Can Best Buy Be Fixed? Reply To @vitaliyk

A value investor by the name of Vitaliy Katsenelson, whose blog I subscribe to, just posted his ideas on How to Fix Best Buy:

Best Buy cannot have lower prices than its online competitors, and its stores lack the breadth of selection of Amazon.com, putting it at a permanent competitive cost disadvantage.

The new strategy Dunn announced a few weeks before his resignation — of closing big stores and opening a lot of smaller stores — made little sense. It was basically turning Best Buy into RadioShack Corp. It would have been great if this approach had worked for RadioShack, but it hadn’t.

Katsenelson is correct. Best Buy’s business model is cooked. It provides a service that is increasingly out of touch with how consumers of its products shop, and it does it within a cost structure that is not price competitive with the other participants in its market.

So, Katsenelson proposes a solution for Best Buy:

Best Buy’s strategy for the brave new world requires thinking that cannot be delivered by somebody who spent 28 years in the Best Buy box. It requires the strategy of an Amazon or Netflix, where management was willing to bring forward and execute a disruptive new approach that undermined its current cash-cow business. Amazon did this by bringing electronic readers to the masses. Netflix did it by streaming movies and TV shows.

The rest of Katsenelson’s proposal, while creative and worth pondering on its own from a strategic value point of view, is unimportant for the purposes of our present discussion, which is actually to highlight the role of innovation.

According to our reading of The Innovator’s Dilemma, Katsenelson is suffering from two confusions in his analysis:

  1. He is confused about the difference between sustaining and disruptive technologies
  2. He is confused about the likelihood of success in a firm disrupting its own business model

Let’s tackle each confusion separately before reaching a new conclusion.

Confusion #1 – sustaining vs. disruptive technology

In building his analysis of Best Buy’s current predicament, Katsenelson cites the examples of Amazon’s Kindle and Netflix’s digital streaming technologies as examples of “disruptive” technology.

It might be useful at this point to revisit the definition of sustaining versus disruptive technology provided to us by The Innovator’s Dilemma before proceeding:

  • sustaining, which are new technologies that improve a product or service in a way that is valuable to existing customers or markets
  • disruptive, which are new technologies that are uncompetitive along traditional performance metrics, which are unusable or undesirable to existing customers or markets but which nonetheless can eventually come to replace the traditional market over time

(A disclosure here, as well– I have not studied Amazon nor Netflix in depth, so I am making some conjectures here about margins and pricing which may be incorrect, and I realize they are central to the point I am making so it could weaken my argument slightly if I am speaking out of turn here.)

Now, judging by the definitions above, I’d say both Amazon’s Kindle and Netflix’s digital streaming service are actually sustaining technologies, not disruptive. A good clue to the truth of this might come in the fact that these technologies each were developed and implemented from within the firms in question, rather than being produced by an entrant, competitor firm.

But even if that is not the give away, sure both of these technologies improved their existing products and services (books and movie rentals, respectively) and both were appealing to existing customers. It is not my understanding that there were a bunch of people who were not buying books and not renting movies until Amazon and Netflix released their new services, at which point they jumped on board. In fact, it is my understanding that many customers who now use the Kindle or digital streaming were previously physical book readers or mail-order movie renters.

Additionally, my understanding is that these new businesses are either similar margin or better margin businesses than what came before. I understand Netflix has had issues with the cost of acquiring distribution rights to film properties but that seems a separate issue from the actual question of the cost of distribution– digital streaming seems far more cost effective than sending things through the mail. Same with e-readership; the question of acquiring separate rights for digital distribution is a different one than the cost of distribution, of which digital book distribution seems to be a far higher margin business than the one involving costs of inventorying and mailing physical copies of books.

This is another aspect of the sustaining vs. disruptive technology debate– firms on sustaining technological pathways look for higher margin business that satisfies their existing customers and provides them with improved, but similar service to what they had before. Disruptive technological pathways involve different (usually lower) cost structures and different products or services which are competitive on metrics or feature sets that were previously not an issue in the pre-existing competitive paradigm.

