What You Will Learn
- What is the framework for strategic thinking?
- Which competitive advantages are strategic?
- The process of strategic analysis
“The existence of barriers to entry means that incumbent firms are able to do what potential rivals cannot. Being able to do what rivals cannot is the definition of a competitive advantage.”
—Bruce Greenwald, Competition Demystified
Strategy and Competition
In the preface to Competition Demystified Bruce Greenwald writes about the confusion that’s often present when it comes to competition and strategy, and the understanding of the nature and direct relationship of these two elements.
Anyone running a business knows that competition matters and that strategy is important. But although most experienced business people recognize that these two critical elements of business are associated, few understand their essential natures or the direct relationship between them.
A Framework for Strategic Thinking
Understanding a certain business pretty much comes down to understanding the inherent structural characteristics and the fundamentals impacting the revenues, expenses, and thus profits, and in the end the return that the business is able to generate on its invested capital. Obtaining this knowledge requires an in-depth analysis of
- the business itself, and
- the industry in which it operates.
Just looking at a specific business in isolation could be compared to a situation where you only have one year of financial statements in front of you.
It’ won’t help that much.
One business, just like one year, is only a part of the puzzle. A crucial part for sure, but far from everything you need to carry out a business analysis that will be of any value to you, for example as an investor when thinking about whether or not to buy a few shares in a certain business.
And to be able to make this conclusion, you’ll need an understanding of the relative performance of the business compared to its competitors.
Greenwald also brings up the issue of the need to understand the difference between strategy and planning (emphasis added).
Executives often confuse strategy with planning. They think that any plan for attracting customers or increasing margins is a strategy. Any large-scale plan that requires a lot of resources or takes a long time to execute is considered strategic. Essentially, any plan that answers the question “How can we make money?” qualifies as a business strategy. As a result, too many leaders end up fighting wars they cannot win while failing to protect and exploit the advantages that are the real bases for their success.
Strategies are indeed plans for achieving and sustaining success. But they are not just any ideas for how to make a product or service and sell it profitably to customers. Rather, strategies are those plans that specifically focus on the actions and responses of competitors.
At its core, strategic thinking is about creating, protecting, and exploiting competitive advantages. On a level playing field, in a market open to all competitors on equal terms, competition will erode the returns of all players to a uniform minimum. Therefore, to earn profits above this minimum, a company must be able to do something that its competitors cannot. It must, in other words, benefit from competitive advantages. The appropriate starting point of any strategic analysis is a careful assessment of those economically advantageous aspects of a firm’s market situation that cannot be replicated by its competitors or, at most, can be reproduced by only a handful of them.
The existence or absence of competitive advantages forms a kind of continental divide when it comes to strategy. On one side are the markets in which no firms benefit from significant competitive advantages. In these markets, strategy is not much of an issue. Lots of competitors have essentially equal access to customers, to technologies, and to other cost advantages. Each firm is in more or less the same competitive position.Anything that one does to improve its position can and will be immediately copied. Without any firm enjoying a competitive advantage, this process of innovation and imitation repeats itself continually.In these markets, the sensible course is not to try to outmaneuver the competitors, but rather to simply outrun them by operating as efficiently as possible.
Constant pursuit of operational efficiency is essential for companies in markets without competitive advantages. However, operational efficiency is a tactical matter, not a strategic one. It focuses internally on a company’s systems, structures, people, and practices. Strategy, by definition, looks outward to the marketplace and to the actions of competitors.
On the other side of the divide are the markets where strategy is critically important. In these markets, incumbents have competitive advantages, and the race for profitability is shaped by how well companies manage the competition among their peers and how effectively they are able to fend off potential entrants. A focus on outsiders lies at the heart of business strategy.
Which Competitive Advantages?
According to Greenwald any strategic analysis should begin with two key questions:
- In the market in which the firm currently competes or plans to enter, do any competitive advantages actually exist?
- And if they do, what kind of advantages are they?
Greenwald then goes on and lays out a brief description of the different competitive advantages one should be aware of.
The analysis is made easier because 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.
