In chapter one of “Competition Demystified: A Radically Simplified Approach to Business Strategy,” authors Bruce Greenwald and Judd Kahn explained that there are three broad types of competitive advantage: supply, demand and economies of scale. In chapter two, they drilled down into the first two types, supply and demand, which are strongly interconnected.
There is an associated idea covering both of these areas, and that is the idea of differentiation. That's the idea that companies must distinguish themselves from other companies, and they must avoid, at all costs, being trapped in a commodity business (that is, a business in which multiple companies sell the same or very similar products to price-sensitive customers). Obviously, such companies are unlikely to command much in the way of profits beyond the cost of capital.
Greenwald and Kahn challenge the "differentiation myth," saying it does not work. They pointed out that the problem is a lack of barriers to entry, not a lack of product differentiation. For example, Daimler's (XTER:DAI, Financial) Mercedes-Benz and General Motors' (GM, Financial) Cadillac have extremely strong brands and a proxy for differentiation, yet are unable to convert their brand power into highly profitable businesses. Differentiation fails in the high-end car business because there are no barriers to entry.
When there are no barriers to entry, it is crucial for companies to concentrate on efficiency. In copper, steel and bulk textiles, long-term survival often depends on their ability to match the prices of the most cost-effective producers. In non-bulk industries, such as the auto industry, differentiation is costly; just look at the billions car companies spend on advertising each year.
Into this mix, the authors added the importance of “normal” returns on investment. Specifically, “normal” refers to the equivalent of what investors can generate on other investments, risk-adjusted. If companies cannot reach that benchmark, capital will drain away and the company’s future becomes questionable.
According to the authors, barriers to entry are at the core of strategy. Specifically, it involves being able to identify barriers, knowing how they function, how to create them and how to defend them. Further, barriers to entry are the same as “incumbent competitive advantages” (companies that successfully enter a market are called incumbents).
It’s not always easy to become an incumbent, and for investors it’s helpful to know that if the newest firm to enter the market has an advantage, then that market must have no barriers to entry - and that means no sustainable, excess returns.
Supply advantages
The emphasis in the supply area is on competitive costs. An incumbent company often enjoys a lower cost structure, one that can’t be matched by other companies. It not only provides several important advantages, including higher profitability, but also discourages new entrants from trying to get into the market.
The source of a lower cost structure is usually from lower input costs or from proprietary technology. Frequently underlying the latter are product or process patents. In the case of some industries, a new entrant would face the challenge of developing complex processes; chemical and semiconductor firms often have this type of moat.
Cost advantages don’t necessarily last over the long term, since there may be technological change or process disruptions. Even patents last less than two decades, and some of them nowhere near that long because they protect relatively simple processes or products. There is also the possibility that other companies will hire away employees with special or proprietary knowledge. These are some of the reasons they say a belief that information technologies will produce moats is misguided.
Greenwald and Kahn are similarly skeptical about the sustainability of competitive advantages based on lower input costs. Among the several reasons they list are the short shelf life of lower labor costs, as in the case of firms with unionized employees. While unionized firms may get squeezed out due to high costs, the non-union firms that pushed them out are in turn challenged by new firms with even lower labor costs.
The notion of “cheap” capital is also rejected as a source of a sustainable competitive advantage, as are geographic locations and exceptionally talented people.
Demand advantages
The edge from demand can be summed up in a couple of words: “customer captivity.” The authors reminded those of us who have reached a certain age that there used to be a cigarette commercial in which we were told their smokers “would rather fight than switch.”
Yes, it is possible for new entrants to make offers that might tempt customers of the incumbent firms to switch, but it could be a long and costly challenge. What’s more, the incumbent has a big advantage because it can sell its products at a profitable price, whereas the challenger may not. Greenwald and Kahn say there are only a few reasons why customers become the captives of suppliers: habit, switching costs and search costs.
Starting with habit, the authors observed that customers become captives when they make frequent and virtually automatic purchases. It’s a phenomenon that occurs in supermarkets, but not at automobile or computer dealerships.
Switching costs become barriers because replacing one supplier with another requires time, money and effort. Those of us who have switched from a personal computer to a Mac (AAPL) or vice versa know that means buying and learning new software as well as hours and hours of learning how the new system works. It’s particularly hard when networking is involved.
The same holds for replacing one lawyer with another, as briefing the new lawyer will require many hours and much effort. Doctors tend to prescribe familiar medicines and don’t like to switch to new drugs, and so on.
Search costs is the third type of competitive advantage based on demand. As Greenwald and Kahn noted, search costs matter when the products are “complicated, customized, and crucial”. That’s often the case with home insurance, although not necessarily a factor in auto insurance. Usually, homeowners need to be quite unhappy with their existing insurer to go to the trouble of switching to another.
Greenwald and Kahn concluded by reporting that competitive advantages on the demand side are usually more robust than those on the supply, or cost, side. However, even advantages on the demand side have limited sustainability. Old customers die and new customers arrive in the market, and of course, many of those new customers arrive without existing preferences.
Conclusion
In chapter two of “Competition Demystified: A Radically Simplified Approach to Business Strategy,” Bruce Greenwald and Judd Kahn looked under the hood to see what drives (and does not drive) competitive advantages.
They found that supply-side advantages based on lower cost structures, proprietary technology and lower input costs provided only short-term advantages. Demand-side advantages such as habit, switching costs and search costs provide more sustainable advantages, but even these are limited.
For investors, I believe one of the takeaways is that we should see competitive advantages, or moats, as adding value while they last.
Read more here:
- Competition Demystified: Strategy and Competitive Analysis
- High Returns From Low Risk: Is the Investment Paradox Really True?
- High Returns From Low Risk: Don't Trip Yourself
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