Editor’s note: In 1993, Pankaj Ghemawat wrote “The Risk of Not Investing in a Recession,” addressing an issue organizations now confront with fresh urgency. The logic of the article remains relevant: Thinking long term, focusing on competitive position and recognizing the moving competitive baseline are still the antidotes to the bias toward excessively large cutbacks in capital investment during downturns.
There are two different ways of thinking about risk. One emphasizes the financial risk of investing. The other concerns the competitive risk of not investing. In normal times the bearishness of the first tends to complement the bullishness of the latter. But during the extremes of a business cycle this balance breaks down. At the bottom of a cycle, companies overemphasize the financial risk of investing at the expense of the competitive gain they might incur if they did invest. This kind of error can hurt companies, putting them at a lasting disadvantage.
The following case study will illustrate that this emphasis is misplaced -- that although the financial risk of investing during a downturn may be high, the competitive risk of not investing can be even higher.
Consider how the United States lost its position of leadership in semiconductors. The U.S. dominated the industry from its inception through the mid-1970s. It had access to leading research at universities, Bell Laboratories, and other institutions. It had governmental support from the Department of Defense and the National Aeronautics and Space Agency. It also had the largest and most sophisticated home market in the world, a strong supporting cast of industries 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 suppliers’ revenues had dwindled to two-thirds of the Japanese level. Although the issue is complex, with many elements causing the decline, the one we’ll focus on stems from comparing revenue shares and investment shares of Japanese and U.S. merchant suppliers from 1973 to 1989. The data suggest that in the aftermath of the 1974-1975 recession, U.S. competitors in semiconductors metaphorically took their foot off the pedal while the Japanese competitors did not. Those in the U.S. stopped investing.
The data are highly aggregated. Does it make sense in more specific terms? Look at dynamic random access memories (DRAMs), the discrete memory chips that constituted the single largest segment of the semiconductor’s overall market. Texas Instruments Inc. and other U.S. companies introduced DRAMs with 64-component memories in the mid-1960s, and over the next decade, they outpaced non-U.S. competitors, introducing a new product generation every three years. When the downturn hit, U.S. companies mostly deferred their investment in capacity to produce 16K chips, but their Japanese rivals didn’t. And when the upturn came, IBM Corp. and other U.S. customers, unable to get these 16K DRAMS from domestic suppliers, turned for the first time to the Japanese.
By 1979, the Japanese had captured 43% of the U.S. market for 16K DRAMs. They never looked back. The U.S. companies’ failure to invest during this time proved fatal for three reasons. First, this segment grew very fast. Second it afforded opportunities for rapid yet relatively cumulative technological progress. And, third, the customers were willing to switch vendors to get the improved, next-generation chips. This failure occurred after the economy had bottomed out and during a general recovery.
What would have happened if the U.S. manufacturers had invested more aggressively in 16K DRAMs in 1975 and 1976? We can’t know with certain, although one industry expert guesses that U.S. DRAM manufacturers would have kept 95% of their customer base if they’d 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 have allowed the U.S. to remain the leaders in the most important industry segment.
What happened? U.S. producers, for the most part, seemed to have adopted balanced capacity expansion strategies. They were to limit their investments during downturns so as to staunch losses and push profits back up during upturns. Although most U.S. producers could have invested during the 1975-1976 downturn, they stuck to those “balanced” strategies, even though they saw their Japanese competitors maintaining or increasing their own investment levels. Concern about financial risk, however, had crowded out consideration of the competitive risk of not investing. What managers need, in good times and in bad, are not exhortations to invest or not invest, but ways to separate the good investment opportunities from the bad ones.
Fundamentally, it’s important to think long-term when it comes to investing because implementing major investment programs has its own lag time. For instance, as a rule of thumb, it takes two years to build the average plant. Building a new distribution system or reforming an existing one may take even longer. The mean lag in returns for R&D expenditures tends to be four to six years. Changes in human resource practices may require up to seven years. And restructuring a corporate portfolio may take a decade or longer.
The appropriate investment planning horizon should be 10 or more years into the future. Meanwhile, typical business cycles are often shorter. The wise thing to do, even so, is to maintain a long-term perspective on investment. But just as important, companies must focus on their competitive positions, which will help them assess the long-term profitability of their investments. Comparing yourself to competitors will help orient you externally, looking out instead of within.
Finally, companies need to recognize that there is always a moving baseline. Analyzing a long-term competitive position helps establish a benchmark for deciding whether to invest. But it alone is not enough to base decisions on, since competitors’, buyers’ and suppliers’ reactions tend to shrink returns. Don’t focus purely on positioning, since another’s superior position might not itself be stable.
This article is adapted from “The Risk of Not Investing in a Recession,” by Pankaj Ghemawat, which appeared in the Spring 2009 issue of MIT Sloan Management Review. The complete article is available at http://sloanreview.mit.edu/smr/
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