.S. markets for consumer finance and detergents, respectively (the largest such markets in the world), are reminders that many multinationals have chronically unprofitable operations in their global portfolios.Thus, a detailed analysis of a number of companies done for me by Marakon Associates Inc. indicated that half had signif- icant geographic units that earn negative economic returns on an ongoing basis. Downturns are more obvious times to restructure such portfolios than upturns. against the new plant on the basis of particular as- sumptions about its timing with respect to market cycles, even though they would significantly affect its ultimate financial performance. We decided, in- stead, to look at whether the long-term margin expected from new capacity would allow an ade- quate return on the capital sunk into the project. To facilitate the analysis, we split long-term margin into three components: the average industry mar- D O WNTURN: STR ATEGIC INVESTMENT INNOVATION gin, the cost advantage of new plants relative to old plants, and the cost advantage of the client’s new plant relative to the average NEW PLANT. Assessment of the first component, the average long-term margin on ethylene, involved assessing the industry’s structural attractiveness in the 1990s. to increase the probability and penalties of excess capacity. This was strike one against the new plant. The second component of the long-term analy- sis involved comparing the cost positions of new ethylene plants and old ones. The low operating costs of new plants would place them fairly far down the industry cost curve. But when we took ac- count of their capital costs (which for old plants My 1993 article focused on whether to make large irreversible commitments during a recession.The emphasis was on stripping out inappropriately short-run cyclical influences from long-run investment decisions. But as the recent examples of companies such as Ryanair and Fiat suggest, it also makes sense to try to identify strategies that go beyond riding out the cycle. For further illustration along these lines, let’s reconsider the final case study from my 1993 article: De Beers’ decision to ride out the downturn of the 1980s in the diamond business by continuing to buy and stockpile others’ production. During the 1990s, this strategy, which was aimed at preserving the prestige of the category, appeared to pay off: Existing markets recovered, and De Beers established itself in new markets, particularly Japan. But diamond supplies from Angola and other countries also continued to expand more rapidly than expected, and by the late 1990s diamond inventories reached several times the maximum levels contem- plated when De Beers decided to be the buyer of last resort in the early 1980s. De Beers chairman Nicky Oppenheimer’s response was to revolutionize a strat- egy that had been in place for more than a century. De Beers has finally stopped supporting the industry by paying for and stockpiling everyone’s diamonds and has focused, instead, on pursuing a strategy of becoming “the supplier of choice” by: · Pumping up advertising and focusing it on its own brand instead of generically advertising the category; · Further tightening controls on the diamond trade; · Integrating forward into jewelry retailing in a joint venture with LVMH Moët Hen- nessy Louis Vuitton SA; · Capitalizing on its superior infrastructure and information to address social con- cerns about “conflict diamonds” that fuel civil wars in Africa; and · Trying to clean up its image with the public and with governments (particularly in the United States, where it was unable to operate legally). In other words, as stockpiles grew in the late 1990s, De Beers decided to stop simply trying to ride out the cycle and engaged, instead, in strategic innovation. The optimal response to a recession isn’t always this revolutionary. But it is worth trying to think broadly about ways of coping with cycles and ideally even capitalizing on them. Responses that have already been mentioned include ramp- ing up for growth, restructuring or refocusing geographically, and recruiting/ retaining the right people.These are not mutually exclusive, and one can think of many other responses. In many large companies, restructuring or refocusing could occur along the horizontal or vertical dimensions as well as the geographic one. Downturns are a good time to perform physical and organizational repair work that simply isn’t practical when a company is running flat out trying to meet demand. Would the industry go through booms and busts as it had in the 1970s and 1980s, or would it track the more stable 1960s, during which industry profit- ability had been quite healthy? The structural changes since the 1960s — the tripling of efficient plant scale, the maturation of the market, and the entry by oil companies and others — all appeared were already sunk), the total costs of new plants substantially exceeded the (operating) costs of old plants. In other words, existing plants had to oper- ate at capacity if new ones were to make money because the improvement in ethylene process eco- nomics over time had been relatively limited. This was strike two against the new plant. The final component of the long-term analysis in- volved comparing the relative costs of the new plant the client was contemplating and the capacity