Competition Demystified, by Bruce Greenwald and Judd Kahn

Bruce Greenwald (born in 1946) is a professor of finance and asset management at Columbia Business School, and the author of several value investing and strategy books.

Judd Kahn is COO of Hummingbird Management, an investment management firm.

Below are the key insights from their book Competition Demystified.

• Barriers to entry (i.e., incumbent competitive advantages) are the most important force. If no forces interfere with the process of entry by competitors, profitability will be driven to levels at which efficient firms earn no more than a “normal” return on invested capital.
• There are two types of competitive advantages: (1) supply-related advantages: lower cost structure (proprietary technology, cheap inputs, learning and experience, economies of scale), government intervention (licenses, tariffs and quotas, authorized monopolies, patents, subsidies, and regulation), and (2) demand-related advantages: customer captivity (habit, switching costs, search costs).
• The most durable competitive advantages arise from the interaction of economies of scale with customer captivity. If an entrant has equal access to customers as the incumbents have, it will be able to reach the incumbents’ scale.
• There are two tests to confirm the existence of competitive advantages: (1) the market share test (stable market shares, less than five large firms, low entries and exits) and (2) the profitability test (after-tax ROIC of of 15-25% or above).
• Most firms operate in markets with no competitive advantages. When there are no competitive advantages, visionary dreams are of little concern, and operational efficiency is the only priority.
• Growth of a market is the enemy of competitive advantages based on economies of scale. As a market grows, fixed costs decline as a proportion of total costs, reducing the advantage of greater incumbent scale.
• It is the share of the relevant market, i.e. the geographic area or product line in which fixed costs stay fixed, rather than size per se, that creates economies of scale.
• Companies that manage to grow and achieve a high level of profitability tend to:
  • Establish dominance in an attractive local niche:
    • Customer captivity,
    • Small size relative to the level of fixed costs,
    • Absence of vigilant, dominant competitors,
  • Defend their dominant position:
    • Respond aggressively to competitive initiatives (price cuts, new products, niches),
    • Improve technology,
    • Produce waves of patentable innovations,
    • Encourage habit formation: advertising, customer loyalty programs, razor/razor blades strategy, cheap initial subscriptions, annual style changes, customer financing,
    • Increase switching costs: extend and deepen the range of services offered, integrate multiple features, increase the importance and added value of products and services,
  • Grow in one of three ways:
    • Replicate their local advantages in other markets (e.g., Coca-Cola),
    • Focus on their product space as it becomes larger (e.g., Intel), or
    • Expand their activities outward from the edges (e.g., Walmart, Microsoft).

Strategy, markets, and competition

What is strategy?

• Strategic decisions are those whose results depend on the actions and reactions of other economic entities. They are outward looking.
• Tactical decisions are ones that can be made in isolation and hinge largely on effective implementation.
• Formulating effective strategy is central to business success. It is also extremely challenging.
• The first strategic issue is selecting the arena of competition, the market in which to engage.
• The second strategic issue involves the management of external agents.

One single force

• While the five forces described by Porter can affect the competitive environment, not all of them are of equal importance.
• Barriers to entry are clearly much more important than the others.
  • If there are barriers, then it is difficult for new firms to enter the market or for existing firms to expand. The existence of barriers means that incumbent firms are able to do what potential rivals cannot, which is the definition of a competitive advantage.
  • If the industry is not protected by barriers, returns will be driven down to levels where there is no “economic profit”. If demand conditions enable any firm to earn unusually high returns, other companies will notice the same opportunity and flood in, causing fixed costs per unit to rise, prices to fall, and the high profits to disappear.
  • Without the protection of barriers, the only option a company has to prosper is to be continually on its toes, and run itself as efficiently and effectively as possible.

Local champions

• Competitive advantages are almost always grounded in what are essentially “local“ circumstances. Companies such as Walmart, Microsoft, or Intel first established local dominance and then expanded into related territories.
• The distinguishing future of most services is that they are produced and consumed locally. As service industries become increasingly important, opportunities for sustained competitive advantage are likely to increase.

Which competitive advantages?

• Strategic analysis should begin with two key questions: (1) Do any competitive advantages actually exist in the market? (2) And if they do, what kind are they?
  • When there are no competitive advantages present, strategic issues are little concern, and the only priority is a relentless focus an operational efficiency.
  • For markets where companies do benefit from competitive advantages, the next step is to identify the nature of the competitive advantages and then to figure out how to manage them.
• There are only three kinds of genuine competitive advantage:
  • Supply. These are strictly cost advantages that allow a company to produce and deliver its products or services more cheaply than its competitors. These can stem from privileged access to crucial inputs, proprietary technology that is protected by patents and/or by experience.
  • Demand. Some companies have access to market demand that their competitors cannot match. These demand advantages arise because of customer captivity based on habit, the costs of switching, or the difficulties and expenses of searching for a substitute provider.
  • Economies of scale. If cost per unit declines as volume increases, because fixed cost make up a large share of total costs, then an incumbent firm operating at large scale will enjoy lower costs than its competitors.
• Most companies that manage to grow and still achieve a high level of profitability do it in one of three ways:
  • They replicate their local advantages in multiple markets, like Coca-Cola.
  • They continue to focus on their product space as that space itself becomes larger, like Intel.
  • They gradually expand their activities outward from the edges of their dominant market positions, like Walmart and Microsoft.

The process of strategic analysis

• When there are no competitive advantages present:
  1. Genuine strategic issues are of little concern.
  2. Operational efficiency is the only priority.
• Where companies do benefit from competitive advantages, the next step is:
  1. To identify the nature of the competitive advantages.
  2. To figure out how to manage them.

The competitive landscape

• In markets in which companies enjoy a competitive advantage, there will be a short list of legitimate competitors. At the extreme, there is one large firm (the elephant) and many smaller ones (ants). Ants should consider getting out as painlessly as possible. Elephants should sustain their competitive advantage, which requires understanding its sources and limits.
• A thorough understanding (1) allows the firm to reinforce and protect existing advantages, (2) distinguishes areas of growth likely to yield higher returns from tempting areas that would undermine the advantages, (3) highlights policies that extract maximum profitability from the firm’s situation, (4) spots likely threats and required countermeasures, (5) enables functional departments to deal with capital budgeting, marketing, M&A, and new ventures.
• In markets in which several companies enjoy roughly equivalent competitive advantages, the firm needs to know what its competitors are doing, but also to anticipate their reactions to any move it makes.
• Several approaches are valuable in developing competitive strategy: game theory, simulation, and cooperative analysis.
  • Game theory is the study of the ways in which interactions among rational players produce outcomes with respect to the preferences of those players. Competitive situations involve (1) players, (2) the choices that are available to them, (3) the motives that drive them, and (4) the rules that govern the game. Most situations can be captured by two games: the prisoners’ dilemma, and the entry/preemption game.
  • In simulations, individuals or teams can be assigned to represent each competitor, be provided with appropriate choices for actions and motives, and play the game several times.
  • In cooperative analysis, players need to think about what the ideal state of affairs would look like, in other words what the market would look like if it were organized as a cartel.
• There are three types of competitive advantage (1) demand, (2) supply, (3) economies of scale.
• There are two straightforward tests to confirm their existence : (1) market share stability, and (2) high return on capital.

