(Business 2.0) – R.J. Pittman is a classic business daredevil, a 33-year-old with a new technology and a taste for adventure. Larry Brilliant is a more established quantity, a four-time entrepreneur who co-founded the Well, the prototypical online community, in 1985. Though the two haven't met, the novice and the veteran are united in an act that, in this forbidding business environment, isn't just daring. It's practically unnatural. They are starting businesses.

Pittman is launching Groxis, which is built around software that makes Web searches more efficient. While some may question the appetite people have for such a product right now, Pittman thinks this is a far more auspicious time for entrepreneurs than, say, 1999. "Office space is cheap, and talent is available," he points out. "And the signal-to-noise ratio is much better now that all the junk dotcoms are out of the picture." Brilliant, for his part, recently founded Cometa Networks, a joint venture that is planning a nationwide system of wireless broadband Internet access spots. Building out yet another communications network may seem like the errand of someone who missed the memo about the telecom bust. But Brilliant dismisses any doubts. "The irrational exuberance of the 1990s has been replaced by an irrational lethargy," he says. He sees Wi-Fi as a huge opportunity, and he doesn't intend to let recession or war or corporate paralysis keep him from it.

This entrepreneurial bravado, so common just a few years ago, stands in marked contrast to the apprehension that seems to grip so many hearts in business today. Wherever you look, the forces of retrenchment are on the march. During the past two years, capital investment has declined about 11 percent--more than during the 1990-91 recession and almost as much as during the recession of 1981-82. Billions of dollars are disappearing from balance sheets as companies write down the value of poorly conceived acquisitions, struggling venture divisions, and unsold inventory. The hiring slump is persisting, with more than 1.5 million jobs lost since the start of the 2001 recession. And among venture capitalists, 70 percent of current cash goes to fix problems at existing companies rather than to fund fresh ideas.

While retrenchment is a perfectly understandable reaction to an unexpected drop in revenues, at too many companies it threatens to become a habit. The trick in tough times is to downsize your cost base without downsizing your future. Even as your company sweats off fat, it needs to bulk up on some of the courage and faith in innovation shown by Pittman and Brilliant (tempered, of course, by a healthy dose of prudence). No company ever beat a bear market by starving itself.

You can't move forward when you're cutting back.

Like a crash diet, retrenchment may help you look less like an inflated marshmallow, but the improvement will be temporary unless you commit yourself to better nutrition and a sustained exercise regime. "Denominator management"--whacking away at head count, paring down inventory, and slashing capital budgets to buttress your financial ratios--can take you only so far.

Retrenchment doesn't fundamentally transform a company's cost structure; it simply establishes a new, lower equilibrium between revenues and expenses. It doesn't create competitive advantage--not unless you're taking costs out a lot faster than your competitors are and doing so in ways that don't imperil long-term success. In other words, retrenchment can buy you time, but it can't buy you a future.

At some point, in fact, it becomes retreat. Studies suggest that this point often comes sooner than most businesspeople expect. A Mercer Management study of 116 companies that aggressively cut costs in the 1990-91 recession, for instance, determined that only 29 percent of them grew profitably in the latter half of the decade. A more recent study by Strategos, the Chicago-based consultancy chaired by author Hamel, demonstrated the limits to a single-minded focus on cost cutting. It showed that while a company can grow earnings faster than revenues for a few years--a sure sign of denominator management--one that grows earnings more than five times faster than revenues for more than three years in succession is almost certain to see a subsequent collapse in growth. The point is simple: Retrenchment makes you smaller, not better.

Timidity is not a strategy.

While tough times breed timidity in some, they breed courage in others. Fred Smith launched FedEx into the teeth of the 1973-75 stagflation; Compaq got started in the recession of 1982; Wal-Mart opened a record number of stores during the 1990-91 recession and plans to open a mind-boggling 48 million square feet of new retail space in the current fiscal year, an 8 percent increase over 2002.

