Guru Mantra 15- Competitive Advantage: Racing for Uniqueness (Part I)
Note: this section is bit academic heavy and will be so for some more time.I have tried to use simple words as much, but without understanding concepts behind business and industry its going to be extremely difficult to find out a competitive advantage for company. In later part we will talk about how do we find them from financials and other places. But we will not able to connect the dots unless we understand economic behind such thoughts. Further despite after all these years I understand very little from business strategy, perhaps 10% or less. This is a sincere attempt of offloading the same, apologies in advance for major errors, please do rectify. Happy to include into my practice notes.
If we revisit our understanding about nest building last time we just want to buy company who will produce earnings either at same speed as past or accelerated. Past may not be fool proof indicator as competitor comes in eat away my business earnings.Earnings is that portion of money which is available for shareholders or Earnings Per Share. That pushes us back to think how do we know a company will protect its earnings from competitors for a long period to come? To understand this better we need to go back to history.
Graham, Buffett and Greenwald
Benjamin Graham gave all of us idea that you buy the company if its available less than asset value more specifically net current assets. Buy them and sell them after they spike by 50%, in the process he landed up in buying few hundred shares. Ben Graham didn’t care for much whether company is good or bad, management was poor or better.
Buffett realised during 1970’s that few of Graham companies had gone bankrupt after we sold them beyond a valuation. That forced him to think companies need to stable and at good hands to deliver return, he couldn’t find much companies who survived for a long period. The quest led him to coin a word called, “moat”. As per him moat is the one which protects company from competitors with defence mechanism. Imagine you have a castle which you want to protect from enemies. You may load with water, add crocodiles, make it on top of hills (some of these can be found in real life in Jaipur). In investing sense he started searching for three things:
- Unique product
- Unique Service
- Better Cost Producer
He also wanted to focus on a monopolistic situation which he can understand. This made him buying a bunch of product companies which defined the life style of Americans like Coke, Gillette, Hershey or services which are integrated like Washington Post.
Graham and Dodd wrote security analysis which gave us idea to look at business valuation in tandem with:
Buy at asset value (reproduction, we will touch upon this with margin of safety; this is competitor price tag to buy assets)
Earnings power (how much capital I need to justify the current earnings)
The value of earnings growth
Bruce Greenwald is a passionate professor who spend a lot of time after cracking security analysis post Buffett era. He used both security analysis and moat to propagate a concept which says:
Use reproduction value of assets (same like Graham and Dodd)
Estimate the earnings (again from Graham)
Compute franchise value (he felt if earnings potential are higher than asset value then company is using a moat which gives the extra power. He call it as franchise and tried to value that).
Influence of Charlie Munger
Buffett moving from traditional Graham theory to moat evolution has a lot to do with his partner Charlie Munger which he accepted on public forum as well. During multiple speeches starting from late 90’s at various university, few books authored later on Charlie spoke about multi disciplinary way of managing investment. Charlie advocated on basis that the traditional education doesn’t teach us all that we require to manage day to day work including investment. He was of opinion we need bit physics, economics, chemistry, finance etc and utilise them while investing to a business. Famously he adopted the word mental model and called “network of mental models”. Mental model is a concept as old as 140 years advocated how do we perceive real world by classifying different relationship of particular subject and a persons acts and consequences. In simple word it was psychological tool to think systematically about a subject and seek means of improving it.
Mr. Munger spoke in length about various subjects with their application, a lot of them you can read from Poor Charlie’s Almanack, The Worldly Wisdom and many other books.
Business Strategy
Michael Porter the professor from Harvard Business School chase the word strategy all his life. Strategy as we all know is a an action plan to achieve our objective in long term. Apparently one of the most profoundly used word from home to parliament. Even people sells strategy consulting commands highest respect and money as well.
Prof Porter in famous thesis competitive strategy backed up second sequel competitive advantage spoke in length about value chain of industry, the drivers behind such value chain and nuances of those drivers. Ostensibly the popular usage of word competitive advantage, credit goes to Prof Porter only.
But before I get overwhelmed by Prof Porter, it has a second side too. Prof Porter with equally another genius Mark Fuller created a strategy consulting firmed called Monitor group. Their first assignment was Libya with Mr Gadaffi for transforming country. Not only Gadaffi sir went to oblivion but Monitor also filed for bankruptcy in 2012 and subsequently acquired by Deloitte group. Hence the application of Porter’s thesis remain questionable though widely used.