Best Buy was, in its heyday, an electronics and appliance retailer where customers not only shopped but transacted. Nobody wants to transact with Best Buy anymore. That truly is a disruption as now people just want to shop. Any proposal that involves Best Buy no longer being a retailer (shopping AND buying) is a proposal for disruptive innovation within Best Buy’s existing business model, and a change in cost structure that would go along with it.

Confusion #2 – the likelihood of success in self-disruption

The other thing that’s clear from reading The Innovator’s Dilemma is that responding to a disruptive threat from an entrant firm is hard enough, but successfully disrupting one’s own business model is nearly impossible.

There are myriad reasons why this is so but what it essentially boils down to is that, as Geoff Gannon says, businesses have DNA and part of their DNA is their cost structure. Asking a business to change its cost structure is like asking it to change its DNA; it’s akin to expecting a megalodon to transform itself into a tick.

Another part of a business’s DNA is its management culture and accumulated experience. Just as certain animal species seem to have integrated various memory experiences into their DNA which are expressed as subconscious, instinctive behavior that comes naturally and effortlessly to the animal, a business develops a management culture (tightly interwoven with and often times predicated on the business’s cost and incentive structures) that possesses a kind of collective memory, or instinct. Management culture is “evolutionary”– it’s highly specialized and adaptive, designed to excel in the conditions unique to that business’s industry but which may prove maladaptive in conditions dominating outside of the industry.

Expecting a company’s management to successfully adapt its culture, its DNA, to new competitive circumstances is like expecting a polar bear to hunt successfully after air dropping it into the African savannah, or a jungle on the Indian subcontinent.

Getting rid of the top executive is not enough. CEO Brian Dunn might be gone, but all his lieutenants remain. They’re like mini-Brian Dunns, the children of Brian Dunn, they might not be exact replicas but they’ve undoubtedly learned a lot and probably “grown up” believing in his authority and vision the way children have trouble question their parents. They bring all that along with them. (David Merkel discussed this phenomenon in his bond manager series where he talked about the way a corporate debt team will come to be subtlety but surely influenced by the PM, and it applies in other business organizations outside the world of corporate bond management.)

Everyone who works at Best Buy is used to succeeding (and failing) a particular way. It is unlikely they’ll find themselves succeeding in a new paradigm that’s completely foreign to them when they are failing to sustain their business in a paradigm they’re intimately familiar with and once dominated.

A third way? Dissolution, sub-disruption, liquidation?

Katsenelson’s two examples don’t shed much light on what Best Buy should do because they’re examples of successful adoption of sustaining, not disruptive technologies. Best Buy is facing disruptive competition, it is beyond the point where its business could be improved by a sustaining technology.

And self-disruption doesn’t appear to be a viable strategy because Best Buy has built-in business DNA which can not be easily mutated, if it can be changed at all.

So, what should Best Buy do?

One perfectly reasonable strategy could be dissolution (aka liquidation by change in ownership)– Best Buy could sell itself to a strategic buyer who values Best Buy more as a sum-of-parts than as its currently operating whole. The new owner could salvage and re-orient what it can and then re-sell the rest as “scrap”. Just because the Pinto explodes when it gets rear-ended doesn’t mean the metal and upholstery in the vehicle couldn’t be used elsewhere. This is an option.

Another strategy is for the company to liquidate itself– managed, slow-motion suicide. The company could cut cap-ex to zero, start winding down its inventory buying and other business activities in line with the maturation of its existing facilities leases and then close out the stores one by one (selling property, plant and equipment when possible as this process continues). The proceeds could be distributed as periodic dividends to shareholders or be distributed as a lump-sum cash payment in exchange for shares at the end of the process several years from now.

But there is a third way and it actually does involve self-disruption: Best Buy could set in motion the slow-motion suicide or not, and at the same time use some of its capital to set up a small subsidiary to either compete in the world of Amazon, or work at discovering another disruptive technology which could re-jigger the industry even more and prove a disruptive threat to Amazon. This subsidiary would have completely separate managementcompletely separate capital and a completely separate cost structure which would be appropriate to the new market it is attempting to compete in.

