Book: Competition Demystified
Authors: Bruce Greenwald & Judd Kahn
Key takeaways: Executives think that any plan to attract customers/increase margins is strategy, but strategy is a set of plans that focus specifically on the competitors. Porter’s five forces–substitutes, suppliers, potential entrants, buyers and competitors, is a useful tool, but “potential entrants” (aka barriers to entry) is far and away the most important factor to consider. At its core, strategic thinking is about looking outward and creating, protecting and exploiting competitive advantages; operational efficiency is a tactical matter, not a strategic one (tactical decisions can be made in isolation and are dependent on effective implementation).
Companies that grow and still achieve a high level of profitability do it one of the 3 ways:
- Replicate local advantage in multiple markets: Coca-Cola
- Focus on product space as it becomes larger: Intel
- Gradually expand activities outward from edges of their dominant positions: WMT/MSFT
How Do We Know That Competitive Advantages Exist In a Market?
There are two straight forward test to confirm existence of a competitive advantage:
- Stable market-share: if the top firms can’t be counted on one hand, there are likely no barriers to entry. Also, if over a 5-8 year period, m/s change > 5%, there are no barriers to entry, but if m/s < 2%, barriers are formidable.
- High return on capital / profitability of firms within the segment: 15-25% after-tax returns usually imply presence of competitive advantages whereas 6-8% after-tax returns typically imply absence of competitive advantages.
Sources of Competitive Advantages
Sources of competitive advantage tend to be local and specific (such as product space), not general or diffuse. Skills and competencies of even the best-run companies are available to competitors (talent, systems etc. can all be improved). Strategy is concerned with structural barriers to entry.
There are only 3 kinds of genuine competitive advantages. The strongest competitive advantages arise from the interaction of one or more of the competitive advantages listed below (in order of weakest to strongest).
- Supply: strictly cost advantages
- In industries with complicated processes, learning and experience are a major source of cost reduction (if a company is tinkering with a product years after first producing it, although it may look ungainly, it also signals how hard it is to conquer that market quickly). Cost advantages is correlated with pace of technological change and have a shorter life expectancies in rapidly changing areas (like semicap/biotech).
- Demand: not product differentiation / branding, but customer captivity (because of habit/cost of switching/difficulties and expenses of substitute search).
- Product differentiation is over-rated. Think of Mercedes/Cadillac–it’s widely coveted by heads of states and so on, but still has a average rate of return because there’s no barrier to entry (think Lexus, Tesla)
- Habit needs to be classified as a lifecycle. Some can be inter-generational (such as Heinz), some can last a good part of a life-time (Coca-Cola/Pepsi), and last while someone is of a certain age.
- Switching costs can be increased by encouraging by making purchases more frequent, spreading payments over time, and/or extending and deepening the range of services offered to ensnare customers in an ongoing relationship.
- Economies of scale
- This depends not on the absolute size of the company, but rather the size difference between it and its rivals (on market share, or even on a factory level–really any area where fixed costs stay fixed). One thing to think about is that if the incumbent build large factories but the efficient size is smaller, it makes no difference (ala Coors building 13 mm barrels factory in ’85 when the efficient size is 5 mm).
- Most competitive advantages based on economies of scale are found in local/niche markets. Best course is to establish dominance in a local market and expand outward (ala WMT)
- The cannot be just about lower production costs. If an entrant has equal access to customers as incumbents, it can reach incumbents’ scale. Thus, for economies of scale to serve as a competitive advantage, it needs to be coupled with some degree of customer captivity.
- In order to persist, this advantage has to be defended continuously because any market share gain by a competitor narrows the incumbents’ edge; thus if the rival introduces an attractive new feature, it has to be adopted rapidly. Mistakes include when Pepsi targeted supermarkets in ’50s as a distribution channel, or when American motorcycle industry didn’t challenge Honda when it introduced inexpensive cycles in ’60s.
- Finally, growth of the market is generally not a good thing for competitive advantage based on economies of scale, because as markets grow, fixed costs stay fixed and variable costs increase as % of total costs and this lowers the hurdle for an entrant, undercutting the advantage of the incumbent. Furthermore, growing markets imply new customers, who by definition non-captive, offering base of viable scale for new entrants.
