Knowledge of cycle management is more critical today than ever before. It implies making in-out decisions and long-short decisions. But how can leaders and managers do this effectively? The author, the former president of IMD, Lausanne, and the former owner of a not-so-small trans-ocean shipping company, has some excellent suggestions for managing through business cycles, both relatively stable and predictable ones, and volatile, almost-violent ones as well.
Virtually all businesses are cyclical and reflect the imbalances between supply and demand among the underlying activities of each given business. Perhaps some of the most extreme examples can be found in the shipping industry, in many commodities (metals, ores, agri-business), and in real estate and stock markets. In fact, cyclical businesses are everywhere. This is why good timing is especially critical for example, in deciding whether to get in or out of a particular market, to take a long or short position, or in judging the turning points. Still, we do not find much coverage of these issues in the typical business-school curriculum, or in business research or writing, for that matter.
In this article, I shall lay out what I see as the basic elements of effective management over business cycles. I shall draw heavily on examples from ocean shipping*. After all, which major industry might be more cyclical? For example, a modern Cape Max bulk carrier, say, of 140,000 tons d.w. size, would have, for instance, commanded a spot freight rate of approximately U.S. $140,000 per day in May 2008. Four months later, the same ship might have earned a mere U.S. $8,000 per day. So here, indeed, we are talking about violent cycles, much like we are experiencing today, and it appears, much like we will experience for the next while.
Much of what I shall be arguing seems to be generally valid when it comes to all businesses that are faced with cycles.
We do, of course, have general economic cycles. It should also be pointed out that there is a difference between cyclicality and volatility. The extremes I am referring to reflect the volatility that results from shocks, not only from cyclicality in its “pure” sense.
So, we know that most markets follow certain cyclical patterns. To achieve a meaningful return on capital, investors typically need to be present over long periods of relatively low earnings interspersed with shorter periods of stronger earnings. An alternative to this, of course, would be to go in/out during the peaks, totally avoiding the lean periods. While appealing, this is hard to pull off in practice. Figure 1 illustrates a typical market-development cycle over time.
Figure 1 Typical market development
An understanding of this type of cyclical pattern is critical for any sector in a given business. But for those firms who are exposed to this type of cyclical pattern, it would not necessarily be the best basis for making strategic decisions, because stability and predictability of earnings would typically be critical, above all for publicly listed firms. For many of these firms, a stable income stream, ideally portraying stable growth from an upward-moving market, would be essential to attract financing and capital.
When it comes to market cycles, one should remember that they tend to be relatively prominent in relatively mature industries, i.e. with the expectation that cyclical patterns of the past will continue into the future and be relatively “normal”, such as depicted in Figure 2. What happens if this turns out not to be the case? For instance, what happens if the cycle does not flatten out as it approaches the top, but extends itself and climbs even higher? Or, alternatively, what if the bottom of the cycle does not lead to a flattening out and the market continues to decline? Figure 2 illustrates the potential of these developments, which are often deemed unlikely, according to conventional wisdom in the industry.
Figure 2 Abnormal shipping market-freight rate developments:
How might these discontinuities impact strategy? We know that, traditionally, buying and selling are critical. The key is to try to buy low and sell high. This asset-play strategy may no longer be always valid – the market may simply not recover in the foreseeable future. Therefore, a strategy based on having the lowest operating costs will always be important. A low breakeven point will always be an advantage, particularly perhaps in weak markets. Attention to costs and breakeven points is thus an essential part of successful cycle management.
The key decisions in cycle management
Armed with a deep understanding of the relevant markets, one would then weigh the key factors for securing competitive success.
In/out. When do you enter the market? When do you get out? Experience and outlook, coupled with relevant market data, are critical factors. It is true that one would enter the market when it is expected to go up and exit when it is expected to fall. However, the ability to consistently determine the right timing is everything. To do this, one must keep track of underlying factors that might impact the market. While many have focused on supply-side factors, such as the availability of new capacity, there is strong evidence that demand-side factors, most notably those to do with levels of world trade, are of overriding importance.
Long/short. Another key decision, again dependent on market expectations, is whether to go for a longer-term contract or to choose to employ one’s asset capacity in the spot market. With a rising market, one would stay in the spot market; with a falling market, one would attempt to secure a longer-term charter. However, in reality, it can be difficult to implement such policies. For instance, who would grant a longer-term charter to a ship owner if market expectations were pointing down? Unless of course, there were different market outlook expectations, you would turn this down. Alternatively, would a firm keep all of its ships in the spot market when the outlook might indicate a rising market? Or, would the firm’s bankers insist on some longer-term chartering coverage?
