“Getting Ready for the Storm”: How Industrials Can Prepare for a Possible Slowdown

In 2022, several economic indicators and measures began signaling that US economic growth was likely to slow or reverse. The combination of inflation and high interest rates has strained markets and the macroeconomy. While a recession isn’t certain, executives would be wise to prepare their companies for very slow growth and a possible downturn. Companies that are prepared will be better positioned to endure whatever headwinds may come.

During the previous low-liquidity cycle, successful industrial companies followed a two-pronged strategy. They adopted a holistic approach to building recession resilience through improved operating leverage, lowered working capital turnover, and limited debt-to-equity ratios. At the same time, they “played offense” by pursuing a higher quality of revenue and optimizing the company’s portfolio. Decision makers at industrials companies can increase the likelihood of success with such a strategy by applying our Recession Resilience Index.

Recession Storm Clouds Are Gathering

In 2022, several economic indicators and measures began to resemble patterns that in the past have been associated with recessionary periods in the US economy. A spike in prices triggered an aggressive response from the Federal Reserve. Between March and December 2022, the Fed hiked rates by 3.9 percentage points, a faster rate than in any of its cycles of hiking since 1988–89. The Fed also scaled back its balance sheet, begin to reduce the high level of liquidity it had provided to the market since 2020 (Exhibit 1). The stock market entered bear territory, and the housing market showed signs of a slowdown. The first two quarters of 2022 also saw contraction in the gross domestic product.

Exhibit 1

The Importance of Getting Ready

Many analysts continue to speculate that a recession is quite possible in the next 12 to 18 months. Many banks and research outlets (including Goldman Sachs, J.P. Morgan, S&P, The Conference Board) forecast GDP growth at 1 percent or less for the year 2023. Surveys of executives indicate similar perspectives. Economists are likelier than executives to forecast a recession, but even they expect little growth.

While a recession isn’t certain, executives would be wise to prepare their companies for very slow growth and a possible downturn. Companies that are prepared will be better positioned to endure whatever headwinds may come.

Key Lessons from History: Playing Defense and Offense at the Same Time

Recent economic history supports the value of preparation. The previous low-liquidity cycle, in 2002–07, showed the relative success of companies that strengthened their P&L while readying themselves to grow during the next upturn. Looking across sectors, the industrials sector was in the middle of the pack (Exhibit 2). In terms of total shareholder returns (TSR), the industry average during the low-liquidity period equaled the overall market average, at 17 percent.

Exhibit 2

While industrials were average overall, some industrials companies not only outperformed their peers but exceeded the market average. Successful industrial companies of that period followed a two-pronged strategy: playing defense and offense at the same time (Exhibit 3). They adopted a holistic approach to building recession resilience—improved operating leverage, lower working capital turnover, and limited debt-to-equity ratios. At the same time, they “played offense” by pursuing a higher quality of revenue and optimizing the company’s portfolio.

Exhibit 3

Recipe to Address Your Readiness: Recession Resilience Index (RRI)

To take their place among the successful companies during the next recession, industrial companies need to assess where they stand today and where they need to quickly prepare for the storm. To help companies with this, our Recession Resilience Index (RRI) scores companies in five key areas: operating leverage, working-capital turnover, debt to equity, quality of revenue, and portfolio optimization, using the metrics listed in Exhibit 3.We have found that, during the low-liquidity period, the RRI of industrials companies was correlated with their shareholder value creation (Exhibit 4). Typically, the companies that excel in those five areas and perform above market also have high TSRs. A resilient growth strategy would therefore, establish and monitor the metrics listed in the exhibit.

Exhibit 4

To establish viable metrics, leaders of industrials companies could begin by answering the following questions:

• How is our operating leverage? Is our cost base optimized to deliver EBITDA growth in excess of revenue growth? Is our operating leverage multiple above 1?
• How is our working-capital turnover? Has the company unlocked more cash with net working capital improvements over time? How does our cash conversion cycle compare with that of our peers? What is our cash management drumbeat (e.g., weekly cash war room, daily cash reconciliation)?
• How well are we limiting debt? Has the company prioritized its sources of financing between debt and equity? What are our sources of stress financing?
• What is the quality of our revenue? Are our products and services differentiated enough for above-market revenue growth? What portion of R&D do we spend on developing new products and IP? What portion of our revenue comes from services or aftermarket? Is it close to 50%?
• How well do we optimize our portfolio? What is the company’s approach to M&A (programmatic, large deals, selective)? Does the company conduct a periodic review of all portfolio assets?