Competitive advantages: supply and demand

The differentiation myth

• On its own, differentiation does not eliminate intense competition and low profitability, as shown by the example of US luxury car brands. While imports did not undercut them on price, as would happen with a commodity business, with a wider variety of luxury cars available, their sales and market share went down, causing fixed cost per auto to increase, and profit margin per car to drop.
• If no forces interfere with the process of entry by competitors, profitability will be driven to levels at which efficient firms earn no more than a “normal” return on their invested capital. It is barriers to entry, not differentiation by itself, that creates strategic opportunities.
• Since the market price of a commodity is determined in the long run by the cost levels of the most efficient producers, competitors who cannot match this level of efficiency will not survive. But essentially the same conditions also apply in markets with differentiated products.
• To differentiate their offerings, firms must invest in advertising, product development, sales and service departments, purchasing specialists, distribution channels, and other functions. If they cannot operate all these functions efficiently, then they will lose out to better run rivals (lower prices or lower market share) and earn a lower return on their investments.
• When successful companies expand, the market shares of less efficient firms decline. Even if they can continue to charge premium prices, the returns they earn on their investments in differentiation will fall.
• The need for efficiency when products are differentiated is no less crucial then when they are commodities, and it is more difficult to achieve, as it is both a matter of production cost control, and effectiveness in all the functions that underlie successful marketing.
• Investors in the business need to be compensated for the use of their capital. To be normal, the returns need to be equivalent to what the investor can earn elsewhere, adjusted for risk. Otherwise, investors will ultimately withdraw their capital, and the firm will succumb over a period of years.

Barriers to entry and competitive advantages

• Barriers to entry lie at the heart of strategy. The first task is to understand what barriers are and how they arise. It is important to distinguish between (1) the skills and competencies a firm may possess, which are theoretically available to competitors, and (2) genuine barriers to entry, which are characteristics of the structural economics of a particular market.
• If barriers to entry exist, then firms within the barriers must be able to do things that potential entrants cannot, no matter how much money they spend or how effectively they emulate the practices of the most successful companies.

Entry, exit, and long-run profitability

• Just as extraordinary profits attract competitors and motivate existing ones to expand, below-average profits will keep them away. But it takes less time to add capacity in an industry with above-average returns, than it does to eliminate excess capacity in an industry with below-average returns. Problem is compounded by the longevity of plants and products. Mature, capital intensive businesses such as commodities have durable assets and products, which explains part of their poor performance.
• Barriers to entry and incumbent competitive advantages are alternative ways to describe the same thing.
• Because competitive advantages belong only to the incumbents, their strategic planning must focus on maintaining and exploiting those advantages.

Types of competitive advantages

• Competitive advantages may be due to
  • Superior production technology and/or privileged access to resources (supply advantages),
  • Customer preference (demand advantages).
  • A combination of economies of scale with some level of customer preference (interaction of supply and demand advantages).
  • Governmental interventions, such as licenses, tariffs and quotas, authorized monopolies, patents, subsidies, and regulation.
• Measured by potency and durability, production advantages are the weakest barrier to entry, while economies of scale, when combined with some customer captivity, are the strongest.

Supply advantages: competitive costs

• One way a market incumbent obtains a competitive advantage is by having a lower cost structure that cannot be duplicated by potential rivals, due either to (1) lower input costs or, (2) more commonly, proprietary technology.
• In its most basic form, proprietary technology is a product line or a process that is protected by patents. But patents expire, generally after seventeen years. Thus, cost advantages based on patents are only sustainable for limited periods.
• In industries with complicated processes, learning and experience are a major source of cost reduction. Companies that are continually diligent can move down these learning curves ahead of their rivals and maintain a cost advantage for periods longer than most patents afford.
• But if the technological shifts are swift, they can undermine advantages related to outdated processes. And if they are slow, rivals will eventually acquire learned efficiencies.
• Simple products and processes are not fertile ground for proprietary technology advantages, as they are hard to patent and easy to duplicate and transfer to other firms. This limitation is particularly important in the vast and growing area of services, where technology is either rudimentary or developed by third-parties.
• Cost advantages based on lower input costs are rarer. Labor, capital, raw materials and other inputs are generally sold in competitive markets. Some companies do have privileged access to raw materials, advantageous locations, or exceptional talent, but these tend to be limited both in the markets to which they apply and in the extent to which they can prevent competitive entry.

Demand advantages: customer captivity

• For an incumbent to enjoy competitive advantages on the demand side of the market, it must have access to customers that rivals cannot match. This requires that customers be captive to incumbent firms. Branding by itself (quality image and reputation) is not sufficient to establish this superior access.
• There are only a limited number of reasons why customers become captive to one supplier:
  • Habit. Habit leads to customer captivity when frequent purchases of the same brand establish an allegiance that is difficult to undermine. Habit arises when purchases are frequent and virtually automatic. It is usually local in the sense that it relates to a single product, not to a company’s portfolio of offerings.
  • Switching costs. Customers are captive to their current providers when it takes substantial time, money, and effort to replace a supplier within another one.
  • Search costs. Customers are also tied to their existing suppliers when it is costly to locate an acceptable replacement. They are an issue when products or services are complicated, customized, crucial or involve personal relationships.
• But even these advantages fade over time. New customers, by definition, are unattached and available to anyone. Existing captive customers ultimately leave the scene; they move, mature, or die.

Competitive advantages: economies of scale and strategy

Economies of scale and customer captivity

• The truly durable competitive advantages arise from the interaction of supply-and-demand advantages, from the linkage of economies of scale with customer captivity.
• The competitive advantage from economies of scale comes from the size difference between the firm and its rivals, that is, on market share. But if an entrant has equal access to customers as the incumbents have, it will be able to reach the incumbents’ scale. For economies of scale to serve as a competitive advantage, they need to be coupled with some degree of incumbent customer captivity.
• If the incumbent is not vigilant in defending its market position, the entrant may catch up, making poorly safeguarded economies of scale vulnerable.

Defending economies of scale

• In order to persist, competitive advantages based on economies of scale must be defended, by matching the moves of aggressive competitors: price cut for price cut, new product for new product, niche by niche.
• It is the share of the relevant market, i.e. the geographic area or product line in which fixed costs stay fixed, rather than size per se, that creates economies of scale.
• Growth of a market is generally the enemy of competitive advantages based on economies of scale. As a market grows, (1) fixed costs decline as a proportion of total cost, reducing the advantage of greater incumbent scale, and (2) the hurdle an entrant must clear to become viably competitive is lowered.
• Most competitive advantages based on economies of scale are found in local and niche markets, where either geographical or product spaces are limited and fixed costs remain proportionately substantial.