com- petitors might add. The competitors who were judged most likely to expand to meet the market opportunity were expected to add full-scale plants, each capable of producing up to 1.5 billion pounds of ethylene per year. Because this scale was incompatible with the cli- ent’s resources and other plans, the company was contemplating a smaller addition. Subscale design sig- nificantly increased the investment required per pound of ethylene capacity, to an extent that more than offset the client’s other advantages. This was the third strike against the option of adding a plant as soon as possible. The client decided not to expand in ethylene, at least until it could do so at full scale. As it turned out, prices collapsed around the time when the new plant would have started up. Recognize the Moving Baseline The analysis of long-term competitive position provides a useful benchmark for deciding whether to invest. It is an incomplete basis for choice, however, because reac- tions by competitors, buyers and suppliers typically shrink the returns. This threat to strategies that focus purely on positioning deserves to be stressed because managers seem to slight issues regarding the (un)sustainability of superior positions. Consider the returns on investment reported over a 10-year period by the 692 business units in the Profit Impact of Market Strategy database for which such data were available. I split this sample into two equal- sized groups based on their ROI in year one and, keeping businesses in the groups in which they started out, tracked the group averages through year 10. In year one, the top group’s ROI was 39\% and the bot- tom group’s was 3\%. It is safe to say that the businesses in the top group started out with generally superior positions and those in the bottom group with gener- ally inferior ones. What do you think happened to that 36-point spread between year one and year 10? Managers tend to guess that the initial ROI spread between the two groups shrank by one-third to one- half over the 10-year period. This overestimates the sustainability of performance advantages: The correct answer is that the spread shrank by more than nine- tenths! (See“The Threat to Sustainability.”) Therefore, managers should think through the sustainability of the superior positions to which they aspire — instead THE THREAT TO SUSTAINABILITY A study of the return on investment of business units in the PIMS database indicates that performance dif- ferences were largely wiped out over a 10-year period. Percent ROI ( Group One: High ROI in year one Group Two: Low ROI in year one )40\% 30\% 20\% 10\% 0\% of taking them for granted. Although sustainability is a topic of general strategic significance, it is particu- 1971 1974 1977 1980 larly important in the context of investment because investment can help a company achieve a sustainable advantage or avoid a sustained disadvantage. The simplest way of thinking through these benefits of in- vestment is to compare the competitive implications of investing and not investing. In other writings, I have described the sustainable competitive advan- tages that might be created through investment.7 Here I take a complementary perspective: the risk of a permanent erosion of competitive position as a con- sequence of not investing. The importance of thinking through sustainability from this perspective is illustrated by De Beers Con- solidated Mines Ltd., the orchestrator of the longest-running cartel of modern times. De Beers’ share of world diamond production slipped steadily with the discovery of diamond mines outside South Africa: from 95\% at the end of the 19th century to 10\% in 1993. De Beers nevertheless was able to domi- nate the industry through its distribution arm, the Central Selling Organization, which marketed 80\% to 85\% of the world’s rough (uncut) diamond supply on the basis of multiyear contracts with independent producers and its own captive production. The CSO functioned, in effect, as a valve that regulated the flow of rough diamonds into the market. This function was sorely tested by the short, sharp recession of the early 1980s, which reduced final demand for polished diamonds by 5\%. De- stocking by jewelry retailers and manufacturers and by diamond dealers and cutters compounded this change as it traveled back up the pipeline: The de- mand for the CSO’s rough diamonds collapsed by about 10 times as much as final demand. On the supply side, a large new mine in Australia and sig- nificant expansion of an existing one in Botswana threatened to double the production of natural dia- monds within five years. De Beers was forced, as a result, to reconsider the CSO’s traditional strategy of mopping up rough diamonds from suppliers, propping up their prices to buyers, and, by implica- tion, stockpiling them during downturns. Continued commitment to the traditional strat- egy would require the CSO to stockpile between $1 billion and $2 billion worth of diamonds while the recession ran its course and then to try to draw the stockpile down over a five- to 10-year term. It might seem unwise to tie up the bulk of the compa- ny’s net worth in diamond inventories, which afford no interest, at a time when interest rates were high and inventory reduction was starting to become a craze. But De Beers did invest in the billion-dollar- plus unsure thing — and