That’s one way Best Buy could successfully respond to innovation in its industry. But it’s most likely far too late for that.

Which is why I think it’s pretty clear Best Buy is a value trap outside a strategic buyer coming into the picture (Schulze might be a little slow to the draw, but at least he’s got the good sense to go for his revolver before his opponent six-shoots him into a shallow grave), or the current management dedicating itself to a program of self-liquidation over the next several years.

Notes – Competition Demystified: Chapter 5

Reading notes to Competition Demystified, by Bruce Greenwald and Judd Kahn

Looking for competitive advantages through industry analysis

One way to approach competitive analysis is by critically examining two key measures of performance:

  • operating margins; most useful when comparing firms within an industry
  • return on invested capital; useful for comparing between industries and within

These ratios are both driven by operating profit so they should track one another; when they do not, changes in how the business is financed may be the cause.

As the authors state,

Though the entries on the income statement are the consequences, not the cause, of the differences in operations, they tell us where to look for explanations of superior performance.

Learning by example: the Wal-Mart (WMT) case study

The explanations for Wal-Mart’s success have been numerous and diverse:

  1. WMT was tough on its vendors
  2. WMT monopolized business in small towns
  3. WMT had superior management and business systems
  4. WMT operated in “cheaper” territories in the Southern US
  5. WMT obtained advantages through regional dominance

Let’s examine these claims in order.

The first explanation fails the sniff test because WMT in fact had a higher Cost of Goods Sold (COGS) than it’s competitors. Additionally, its gross profit margins did not increase as it grew larger, implying it was not getting better and better economies of scale with suppliers by buying in bulk.

And while Wal-Mart did manage to generate additional income from higher prices charged in monopoly markets, this advantage was more than offset by its policy of “everyday low prices” in more diverse markets where WMT did higher volumes.

Technologically, WMT was a buyer of logistics and distribution technologies, not a developer of them. Anything it used, its competitors could use as well. Managerially, WMT appeared to have no advantage when it expanded its retailing into hardware, drug and arts and crafts stores. Why would WMT’s superior management be effective at discount general merchandise retailing but not add additional value in these markets?

The fourth explanation fails because Wal-Mart’s opportunities for expansion in the home markets of the South were not very large. Much of Wal-Mart’s growth and success took place in larger markets outside the South.

Wal-Mart’s secret sauce was regional dominance

Competitive advantages occur in numerous, often complementary ways. In the case of WMT, the initial competitive advantage was centered around a concentrated, regional dominance. Though smaller than its competitor Kmart, by focusing on one local region WMT was able to create a number of other competitive advantages for itself, including local economies of scale, that were not available to its competitor:

  • lower inbound logistics due to density of Wal-Mart stores, distribution facilities and vendor warehouses
  • lower advertising costs due to concentration of stores and customer base in target markets
  • concentrated territories which allowed managers to spend more time visiting stores rather than traveling to and from

Looking at Wal-Mart’s activities within the relevant boundaries in which it competed, it was far larger than its competition.

Eventually, economic law won out and growth took its toll on WMT’s great business,

it was unable to replicate the most significant competitive advantage it enjoyed in these early years: local economies of scale combined with enough customer loyalty to make it difficult for competitors to cut into this base.

WMT’s margins and return on capital both began to fall during the 1980s as it began its aggressive growth into the national market. Until then, WMT enjoyed the absence of established competitors.

What could WMT have done if it wanted to grow but maintain its competitive advantages?

If it had wanted to replicate its early experience, Wal-Mart might have targeted a foreign country that was in the process of economic development but that had not yet attracted much attention from established retailers.

