Competition Demystified

Porter’s Five Forces

Michael Porter famously described the five forces of competition: (1) threat of new substitutes, (2) threat of new entrants, (3) bargaining power of buyers, (4) bargaining power of suppliers and (5) intensity of competitive rivalry. While Porter’s Five Forces remains a timeless aid in strategic analysis, Bruce Greenwald and Judd Kahn go a little further in Competition Demystified: A Radically Simplified Approach to Business Strategy.

Barriers to entry

Greenwald and Kahn suggest that some competitive forces are more important than others. In particular, they believe barriers to entry an essential consideration. Barriers to entry pertain to characteristics that rival firms or new entrants cannot replicate. Competitive advantages and barriers are really two sides of the same coin.

Without barriers to entry, new entrants will enter and competing incumbents will imitate. This will drive the firm’s returns down towards its cost of capital. To remain viable, these firms have to operate efficiently, or otherwise always be one step ahead of the game.

This post will summarise the key lessons I took from Competition Demystified. I found Greenwald and Kahn’s text invaluable. It’s essential reading for students and professionals that want a deeper understanding on barriers to entry, competitive advantages and the creation of enduring business value.

Competitive advantage

Great managers must recognise their firm’s competitive advantages (or lack-off) and execute on a vision that positions the firm strategically. The durability of the firm’s competitive advantages, productivity and/or operating efficiency depends on management’s attentiveness and capacity to respond to structural shifts over time. Following their simplified framework, Greenwald and Khan believe there are three sources of genuine competitive advantages: (1) supply advantages, (2) demand advantages, and (3) economies of scale.

Supply advantages

Supply advantages allow companies to produce goods and services more efficiently than their competitors. This could arise, for example, from proprietary technologies, in-house know-how or unique locations that competitors cannot replicate. It’s a more common advantage for businesses in industries with complex process, learning and/or experience requirements

Demand advantages

Demand advantages describe the degree of customer captivity and/or access to market demand. This could arise from habit formations, high switching costs, high searching costs and strong network effects that discourage customers from seeking alternative providers.

Economies of scale

Economies of scale refers to the decrease in cost per unit as the volume of units sold increases. It is a type of efficiency that scales with organisational output. Large incumbents may operate more efficiently than their smaller competitors, even if they share similar supply and demand advantages.

Companies that rely on economies of scale must defend this advantage aggressively. Additionally, sheer size alone does not confer a scale advantage. Rather, economies of scale is tied to the relevant market or geography for which costs remain fixed. Furthermore, it’s operating scale relative to competitors that is most important to consider. Industry growth may weaken the advantage of scale if fixed costs as a proportion of total expenses decline for both the firm and its competitors as a result.

Durability, locality and captivity

Greenwald and Khan highlighted several more considerations when thinking about competitive advantages. Firstly, competitive advantages tend to emerge locally, whether by geographic or product specialisations. Other barriers to entry, such as government regulation or access to information, may add to these advantages as well.

Secondly, differentiation by itself does not confer a demand advantage. Only brands that create customer captivity constitute a valuable demand advantage.

Thirdly, it’s important to consider the durability of each competitive advantage. The authors believe that firms are most durable when they combine demand advantages with economies of scale. It’s for this very reason that companies like Facebook are difficult to topple.

But many advantages are only temporary if competitors can replicate it over time. For example, companies that rely purely on general know-how, like consulting firms or marketing agencies, are susceptible to imitation and new entrants.

Likewise, new innovations are unlikely to offer an advantage if they are replicable. An industry in which the ‘latest’ firm wins is an industry in which barriers to entry are unlikely to exist.

Finding economic franchises

I’m reminded of Warren Buffett’s distinction between franchises and businesses when talking about competitive advantages. In his 1991 letter to Berkshire Hathaway’s shareholders, he said franchises that earn high returns on capital tend to: (1) offer goods that are needed or desired, (2) is perceived to have no close substitute, and (3) possess pricing power that is not subject to regulation.