Sometimes the lower costs stem from privileged access to crucial inputs, like aluminum ore or easily recoverable oil deposits.
More frequently, cost advantages are due to proprietary technology that is protected by patents or by experience—know-how—or some combination of both.
• Demand. Some companies have access to market demand that their competitors cannot match.
This access is not simply a matter of product differentiation or branding, since competitors may be equally able to differentiate or brand their products.
These demand advantages arise because of customer captivity that is based on habit, on the costs of switching, or on the difficulties and expenses of searching for a substitute provider.
• Economies of scale. If costs per unit decline as volume increases, because fixed costs make up a large share of total costs, then even with the same basic technology, an incumbent firm operating at large scale will enjoy lower costs than its competitors.
Beyond these three basic sources of competitive advantage, government protection or, in financial markets, superior access to information may also be competitive advantages, but these tend to apply to relatively few and specific situations.
The economic forces behind all three primary sources of competitive advantage are most likely to be present in markets that are local either geographically or in product space.
As we examine the workings of the different sources of competitive advantages through detailed examples, the benefits of operating in markets with limited boundaries will become apparent, as will the difficulties of establishing or sustaining dominance where the boundaries are vast.
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 within their product space as that space itself becomes larger, like Intel. Or, like Wal-Mart and Microsoft, they gradually expand their activities outward from the edges of their dominant market positions.
The Process of Strategic Analysis
So far, so good. But, how should one proceed to ensure that the strategic analysis will add value to the business analysis, and in this case whether or not the company in questions enjoys any competitive advantage(s) or not, and if it does, what the sources of any competitive advantage are.
Greenwald advises the reader to start any strategic analysis by performing “a market-by-market assessment.”
To keep it simple, always refer back to the two basic questions, as mentioned above, that we are trying to answer:
In the market in which the firm currently competes or plans to enter, do any competitive advantages actually exist? And if they do, what kind of advantages are they?
So let’s say that we have come to a conclusion, then what? Well, it depends on whether a competitive advantage has been identified or not (emphasis added).
When there are no competitive advantages present, then genuine strategic issues are of little concern. Therefore, in markets along the “Competitive Advantage: No” branch in figure 1.1, operational effectiveness —efficiency, efficiency, efficiency—is both the first priority and the last.
But for markets along the “Competitive Advantage: Yes” branch, 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.
The alternatives are not pleasant.
If the advantages dissipate, whether through poor strategy, bad execution, or simply because of the unavoidable grindings of a competitive economy, these firms will find themselves on a level economic playing field—the no-competitive-advantage branch—where life is all work and where profits, except for the exceptionally managed companies, are average at best.
Competitive Strategy Recap
From this introduction of the basics of strategic analysis, it might seem like a lot to keep in mind at first sight.
That’s perfectly normal.
However, there are a few things to learn, but as always, you have to give it some time. In the beginning, attention should be focused on the basic core concepts, the competitive strategy framework, that we will use further on when performing our analyses, and that will serve as a road map in our analysis of different businesses.
Strategic analysis is an area in business analysis that is hard. But, it’s also a very important part.
Why?
Because a strategic analysis done well will give you answers and some very important and valuable insights into your decision making regarding the price you are going to be willing to pay in the end for any business.
We will get back to this later on. For now, the most important thing to remember is that there are two questions to ask:
- In the market in which the firm currently competes or plans to enter, do any competitive advantages actually exist?
- And if they do, what kind of advantages are they?
Also, on top of these two basic questions, there are three genuine competitive advantages; cost advantages, customer captivity, and economies of scale, that each must be remembered going forward.
Below is my own little table with the different kinds of competitive advantages there are to keep in mind.
“Everything should be made as simple as possible, but no simpler.“
―Albert Einstein
About the Author
The pseudonymous Hurricane Capital was Born in the 80’s, lives in Sweden with a Masters of Science in Business and Economics from Stockholm University. Got interested in value investing and devotes his free time and investing. The main goal through the Hurricane Capital blog is to learn about different investing topics, investors and business cases for investment.