maintained control of the market. De Beers decided to invest in stockpiling in the early 1980s because it understood that that in- vestment was absolutely critical to long-run sustainability. Gem-quality diamonds, whether pur- chased for adornment or investment, have no intrinsic value. Purchasers are nevertheless willing to pay high prices for them that bear little relation to D O WNTURN: STR ATEGIC INVESTMENT their cost because they perceive that such diamonds are and will remain scarce. De Beers has cultivated that perception over several decades by advertising heavily (“A Diamond Is Forever”) and otherwise de- veloping demand; by building up a downstream infrastructure capable of handling rapidly expand- ing supply; and, perhaps most remarkably, by publicizing and persisting with a pledge never to cut the list prices charged by the CSO. Allowing inde- pendent producers to flood the market — the only real alternative to stockpiling output at the CSO — would have shattered the perception that diamonds are safe stores of value and probably destroyed the diamond cartel. De Beers therefore had to weigh the risk of investing in a stockpile it might not be able to work off against the risk that not investing would wipe out most of the scarcity value of its own (and affiliated) diamond mines — scarcity value that might be sustainable with investment. It came to the conclusion that the risk of not investing outweighed the risk of investing. Of course, not all companies can dominate their markets to the extent that De Beers does. But the importance of investment’s effect on sustainability is, if anything, even greater when a company faces capable competitors than when it doesn’t. Capable competition, as in the semiconductor industry, places a company on a treadmill where it may have to run very hard (invest) just to maintain its relative position. To assume, as seems common, that the al- ternative to investment is perpetuation of the competitive status quo is to fail to grasp this point. Following the recommendations listed above will help managers reduce the probability of error but probably won’t rule it out. It is important, therefore, to maintain a margin for error. More spe- cifically, a balance should be maintained between errors of omission and of commission. Ideally, con- cern about financial risk shouldn’t force you to incur a serious risk of competitive collapse by ac- cepting too few investment opportunities. Nor should concern about competitive risk force you to incur a serious risk of financial bankruptcy by ac- cepting too many investment opportunities. Having said this, I should acknowledge that the ability of companies to live up to these risk manage- ment ideals depends in important ways on their initial positions. Reconsider that Intel Corp. spent $800 million to $1 billion on plant and equipment in 1991. The company announced its intention to sus- tain this level of expenditure for several years. None of Intel’s competitors invested nearly as aggressively. Some of the difference may have had to do with dif- ferences in foresight, but much of it was surely due to Intel’s sustained competitive advantage in micropro- cessors, which allowed it more room to maneuver than many of its competitors. More generally, invest- ing to create and sustain a competitive advantage is still the single best recipe for dealing with downturns and other challenges if an advantage can be achieved cost effectively. The framework for investment analy- sis that underlies this article will help prudent managers with the hard part of the recipe: judging whether investment is cost effective in a sense that encompasses competitive and financial consider- ations rather than just the one or the other. Pankaj Ghemawat is the Anselmo Rubiralta Profes- sor of Global Strategy at IESE Business School in Barcelona. His most recent book is Redefining Global Strategy (Harvard Business School Press, 2007).The original version of this article was published in SMR in Winter 1993. Comment on this article or contact the author at smrfeedbac [email protected] REFERENCE 1. R.H. Hayes and D.A. Garvin, “Managing as if Tomorrow Mattered,” Harvard Business Review 60, no. 3 (May-June 1982): 71-79. 2. G. Donaldson and J.W. Lorsch, “Decision Making at the Top: The Shaping of Strategic Direction” (New York: Basic Books, 1983). 3. For additional specifics on how the analysis ought to be conducted, see P. Ghemawat, “Commitment: The Dynamic of Strategy” (New York: Free Press, 1991), especially chaps. 4 and 5. 4. W.M. Cohen and R.C. Levin, “Empirical Studies of Innovation and Market Structure,” in “Handbook of Industrial Organization,” eds. R. Schmalensee and R.D. Willig (Amsterdam: North-Holland, 1989). 5. C.W. Skinner, “Big Hat, No Cattle: Managing Human Resources,” Harvard Business Review 59, no. 5 (Sep- tember-October 1981): 106-114. 6. See, for example, G. Donaldson, “Voluntary Restructur- ing: The Case of General Mills,” Journal of Financial Economics 27 (1990): 117-141. 7. P. Ghemawat, “Sustainable Advantage,” Harvard Busi- ness Review 64, no. 5 (September-October 1986): 53-58. Reprint 50309. Copyright © Massachusetts Institute of Technology, 2009. All rights reserved. PDFs  Reprints  Permission to Copy  Back Issues Articles published in MIT Sloan Management Review are copyrighted by the Massachusetts Institute of Technology unless otherwise specified at the end of an article. Electronic copies of MIT Sloan Management Review articles as well as traditional reprints and back issues can be purchased on our Web site: sloanreview.mit.edu or you may order through our Business Service Center (9 a.m.