- Incumbents should put in effort to change as many variable costs to fixed costs to cement their dominance (advertising heavily, adding features that require significant capex, accelerating product development cycles etc.)
If an industry has high rates of return and none of these competitive advantages exist, then look for things such as government intervention that favors incumbents (licenses, subsidies, regulation etc.). If even these are not present, then it is likely that (a) market share/rate of return are temporary, or (b) this is the consequence of good management and can be emulated by a very focused entrant.
One thing to remember is that competitive advantages are invariably market-specific and do not travel well with growth-obsessed management. For example, when Cisco move to provide services to telecom providers (vs. corporations and universities) in the late ’90s, it faced off with entrenched competitors such as Lucent and new competitors, had no captive customers (and thus, no scale advantages), and its R&D ballooned. Choice of markets is a strategic decision as it determines the set of external characters who will affect company’s economic future.
GAMES COMPANIES PLAY
Strategies become complicated only when a small number of powerful firms enjoy competitive advantages in common. Otherwise the options are simple:
- If a company does NOT have a genuine competitive advantage, then it should focus on just one thing–operational effectiveness–efficiency, efficiency, efficiency. If the product is a commodity, operational effectiveness is about controlling costs; if not, it is about both controlling costs and marketing effectively (and financing appropriately). Operationally effective systems tend to focus on a single business and on their own internal performance.
- If the company does have a genuine competitive advantage AND is a large dominant firm, then it should focus on managing that competitive advantage.
- If the company does have a genuine competitive advantage AND is NOT a large dominant firm, that is when things get interesting. Now, when companies interact, they have to think about the move of their competitors, which is dependent on the competitors’ interpretation of signals sent by the company based on its actions and statements. Analysis of these dynamics is difficult because of this complexity can quickly spiral and feel akin to tracking a bouncing ball into a room of mirrors. Hence, we need some tools to get out of this:
Fortunately, the essential dynamic of most competitive interaction revolve around two issues: price or volume, and of this, price competition is the most common form of competition among a small number of competitors. This can be represented with a 3D Prisoners’ Dilemma game (which can fit 80-90% of such price competition interactions). Reaching equilibrium in the Prisoners’ Dilemma game (equilibrium being the situation where all players are happy), depends on two conditions: (a) stability of expectations (everyone will continue to adhere to present choices), and (b) stability of behavior (no competitor can improve its outcome by choosing an alternative course of action).
Maintaining a cooperative outcome, with everyone charging higher prices, is the mot important skill that interacting competitors can develop. These skills are easier to develop if the owners/managers come from similar backgrounds/geographic areas. This is why globalization of certain markets is a precursor to a complete breakdown of pricing discipline because the new entrants don’t play by the rules laid down by incumbents. It is important to remember that bottom-line may not be everybody’s concern (empire-building, drive to kill the other guy etc are not uncommon) and in such cases, the equilibrium is destroyed. When elephants fight in an industry with barriers to entry, it tends to flatten a lot of grass and rarely ends with a dead elephant (ala Coke/Pepsi cola warns in ’70s).
There are a few structural ways to avoid slipping in the Prisoners’ Dilemma game and destroying the equilibrium:
- Avoid direct product competition: easier said that done
- Customer loyalty programs: must be tied to the cumulative purchases, else this would fail.
- Limiting output capacity: again, easier said than done (just see TiO2 prices as of fall of ’15)
- Universal compliance of programs that hurt firms lowering costs: MFN clause
- Limit purchasing and pricing decision to a narrow window: television networks operating preseason purchasing markets for only 2-3 weeks before the beginning of the annual season
- Reward systems within the companies favoring profits over sales growth
If these structural means do not work, then tactical responses are the next best option. Tactical responses are two-pronged:
- Immediate/automatic reaction to competitors’ price reduction: It is important to signal that price-cutting is not going to help, otherwise it is very difficult to correct that behavior later on. Also, companies responding to aggressive price behavior should pick their spots carefully because the temptation is to hurt the competitor where they’re weakest (small m/s), but one can end up inflicting pain on oneself (presuming higher m/s)–instead lower prices in the area where competitor has a high m/s and you have lower m/s.
