What Makes for Good Business? Part 3: Competitive Advantage: Sources and Symptoms

In our last post, we covered a concepts like cost of capital and economic profit to consider as a yardstick when evaluating performance of different companies. Now we need to look further at what causes firms to earn economic profits—that is, profits above their cost of capital.

It’s important to understand that many firms fail to cover their cost of capital—NYU professor Aswath Damodaran estimates that ~60% of companies have underearned their cost of capital on average over the last ten years. And we mentioned in the previous post that economic profits trend toward zero in the long run. So how exactly do companies earn economic profits?

Before we answer this question, let’s take a quick trip through Econ 101. Here are four theoretical market models to consider:

• Perfect Competition: In perfect competition, each firm is selling an identical product, and customers can easily switch from one to the other. Because of this, no firm that survive unless matching all the others on price, and the aggregate price will be low enough to where no firm can earn sustainable economic profits. If incumbent firms are earning positive economic profits, more firms will enter, and the ensuing supply glut will push prices and profits down. If firms are losing money, the least efficient will choose to exit the market, constraining supply and pushing economic profits back to zero. It’s key that in this case, there is no differentiation, and price is the only factor driving consumer choices.
• Monopolistic Competition: The only difference between monopolistic and perfect competition is that the products are slightly different. Because of this, some firms can successfully differentiate their product to the point that customers would be willing to pay a small premium for it. Economic profits will be a bit stickier, but should still be zero in the long run, as any successful firm is likely to attract imitators wanting a piece of the pie.
• Oligopoly: Just like oligarchy is rule by the few, oligopoly is a market with few firms. Think of Boeing-Airbus, Coke-Pepsi, Windows-Mac, etc. A few large firms dominate a market, each likely with their own advantages and disadvantages. Some customers would pay a premium for a Windows PC rather than a MacBook, while others will feel the opposite. Because of this, players have pricing power, but are also highly dependent on the actions that their competitors take with respect to product lines, pricing, etc. Game theory models can be used to think about how one actor’s decisions can affect others. Economic profits here are generally more common.
• Monopoly: A monopoly is a market with one firm. A firm with a monopoly doesn’t have to compete within their market. Some monopolists will face price-sensitive consumers—a utility that charges excessive rates for electricity will force customers to either use less or look to escape the grid—but not all of them do. If a firm has a monopoly on a life-saving drug, they may be able to name their price, and all customers able to pay will have no other choice. These features of monopolies can be unseemly, and most monopoly cases in the U.S. face stringent regulations (utilities, for instance) that set limits on the levels of profit and return the firms can earn. Unregulated monopolies are often able to earn economic profits as long as their market dominance persists—but even this seldom lasts forever.

These models are more theoretical than practical examples. The grocery store market that Kroger competes in exhibits some traits of monopolistic competition and oligopoly—although in towns with only one grocery store, that operator will have a monopoly. But the key theme throughout is competition (or lack thereof). Which answers our question on how companies earn economic profits and beat their cost of capital benchmarks: they compete for them.

A brief historical aside: it was not inevitable that competition would become the defining feature of American capitalism. In the late nineteenth century, large business interests often collaborated across industries to improve profits for all—with John D. Rockefeller of Standard Oil being among the most notorious. The effects of this eventually become politically unpalatable, and anti-trust legislation in the early 1900s was the start of setting a new tone. The U.S. government has since sought to either regulate or forestall monopoly powers, and has outlawed competitors from colluding on price-fixing or other schemes.

The monopoly power concerns are taken seriously. Kroger’s pending merger with Albertsons would create the second-largest grocer in America (behind Wal-Mart) with roughly ~20% of the market. This may not seem to be a step toward monopoly, but regulators also consider local markets where the merger may give the combined company 100% of the market, effectively granting a local monopoly that might exploit customers.

How To Compete?

In the cutthroat competition for economic profits, companies need to seek what advantages they can, so it’s important for us to understand what kinds of factors drive competitive advantages. There’s a lot of literature out there on this. Harvard’s Michael Porter developed the Five Forces, one of the better-known frameworks, in 1980.