So it seems critical to be able to gauge how the markets are likely to develop in order to initiate cycle-management strategies along the following lines (Figure 3).
Figure 3 In/out and long/short strategies
Such a strategy is obvious when it comes to determining how actors will behave in relation to expected developments in the markets. It is also true for the second-hand market for assets, and for the market for placing new capacity orders (Figure 4).
Figure 4 Buy/sell assets and place new capacity orders
The role of capacity / demand balance
The actual capacity-utilization rate for each particular type of producing asset, i.e. in the various segments, is a significant driver of freight rates that can be put into effect. With high fleet utilization, the rates tend to go up – and vice versa. Figure 5 illustrates this phenomenon.
Figure 5 Market behaviour as a consequence of capacity-utilization rate
Source: Dr D Jessel, Howe Robinson & Co.
Let us apply this to an example from shipping, i.e. the Capesize bulk carriers. As noted, the daily freight rate as of June 2008 was more than U.S. $200,000 per day. By the end of November 2008, it was less than U.S. $4,000 per day, which is less than the typical operating costs of approximately U.S. $8,000 per day. The owners might expect that rates would go up somewhat – the one-month forward rate was U.S. $7, 600 per day (end of December 2008) and the three-month forward rate was U.S. $12,000 per day. Still, many owners decided to anchor their Capesize bulk carriers. As of the end of November 2008, an estimated 200 Capesize bulk carriers were anchored out of an overall fleet of approximately 850 Capesize bulk carriers, i.e. a fleet-utilization rate of approximately 71 percent.
The full cost of operating a Capesize, including financing costs, might be around U.S. $20,000 per day. The cost of a five-year old Capesize was approximately U.S. $150 million in December 2007. By the end of November 2008, the cost was approximately U.S. $50 million. The full cost estimate of approximately U.S. $20,000 per day would be based on the former price.
Consequently, one might expect the daily freight rates for Capesize bulk carriers to typically be between about U.S. $8,000 and U.S. $20,000 per day until extensive scrapping and cancellations/delays of new buildings have taken place, which might, over time, bring the fleet utilization up.
It should be noted that the average daily freight rates for Capesize bulk carriers were:
- for the period 1990-2003: U.S. $17,000 per day
- for the period 2003-2008: U.S. $76,000 per day
- for the period 2008-2011: U.S. $17,000 per day (According to the leading ship freight market forecaster, Marsoft’s, estimate)
Figure 6 shows the relationship between freight rates and utilization for Panamax bulk carriers. This gives an empirical view of the importance of the capacity- employment/utilization rate.
Figure 6 Dry Bulk Rates and Utilization
Source: Marsoft, 2009
A personal story
In January 2008, I sold my shipping company, a small firm that specialized in platform supply ships that served offshore oil platform installations with containers, drilling pipes, fuel, fluids of various sorts and the likes. The company was 100 percent owned by me. While the freight market in this segment was very strong, I had become concerned by the rate of new building orders relative to the existing fleet. In other words, I was becoming increasingly concerned about the possibility of having far too much capacity relative to future demand. In general, the rate of new building orders relative to the existing fleet has turned out to be a strong indicator of future freight rates.
The offshore platform-supply ships market did indeed collapse, but only 1.5 years after I had sold, and well after I had expected it to collapse. But it is hard to hit the exact tops and/or bottoms in cycle management. Typically, “approximately right” is fine.
The decision to sell was a lonely one, not the result of broad debates. At the time that I sold, many people felt that I was exiting too early. Later, many of the same people said that I made the correct decision. When it comes to cycle management decision-making is typically a lonely decision. In general, execution of asset plays is almost always done by one principal, and not by large teams of executives or the board. It should be pointed out that some of these individuals at times might over-estimate their capacity for risk taking. A strong vision regarding the relevant cycle is always the key, as is strong decisiveness.
Knowledge of cycle management is more critical today than ever before. It implies making in-out decisions and long-short decisions. To do this effectively can be easier said than done. There will always be a tendency to “wait and see.” But this can typically end up becoming “too late.” In cycle management, timing is everything, and as with many other management tasks, this requires discipline.
* Edwin Dutson and Paul L. Eckbo provided valuable comments on an earlier draft.
Lorange, Peter, Shipping Strategy, Cambridge University Press, Cambridge, 2009
Marsoft, Dry Bulk/Tanker/Container Ship Reports, Boston, 2008 – 2009