Lessons learned from the WMT case study

The WMT case study leaves several general impressions:

  1. Efficiency always matters
  2. Competitive advantages matter more
  3. Competitive advantages can enhance good management
  4. Competitive advantages need to be defended
Learning by example: the Coors case study

From 1945 to 1985, the brewing industry experienced significant consolidation due to the following factors:

  • demographic trends, as home beer consumption rose at the expense of tavern consumption
  • technological disruption, as the size of an efficient plant grew from 100,000 bbl/y to 5M bbl/y, leaving many smaller brewers in a position where they could not afford to keep up
  • advertising trends, as the advent of television meant national brewers could spread fixed advertising costs over a larger revenue base
  • growth in brands, the market segmentation of which did not lead to growth in consumption but did result in larger advertising burdens for smaller brewers
The organization of Coors business

Coors’ business operations were characterized by a few fundamental structures:

  1. vertical integration, Coors produced its own strain of barley, designed its own cans, had its own bottle supplier and even had its own source of water, none of which produced a meaningful cost advantage
  2. operated a single brewery, which required it to transport all its product to national markets at great cost rather than producing within each market and shortening transportation routes
  3. non-pasteurization, which led to shorter shelf life than its rivals, adding to spoilage costs
  4. a celebrity aura, which, like most product differentiation strategies, did not result in a meaningful premium charged for a barrel of Coors compared to its rivals
For Coors, geographic expansion brought with it higher costs and reduced competitive advantage as these business organization decisions interacted with the wider distribution network in unforeseen ways:
  • longer shipping distances from the central plant in Golden, CO, resulted in higher costs that could not be passed on to consumers
  • the smaller share of new local markets it expanded to meant it had to work with weaker wholesalers
  • higher marketing expenses were incurred as Coors tried to establish itself in new markets and then keep up with the efforts of AB and Miller
The net result was that Coors was “spending more to accomplish less.”

Why Coors expansion was so costly

First, although Anheuscher-Busch, the dominant firm in the brewing industry, spent almost three times as much in total on advertising compared to Coors, it spent $4/bbl less due an economy of scale derived from larger total beer output.

Second, Coors experienced higher distribution costs because distribution has a fixed regional component which allows firms with a larger local share of the market to drive shorter truck routes and utilize warehouse space more intensively.

Third, advertising costs are fixed on a regional basis. Again, the larger your share of the market in a given region, the lower your advertising costs per unit. Coors never held substantial market share in any of the national markets it expanded into.

If Coors had “gone local” (or rather, stayed local), all of its competitive disadvantages could’ve been turned into competitive advantages. Advertising expenses would’ve been concentrated on dominant markets instead of being spread across the country. Freight costs would’ve been considerably lower as it would not have been transporting product so many thousands of miles away from its central plant. With a larger share of the market it could’ve used stronger wholesalers who might have been willing to carry Coors exclusively because it was so popular in local markets.

Additionally, Coors sold its beer for less in its home regions, allowing it to win customers from its competitors by lowering prices, offering promotions and advertising more heavily. Expansion, when and if it occurred, should’ve worked from the periphery outward.

The Internet and competitive advantages

Greenwald and Kahn are skeptical of the virtues of combining the Internet with traditional competitive advantages:

The main sources of competitive advantages are customer captivity, production advantages and economies of scale, especially on a local level. None of them is readily compatible with Internet commerce, except in special circumstances. [emphasis added]

With the Internet,

competition is a click away,

and furthermore,

economies of scale entail substantial fixed costs that can then be spread over a large customer base

a state of affairs which often doesn’t exist with virtual, e-businesses.

The Internet is great for customers, but its value to businesses as a promoter of profits is questionable. The Internet doesn’t provide a strong barrier to entry because it is relatively inexpensive to set up an e-commerce subsidiary. Additionally, there are no easily discernible local boundaries to limit the territory  in which a firm competes which is another essential element of the economies of scale advantage.

In other words,

the information superhighway provided myriad on-ramps for anyone who wanted access.