• Barriers to entry. Some firms have access to unique or expensive resources that would be difficult or impossible for competitors to duplicate. In other cases, a government will grant a monopoly (most common in utilities), effectively barring all competition, in exchange for a firm to submit to regulatory authority. All else equal, a firm operating in a market with high barriers to entry will have an advantage, since new firms will face hurdles in entering the field to partake in any economic profit.
• Rivalry among competitors. The intensity of rivalry can shape a market landscape. Do firms compete aggressively on price, like in a commodity industry? Or do they compete on quality, features, and service? A firm facing less intense competition will do better.
• Availability of substitutes. I’ve always interpreted this to mean substitutes at a “market” level. For instance, auto makers face intense competition within their industry, but they also face substitutes outside of it—mass transit options, bicycles, or just walking—that customers may choose if they are more attractive options. Firms that sell a product with more available substitutes should expect to do worse.
• Bargaining power of customers. Not all customers are created equal. In many industries, large buyers can often command lower prices. In 2009, warehouse retailer Costco announced intent to cease stocking Coca-Cola products as a result of a pricing disagreement. Within weeks, Coca-Cola moved the price to Costco’s liking, and the dispute was resolved. A firm with more powerful customers will struggle to earn above the cost of capital, as the customers will seek to capture greater shares of any economic value.
• Bargaining power of suppliers. The same goes for suppliers. Lots of firms in the aerospace industry have developed proprietary parts that play critical roles on Boeing & Airbus planes. Part manufacturer Transdigm is one example of this—the company makes small, critical components, which represent a tiny fraction of the total cost of a finished plane. But switching costs are high, and some parts are only made by Transdigm. Because of this, Boeing and others are forced to accept the prices Transdigm sets. This is an advantage for Transdigm, and a disadvantage for Boeing—strong suppliers will flex their muscles to try and capture as much value as possible, making it tougher for their customers to retain economic profits themselves.

Michael Porter’s work was groundbreaking it its descriptions of competitive forces. He goes further and describes three generic strategies that companies can follow.

• Cost Leadership. A firm seeking to compete by cutting costs, seeking efficiencies, and keeping prices low is following a cost leadership strategy. Wal-Mart in retail or Spirit (notoriously) in airlines would be examples of this.
• Differentiation. Differentiation is about setting yourself apart from competitors in ways other than price—quality, service, etc. Whole Foods is likely pursuing a differentiation strategy relative to other grocers.
• Segment Focus. By taking a segment focus, a firm commits to competing in just one segment of an industry. Tesla makes cars, but only electric ones. It usually makes sense to combine a segment focus with one of the other two strategies—in this sense, Tesla can be said to follow a “differentiation focus” strategy.

Since the Five Forces, a host of other frameworks and terms have sprung up to help us think about competitive forces. For now, I’ll highlight one more that goes a bit further: Competition Demystified by Columbia professor Bruce Greenwald and Judd Kahn. This work reduces sources of competition to three:

• Supply. Cost advantages may come from superior manufacturing processes, exclusive access to cheaper inputs, or proprietary technologies. Any such advantage that enables a company to produce and deliver cheaper is an advantage of supply.
• Demand. Some companies have captive customers (like Boeing-Transdigm mentioned above), or customers may have high switching costs (Apple vs. Samsung phones). Others may simply have a superior brand that customers will pay for (Apple again). These are advantages of demand, because they influence customer choices.
• Scale. Economies of scale exist if average cost per unit gets lower as the volume of units increases. If this is the case, a company at large scale will have an advantage over smaller players. Note: in practice, economies of scale usually have a limit. Toyota should be able to produce a million cars at an average cost lower than if they produced a hundred. But if Toyota set out to produce a trillion cars, they would likely face rising average costs at some point on that curve. This should make sense, since Toyota would have to spend excessively in this case to ensure that raw materials and other inputs are available for that kind of scale—how much money would they have to shell out just to urge aluminum producers to massively increase capacity and output? A lot.

Greenwald and Kahn’s response to the Five Forces framework is to simply it dramatically. The most important of the Five Forces by far, they say, is barriers to entry—not only because a traditional barrier to entry like regulated-monopoly would exclude all other firms, but because every competitive advantage possessed by incumbent firms is a barrier to entry for all would-be entrants that lack those advantages. Take Apple’s demand advantages for the smartphone market. These won’t prohibit other companies from launching their own phones, but they will serve to make any wannabes think long and hard before trying. Such advantages send a clear signal: “You’d better come prepared if you want to compete with us.”