Strategy and competitive advantage through supply or demand

• Prescriptions for strategy depend on the existence and types of competitive advantages that prevail in it.
• Where there are no competitive advantages in the market, the firm should forget visionary dreams and concentrate on running itself as effectively as it can.
• Where a company enjoys advantages related to proprietary technologies or customer captivity, its strategy should be to both exploit and reinforce them where it can:
  • Improve technology continually, and produce successive waves of patentable innovations,
  • Encourage habit formation (i.e. repeated, virtually automatic and nonreflective purchases) to discourage customers from carefully considering alternatives (customer loyalty programs, razor/razor blades strategy, inexpensive initial subscription)
  • Increase switching costs (extend and deepen the range of services offered),
  • Make the search for alternatives more complicated and difficult (integrate multiple features, increase the importance and added value of products and services).
  • For expensive items, make purchases more frequent (annual style changes) and spread payments out over time (customer financing, leasing).

Strategy and economies of scale

• Where a firm enjoys advantages related to economies of scale, the best course is to (1) establish dominance in an attractive local niche market (characterized by customer captivity, small size relative to the level of fixed costs, and the absence of vigilant, dominant competitors), (2) defend it by responding aggressively to competitive initiatives or take the first step (advertising, R&D to accelerate the product development cycle, capital expenditures to automate production), and (3) expand outward from it.

Assessing competitive advantages

Three steps

• There are three basic steps to assessing whether a firm benefits from a competitive advantage.

  

• Identify the competitive landscape. Which market is it really in? Who are its competitors in each one? Develop an industry map identifying the market segments, and the leading competitors in each segment.

• Test for the existence of competitive advantages in each market. Do incumbent firms maintain stable market shares? Are they exceptionally profitable for a substantial period? Determine the list of top firms (more than five likely signals the lack of barriers to entry), the absolute share change over 5-8 years (<2% indicates high barriers, >5% no barriers), the history of the dominant firm, the history of entry and exit, and profitability (ROIC, ROE, ROA or adjusted operating margins) over at least a decade in the relevant business (after-tax ROIC of 15-25% are evidence of competitive advantages, after-tax ROIC of 6-8% generally indicate their absence). When the analysis of market share stability and profitability are consistent with one another, the case for the existence of competitive advantages is robust.

  

  

• Identify the likely nature of any competitive advantage that may exist. Do the dominant firms have proprietary technologies or cheap resources? Do they have captive customers, thanks to consumer habit formation, switching costs, or search costs? Are there significant economies of scale in the firm’s operations, combined with some degree of customer captivity, or network effects? Do incumbent firms profit from government intervention, such as licenses, subsidies, regulations, or some other special dispensation? If the analysis fails to find clear identifiable advantages, the likely explanation is that the market share and profitability figures are temporary or that they are a consequence of good management (operational effectiveness) that can be emulated.
• To keep the analysis manageable, move one step at a time. Begin with one force (potential entrants / barriers to entry), not five. Start simply and add complexity later. Whenever things become confusing, step back and simplify again. Finally, think local.

Local economies of scale

Walmart case study

• In four decades, Walmart rolled out of small towns in Arkansas to become the largest retailer in the world. It has managed to combine sustained growth with sustained profitability in one of the most competitive industries.
• Industry analysis. Retailers sell directly to household consumers, and are supplied by manufacturers (which range from national brands, to contractors who produce private label products for the retailers, to small local suppliers of nameless merchandise). Walmart sells a broad range of goods, and competes on some products with virtually every other retailer. Its competitors are numerous.

  

• Comparative performance over time. Walmart outperformed competition both in terms of operating margins and return on investment capital, with peak profitability in the mid-1980s. It had (1) a higher cost of goods sold as a percentage of sales, because of lower prices (4 points), but offset this with (2) much lower overhead costs (7 points), as management ran a very tight ship and enjoyed local economies of scale with customer preference.

  

  

  

• Competitive advantage. Walmart enjoyed a competitive advantage based on the combination of economies of scale and customer captivity, both on a regional basis. The high density of stores enabled lower inbound logistics costs, lower advertising expenses, and a closer managerial oversight and supervision. As it expended across the country and overseas, it was unable to replicate local economies of scale and customer loyalty, thereby causing lower operating margins and ROIC.
• Operational efficiency. Good management kept overhead substantially below industry average, due to (1) early adoption of technologies (barcode scanning, requiring an investment of $500,000 per store, merchandise planning software, machinery to automate warehouse operations) and (2) efficient HR management (solicit opinions of employees on what goods to carry and how to display them, incentive programs to reward store managers for exceeding profit targets, lower rate of pilferage and shoplifting by sharing reductions with employees) leading employees to endorse Walmart as a good place to work.
• Insights: (1) Efficiency always matters, (2) Competitive advantages matter more, (3) Competitive advantages can enhance good management, (4) Competitive advantages need to be defended.

Coors case study

• Coors. In 1975, Coors, which operated one enormous brewery from which it sold its beer in Colorado and ten neighboring states, and was different in other ways (integrated operations, labor force not unionized, emphasis on operating control and efficiency, draft-like quality taste), earned $60 million on sales of $520 million, i.e., an 11% net profit margin. Anheuser Busch, which served a national market from ten breweries spread across the country, earned $85 million on sales of $1.65 billion, i.e. a 5% net profit margin. By 1985, Coors had expanded into 44 states, and doubled sales, but margins had fallen to 4%, leaving earnings below 1975; by contrast, AB’s sales had increased fourfold, and margins had improved from 5% to 6%. In 2000, Coors earned $123 million, a 5% net profit margin, while AB earned $1.5 billion, a 12% net profit margin.

  

• The beer market. Between 1945-1985, beer consumption increased at a rate of 3% p.a., compared to a 2.5% population growth. The market share of the top 4 players increased from 20% to 70%: local beer makers, which sold their output in kegs to bars and restaurants, were pushed aside by regional and national firms as (1) home consumption and TV advertising developed, (2) advances in packaging technology raised the size of an efficient integrated plant, and (3) segmented brands came out. The two big winners were Miller (20% share in 1985 vs. 6% in 1965) and AB (37% share in 1985 vs. 12% in 1965). Coors’s market share remained stable at 8%.
• Coors differences: (1) Coors was highly integrated, but this did not produce a significant cost advantage, (2) it operated a giant plant (16 million barrels of annual capacity) but with the efficient brewery size around 5 million, and an increased transportation costs, scale advantages did not materialize, (3) unpasteurized draft-like beer meant a shorter shelf life and added costs to keep the beer cold and the facility sterile, while the mystique about Coors did not convert into higher prices. As it expanded from 11 to 44 states, Coors had to (a) settle for weaker wholesalers, and (b) ratchet up its marketing and distribution expenses. In hindsight, the decision to go national seems like a major error. Coors might have fared better had it concentrated on its three strong regions.