Questions from the reading

  1. Greenwald and Kahn argue that management time is the scarcest resource any company has. Is this true? Why can’t companies solve this simply by hiring more managers and increasing the manager-employee ratio?
  2. In the case study with WMT, why couldn’t Kmart at least match WMT’s efforts in establishing critical infrastructure organization and technology and compete on that basis?
  3. What were the sources of WMT’s customer loyalty?
  4. Which publicly-listed firms have regional dominance as a specific strategy they follow? Do these companies’ financial performance seem to suggest they derive a competitive advantage from this strategy?
  5. In the case study with Coors, what were the industry conditions in beer brewing that made national competition more efficient than local competition?
  6. Standard Oil, another producer and distributor of “valuable liquids” was vertically integrated. Why was vertical integration beneficial in the oil industry but not in the brewing industry for Coors?

Notes – Competition Demystified: Chapter 4

Reading notes to Competition Demystified, by Bruce Greenwald and Judd Kahn

Putting it all together (so far)

All business analyses should begin with a study of competitive advantage by exploring the following, in order:

  1. identify the competitive landscape; which markets? who are the competitors?
  2. test for existence of competitive advantages; stable market shares? exceptional profits for extended periods of time?
  3. identify the likely nature of competitive advantages; supply, demand, economies of scale, regulatory hurdles?

Carrying out the analysis

Start by identifying the market segments that make up the industry as a whole and make a list of the leading competitors in each one, by market share. This is an organizational tool to study the breadth and depth of a competitive market place where the target firm’s role can be placed within.

Then, look for signs of existing competitive advantages by observing the stability of incumbent market shares and the profitability of firms within the market segments.

The more movement in and out, the more turbulent the ranking of the companies that remain, and the longer the list of competitors, the less likely it is that there are barriers and competitive advantages.

Quantitatively,

if you can’t count the top firms in an industry on the fingers of one hand, the chances are good that there are no barriers to entry.

And,

if over a five- to eight-year period, the average absolute [market] share change exceeds 5 percentage points, there are no barriers to entry; if the share change is 2 percentage points or less, the barriers are formidable.

Profitability across an industry is best measured by the use of return on equity (ROE) or return on invested capital (ROIC). As a broad rule of thumb:

After-tax returns on invested capital averaging more than 15 to 25 percent — which would equate to 23 to 38 percent pretax return with tax rates of 35percent — over a decade or more are clear evidence of the presence of competitive advantages. A return on capital in the range of 6-8 percent after tax generally indicates their absence.

Utilize the principle of Occam’s Razor in your industry analysis, keeping things simple until there is a clear need to make them more complex.

Questions from the reading

  1. In the case study in the book, Apple (AAPL) seemed to have spread itself thin by trying to compete in multiple computer industry market segments where it had no clear competitive advantage. Eventually, Apple abandoned manufacturing its own chips and adopted the industry-standard hardware while focusing its efforts on smaller niche markets that had no clear incumbent (including new market segments it created, such as the tablet computer market). Was this the brilliant strategic move responsible for Apple’s current success, or was it something else entirely? Does Apple actually have a clear, sustainable competitive advantage?
  2. A lot of Greenwaldian strategic analysis seems dependent on the observation of historical trends in profitability and market share to arrive at conclusions about the existence of competitive advantage. Is there a way to predict and identify competitive advantage in a new or immature industry without the benefit of historical hindsight?

[amazon asin=1591841801&template=iframe image2]

Notes – Competition Demystified: Chapter 3

Reading notes to Competition Demystified, by Bruce Greenwald and Judd Kahn

Economies of scale depend on market share

Economies of scale are a competitive advantage that work most effectively in combination with another advantage such as customer captivity.

With some degree of customer captivity, the entrants never catch up and stay permanently on the wrong side of the economies of scale differential.

In general, smaller markets (in terms of geography or product space) present easier realms to obtain a competitive advantage, even with regards to economies of scale. As a market grows in absolute size, it becomes easier and easier for competitors to obtain their own economies of scale and erode the incumbent firms advantages in terms of fixed costs.

By keeping a competitive market small, the incumbent firm can outspend entrants in absolute dollars even if each firm spends the same proportion of revenues on things like R&D, advertising, marketing, distribution, etc.

Erosion in market share are the greatest threat to a firm with competitive advantages derived from economies of scale because as market share falls, the proportion of total costs which are fixed rises and thereby defeats the cost advantage of economies of scale.

