We’ve spent a lot of time these days thinking about how to identify economic moat, or a firm’s ability to defend against competitive forces in the marketplace. In our search for better understanding we ran across a book by Bruce Greenwald and Judd Kahn, two professional value investors who know a thing or two about investing. The book is a few years old, published in 2005, but the ideas are still fresh and relevant.
Competition Demystified provides an intellectual framework for undertaking competitive analysis and effective strategic thinking.
Anyone with an MBA is familiar with Porter’s 5 forces, which represent the antecedents to many of the ideas in this book. But the authors argue that Porter’s approach is too complex; there are too many economic actors to account for, and it’s too hard to weight Porter’s various forces. The solution is to simplify. They believe one factor in particular–barriers to entry–is more important than the others, and this is the key to understanding markets and the competitive advantages that shape them. If you can say a market has barriers to entry, that is the same thing as saying firms within that market have specific competitive advantages. Thus it is the existence of moats that result in barriers to market entry, and drive competitive dynamics.
What I like about the book?
The book’s main strength is that it provides a straightforward approach to thinking about strategy, which is refreshing in a world filled with business authors who sometimes seem bent on making things more complicated. Having spent a good deal of time over the past few years thinking about economic moats, I also really enjoyed how the authors got into the specifics of sustainable competitive advantage. There are numerous case studies, with concrete examples of how different firms were able to preserve advantages over their competitors.
The authors present their simplified view of strategy, with its focus on understanding barriers to entry, and then conduct competitive analysis by following a systematic process:
- First, identify and define the market and competitive landscape.
- Second, determine whether some form of competitive advantage exists. Are market shares stable? Are profits high and stable?
- Third, if there signs that competitive advantages exist in a market, identify the competitive advantages at work.
The authors argue that competitive advantage exists on either the supply side, or on the demand side.
- Supply. Supply-related advantages are represented by some input cost advantage, or by know-how, which is protected by patents or experience.
- Demand. Advantages associated with demand are are primarily related to customer captivity. This competitive feature is driven by habit, switching costs, and search costs. Here, crucially, and perhaps somewhat controversially, the authors argue that competitive advantage is not due to branding or differentiation, since these do not necessarily preclude competition.
Another advantage on the demand side is economies of scale, which are cost advantages derived from spreading fixed costs over a larger base. But scale itself does not create an effective competitive advantage. For economies of scale to matter, incumbents must have some privileged access to customers, and this usually involves some form of customer captivity. Additionally, scale economies can be effective in local markets, but firms should take care not to expand to more geographically dispersed markets which subject them to increased competition.
Underpinning these concepts is the reality that in the absence of such competitive advantages, competitors are free to enter a market, and firms will compete based on efficiency alone, and thus will be unable to earn returns in excess of their cost of capital. In these cases, success its all about focus and execution, but the authors argue that operational effectiveness is a tactical rather than a strategic matter. In this view, there is no strategic dimension to efficiency.
Once existing competitive advantages in a market have been identified, the next step is to analyze the nature of competition, and how competitors interact. Many competitive dynamics can be understood in terms of game theory, and in particular by applying the Prisoner’s Dilemma to analyze interactions. Are competitors adversarial and engaged in constant price wars? Are they cooperative? Is it a mix of competition and cooperation?
Now that the framework is established, the authors take us through a number of case studies to demonstrate analytic methods for exploring the various competitive advantages and game theory dynamics that shape competitive interactions. There were a number of great examples from the business world, and these were artfully integrated into the strategic framework laid out earlier in the book.
The authors discuss the competitive markets for Apple, Inc., which included chips, software and PC manufacturing, and conduct a review of competitive advantages existing in each. Next, the authors focus on local economies of scale, and show how Wal-Mart leveraged local economies of scale to succeed in its markets. Then as counter-example, they cite the experience of Coors, which was also originally a regional champion, but subsequently strayed from this vision, and found that wider distribution killed margins. Likewise, Compaq experienced early success by initially competing based on economies of scale, but as the market grew this advantage disappeared, as others also began to compete based on scale advantages, in the so-called “dilemma of growth.” Phillips and the market for CDs also exhibited a similar dynamic; once again, the market grew, eliminating economies of scale advantages. The authors also describe how Cisco tried to broaden beyond their core markets, for corporations and universities, and into the telecom space dominated by the traditional carriers, (phone co’s, former bells, CLECs) and found themselves at a competitive disadvantage. So in these examples, we see a range of outcomes that illuminate various aspects of competition.
In the next section, the authors explore price competition and the prisoner’s dilemma, and begin with the example of Lowe’s and Home Depot. Next, they explore the “cola wars,” in which Coco Cola and Pepsi played the prisoner’s dilemma. At first they competed aggressively, and then began to cooperate and profits increased. Another example was Rupert Murdoch and the entry of Fox News into network television market. Knowing that it would be very costly for the incumbents to drive out Fox, Murdoch positioned Fox with measured price cuts, and competed with independent stations, rather than in prime time. This let the proverbial fox into the hen house, ushering in a new, more competitive ere in network broadcasting.
Next are the dynamics of entry/preemption, beginning with the story of Kiwi air. Like Murdoch, Kiwi’s band of laid off pilots and entrepreneurial airline executives signaled the company intended to cooperate, by using a low competition hub, and avoiding price wars, and other aggressive actions like poaching pilots. Yet when the industry dynamics shifted, and it became easy to lease planes, and hire pilots, price wars returned and the cooperative culture fell apart.
There is also a discussion of Kodak versus Polaroid, when Kodak ran into a competitive buzzsaw when in tried to enter the market for instant photography. The authors also explore the market for gasoline additives, Nintendo, and others. These were fascinating examples, which highlighted subtle aspects of competition.
It’s difficult to encapsulate in this brief review the many insights contained in these examples, but suffice it to say that the authors provide a comprehensive exploration of the elements of competitive advantage and market dynamics. If you enjoy business school case studies, and the deep analysis and careful examination they facilitate, then you will love the style of this book.
Although the over-reliance on case studies and heavily academic tone may be my main criticism of it. I did come away from reading this book with a better understanding of the nature of competition, but a lot of the writing felt a little too much like an academic text or even a textbook. Or like regurgitated business school case studies. I guess there’s nothing inherently wrong with that, but it can make for slightly dry reading at times.
I also questioned some of the premises in the book. For instance, the authors say that branding is not a competitive advantage and differentiation is a myth, and “it doesn’t work.” Okay, I guess I can buy that. Then, I read through the Apple section, in which the authors perform a detailed analysis of Apple (circa 2005) and conclude it effectively has no competitive advantages. Yet here we are 10 years later and Apple has had wild success. Isn’t it kind of hard to argue that Apple’s success wasn’t due to branding and successful product differentiation?
Additionally, early in the book, I found the ideas were presented in kind of a hodgepodge manner. It was only toward the end of the book that the analytic structure that was being presented emerged in a coherent way and came together for me.
But in the end, it did come together for me, and in a powerful way. This book provides an excellent overview of the key drivers of competitive advantage, and the dynamics of competition, and reinforced for me many core business concepts that apply across the business world. If you are looking for a framework for strategic thinking, this book is an excellent resource that will give you the tools to analyze and evaluate virtually any industry. It is a great read for strategy executives looking to broaden their perspective, and is also a great addition to the bookshelf for the educated investor.