JetBlue is another case study in courage. While the airlines have suffered from terrorism and recession as much as any industry has, CEO David Neeleman avows, "This is definitely a time to try new things." In 2002, when most carriers were trimming routes and deferring new aircraft orders, JetBlue added flights to many of its routes and almost doubled its fleet. While Neeleman acknowledges the possibility that things could get even tougher, he quickly adds, "If you get into the mode where you are too petrified to do anything, you will fall behind."

You may argue that it's easy to be courageous when, like JetBlue or Wal-Mart, you have a pronounced cost advantage. But there are other reasons to be courageous. Says Peter Bernstein, author of Against the Gods: The Remarkable Story of Risk, "It is precisely when people are most scared that resources are the most undervalued." Look around: Talent is plentiful, and assets ranging from office leases to brand names to new technology are going at fire-sale prices. IBM, for example, has used the downturn to substantially bolster its software and consulting businesses with timely and cheap acquisitions. Last October, it acquired for $3.5 billion the IT consulting business of PricewaterhouseCoopers, a property that Hewlett-Packard reportedly came close to buying for $18 billion just two years earlier.

It's not only the big guys who are buying cheap. Says Nazim Kareemi, CEO of Canesta, a Silicon Valley startup that has developed an uber-cool laser-light keyboard for mobile devices, "We've been able to find outstanding people, and we didn't have to offer them BMWs." Never mind the Beemers: the average worker in Silicon Valley can be had for $62,500 this year, 22 percent less than in 2000. In the hardest-hit corners of the Valley, some of the most desperate are freelancing without salary--just for options, or even just for experience. Moreover, these days, employees are much less likely to hop around every few months.

Of course, it's hard to be bold unless your organization understands what it wants to be bold about. Dell, for example, possesses more than just a supermodel-skinny cost structure--it also has a Yao Ming-size vision of its opportunity space. Throughout the recession, Dell has continued to expand aggressively into servers, printers, data storage equipment, and communications gear. Toyota has recently raised its target for global market share from 10 to 15 percent and is in the midst of launching a new brand, Scion, which aims to win over young buyers with a line of hip and funky vehicles. Pfizer is spending $5 billion a year on research and development to find the next Viagra, and it's supplementing that with more than 500 external alliances. And, in a bold bid to become an American retail icon, UPS has announced it will put its brand on the 3,300 Mail Boxes Etc. outlets it acquired in 2001.

Opportunities are the antidote to fear--but you have to go out and find them. We're willing to bet that if your company took even 20 percent of the energy it is currently devoting to retrenchment programs and focused it on a disciplined search for new opportunities, the downturn wouldn't appear half so daunting.

Innovation is (still) the engine.

Some of the current enthusiasm for retrenchment stems from a belief that the bubble was caused by too much innovation. That's just plain wrong. The bust occurred because there was too much cash--way too much cash--and too little genuine innovation. For every industry, there were a dozen companies hoping to create a business-to-business exchange; for every product category--from cosmetics to panty hose to dog food--there were at least half a dozen online retailers hoping to become the next Amazon; and for every stretch of unplowed earth, there seemed to be a telecom ready to lay optical fiber. That wasn't innovation; it was mindless imitation.

No company can advance against the gale-force headwinds of today's economy without an engine. And the best such engine is a capacity for break-the-rules innovation. Consider Kohl's. The highly successful Wisconsin-based retailer is positioned midway between Wal-Mart and Macy's--a market space that any retail consultant would have said didn't exist. Yet Kohl's has managed to provide consumers an inviting and efficient shopping experience (its stores are laid out around "racetracks" that allow consumers to visit every department in less than 15 minutes) along with penny-pinching prices. The retailer offers a clear alternative to the soulless canyons of Wal-Mart and the time-wasting maze of the typical department store. Consumers seem to agree: With about half the stores of Sears or J.C. Penney, Kohl's has a market value more than twice as big as either of them.

