Berkshire Hathaway: COVID-19 and the Great Disconnect

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 k@mit.edu.

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.

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