Maintaining market share through customer captivity is critical

Customer captivity can be enhanced a number of ways:

  • habit – make purchases more frequent and spread their cost out over time to create a relationship that is easier to continue than replace; encourage repeated, nearly automatic purchases that don’t allow time for critical consideration of alternatives
  • switching costs – extend and deepen the range of services offered, thereby increasing the opportunity cost of switching to a competitor
  • search costs – integration of multiple features into one pricing plan complicates comparison shopping and increases risk of picking a half-effective service or product
The strategy of economies of scale

Economies of scale…

  1. tend to be the longest lived of the three major types of competitive advantage
  2. are vulnerable to gradual erosion and therefore must be defended vigorously
Establishing dominance in a local market and then expanding outward gradually from that hub is the best strategy for firms relying on EoS. Small, local markets only have room for a few competitors, at most, meaning the firm that gains dominance will also gain EoS (if possible) while preventing the competitor from obtaining that same advantage.

Markets grow rapidly because they attract many new customers, who are by definition non-captive. They may provide a base of viable scale for new entrants.

Both incumbents and entrants should focus on niche markets, characterized by:

  • customer captivity
  • small size relative to the level of fixed costs
  • absence of vigilant, dominant competitors
  • readily extendable at the edges
Ultimately, the more variable costs can be shifted to fixed costs, the stronger will be the competitive advantage from EoS.

Remember:

Competitive advantages are invariably market-specific. They do not travel to meet the aspirations of growth-obsessed CEOs.

Questions from the reading

  1. The authors mention an example of Aetna vs. Oxford in the metropolitan insurance market. They argue that because medical service is a local market, Aetna’s national network confers no economies of scale advantage because Oxford has a larger market share of in-network medical providers in specific local markets, such as NYC (60% of market vs. 20%). But part of Aetna’s cost advantages come from general administrative overhead, where EoS at the national level become important. How do you weigh the value of EoS in adminstrative/overhead costs at the corporate level against specific EoS in supply/inventory costs at the local level?
  2. Suggested case study– In 2006, Nintendo (NTDOY) introduced their  Wii home video game console as a part of their effort to achieve the corporate goal of “Gaming Population Expansion“. However, this is a goal with strategic implications as well as tactical ones because it serves to broaden the total market for NTDOY as well as competitors’ (MSFT, SNE) products and thereby changes the way NTDOY competes in that market. Considering the lessons of Chapter 3, how would you judge NTDOY’s strategy? Is this a brilliant way to create a new market niche (casual gamers) that have traditionally been ignored and underserved by the market that NTDOY can profitably keep to itself? Or will this decision result in a growing market that invites new entrants while eroding any advantages NTDOY may have had as a result of EoS? Additionally, NTDOY has been criticized for ignoring the massive, wildly profitable “hardcore gamer” market. Would you criticize NTDOY for this decision? Would you recommend they attempt to make inroads? What broad strategic recommendations might you make to NTDOY with regards to maximizing competitive advantages related to EoS and customer captivity?

Notes – Competition Demystified: Chapter 2

Reading notes to Competition Demystified, by Bruce Greenwald and Judd Kahn

Differentiation is not a competitive advantage

The tired old story that many companies tell their investors (and many managers tell themselves) is that they can avoid the commoditization of their product through “differentiation”. Convince your customers that your limestone is not generic limestone but “Jeff’s Best limestone”, for instance, and they’re sure to pay a premium price!

The trouble with this strategy is not the gullibility of the consumer, but the mutual ability of the competitor to adopt it for himself.

The reality of the competitive market is that high profits attract competition and without real, sustainable barriers to entry, high profits will be eroded by market fragmentation and declining margins. Product differentiation may allow a firm to charge a “premium” for their product, but it will not protect their market share and as market share falls, the effects of fixed-costs on margins will rise.

