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Small Business - A Special Advertising Supplement sponsored by Scotiabank - Monday, October 22, 2001

What small businesses have to do to thrive

Monday, October 22, 2001

A recession is pretty much upon us and small business is up against tough odds. Sheer scale of operation and the resulting economies that go along with being big, such as being able to order supplies with big discounts, favour large firms.

The conventional theory of what it takes to get through a recession used to divide the world into upscale and downscale goods. Upscale merchandise would decline in sales as consumers shifted to downscale goods. Fewer new cars bought, more auto parts sold at Canadian Tire stores was the usual recession prescription. No more. New-car sales have slipped, but sales of less glamourous products have not taken up the slack. After all, car repairs can be postponed as readily as purchases of the latest luxury vehicle.

In this new market, the fate of small firms will depend to a substantial extent on the industries in which they operate, says Irwin Michael, portfolio manager of the ABC Fundamental Value Fund in Toronto. Known for his savvy in picking small-cap winners, he says that the fate of small firms also will depend on their marketing and financial characteristics.

"Any firm that sells products that tend to have inelastic demand, such as bread, cigarettes and groceries, should be fine," Michael says. Bakers, butchers and smoke-shop owners thus have only competition to worry about.

Eroding consumer confidence will therefore harm sellers of all consumer durables, while doing less harm to firms that sell non-postponable necessities, Bank of Nova Scotia says in a fixed-income research report on Sept. 21. However, firms in industries that have highly elastic demand and in which people can postpone or cancel purchases have a lot to worry about, the bank warns. Not only cars, but homes and major appliances can be hit by declines in orders, too.

There will be other consequences of recession. Firms that are highly leveraged on interest rates should do well as their interest costs fall, Michael says. On the other hand, he adds, firms that are leveraged on operating income could suffer.

In a declining economy, small firms that can build niches in their markets and defend themselves against competition can improve their chances of survival, says Alex Sasso, vice-president of equities at Altamira Investment Management Inc. in Toronto. "If a firm can create a market for itself, as Sleeman Breweries has done in Ontario with its products, then it has a defence against the big brewers."

Today, the best market for small-cap survival looks to be consumer products, where there is room for things that are better, faster or cheaper, Sasso adds.

"What products make for strong small-cap growth change? Two years ago, it was high tech, then it was oil and gas and related services. Now it's financial services and consumer products."

Tom Caldwell, chief executive officer of Caldwell Investment Management Ltd. in Toronto, says that "there is going to be a decline in the value of the Canadian dollar as a result of American perceptions that we are making life easy for terrorists. Expect more trade barriers that reduce the flow of Canadian exports. That will make our dollar decline. There will also be less trade with the U.S. So, the export business is going to be tougher."

The unknowns in the coming months will be how Canada is perceived by U.S. security authorities and even by U.S. consumers. If, as Caldwell suggests, "Canada is seen as friendly to questionable immigrants and open to terrorists, the volume of American travel to Canada might decline." And as Bob Tattersall, president of Howson Tattersall Investment Counsel in Toronto says, "If Americans are more fearful of travelling outside of North America or of flying in general, they could drive more, which would help motels and bus lines."

Caldwell figures that Canada is going to have what he calls "a recession on steroids" driven by U.S.-imposed trade controls. Geopolitical forces, the outcome of military efforts in Afghanistan and political rhetoric will affect this recession, he adds. Yet even in this uncertain climate, some companies can do well, he says. "Energy is priced in U.S. dollars, so the earnings of oil and gas companies and oil-field service firms could soar," he says.

The litmus test of how a firm of any size will do in the recession is going to be how much cash it has and how much it can generate. "Cash is the key to survival," Caldwell says. His advice to the small-business owner is to use it very wisely. If declining spending should lead to deflation, then the best-laid plans to capture consumer and business spending would go awry.

Deflation, after all, pays a premium to those who postpone spending and wait for prices to drop.

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