  

  

Niche advantages and the dilemma of growth

The PC market

• IBM introduced its PC in 1981. To speed up development, it adopted an open architecture, buying off-the-shelf components from other companies (including a CPU from Intel and an operational system from Microsoft) and operating without patent protection. IBM’s endorsement of MS-DOS and the Intel chip established standards in an anarchic environment, enabling software developers to offer better programs. IBM was soon joined by other PC manufacturers.
  • Compaq was started in 1981 with a plan to sell a computer compatible with IBM but of higher quality, to corporate customers and at premium prices.
  • Dell and Gateway 2000 popularized the direct sales channel.
• The PC industry. Industry sales grew from $30 billion in 1986 to $159 billion in 1995, i.e. a 23% CAGR, as the machines became more powerful, more useful, and less expensive. The absence of barriers to entry (footloose customers, widespread access to multiple channels of distribution, simple and commonly available technologies, relatively low investment requirements, and limited economies of scale) ensured that the players arrived and competed aggressively for customers. The large number of manufacturers (box makers) and the shifting market shares are strong indications that this was a highly competitive industry with ease of entry and ease of exit.
• Competitive advantages. The only segments within the PC world with features suggesting that there are barriers to entry are operating systems and CPUs (small number of competitors and stable market share).
  • Customers prefer to stick with what they know, especially regarding software.
  • Intel devotes major resources to production technology, aggressively defending patents and developing its expertise to keep yields high and defects low.
  • The most important advantage is economies of scale. Because they can spread their investments over millions of units, Microsoft and Intel are by far the lowest-cost producers.
  • Network effects enhance both customer captivity and economies of scale.
• By contrast, the box maker market is highly competitive:
  • Long and shifting list of players, with firms entering and leaving regularly, and top 20 firms rarely accounting for more than 60% of the market.
  • Purchases not frequent enough to be habit-forming.
  • No switching costs to buying a different brand.
  • No technological advantages (assembly).
  • No high-fixed-cost/low-marginal-cost structure that gives rise to economies of scale.
• Compaq. In the early years, Compaq’s “do it ourselves” approach was a success. A few years later, that advantage had disappeared: as the market grew, specialized component makers were making cheaper and more qualitative products. Compaq had lost its competitive advantage and the resulting high levels of profitability as the markets grew and allowed competitors to develop equivalent economies of scale. The company then decided to pursue the only strategy that makes sense in the absence of a competitive advantage: the determined pursuit of operational efficiency. For a time, the approach was successful, but Compaq embarked on hard to digest acquisitions, lost its focus on operational efficiency, and was eventually sold to HP.
• Apple operated, either by itself or in partnership with Motorola, in five market segments within the PC universe. In none of these segments did Apple possess a competitive advantage. Apple, alone among the major box makers, used its own operating systems (text-based system for its Apple II line and graphical user interface operating system for its Macintosh line), and manufactured or designed all of the important components and peripherals that made up a complete personal computer system. Macintosh machines had devoted users due to important advantages compared to PCs: (1) easier to use (intuitive interface), (2) plug-and-play compatibility with printers and peripherals, (3) easier to network, (4) superior for graphics applications. They also faced disadvantages: (1) more expensive, (2) underpowered, (3) limited inroads in the corporate world and thus (4) fewer packaged application programs.

  

  

Production advantages lost

• What matters in a market are defensible competitive advantages, which size and growth may actually undermine.
• Philips is a Dutch conglomerate with a long history in consumer electronics (they had pioneered the audiotape cassette). In the late 1960s, its engineers were impressed with the promise of laser scanning combined with digital encoding of audio and visual content. In 1979, they were active in two segments of the music industry: audio components and record production (50% stake in Polygram). Executives saw the compact disc as an opportunity if two obstacles could be overcome: (1) standards (collaboration with Sony), and (2) price-cost of the CD. Philip’s effort to be a pioneer worked out well for consumers, but not so much for Philips: (1) it never established customer captivity (large and sophisticated customers, no need for support), (2) it never benefited from economies of scale advantages (plant and equipment were a once-and-for-all expense, the CD market became large relative to the efficient plant size of 2 million discs per year).

  

• Cisco was founded in 1984 by engineers at Stanford who wanted to send e-mails to one another. They developed the router, that could tie together disparate computing systems operating within an organization. There were other competitors almost from the start, but Cisco was always the largest, most profitable, and fastest-growing. Sales grew from $70 million in 1990 to $19 billion in 2000 (60% CAGR), average pretax ROIC was 142%, and market cap grew from $350 million to $450 billion (90% CAGR). Cisco’s market had two elements missing from the CD market: (1) substantial customer captivity (driven by complexity) and (2) economies of scale (high software content and attendant high-fixed costs for its routers). As the performance of routers improved rapidly, Cisco’s larger market share gave it a powerful economies of scale advantage over its competitors in writing the software code and designing upgraded models of the router. Having access to a stable base of customers who made up most of the market for routers, Cisco was in a position to disseminate new technologies far more efficiently than its competitors. This privileged position meant that Cisco could afford to spend more than its rivals to acquire that technology, whether through higher R&D spending or the acquisition of smaller competitors. Cisco pursued both courses aggressively. Thanks to its economies of scale advantages in distribution, maintenance, and R&D, Cisco was able to extend its franchise beyond its original router competence to LAN switches. By the late 1990s, the market for enterprise networking systems had become relatively mature. For Cisco, the natural move was to get into “carrier class” customers, i.e. telecom service providers, fiber-optic carriers, and internet service providers. But (1) there were entrenched competitors, (2) customers were big and sophisticated, (3) as a new entrant, Cisco had no captive customers, (4) without an established customer base, it had no economies of scale in distribution or service support, nor in R&D. In 2001, Cisco reported a $2 billion operating loss. Management cut costs, pulled back from the parts of the carrier business where it operated at a disadvantage, and restored margins.

Games companies play

• For markets where there are no competitive advantages, the only strategy is a relentless focus on operational efficiency. For markets with competitive advantages, the strategic challenge of dominant firms is to sustain and extend their competitive advantages. In markets in which a few firms enjoy competitive advantages, strategic success depends on the deft handling of conscious mutual interactions among firms, which can encompass both competition and tacit cooperation.