For most companies, the risk of innovating too little is at least as great as the risk of spending too much. That's one reason CEO Jeffrey Immelt has made innovation the new mantra at General Electric. In the past three years, GE has tripled the share of its R&D budget dedicated to bleeding-edge technologies such as nanomaterials, fuel cells, and molecular imaging equipment. GE's research chief, Scott Donnelly, estimates that 30 percent of his budget now goes toward such advanced science. "If you work at the incremental stuff for too long," he explains, "your products can get commoditized." Art Collins, CEO of medical device maker Medtronic, knows that the damage can go even deeper. Firms that don't innovate, he says, "lose not only their current market position but also the ability to develop new markets." Medtronic is spending an annualized $750 million on R&D, up 15 percent from last year.

Business cycles ebb and flow, but as any R&D chief will tell you, the quickest way to waste money is to turn development programs on and off and on again. Yet stick-with-it tenacity is hard to sustain during hard times, when projects with promising but distant payoffs are all too likely to get flushed away. For this reason, top management must clearly identify opportunities that will be funded come what may.

Scarcity is a blessing.

The bean counters are in control again, and after the excesses of the 1990s, you can't blame them for being suspicious. Too many foolhardy ventures and billion-dollar manias found it too easy to get funded.

The new skepticism is not all bad. "In the dotcom explosion, you could go have lunch with someone and walk out with a check," Cometa's Brilliant says. This time around, in contrast, he and his team needed nine months of market research, cajoling, presentations, and fine-tuning of their plan to persuade backers AT&T, IBM, and Intel to give them the green light. "We did surveys, interviews, and research at a level I have never known before at a startup," Brilliant says. In the end, Cometa benefited from the intense scrutiny, which forced the execs to focus on a narrow, easily understood subset of the overall wireless market: road warriors who want to stay connected with the corporate office.

While tight money can't guarantee a higher return, it does act as a kind of abrasive, polishing and refining ideas in ways that simply did not occur a few years ago. That has certainly been true for Julio Estrada and his startup, Kubi Software. In a masterpiece of unfortunate timing, Estrada, a respected software engineer from Lotus, incorporated the company on Sept. 12, 2001. Funding Kubi out of his own pocket for the first nine months, Estrada started with a big idea: to use software agents that observe your e-mail inbox and then crawl around your organization and the Web to bring back information related to the projects you're working on. But in the wake of 9/11, customers and investors were in no mood for such an ambitious product. "In a Darwinistic way," he explains, "that skepticism forced us to find the biggest [client] pain and the most cost-effective way of solving it." The redesigned product, which launches in April, is a sophisticated knowledge-management system disguised as a set of cool new e-mail features that can organize chaotic inboxes. The smart crawlers will have to wait for a return to more adventurous times.

If we learned anything from the Internet bubble and the telecom bust, it's this: An overabundance of resources turns the brain to mush. Conversely, privation spurs ingenuity. Starbucks grew out of a single coffee shop. Linux, a computer operating system built largely by volunteer labor, has become the No. 1 threat to Microsoft. So here's some advice for any would-be entrepreneur. Rather than whine about this skinflint CFO or that disbelieving VC, get creative. Find ways to test hypotheses about new opportunities without exposing yourself or your company to undue risk. Pittman is doing precisely that with his startup, Groxis. His software organizes data searches into visual maps, making it easier for users to get a handle on massive data dumps. Rather than selling directly to corporate IT departments, he is attempting to license his innovation to other knowledge-management software firms whose products customers have already deployed.

In the midst of all the hunkering down, we need to remind ourselves that we are still living in a world pregnant with possibility. The hard times will end. Billions of dollars in new wealth will be created. Focus too much on retrenchment, and your company will emerge from the downturn weakened, diffident, and uncertain of its future. Manage this period well, and your company will emerge lithe, impassioned, and raring to go. Those who beat the bear will be ready to ride the next bull.

Gary Hamel is a management strategist and the chairman of Strategos. Erick Schonfeld (eschonfeld@business2.com) is an editor-at-large for Business 2.0.