Preparing For the Second Wave

The Three Types of Small Businesses: As I have previously wrote I have observed three main types of small business. The first is the largest of the groups and they are small businesses who depend on other small businesses and consumer discretionary spending for their revenues. Generally speaking these companies have had ineffective business models and were slow to respond to the economic conditions. As a result they have poor financial health and were late to take action (beginning of 2009) to change their debt based business model to a more efficient and effective one. This group also has the lowest barriers to entry in their industries and will see an increase in competition over the next 3- 5 years. This group continues its challenges with pricing pressures and other deflationary forces since this group depends on other small businesses and consumer discretionary spending. Other small businesses are price sensitive and the consumer is only spending money if there is a deal.

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The second group is the second largest group and they depend on acts of God and or Mother Nature (roofing, disaster recover, etc.). The housing and commercial infrastructure in our nation is aging and some of the more modern structures quality has not stood up to standards. A result is replacing roofs and pipes breaking. Certain areas of our country have gone from drought to flooding. Basements and houses have been flooded and need to be rebuilt. This industry has stayed stable through our Great Recession. However, the name of the payer for these companies is not the owner of the property, but the insurance company. The risk to this group is the insurance pay-out amount and timely delivery. These types of companies should remain stable over the next 3 years or as long as insurance companies remain financially healthy.

The smallest of the three main small business types is the small business which depends on large mega-corporations (Fortune 500 companies). This group has not felt the effects of the Great Recession. In a matter of fact these companies have been growing at full throttle during the past few years since the mega-corporations have outsourced projects to them to save costs. These companies should continue to grow over the next several years since the mega-corporation have lots of cast, clean balance sheets and are using this type of small business to save costs and to fill unique niches. Their biggest risk is for the mega-corporations to cut their budgets and to lengthen payment cycles.

The warning signs: The first sign of the second wave is interest rates. The rhetoric, including the Federal Reserve Chairman and your evening news, say the economy is recovering, stabilizing and even growing. However, interest rates have continued to decline. The 2 year Treasury is only yielding 0.569% which is the lowest yield ever for this type of bond. The 10 year Treasury has fallen from a 4% yield in April to a 3% yield in July 2010. The signs which state interest rates should be increasing include our population's credit scores are at one of the lowest levels in history and the Federal Reserve and US Treasury have stopped purchasing mortgage securities in March 2010. If the economy was healing shouldn't the interest rates be rising? One reason rates might have been lowered is to help banks make their financial positions appear healthier. Banks make loans at locked in interest rates and then record the loan as an asset on their books. When interest rates rise the loans with lower interest rates have a lower fair market value. However when interest rates decline the loans with higher interest rates are worth more!

The rhetoric is stating we are healing, the bond market is indicating the economy still is in choppy weather. Either, the rhetoric is correct and interest rates will be moving up sharply soon or the bond market is correct and the economy still has injuries which need to heal. How can you win no matter which side is right? On the savings side, purchase short-term bonds. This will allow you to re-invest the monies in the future at hire rates and have liquidity. If you are borrowing, lock in your debt for as long as you can at the current low rates.

Second, unemployment is stagnant. The unemployment rate was stated to decline due to more individuals giving up looking for a job. Needless to say, this is not the healthiest way for unemployment rate to decrease. We have minimal job creation as the companies which generate 70% of the employment historically are small businesses. These types of businesses are suffering, have ineffective business models, are financially struggling and see minimal increase in demand for their products and services. The situation of small business will not allow them to hire in the near-term. Unemployment will continue to stay in the 10% range for several years to come. More importantly, the U-6 known as the underemployment is currently around 17%. This data set will need to significantly decrease for the economy to begin to grow once again. If you are employed you should save as much monies as you can, reduce short-term debts and thank your employer. This may causes a shock to your life-style, but it is necessary to survive. If you are unemployed, it may be a good time to chase a dream (hike up a mountain, start your own businesses, etc.). If you are a business owner which depends on consumer spending understand you may not have pricing power for years, take advantage of when consumers are optimistic and spending and understand when consumers are cautious. This may mean you will have to gear up and down frequently.

Third, Gross Domestic Product (GDP) has been revised downward two quarters in a row. The fourth quarter of 2009 and the first quarter 2010 both were materially decreased when revised. The second quarter 2010 was lower than anticipated at 2.4% (before revisions). It makes me wonder if the initially numbers are being released to make me feel safe so I will go out and spend again (which will drive the economy). By the time the GDP is revised downward it is too late not to spend since I already made the purchase a month or two ago. Future growth is now being revised downward by many analysts and CEO's are not willing to brag about future earnings due to poor visibility. An omen to slower future growth might have been the plugging of the consumer confidence in July 2010 of 66.5 from 76 just a month earlier. Small businesses need to take advantage of the current economic conditions of the willingness of individuals to spend. Then, small businesses need to use these profits to help reposition their company. They can invest in themselves by improving operational efficiencies which could help profits in the future; pay down debt which could help future cash flows; or keep the cash to build liquidity which will allow them to reposition in the future.

Most small businesses have a challenging road ahead. Action is needed today to meet tomorrow's challenges and to survive this economy. The aforementioned solutions can help, but if a small business does not have the right business model, business plan, great team members and a board of advisors to hold them accountable amongst other items they may not be able to survive the second wave.

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