  

The prisoners dilemma game

• The essential dynamics of most competitive interactions revolve around one of two issues: price or quantity. Of these, price competition is the most common form of interaction among a small number of competitors.
• The essence of price competition among a restricted number of companies is that although there are large joint benefits to cooperation in setting high prices, there are strong individual incentives for firms to undermine this cooperation by offering lower prices and taking business away from the other competitors.
• Competition can take many forms other than cutting prices, such as enhancing product features, offering longer warranties or discounts, advertising, resources (e.g. sales force).
• Equilibriums depend on two conditions: (1) Stability of expectations, (2) Stability of behavior.
• Despite the incentives to deviate and the ease with which competitors arrive at a negative equilibrium, there are steps that can be taken to reduce the impact of the prisoner’s dilemma, if not eliminate it entirely.
  • Structural adjustments: for these adjustments to be successful, all the firms involved must agree to play by these rules. (1) Occupying separate and distinct niches in the market. (2) Customer loyalty programs (if properly designed). (3) Limit output capacity in the market. (4) Adoption of pricing practices that raise the cost to any firm that lowers its prices (e.g. MFN provision). (5) Agreement to limit purchasing and pricing decisions to a specific and narrow window in time. (6) Social interactions within an industry. (7) Basic reward system focused on profits (vs. sales growth or market share gains).
  • Tactical responses: (1) Immediate and automatic reaction to a competitor’s price reduction, preferable by being selective (match the cuts for better customers while letting the marginal ones escape, pick a market where the intruder is large and the incumbent small). (2) Simultaneous signal of a willingness to return jointly to higher prices (public attitude stressing the welfare of the industry, announcement of actual price increases.
• Customers of companies in a cooperating industry should (1) seek private, nontransparent price arrangements, (2) deal with suppliers individually, offering to concentrate their business with those who defect on price or features, (3) cooperate with other large customers to undermine industry cooperation.

Coke and Pepsi case study

• The following case study illustrates that the urge to grow, to hammer competitors and drive them out of business, or at least reduce their market share by a meaningful amount, has been a continual source of poor performance for companies that do have competitive advantages and a franchise, but are not content with it.
• The soda market. Suppliers of raw materials and operators of retail outlets are not integrally related to soda companies. By contrast, bottlers and distributors are joined to soda companies at the hip (shared advertising and promotion). Bottling is the part that demands the most capital investment.

  

• Competitive advantages. The presence of barriers to entry and competitive advantage is confirmed by two indicators: (1) Stable market shares, and (2) High operating margins and ROIC. The sources of these advantages are the following: (1) On the demand side: customer loyalty, (2) On the supply side, large economies of scale at the concentrate-maker and bottler levels (fixed costs of product development and advertising) and regional economies of scale in distribution (the more customers in a given region, the more economical).

  

  

• Competitive initiatives and responses. While Coca-Cola and Pepsi-Cola had similar origins, the former was more successful during the first 50 or 60 years. In the 1930s, Pepsi doubled the size of the bottle at constant price; in the 1950s, it introduced larger, family-sized bottles sold in the newly popular supermarkets; in the 1960s, it focused on younger drinkers, who had not yet developed the habit of ordering Coca-Cola (pop music stars, concert sponsoring) and ridiculed Coke as the old folks’ drink; by 1975, Pepsi outsold Coke in food stores for the first time. Until then, Coca-Cola’s primary strategy was to deny its rival’s existence.

  

• In 1977, faced with eroding market share and decreasing operating margins, Coke initiated a price war to regain market share, but chose a mistaken way: it lowered concentrate prices in the regions where its market share was high (80%) and Pepsi’s low (20%), thus ensuring it would surrender $4 for every $1 Pepsi gave up, and where the Coke bottler was company-owned while the Pepsi bottler was an independent franchisee. Pepsi had no choice but to support the bottler with its own price cuts.
• Both companies introduced new drinks (diet, decaffeinated, other flavors) and battled for shelf space. As both activities benefited from economies of scale (development costs, advertising campaigns, local scale economies in direct delivery), the proliferation of varieties and superior service allowed them to capture market share at the expense of smaller players.

  

• By 1985, Coca-Cola, concerned by Pepsi’s forays into younger customers (attracted by its sweeter taste) and food stores, substituted its main drink by a sweeter version, New Coke. After an outpouring of protest, the old recipe was back. The fisaco ended up providing Coke with a new weapon (New Coke) to compete in the sweeter/younger segment of the market.

  

• The companies changed strategies and, under the stewardship of Calloway at PepsiCo and Goizueta at Coke (both focused on ROE rather than market share) entered a cooperative relationship, which helped increase their operating margins.

  

• Their successors Enrico and Ivester unsuccessfully returned to the cola war.

Fox Broadcasting

• The broadcasting industry. The government licensed, but did not own, the airways. The ultimate revenue stream came from advertisers, who bought time in which to air commercials. The production of content was split among the networks and local stations (national and local news, sporting events, shows) while the major prime time entertainment pieces were purchased from movie studios. The networks paid producers 80-90% of their cost, and the producers recovered their cost and earned a profit by selling rerun rights to syndicators. Government regulators prevented networks from reaching more than 25% of the population through their “owned and operated stations”, so they struck “affiliated” deals with local stations.

  

• Competitive advantages. The presence of barriers to entry and competitive advantage in the network segment is confirmed by two indicators: (1) Stable market shares (among the top 3 networks), and (2) Exceptional ROIC (120-130%) driven by 12-13% operating margins combined with limited capital requirements (ads sold before the start of the season, no inventory, limited PP&E). Competitive advantages stemmed from: (1) Customer attachment (successful shows developed a loyal following), (2) Government regulation (limited number of VHF licenses issued, regulated costs paid to AT&T to transmit the programs), (3) Economies of scale (fixed programming costs, network distribution costs, local production costs, advertising costs). The networks made a lot of their money from the ownership of local stations, which were like tollgates on the road advertisers needed to travel. By contrast, there were no barriers to entry in the production segment (new players emerged all the time, thanks to the allure of the entertainment world).
• Competition. The three networks were headquartered in New York City, had backgrounds in radio broadcasting, and did not undercut each other on what they would charge or pay: (1) Advertising arrangements: networks took care never to offer selling time at discount prices (most ad time was prebought under long-term contracts, during a limited time period which restricted bargaining; supply was restricted by limiting the number of advertising minutes in prime time; if actual viewers fell short of estimates, networks made good by offering more slots at no charge; if there was not enough demand, networks ran ads for their own shows or broadcast public service announcements), (2) Purchasing programs: networks did not compete aggressively for new shows (program ideas were shopped during a 2-week period) nor tried to woo established programs from one another, (3) Local station affiliations: networks did not steal each others’ affiliated stations and regulation only permitted one affiliate per network in a given market.
• Fox. In 1985, Robert Murdoch announced that he was going to form a fourth television network, alongside ABC, CBS, and NBC. He had to make them realize that letting him enter peacefully would serve them better than a scorched-earth defense. (1) Local stations: His first move was to buy 6 independent stations as a base, and to sign affiliates in the rest of the country, without trying to steal the other networks’ affiliates. (2) Advertising: He agreed to limit the number of advertising minutes for each half-hour of prime-time broadcasting, establishing his price per rating point 20% below other networks, a marginally aggressive discount. (3) Programming: Fox ran programs the other networks had rejected or were not likely to run, went down-market, and targeted and a teenage and youth audience that had no established viewing habits. The networks did not try to kill Fox Broadcasting and Murdoch succeeded in establishing itself as the fourth network where previous entrants had failed. Over time, the environment changed and became more competitive (regulation loosened, subscription cable channels grew in number and appeal, satellites lowered the cost of distribution to local stations, syndicators bought first-run programming, the remote control and VCR enabled viewers to switch channels and avoid advertising).