By contrast, businesses without these attributes can only earn abnormal profits when they’re low-cost operators, or when the market supply is tight. Low-cost operators requires superior management and execution. Market contractions and expansions tend to move with the cyclicality of industry and the broader economy. Is it no wonder that companies in the airlines or minerals business face such a difficult game?

Stable returns, margins and shares

According to Greenwald and Kahn, businesses with enduring competitive advantages tend to share common properties.These businesses tend to maintain stable market shares, stable operating margins, and consistently high returns on capital over time. The number and stability of dominant players, and the intensity of firm entry and exits, may add additional colour to this.

Once a firm’s competitive advantages are understood, the strategic course of action is generally straight forward. For example, companies with durable competitive advantages in industries with high barriers to entry must understand, protect and extend their moat.

By contrast, companies in industries with zero competitive advantages must focus on operational effectiveness. For industries with dominant “elephants”, “ants” without a niche may have to find their most effective exit strategy.

In Good Strategy / Bad Strategy, Richard Rumelt says you can tell when executives lack a coherent strategy. Some will pursue a “dog’s dinner”, an unprioritised laundry list that lacks direction. On the other spectrum, many will sell their “blue-sky” vision that is fluffy and vague. They conflate aspiration with strategy.

Good strategies, Rumelt says, must contain: (1) piercing diagnosis of the problem; (2) guiding policies for direction; and (3) coherent actions for the organisation to take. If one or more of these kernels are missing, you’ve got a bad strategy on your hands.

Growing profitability

Companies with competitive advantages tend to extend their profits and profitability in one of several ways. Firstly, they may replicate local advantages in additional markets. Secondly, they may increase focus within their niche or product space as they grow. Finally, they may seek expansion in segments that complement their existing dominance.

However, growth can sometimes bring undesirable challenges to profitability. For example, globalisation in the form of lower trade restrictions and transportation costs may weaken barriers to entry. This can allow once unseen entrants to match the economies of scale of incumbents and compete for profits.

Greenwald and Kahn note that in increasingly globalised markets, effective positioning requires even greater localised advantages. We can draw similar parallels here with the impact of technological progress on competition. Physical retailers, for example, that create great experiences for their customers may keep their place alongside the online world.

Prisoner’s dilemma

It’s important to consider how firms might respond to competitive pressures, as well as its impact on margins and return on capital. This includes their capacity to raise prices, lower expenses and undertake expansion without pushback. Highly competitive industries, for example, tend to encourage price wars and high reinvestment rates. Creating a relative edge is difficult when everybody is trying to do the same. This prisoner’s dilemma can downward pressures on margins and returns.

Finally, the stability of competition depends on the number of participants, and the motivations, expectations and preferences of competitors. For example, competitors that prize relative performance over absolute performance may exhibit greater appetite for undercutting and excessive expansion.

Navigating the intensity of competition

Greenwald and Kahn offer several suggestions to restrain the intensity of competition, to create opportunities for raising prices and lowering expenses:

Avoid confrontation: Carving specialisations and niches can help companies to avoid direct competition, reduce duplication in overhead, and increase economies of scale. Similarly, entering quietly and/or delineating between distinct niches may minimise the risk of direct confrontation and aggressive reactions.
Increase the cost of switching: Creating loyalty programs with cumulative rewards to increase the cost of switching and minimise the likelihood of price competition. This is a common practice for retailers and airliners.
Signal predictably and responsively: Set signals or code-of-conducts to demonstrate orderly behaviour, avoid excess capacity or aggressive pricing, or confine aggressiveness to specific periods or produce spaces. Likewise, matching or responding to price changes quickly and consistently can help to establish price discipline, minimise competitor payoffs, discourage future price reductions, and avoid the prisoner’s dilemma.
Use rational incentives: For example, designing remuneration systems that reward profitability over sales growth since the latter tends to encourage more intense price competition. Another good example is to reward returns on invested capital over total earnings, since the latter may generate distortionary behaviours amongst executives.
Spread costs between competitors: Entry and expansions that spread costs across many incumbents, as opposed to concentration on single competitors, may also reduce the severity of retaliation.

Competition Demystified — Bruce Greenwald on Competitive Advantages