An Incoming Recession

Dear partners, associates, and friends of nøught labs,

We believe a recession is imminent and signs of it swinging into action will be apparent by US mid-term elections in November 2022.

For more than a decade, we’ve existed in an unprecedented macroeconomic environment of incredibly low interest rates, miniscule bond yields, low inflation, and unceasing quantitative easing. Many companies, especially those in the technology sector born after the dotcom crash, have never known anything else.

This ground is rapidly shifting under our feet.

Inflation is the worst it has been in 40 years. The Federal Reserve has had the biggest rate hike in 22 years. There is a ground war in continental Europe, while the US-China trade war has only intensified in the past 5 years. Sri Lanka has become the first Asia Pacific country to default on its foreign debt in this century. Tech companies are laying off employees en masse.

In the last 7 economic cycles, when rates have risen as fast as they have now, a recession followed within a year and a half in 6 of them.

For the past decade, we’ve observed many excesses of the market. As we’ve noted in previous newsletters:

1. Valuations, especially of technology start-ups, have lost all sense and funds have been gobbling up unsustainable businesses, pushing them through multiple funding rounds, and finally offloading them to the public through SPACs.
2. Property markets, especially in China, the UK, and the US have seen a continuing mismatch between supply and demand. Highly leveraged real estate companies are having serious cash flow issues.
3. Supply chains are under severe strain between the pandemic, global conflict, and the trade war. Commodity prices are peaking while borrowing costs continue to rise. Raising interest rates may be the conventional wisdom when it comes to tackling inflation, but may exacerbate cash shortages, as it did in 1980 when business bankruptcies rose more than 52%.

So what now?

When all is said and done, we could be wrong. There are endless data points and we could go back and forth all day long, trapped by analysis paralysis. How then do we proceed?

In 2010, in the most comprehensive empirical study of companies’ performance during recession yet, Ranjay Gulati, Nitin Nohria, and Franz Wohlgezogen studied 4,700 public companies to see how they fared during 3 past recessions and who came out the winners/ losers. The results are worth reading in full, but here’s the big takeaway for us:

One combination has the greatest likelihood of producing postrecession winners: the one pursued by progressive enterprises. These companies’ defensive moves are selective. They cut costs mainly by improving operational efficiency rather than by slashing the number of employees relative to peers. However, their offensive moves are comprehensive. They develop new business opportunities by making significantly greater investments than their rivals do in R&D and marketing, and they invest in assets such as plants and machinery. Their postrecession growth in sales and earnings is the best among the groups in our study.

Further studies have fleshed out what it means to make these moves, including by Bain, McKinsey, Harvard, and more. We’ve gone through the research and here are our 3 big takeaways, the 3Ds:

Deleverage:

Studies found that PE-backed firms performed superior to other companies, primarily because of their ability to raise capital. Those suffering from a cash crunch due to high debt obligations often had to take drastic cost-cutting measures, which in turn, severely impaired their ability to take advantage of market conditions. In any crisis, cash is king, allowing a firm to think beyond survival and act opportunistically.

This is something we are actively moving towards, taking steps to:

• Sell our matured assets as valuations are peaking.
• Refinance projects to lock in long term interest rates before further interest rate hikes.
• Ensure we do not exceed our 60% debt ratio, a policy which has helped us survive the past 2 recessions.
• Slow down M&A activities and focus on assets that have a tangible value. Intangible value is highly volatile and often dissipates during a recession.
• Build up cash reserves so we can pivot quickly and take advantage of market conditions.

Decentralize:

Any recession is full of uncertainty, rapid changes, and the impetus to adapt. More flexible decision making based on facts on the ground, with input from employees at all levels taken into account, performed better during downturns. More decentralized decision making structures are more well positioned to navigate times of crisis.

• One aspect of decentralization is diversification. We are diversified across multiple industries and geographies.
• We have boots on the ground in most of our significant portfolio companies because we are owner-operators. Our lean management structure means we can react rapidly. This is not a defensive tactic we developed for the recession, this is part of our DNA.

Digitalize:

While the instinct of some is to hunker down and stick to what is “safe”, recessions also are wake-up calls for companies to re-evaluate their business models. When things are going well, there’s no reason to rock the boat, the default is to keep chugging along as things always have. When things are going badly, then the opportunity cost to invest in technology is lower. Crisis can generate momentum for digital transformation, resulting in longer term productivity benefits lasting long after the recession.

• This is something that we are already doing for some of our companies and will continue to do even if a recession hits.

Despite saying so much about a recession, at the end of the day, we hope to be proven wrong. Millions of people and businesses will suffer and entire industries will be upended. It will be ugly. When it comes to matters of “what if?” however, we return always to one of the 10 Commandments in our Employee Manual: P5- Proper Preparation Prevents Poor Performance (No Buts).

Many of the above principles (to have low levels of debt, to diversify and decentralize inputs in decision making, to invest in digital transformation, to lean towards tangible assets) are business practices we have upheld for decades, in good times and bad. At times, it has resulted in us being characterized as somewhat conservative; we hope it will prove itself in the resilience of our businesses.

Hoping for the best and preparing for the worst,

Ong Kar Jin

CSO at nØught labs