Entry/preemption games

• After price competition, the other commonly occurring competitive situation involves the decision to enter a market or to expand in an existing market, the essential competitive actions concerning output levels and production capacities.
• The differences between price and capacity competition are the following: (1) expanding capacity requires a significant lead time and is long-lasting, (2) mistakes have enduring consequences, incentives for an aggressive reaction to an entrant’s initiative are reduced.
• The decisions can be represented in a decision tree:
  • The outsider must decide whether to enter the market or stay out.
  • If entry occurs, the incumbent has to decide whether to accept the entrant or attack it.
  • If the incumbent resists, the outsider must decide whether to retreat, advance, or back out.
  • Each outcome has a payoff, and it is possible to rank the various courses of action.
• To avoid an attack by the incumbent, the newcomer wants a strategy that will make it less costly for the incumbent to accommodate than to resist: (1) Avoid head-to-head competition (target different customers), (2) Proceed quietly, one step at a time (no brash public announcements, reassuring signals showing limitations on capacity, financing, advertising reach or product lines), (3) Move by a single player (not the first of many) in a single market (not all the ones incumbents dominate), (4) Spread the impact widely with small inroads (little damage to several incumbents vs. severe injury to only one of them), (5) Difficult to reverse move to signal that the newcomer is in for a long and costly fight if the incumbent tries to crush it (large upfront investment and hefty fixed costs vs. subcontracting).
• Incumbents must be more careful as they have more to lose: (1) Deter entry by its general attitude and posture. (2) Preemptive ferocity: maintain large excess capacity, prepare advertising and sales teams to meet any competitive incursion, product line and geographical coverage leaving few uncovered niches, convey a deep commitment. (3) Punish the newcomer as severely as possible at the lowest possible cost to itself, especially in the entrant’s home markets.
• Unoccupied territories. These are potential sites for an entry/preemption game, but without the role assigned to incumbent or entrant. As such, they often turn out to be lawless frontiers.

General principles to analyze competitive interactions

• Organize the relevant information systematically: (1) Who are the competitors, (2) What range of actions are available to them, (3) What do the outcomes and payoffs look like, (4) What are their motivations, (5) What is the likely sequence in which decisions will be made.
• Lay it out in a tree or matrix form, or simulate competitive interactions.

Kiwi case study

• The airline industry. At the core are carriers, which fly aircraft manufactured by a few airframe companies (three firms manufacture large aircraft, a few others smaller planes for shorter routes). Airlines take care of maintenance, baggage handling, and ticketing, while other elements for the flight (catering, deicing, fueling) are provided by specialized service companies. Financing is provided either internally, or by lenders or leasers. Airlines fall into several categories: large seasoned companies (United, American, Delta), regional / local players (Southwest). They distribute tickets through travel agents, corporate travel departments, and directly to passengers. Some players are able to harvest advantages through their computerized reservation systems. Local authorities control the airports and the allocation of gates.
• Competitive advantages. There are no substantial barriers to entry protecting the airline industry as a whole: existing firms disappear, new ones enter, and the operating margins and ROIC of the leading carriers reflect intense competition. At the local level however, the combination of customer preference (travelers’ first call will be to the carrier with the most flights to the most destinations and the most convenient gates) and local economies of scale (centralized maintenance; better deployment of crew, ground staff, and airplanes; targeted advertising and promotion) create a competitive advantage for carriers dominating a hub.

  

• Kiwi. The company was founded by former pilots. They chose Newark as their center of operations because competition was less intense, and began flying in 1992 with two used leased planes operating on three routes. In order not to antagonize established carriers, Kiwi (1) chose to spread the pain around (choice of routes), (2) aimed at a non-core segment (small business travelers), (3) avoided challenging them directly on price (aligned to the lowest fare the competition was offering), (4) provided enhanced service (unrestricted tickets requiring no advance purchase, lower number of seats per plane, hot meals), (5) did not promote itself in the public media, and (6) did not poach personnel from existing airlines. It leased its planes at bargain rates (glut), and substituted skillful PR for expensive advertising, thus aiming for a much lower cost structure than incumbents. While its entry strategy was well designed, the disciplined approach could not be sustained with growth and Kiwi filed for bankruptcy in 1992: (a) larger and more complex routes led to higher costs without enhancing appeal to customers, (b) growth undermined operating efficiency, (c) an influx of new entrants (attracted by cheap aircraft available for lease, supply of laid-off pilots, and continuing labor-related problems of majors) forced incumbents to respond by lowering prices.

Kodak case study

• Kodak, founded in the 1880s, came to dominate the amateur photography business. It thrived on innovation, and could outspend its rivals on R&D to upgrade the quality of the films. It was hugely profitable (pretax operating margins of 25% over 1950-1975; pretax ROIC of 33% in 1975) and a member of the Nifty Fifty, In the 1970s, facing a saturated market and pressure to grow, it decided to enter photocopiers (dominated by Xerox) and instant photography (dominated by Polaroid). Both investments turned out badly, especially the decision to challenge Polaroid.

  

• Polaroid was devoted to instant photography, which paid off handsomely in terms of sales, operating profits, and valuation multiples (it was a part of the Nifty Fifty). The company owned the entire market, and its pretax ROIC averaged 42% over 1960-1975. Polaroid benefited from (1) Customer captivity (once customers owned Polaroid cameras, they had to buy Polaroid film; more importantly, the cameras were simple to operate), (2) Proprietary technology (complex technology, protected by know-how and patents), (3) Economies of scale.

  

• Kodak did not consider a strategy of restrained entry, and instead came in with trumpets blaring. Its cameras and films were no better, it experienced production difficulties, which delayed the introduction of some models. Customers drawn into stores by heavy Kodak advertising turned to Polaroid because of empty shelves. Polaroid introduced new models, improved relationships with retailers, and brought suits against Kodak. By 1978, Kodak had 35% of the market, but the venture was unprofitable. It exited the market in 1986, and paid Polaroid c.$900 million in damages. In the copier business, Kodak invested heavily, had an early burst of success, but lost ground as Xerox responded. Pretax ROIC declined both for Kodak and Polaroid. Kodak consistently misunderstood its own competitive advantages and those of the companies it decided to challenge. While management attention and resources were being consumed, it failed to protect the core business it did dominate (photographic paper and film) losing ground to Fuji.