Firms producing differentiated goods and services will still face the economics of commodity markets, namely, if they can not produce at a cost at or below the price established in the market, they will fail. This is because differentiated products require additional investments in advertising, marketing, sales and service, product distribution, etc., to make the differentiated claims credible, and these higher costs ultimately lower returns.

Barriers to entry = competitive advantages

As the authors note,

Systems can be replicated, talent hired away, managerial quality upgraded

The only way to obtain real, sustainable competitive advantages is through barriers to entry: obstacles and costs that competitors can not overcome or do not have the resources to cover. These barriers to entry apply only to incumbents, as entrant competitive advantages are essentially available to everyone and therefore are available to no one in the long run, being of limited and transitory value (once you establish yourself in a market, you’re now and incumbent and have lost your competitive advantage).

There are three basic, authentic types of competitive advantage:

  1. supply advantages
  2. demand advantages
  3. a combination of the two

The authors specifically note that,

Measured by potency and durability, production advantages are the weakest barrier to entry; economies of scale, when combined with some customer captivity, are the strongest.

Supply advantages

Supply advantages essentially translate to lower cost structures, which provides the firm with two benefits:

  1. higher profitability through wider margins
  2. ability to strategically lower prices to resist potential entrants or other competitors while maintaining profitability

These lower cost structures normally come from:

  1. lower input costs (special access to a supply that can’t be replicated by the competition at the same cost)
  2. economies of scale
  3. proprietary technology, normally protected by patents/intellectual property laws (any government grant of monopoly would similarly apply as it has the same effect)

Rapid technological change in supply methods can create entrant advantages as pre-existing incumbents find their out-dated technology confers a cost dis-advantage. Conversely, as the pace of technological change in an industry slows, any incumbent advantage due to technological advances can be eroded as rival firms acquire learned efficiencies of their own.

Many strategic analysts cite the role of “innovation” in imbuing certain firms with competitive advantages but these advantages are only sustainable if these innovations can’t be learned, “stolen” or otherwise acquired by competitors over time. In other words,

Innovations that are common to all confer competitive advantages on none.

Meanwhile, privileged access to raw materials is normally only useful in markets which are local in terms of geography or product space.

Demand advantages

Access to customers that rivals can not match translate to demand advantages. Customer captivity is a result of one of three dynamics:

  1. habit – typically applies to one product, not a firm’s portfolio of products, and is a result of frequent and automatic purchases
  2. switching costs – reinforced by network effects, ie, selecting a technology system that becomes common and popular economy-wide
  3. search costs – common when products or services are complex, customized and crucial
Demand side advantages are typically more durable. However, because they rely on the customer for their power they’re susceptible to customers moving, growing old (developing new preferences and needs) and dying. New customers entering the market are uncommitted and can potentially be captured by anyone.

The strongest possible demand advantage, then, would be one which generates an intergenerational transfer of habit.

Questions from the reading

  1. The authors state on pg. 31 that United’s advantageous geographical position at Chicago O’Hare can not be extended to other airports; is this true? Why or why not? Ultimately, what is the source for United’s supply advantage at Chicago O’Hare?
  2. Many of the supply advantages stem from government interference in the market through patent, copyright and other “intellectual property” laws. How might the strategic/competitive landscape change in a “free intellectual market”?

Notes – Competition Demystified: Preface, Chapter 1

Reading notes to Competition Demystified, by Bruce Greenwald and Judd Kahn.

What is strategy?

Strategy is the art of making business decisions with respect to the actions and responses of competitors. Strategy revolves around creating, protecting and exploiting competitive advantages.

Strategy and competitive advantage go hand in hand; where there is no possibility to develop a competitive advantage, there can be no strategic decisions. Markets where competitors have similar access to customers, technology and other cost advantages are not strategic but tactical markets where the only strategy possible is to outrun the competition through operational efficiency– most competitors will be about the same size and none will manage to make or maintain an outsize profit margin as the lack of competitive advantages will drive economic profits toward average cost.

What are the differences between strategy and tactics?

The easiest way to think about the difference between strategy and tactics is to understand that strategic decisions are focused on competitors, while tactical decisions are focused on operations. In other words, strategy is external, tactics are internal in nature.