-5 p.m. ET) at the phone numbers listed below. To reproduce or transmit one or more MIT Sloan Management Review articles by electronic or mechanical means (including photocopying or archiving in any information storage or retrieval system) requires written permission. To request permission, use our Web site ( sloanreview.mit.edu ), call or e-mail: Toll-free in U.S. and Canada: 877-727-7170 International: 617-253-7170 Fax: 617-258-9739 e-mail: [email protected] Posting of full-text SMR articles on publicly accessible Internet sites is prohibited. To obtain permission to post articles on secure and/or password-protected intranet sites, e-mail your request to [email protected] Hyperlinking to SMR content: SMR posts abstracts of articles and selected free content at www.sloanreview.mit.edu. Hyperlinking to article abstracts or free content does not require written permission. MIT Sloan Management Review 77 Massachusetts Ave., E60-100 Cambridge, MA 02139-4307 e-mail: [email protected] Grading Rubric for FNCE 623 Topics Comments Grade Subject Matter (50\%) Subject Matter (50\%) 0 Key elements of assignments are covered Content is comprehensive, accurate, persuasive Displays an understanding of the relevant theory Major points supported by specific references Research is adequate/timely and citations are academically valid. • 50 Organization (20\%) Organization (20\%) 0 Organization and Critical Thinking (20\%) • The introduction provides sufficient background on the topic and previews major points • The structure is clear and easy to follow with proper headings • The conclusion follows logically from the body of the paper • Critical thinking is present through: o Logical argumentation and reasoning o Concrete examples o Valid inferences 20 Style/Mechanics (30\%) Style/Mechanics (30\%) 0 APA (10\%) The title page is present and properly formatted – separate page The reference page is present and properly formatted – separate page Citations/reference page follow APA guidelines Properly cites ideas/info from other sources 10 Grammar/Punctuation/Spelling (10\%) Rules of grammar and punctuation are followed Spelling is correct Formatting follows APA 10 Readability/Style (10\%) Sentences are complete, clear, and concise Sentences are well-constructed with consistently strong, varied structure Transitions between sentences/paragraphs/sections help maintain the flow of thought Words used are precise and unambiguous The tone is appropriate to the audience, content, and assignment. No colloquial language 10 Grade on 100 See additional comments in paper 100 Assignment guidelines: The individual project uses two of the items from the Harvard Business Publishing Coursepack: The Risk of Not Investing in a Recession, by Pankaj Ghemawat, 2009 Berkshire Hathaway: Covid-19 and the Great Disconnect, by Bertrand Guillotin, 2021 The first one is an essay about businesses not investing in capital projects during a recession and the potential negative consequences for them and the second is about Warren Buffet, considered to be possibly the greatest investor of all time, and how he, for once, had a major failure in not responding to the Pandemic and lost 25\% of the value of his company as a result. Analyze Berkshire Hathaway: • What happened to Berkshire Hathaway? What did Warren Buffet do? Was this the correct move? Has anything changed since the paper was written? • How much value did it lose during the Pandemic in dollars and percentage? • Compare with the S&P 500 index – what performance should have been expected? • Has it regained value by now? Why/why not? • If you were Warren Buffet, what would you do to regain what was lost? What about a stock buyback? How much cash is available and how much would you spend to buy it back? Should you divest (sell off) and parts of the company? • If you were the board of directors what are the options? What would you do? Should Warren Buffet be fired? • Does the first paper have relevance to this discussion? Why/why not? • What did you learn that you can apply to your own investing? In order to earn high marks the paper should provide discussion of issues that led up to the situation, the ramifications for the company and the possible future outlook using information outside of the case study. Use relevant financial numbers and calculations to support your discussion. Requirements • This is an individual assignment • Your paper must be in proper APA format • You must use outside references, and you must use proper APA referencing and in-text citations and you must reference the papers from the Coursepack and the textbook • Show your calculations and reference where you obtained the formulae • Max. 2,000 words, no minimum • Do not use “filler material.” Filler material is verbiage that does not add value to your paper. Do not add unnecessary definitions (if we have read about it in class it is unnecessary). • Provide an executive summary (or abstract) of your paper no more than one half page long • Provide a one-page case summary and a conclusion • No table of contents • The rubric is located on the Moodle Course Page