- Simultaneous signal of willingness to return to jointly higher prices: After a decade of cola wars, when Coke spun-off 51% of its bottler as a separate entity, and loaded up on debt (thus, needing C/F to service it debt), it sent a clear signal to Pepsi that it’s ready for a new co-operative relationship. Profits margins increases from <10% to >20% after.
The urge to grow, hammer its competitors etc. can be very dangerous in such situations. But, unfortunately, this drive is often why the person became a CEO to begin with, and it is very hard to turn it off. This is why incentive systems based on profit/return on equity/share price etc. is very important.
The way that Fox entered the broadcasting business (with ABC, CBS and NBC as incumbent giants) is seen as the ideal way to enter a club without directly challenging them (and thus destroying the economics of the club). It secured local stations that weren’t existing affiliates of the big 3, priced its advertising at 20% discount to prevailing rates and filled its time slots with entertainment that was considered not prime-time (Joan Rivers, Simpsons, and other “down-market” shows)–all to send the signal that it wasn’t going to wreck the club’s economics.
Entry / Pre-emption:
After price-competition, the other commonly occurring competitive situation involves the decision to enter a market or to expand in an existing market. The dynamic here is different vs. Price Competition Prisoners’ Dilemma because of following reasons: (a) issue of timing–extending capacity requires significant lead time whereas price changes can be made in one decision, (b) clarity of defender/aggressor–in price competition, any one can lower prices, but in capacity, there’s established set of players who are dealing with aggressors, and they need different strategies, and (c) longevity of mistakes–in price competition, mistakes can be fixed relatively quickly whereas in entry/pre-emption games, mistakes have lasting consequences.
For an entrant, there are a number of ways to minimize the cost of accommodation:
- Avoid head-to-head competition
- Entrant should proceed quietly, taking one small step at a time. Limitations on entrant’s capacity send a reassuring message. This can be done not only by limiting capacity, but also by financing the expansion with idiosyncratic, restricted and one-time sources. A large war chest sends a very aggressive signal, and it is unlikely to make the incumbent back down.
- When there are many incumbents, entrant should try to spread the impact of its entry as widely as it can so that effect on any one incumbent is small.
- If the entrant is getting into a new field, again, going slow and steady is the name of the game. Any aggressive move is unlikely to deter others as they will likely see it as proof of demand and insignificant advantage of small lead time of the first-mover.
On the other hand, an incumbent, who has more to lose in an entry/pre-emption game:
- Can assume a confrontational posture by maintaining large excess capacity to meet any additional demand by entrant offering lower price. Higher the fixed cost of capacity, the better.
- A war chest can serve a similar purpose
- If a company focuses narrowly on a given product, it is more likely to be left alone, as entrant knows that the incumbent will be ferocious in defending its turf
Up until now, we have considered capacities of the firm and their competitive strategies so as to maximize the reward. The co-operation model turn these concepts on its head. It begins by asking what levels of rewards are possible (by optimizing an industry) and how the rewards need to be allocated among the participants (through the principle of “fairness”). Strategic/tactical considerations become secondary considerations in this game.
First, the group needs to implicitly agree on the set of attainable joint rewards. Furthermore, no one participant should feel that it could get more rewards by breaking the co-operation. Once this framework is set, the group needs to maximize its joint awards and agree on how to divide the gains. For example, Nintendo used to have a lock on the video-game industry but because of its aggressive attempt to garner a disproportionate share of the video game industry’s profits left other participants unhappy, which in turn, created an opening for Nintendo’s competitors. On the other hand, the lead-additive industry participants co-operated with each other by (a) uniform pricing, (b) advance notice of price changes (at times done by press releases), (c) joint sourcing and production. This was possible because all the participants were within 300 miles of each other and the management came from similar background.
NPV calculations (ala DCF) take reliable information (usually, near-term C/F estimates) and combines that with unreliable information (distant C/F estimates, esp. the ones that make up terminal value), and finally discounts all of this to get a PV. Beyond the obvious, the PV method discards information that is relevant to the economic value of the company–the assets employed by the company to generate the cash flows.
See this summary to see authors’ way of valuing a company.