This helpful table from Competition Demystified may also convey the differences:

  • Strategic Decisions
    • Management level –> top management, board of directors
    • Resources –> corporate
    • Time frame –> long-term
    • Risk –> success or survival
    • Questions: “What business do we want to be in?”, “What critical competencies must we develop?”, “How are we going to deal with competitors?”
  • Tactical Decisions
    • Management level –> midlevel, functional, local
    • Resources –> divisional, departmental
    • Time frame –> yearly, quarterly, monthly
    • Risk –> limited
    • Questions: “How do we improve delivery times?”, “How big a promotional discount do we offer?”, “What is the best career path for our sales representatives?”

Additionally, there are two major strategic issues every business faces:

  1. the arena of competition – which external characters will affect the firm’s economic future?
  2. the management of competition – how do you anticipate and, if possible, control, the actions of these external agents?

Porter’s “Five Forces” and the Greenwald/Kahn “One Ring” that binds them

Michael Porter, author of [amazon text=Competitive Strategy&asin=0684841487] (1980), identified “Five Forces” critical to the competitive environment:

  • Substitutes
  • Suppliers
  • Potential Entrants
  • Buyers
  • Competitors Within the Industry

Greenwald and Kahn focus on one as being the dominant force, potential entrants, specifically from the viewpoint of barriers to entry.

Either the existing firms within the market are protected by barriers to entry (or to expansion), or they are not.

Barriers to entry are critical for maintaining stable businesses and above average profit margins as without them the market will be flooded with competitors whose existence serves to drive down average industry profitability.

As more firms enter, demand is fragmented among them. Costs per unit rise as fixed costs are spread over fewer units sold, prices fall, and the high profits that attracted the new entrants disappear.

The end result is all firms are placed on the operational efficiency treadmill where no firm ever reaches the goal of above average profitability and everyone must run as fast as they can simply to stay in place.

Operational effectiveness might be thought of as a strategy, indeed, as the only strategy appropriate in markets without barriers to entry.

How to conduct a strategic analysis

Ask yourself, in the market in which the firm currently competes or is considering an entrance:

  1. do any competitive advantages exist? And, if so,
  2. what kind of advantages are they?

Exploring competitive advantage

There are only three types of genuine competitive advantage:

  1. supply – a company can produce or deliver its products or services more cheaply than competitors
  2. demand – a company has access to market demand that competitors can not match, usually based upon…
    1. habit
    2. switching costs
    3. search costs
  3. economies of scale – an incumbent firm operating at large scale will enjoy lower costs than its competitors

Companies which manage to grow yet maintain profitability usually achieve this one of three ways:

  • replicate their local advantage in multiple markets
  • continue to focus on their product space as that space becomes larger
  • gradually expand their activities outward from the edges of their dominant market position

Elephants versus ants

Markets which offer competitive advantages are typically characterized by one or two large firms which possess the competitive advantage, elephants, and several smaller, less profitable “competitors”, the ants.

A firm which finds itself in a market where it is the ant should consider getting out of the market as painlessly as possible. A firm which is considering entering a market where an elephant already resides should reconsider the decision as the only real hope for competing in that market is if the elephant creates an opportunity by making a mistake.

With a competitive advantage in place, an elephant can enjoy the outsized profits of his competitive position. Still, developing strategic awareness about its competitive advantages will allow it to:

  • reinforce and protect existing advantages
  • identify areas of growth (geographic and product line-related) that are likely to yield high returns
  • develop policies that extract maximum profitability from the firm’s competitive circumstances
  • identify threats that are likely to develop
Strategic planning

In other words, strategic planning concerns itself with the different areas of business decision-making that competitors can respond to, such as:

  • pricing policies
  • new product lines
  • geographic expansions
  • capacity additions

Questions from the reading

  1. With regards to the elephant vs. ant paradigm, why do ants exist at all, that is, why don’t more firms exit markets where they are ants?
  2. What are common ways in which elephants misstep and allow competition from the ants?