Executives often issue statements that include catchphrases such as “strategic move”, “enhance our competitive advantage” and so on. What does these words mean? do the executives who use these statements really mean what they say? let’s find out…
This post is highly influenced by a book I read long time ago called The Curse of the Mogul (by Bruce Greenwald). On this post, I briefly touch upon a few types of competitive advantages that companies in any industry may enjoy and also rebuke some myths about sham sources of competitive advantage. As usual, here is the Twitter version (132 characters): “Barriers to entry: scale, customer captivity, cost, government protection. Sham advantages: brand, first mover, deep pockets, talent”
Given my recent interest in a few media companies and deals that are taking place these days, I may write a follow-up post that on that industry and some interesting events that are happening in that industry. But let’s first focus on today’s topic — competitive advantage, this post will set the foundation for later posts about what is happening in the media industry these days.
In business, barriers to entry are required to generate superior returns. If a business earns supernormal returns, sooner or later new entrants will jump on the bandwagon and try to enjoy those returns, intensifying the competition and lowering the returns that are available to all participants. Therefore, only sustainable barriers to entry can support sustainably outstanding performance.
Building on that, the term strategic should be used to describe an activity that creates long-term value for a business if and only if that activity is about establishing or strengthening barriers to entry. Simple, isn’t it? yet how many times have you heard the term strategic used to describe activities that have nothing to do with strengthening barriers to entry? I think that 95% of the times I heard CEOs use this word was to describe activities (usually M&A) that have completely nothing to do with strengthening barriers to entry…
Unfortunately, some businesses operate in industries in which there are no barriers to entry. Those businesses should waste no time talking about strategy and managers of those businesses should focus all their energy into operating as efficiently as humanly possible. No amount of strategic thought can make any difference in some industries. In the early days of Walmart, Sam Walton did not hire consultants to draw a strategy map for his company — he was too smart to do that — so he just focused all his efforts into making Walmart as low cost operation as possible. And it worked pretty well. Efficiency might not sound as sexy as strategy, but in some industries it is the way to go.
There are four types of competitive advantages…
1. Economies of Scale (EOS) is the most common type of competitive advantage. This is not to be confused with merely being big. Unless the business has certain structural characteristics, size can be a disadvantage. First, EOS advantage can arise when a business has a high fixed costs base, in which case, the largest player can spread the fixed costs over large volumes and operate more profitably than competitors. An example for that is P&G’s laundry detergents business, where a huge fixed cost base that is spread across many units produced (in terms of both production and advertising that is required to support sales) makes it almost impossible for new entrants to make inroads into that market. P&G itself used to bleed money when it tried to enter new markets even though it had the knowhow, decades of experience and deep pockets. Second form of EOS is what’s called a network effect. This happens when each consumer makes the product or service more valuable (think Facebook or Craigslist).
2. Customer Captivity advantage may stem from:
- Habit: in the media world think of a soap opera or a TV show you really like, once you got hooked you will probably be very loyal to it. Another example is a cigarette, once hooked, rarely do people opt for another brand.
- High switching cost / search cost: For instance, something has to be really wrong with Yahoo Finance before I will embark on the tedious task of migrating all the watch lists I manually created there over the years to another service. If Yahoo doesn’t make a terrible mistake, I (and many others) will stay captivated.
3. Cost advantage comes in three ways:
- Proprietary technology, like in the case of Qualcomm.
- Path dependent learning curve: think about Google’s index of the web, it takes years over years and a huge investment to build something like that before someone can even dream about competing. Even deep pocketed would-be-competitors such as Microsoft have miserably failed to compete with Google’s search quality. It might take Microsoft years and many billions of dollars in losses just to get to where Google is today and by then, Google will probably be far ahead of the curve because it doesn’t sit idle.
- Access to special resources: an example for this can be seen in ICL’s facilities location at the Dead Sea, which makes it a low-cost producer of Potash. In the commodity business, being a low cost producer is the only competitive advantage that one can enjoy and ICL’s location is an advantage that can’t be replicated by any of it’s competitors.
4. Government Protection: an example for that can be seen in OPAP, a company in which we had invested when debt crisis occurred in Greece. OPAP enjoys a monopoly in most segments of the Greek gambling market and this is guaranteed by the government and is part of it’s operating license. This protects OPAP from potential entrants and creates a barrier to entry that allows the company to command high market share and operate very profitably even at the toughest of times.
Sham competitive advantages
I wouldn’t be able to put it better than Bruce Greenwald, so I will just quote him:
If the universe of genuine competitive advantages is mercifully brief, the catalog of false gods worshipped by some misguided executive or investor is startlingly long.
Here is a list if the most common pitfalls, please feel free to add some stuff on the comments section as this can get really funny:
- Brands: while brands can reinforce one or more of the real sources for competitive advantage, they do not make one in and out of themselves. This can be evident in fashion retail where brands usually become “hot” until they don’t and then the stocks of the companies that own those brands take a nosedive. The reason for that is that there are very low barriers to entry and indeed, many new entreats enjoy their time in the sun, until the sun sets on them.
- First mover: in his book, Greenwald shows a list of companies that were first movers in their fields. The list includes names such as UNIVAC, AltaVista, Visicalc and Nokia. In case you wonder, the list of the current dominant players in those industries is IBM, Google, Microsoft Excel and Samsung, respectively. Being a first mover, in almost all cases, does not set barriers to entry and is not a competitive advantage.
- Deep pockets: businesses that rely on deep pockets have a predictable tendency to empty those pockets over time, or to put it in Richard Branson’s words:
The easiest way to become a millionaire is to start out a billionaire then go into the airline business.
- Talent: here again, Bruce comes up with an amazing example from the media industry. He writes about an artist that was anonymous but his first album turned out to be a big success. The talented artist was signed on a 4-album deal before becoming famous but the record label won’t be able to enjoy the low-cost contract that was signed, or as Bruce Greenwald put it:
If the recording company doesn’t want the second CD to be called ‘Sounds I made in the Bathroom This Morning’ it will renogotiate the deal.
Same is true with “talented managers.” When a talented manager that used to manage a business that enjoys a competitive advantage is thrown into a competitive industry, the result might be ugly. As Warren Buffett puts it:
When a management with reputation for brilliance meets a business with a reputation for bad economics, it is the reputation of the business that stays intact.
How can you tell if a business truly enjoys a competitive advantage?
There are two simple tests to check whether a business you are looking at enjoys a competitive advantage:
- High returns AND
- Stable or increasing market share
Simple, isn’t it?