  

Cooperation

• When there are several firms operating within the barriers, all equipped with competitive advantages, opportunities for the exploitation of mutual benefits becomes an important issue for strategy.
• The cooperative perspective focuses on outcomes: what overall level of rewards are possible (through optimizing an industry) and how they are to be allocated among participants (through the principles of “fairness”).
• Maximizing the attainable joint rewards. This is concentrating first on the size of the pie (fully exploiting joint gains) rather than on how it is divided (getting as big a piece as possible). Effective cooperation has to manage pricing, capacity, cost discipline, R&D, product line management, advertising and promotion, risk, etc. Firms can improve their profit margins by operating in niches with few direct competitors. Most efficient firms should have priority over highest cost producers. Comparative ads and sales calls to competitors’ customers should be avoided. Overhead efficiencies can be achieved by outsourcing to specialists.
• Dividing the gains in rewards according to the principles of “fairness”. A stable outcome depends on fairness. If cooperation is to be sustained over any extended time, then all the participants have to feel that they are being treated fairly in the division of the rewards. (1) No firm in a cooperative arrangement should receive less than it could obtain in a noncooperative setting (individual rationality). (2) Firms that look essentially the same should divide the benefits of cooperation equally (symmetry). (3) Shares of a cooperatively exploited horizontal market should be assigned in proportion to the cooperating firms’ relative economic positions (linear invariance).

Cooperation dos and don’ts

• Nintendo. The firm entered the market for home video games in the mid 1980s, and succeeded largely by improving the quality of the games available. Once the Nintendo system had established a substantial installed base, more outside software companies wanted to write games for it, which made the console more popular, meaning even more games. The virtuous circle extended to retailers as well as game writers. Nintendo was still vulnerable, as its virtuous circle rested on two advantages that turned out to be less solid than Nintendo assumed: (1) the enormous installed based of Nintendo’s console: this advantage would be wiped out by each new generation of technology, (2) the cooperative relationship between Nintendo, the game writers, and the retailers: Nintendo treated retailers and game writers poorly, which paved the way for Sega and other competitors. Nintendo went from a company with a dominant position in an industry and a high return on capital to one competitor among many with at best ordinary returns on investment, in large part because it did not play well with others.

  

• Gasoline additives. This industry sold a commodity product, with limited economies of scale, substantial overcapacity, a declining demand, bad press, and bad marks from government agencies, yet earned exceptional profits. By putting the industry on a certain path to extinction, the EPA ensured that the existing firms would have the business to themselves, to profit as best they could during the slow path to disappearance. Players found ways of working together to keep in check what otherwise might have been brutal competition: (1) Uniform pricing, (2) Advance notice of price changes, (3) Most-favored-nation pricing, (4) Joint sourcing and producing. Even when barred from using some of the specific tactics the additive makers had employed to curb their own competitive juices, they continued to be masters of the prisoner’s dilemma game.
• Sotheby’s and Christie’s. Though they dominated the auction markets for fine art, the two leading auction houses were mediocre businesses. The volatility of the market combined with high fixed costs left them vulnerable. To induce sellers to put their items up for auction, and to try to attract business from one another, they lowered their seller’s commission, offered advance loans, printed elaborate catalogs, gave lavish parties, and donated money to their sellers’ favorite charities. In 1992, the firms colluded to ensure they would not (1) undercut one another on the commission rate offered to sellers, (2) poach key staff members, (3) offer below market rates on advance loans. Despite their illegal agreements, they were ineffective at cooperating to sustain profitability. The key to continued success was restraint on competition, which required primarily that they stay out of each other’s way.

Valuation from a strategic perspective

Strategy and valuation

• Strategic insights are rarely integrated effectively into the investment decision process, which impairs the quality of the analysis.

Shortcomings of NPV

NPV has three main shortcomings:

• It includes unreliable information (long-term cash flow estimates).
• It omits assumptions that can be made with more certainty (strategic assumptions about competitive advantages).
• It omits the assets employed by the company to create cash flows.

A strategic approach to valuation

1. Calculate asset value.
   1. Calculate the value of the assets. If the industry is not viable, assets should be valued at their liquidation value. If the industry is viable, assets should be valued at reproduction cost: (1) cash and marketable securities at reported value, (2) accounts receivable at slightly higher than accounting book value (receivables are loans to customers, some of which will not be repaid), (3) inventory at the cost of producing equivalent amounts, (4) PP&E at the cost of producing equivalent facilities from the cheapest source, either newly created or secondhand, (5) intangibles such as customer relationships, organizational development, workforce acquisition and training, and product portfolios at the cost of producing them efficiently (e.g. cost of a product portfolio at the R&D expenditure necessary to produce from scratch).
   2. Deduct non-interest bearing current liabilities, such as accounts payable, accrued expenses, and taxes payable within the year.
   3. Deduct excess cash (in excess of 1% of revenue).
2. Calculate current earnings power value (EPV).
   1. Calculate earnings power, i.e. the sustainable average cash flow that can be extracted from the firm’s current operating situation, assuming no growth or deterioration in the future. (1) Start with operating earnings. (2) If non-recurring items appear regularly, calculate their average level over a period of years. (3) Adjust earnings for cyclical variations, by applying average operating margins over a period of years to current sales, and if sales are also sensitive to the cycle, by adjusting them to an average level too. (4) Deduct economic depreciation, i.e. maintenance capital expenditures. (5) Adjust for special circumstances: money-losing operations, unexploited pricing power, consolidated subsidiaries. (6) Apply an average sustainable tax rate.
   2. Divide earnings power by the weighted average cost of capital. For the sustainable ratio of debt to total capital, use the lower of two figures: the amount of debt that the firm can carry without seriously impairing its operating performance, or the firm’s historical average debt level. To compute the cost of equity, use the observed return on equity investments of comparable risk. The cost of debt should be after-tax.
3. Compare asset value with EPV (franchise value).
   1. If EPV exceeds the asset value, it means that the current level of earnings power is creating value in excess of the reproduction cost of the asset, which is not sustainable unless there are barriers to entry. The difference is the value of the current level of competitive advantages, or “franchise value”.
   2. If asset value and EPV are approximately equal, it is likely that the firm does not enjoy significant competitive advantages. If an analysis confirms that market share is unstable, that no firms are earning extraordinary returns in capital, and that there are no identifiable source of competitive advantage, then we have an uncontested estimate of value.
   3. If asset value exceeds EPV, then the only possible source of discrepancy is deficient management. The critical issue is what can be done to improve or replace management.
4. Incorporate the value of growth.
   1. When growth is good, i.e. EPV exceeds asset value and there are identifiable and sustainable competitive advantages, a full NPV analysis can be useful to estimate the value of the enterprise including growth and thus determine the “growth” layer of value.
   2. When growth is neutral, it is appropriate to leave it out of the valuation.
   3. When growth is bad, the more energetic management is in pursuing growth, the more value it will destroy.
5. Apply a margin of safety between market price and value.
   • Successful value investors require a gap between price and fundamental value.
6. Apply the same method for investment projects.
   • The early investments constitute the asset value of the project, and the subsequent income flows constitute the earnings power value including growth.
   • Any excess of EPV over asset value must be justified by identifying sustainable competitive advantages.
   • Without competitive advantages, investments will generally return the cost of capital, meaning they will not add any value for the existing owners.

