And didn’t we all “know” that when the stock market dropped over 50% through March 2009 that it had
gone too far into a temporary trough and the market would generate very high returns over the next
few years while it bounced back?
The reality is most of us didn’t see these bubbles and troughs until after they were over or at least until
they were past the peak. Just like the media covering the NBA, we all have a tendency to observe
short term trends and extrapolate them forward. When business activity and employment are strong we
tend to think and act as if it will last longer than it typically does. And when times are less favorable we
also act like it will stay that way for an extended period.
We see this phenomenon at the company level too. When a company misses their expected earnings
the share price often declines rapidly as if the lower earnings will be repeated indefinitely almost
regardless of how extraordinary the cause of the earnings miss. And when companies launch a few
successful new products they are often hailed as an ongoing fountain of innovation, which drives up
the expected level of performance and their valuation soars.
The effect of these changing expectations on the volatility of stock prices is quite profound. Over the
last year, the average company in the S&P 500 had a high share price that was 56% higher than their
lowest share price. Across an entire business cycle the share price movements are even more
This level of share price volatility can be stressful for management but here are some principles for
managing through volatile and cyclical times:
1. Avoid the natural human tendency to extrapolate the present into the future. On a quarterly basis,
examine company, industry and market trends to assess generally where you are in the cycle and to
understand how your company and others are responding to it. Aim to be as fact-based as possible
but also recognize you will not always see cyclical turns coming regardless of how well you prepare.
After all, you are only human.
2. Be skeptical of any forecast that shows straight and steady improvements over time and conduct
adequate thoughtful scenario testing to ensure strategies are robust if the path is less linear. Scenario
testing should be based on realistic situations that could happen, not simple mathematical sensitivities.
3. Avoid falling into the capital and fixed cost versus variable cost efficiency trap. Capital and fixed
costs can often be used to save variable costs and strong rates of return may seem attractive but
the buildup of capital intensity and fixed costs could have very negative ramifications during the next
downturn. Make sure worst case possibilities are considered before ever increasing fixed cost.
4. Avoid predicting the timing of peaks and troughs, but always recognize they will happen and prepare
contingency plans. Create strategic options that allow flexibility so capacity and business activity can
be increased or decreased when appropriate given the changing business climate. For example, use
operating leases for a portion of assets with renewal options that can be exercised or not depending
on capacity needs.
5. Try to practice “buy low and sell high”. For example, aim to make capital investments when the
equipment suppliers have overcapacity and might be more willing to settle for lower prices. Maintain
adequate financing flexibility to be able to be opportunistic when others hunker down.
6. Track the performance and valuation of all possible strategic acquisition targets and seek to make
acquisitions when prices are low. Often, more value is created when acquisitions are made during the
time when share prices are generally low even if the percent acquisition premium ends up higher.
7. Be careful with the timing of stock buybacks as they have a greater chance of being effective for
the shareholders that stay with the company if the buybacks are done when the price is generally low.
Note that most companies get this wrong and buy back more stock when it is high than when it is low.