Thus, Competition Demystified effectively distills competitive analysis into two points:

1. Barriers to entry are everything.
2. Everything is a barrier to entry.

They further provide a decision tree to consider in how to manage competitive advantages:

• If there are no competitive advantages in the industry, the only way forward is to tread water through relentless focus on efficiency. Doing this successfully can ensure that you at least meet your cost of capital.
• If firms have competitive advantages but there is no single dominant player, the industry is likely an oligopoly structure. The firms will face strategic interdependence, where one firm’s decisions will affect the results of the others. Striking a balance between mitigating disadvantages and maintaining advantages is key.
• If there’s a dominant player and it’s you, maintain and strengthen your advantage as much as possible.
• If there’s a dominant player and it’s not you, get the heck out. There’s no need to play a bad hand of cards when you can just cut your losses and fold. Staying around in this scenario turns you into an ant among elephants. Unless you’re serving a profitable niche that’s too small for the big dogs to bother with, there’s little hope of meeting your cost of capital. In these cases, a graceful exit is ideal.

How to Find Competitive Advantages

We’ve covered a lot about what competitive advantages are. But how do we spot them? These factors should be apparent to industry insiders and experts, but what about to regular folks like us? How will we know how to identify the presence of these advantages in a vast sea of industries & firms? Our job is made more difficult by the fact that since Porter, the language of competitive advantage has seeped into the managerial vocabulary—rendering “competitive advantage” a buzzword on par with “maximizing shareholder value” or “disciplined M&A approach”. CEOs know what we want to hear and they’ll make sure to say—whether it’s true or not is our problem to figure out. So how do we find the real advantages out there?

Greenwald & Kahn fortunately do not leave us hanging on this point—they mention two things to look for.

• Stable market shares over time. If competitive advantages exist, then firms should not see wild swings in market share. Further, the firms in the industry should exhibit low turnover, with few entries and exits.
• Profitability of firms over time. Competitive advantages should serve to improve returns on capital for the firms that have them. If returns on capital over a long period are in excess of the cost of capital, there are likely some competitive advantages at play. The authors even provide a benchmark as a rule of thumb (which should be taken with salt, as all rules of thumb should): 15-25% ROICs over at least a decade are strong evidence that an advantage exists, while average returns in the 6-8% range likely indicate their absence.

Alas, this last point comes with a caveat. It’s important in parsing company results that we isolate each market. Ideally, we would be able to come up with a reliable ROIC measure for each of a company’s business lines in cases where the company operates across markets or industries. This is usually a challenge. Even when companies report operating profits by segment, they seldom break out invested capital to that level of detail. One workaround for this is by examining “pure-play” companies in the relevant industries—companies that only focus in that single market/industry. Looking at these returns on capital can help us get a sense for whether or not competitive advantages do exist in that industry.

That was Then, This is Now

Where this becomes a lot harder, of course, is when we need to assess how companies might perform in the future. Competitive advantages are like economic profits: they don’t last forever. Standard Oil and AT&T got broken up by antitrust cases. Henry Ford’s manufacturing brilliance wasn’t enough to fend off General Motors forever, and the entry of Toyota and other foreign players pushed returns back into cost of capital territory. So how can we tell what will stick?

There’s no way to know for sure. That said, we can at least consider a few things.

• How is this company (and its competitors) allocating its investments? Are they improved IT, developing new software, testing new products, or entering new markets? This may help us get a sense for what they plan to do next, and how that may affect competitive advantages.
• Do we trust management? The company’s leaders are ultimately responsible to develop and protect competitive advantages, as well as decide how to allocate capital. What incentives drive their compensation? Do they tend to waste money on unsuccessful new ventures? Do they acquire other businesses? Do they overpay when they do?
• Might the government get involved? Antitrust fears are taken seriously in America—Microsoft has flirted with them for decades. If a firm becomes too dominant, there’s a chance that government involvement may put an end to the party. Kroger-Albertsons’ and Microsoft-Activision Blizzard are two current examples.

Now we’ve got a decent foundation to help us evaluate businesses—from accounting performance to cost of capital to how firms can try to outperform. But at the end of the day, we want to ask ourselves if these companies are good investments. We’ll cover that in our next post.