Corporate development and strategy

Mergers and acquisitions

• Standard acquisitions involve a concentrated investment at above market prices (premium, pro-cyclical nature of M&A), with high transaction costs (hefty fees of investment bankers).
• In strategic acquisitions, the buyer has to bring something to the combined enterprise, either of general value (e.g. improved management, tax advantage) or specific (e.g. special industry-related technology, joint economies of scale, marketing position within the industry).
• Unrelated acquisitions, those of firms outside the acquirer’s principal area of business, have shown especially poor results.
• Porter identified three traits in the combinations that worked: (1) the target company has to be in an “attractive” industry (profitable, fast-growing, etc.), (2) there have to exist synergies between the operations of the acquirer and the target, (3) the acquisition premium can be no more than these synergies were worth.
• If the firm being acquired enjoys no competitive advantages, then synergies are unlikely. Not all competitive advantages foster synergies: customer captivity does not travel well, leaving cost savings as the main source of synergies.
• Many acquisitions are justified by the claim that the superior management of the acquiring company will improve the operations of the target company (payroll cost will be reduced by eliminating the target’s managers, there will be additional cost reductions). The acquisition process itself being an enormous devourer of management attention, productivity improvements at the target may come at the expense of deterioration at the acquirer.
• If a proposed transaction makes no business sense if done with cash, the only reason for doing it with stock is that the acquirer’s shares are overvalued.

Venture capital

• Even new industries with enormous promise can be sinkholes for venture investments if there are no barriers to entry.
• According to conventional wisdom, success in venture capital investments depends upon two factors: the quality of the business plan and the capabilities of the venture team itself.
• Plans that rely on general features, like identifying large markets and describing potential competitive advantages, are unlikely to pinpoint genuinely attractive opportunities. There are many smart venture capitalists and no barriers to entry in generating business plans. Crafting a successful business plan requires a thorough knowledge of the industry and a dense network of industry contacts, both attributes of venture investors. The sponsor should be able to modify and refine the business plan to target those niches in which there is the greatest probability of success.
• An accomplished venture sponsor should also (1) be able to assess the quality of a venture’s management team, and (2) have a network of contacts that include (i) skilled professionals who can be recruited to fill in gaps in the original team, (ii) potential customers who can help refine the venture’s product offerings, and (iii) firms that can provide special facilities or other essentials that the venture needs to deliver its offerings.
• Venture sponsors are ultimately in the knowledge business. They have to create and maintain information collection networks. They bring together knowledge of technologies, markets, people, and other essential resources and try to combine these ingredients to produce a well-functioning entrepreneurial organization. Like other industries in which there are no barriers to entry, success in venture capital ultimately depends on how efficiently the venture operation is run, which means how effectively venture sponsors remain focused within their core circles of competence.

Exploiting brands

• In a market without competitive advantages, competition among brands will eliminate any return in excess of the investment required to develop and nourish the brand. Since investments in failed brands conveniently disappear from view, the return on brand investments is often overestimated, leading to the unwarranted conclusion that brand creation is a source of competitive advantage.
• Brands are associated with competitive advantages when they lead to customer captivity and, more powerfully, when that captivity is combined with economies of scale in the underlying production process. Coca Cola’s brand is valuable for two reasons: (1) a remarkable degree of habit formation in cola drinks, helped by frequent purchases, (2) economies of scale due to large fixed costs in distribution and advertising. To be viable, entrants must capture a substantial part of the cola market, a task made complex by the strength of customer captivity.
• Effective exploitation and protection of competitive advantages generally lead to aggressive brand extension strategies. For Microsoft, successful product introductions strengthen Windows’s competitive advantages: they raise the costs of switching to alternative operating systems, and fill gaps in the application portfolio that might constitute entry points for potential competitors.
• Brand extensions into markets that lie outside the company’s existing franchise will usually be less profitable.

The level playing field

Management matters

• A tenet of the prevailing business strategy wisdom is that companies should operate only in markets in which they possess some sort of competitive advantage. The authors do not share this view.
• Companies with sustainable competitive advantages are the exception, not the rule. Most firms in most markets do not benefit from competitive advantages, and when these advantages do not naturally exist, they are difficult to create.
• Instead of being protected by barriers to entry, most firms operate on a level playing field where they confront a large and frequently elastic set of competitors. Firms in this position have a single strategic imperative: focus relentlessly on being as efficient and effective as possible in all of their business operations.

  

• This means controlling expenses and achieving a productive return on the money spent (output per hour of labor, return on marketing campaigns, R&D and other capex).
• The rewards from superior management that stresses efficiency and productivity can be comparable to those arising from structural competitive advantages. Well-managed companies have been able to outperform their peers over long periods of time in industries without identifiable structural competitive advantages.

The productivity frontier

• Traditional discussions on productivity focus on stimulating capital investment, education, and R&D (i.e. pushing the productivity frontier).
• An alternative perspective considers that higher productivity comes primarily from closing the gap between what is possible and what is achieved by better employing resources (i.e. most firms are well within the productivity frontier).
• The crucial factor, and thus the chief source of economic progress, is good management, especially management that pays close attention to efficiency.

Management and company performance

• While ill-conceived initiatives that ignore the structure of competitive advantage and competitive interactions are a leading cause of business failure, an obsession with strategy at the expense of the pursuit of operational excellence is equally damaging. Effective strategy formulation is not the only source of superior returns.
• The critical element in successful performance improvement is sustained, focused management attention. Companies with outstanding performance tend to adopt a simple and clear strategic focus, while great firms that deteriorate suffer from dissipation of management focus.
• Strategy formulation should have three underlying goals: (1) Identify the competitive universe in which the company operates, and locate its position regarding competitive advantages and barriers to entry, (2) If the company does enjoy competitive advantages, recognize and manage effectively competitive interactions with other firms, (3) Develop a clear, simple, and accurate vision of where the company should be headed, which should allow management to focus the greater part of its attention on getting there.