Chan and Renee both INSEAD guys came out with another business strategy landmark in 2005 called Blue Ocean strategy which analysed 30 industries , 100 years and 150 strategic cases to find out uncontested market places. Of course it did not went scot free without criticism, but Competitive Strategy and Blue Ocean Strategy have been two successful models among billions who chased and are chasing the elusive term strategy.
Fair enough, we are retail investors; we don’t want to be Prof Porter and neither we are going to Harvard. All we want to protect our business from competitors, the concepts unfortunately lie within business strategy. We need not follow completely but basic understanding is a must to survive.
But few bold lines again:
Moat is not competitive advantage, may be a small subset of it.
Mental models are no way competitive advantage. When someone calls network effect or switching cost as mental model they are doing a disservice to Prof Porter. All these words were coined and used by Prof Porter only. Mental models are psychological application to find out situations and solutions, suggested as one of method. This happens to got popular with Charlie bringing on to table. No one knows how many others outside a section of investing fraternity even mention about mental models._
Competitive advantage is a business strategy term used by all stakeholders of business value chain including investors.
Competitive advantage is not something always management is good at, rather it is embedded to economic fundamentals, a link between value I create and how I perform.
Then what is competitive advantage:
** everything I write today comes from 1500 pages two book sequel from Prof Porter.**
Unfortunately Prof Porter theory was very complex, even the managers who wanted to adopt was finding out very tough, still now! We continue to struggle to adopt many of his concepts. Let us try to roll his words what ever we can but with a focus on our objective, “we want to find out those facts which creates a protection for company in grow it’s earnings”.
There is going to be competition within businesses which will require a strategy to conquer. Competition is not “being the best” but becoming unique. Competition is not a direct contest between rivals but a broader struggle over profits, a battle who will capture the value an industry creates. The value I create is my Profit and Loss and competitive advantage is used to perform better. Competitive advantage is doing differently from rivals.
Understanding of Competition and Competitive Advantage
Let us repeat competition is not war fare but creating a unique value. War fare destroys value, competition creates value. As Prof Porter says creating values, not beating rivals is at heart of competition.
How do we know where does superior performance comes from? One is from structure of industry where competition takes place. Because this decides the how the value is created and shared. This is where Porter Five Force comes from which explains industry structure and profit an “average company” can expect. Second leg is “company’s relative position” within industry. A superior position will allow make company to exercise better choices.
The difference between “superior” and “average” companies within same industry traces back to steps taken by company and these “steps” or “strategy as per Prof Porter” are called competitive advantage. It took me 29 readings on 258 pages to understand this. Pretty sure I am a dumb!
Prof Porter said, “strategy explains how an organisation faced with competition, will achieve superior performance. The definition is deceptive simple” yet The Economist magazine all most call me short of megalomaniac!
When everyone jump in chasing same customer the situation is called competitive convergence, all business looks like same which My Guru called earlier sick company. The other important point is customer value may not be company value. For example when competition is limited as a customer you have pay too much extra which something you don’t want. On the other hand company will enjoy but may not be for long as other’s will start joining the race.
Competition should be unique
This is about choosing a path different from others. Let me try to Porter’s example in Indian way. Assume pre-Shatabdi express days between Bengaluru and Chennai. If you want to go you have to spend a full night on train or take a flight, land outside city and drive back and pollute by burning fuel as well. Now Shatabdi starts at 6, by 10.30 I can get down at Bangalore Cantonment and 10.50 I am at MG Road which is my destination. You start at 6 in Chennai to catch a 8 O clock flight, land at 9 and reach ultimately at 11 in MG Road. Does this theory work between Bangalore-Delhi (2200 Kms), no. Shatabdi express is a unique competition, its not competing with airlines or buses but offering it’s uniqueness with added comfort.
Becoming unique is not easy, identifying and executing strategy is not easy either. Otherwise Mckinsey, Bain, BCG, Mercer won’t be charging us a bomb and highly respected as well.
The roots of superior performance lies within 1. Structure of Industry 2. Company’s relative position within industry.
Structure of Industry- The Five Forces
This is nothing but competing for profits within a industry, not between rivals but involves multiple players, let us understand. There is a competition with supplier, customer, substitute and so on.As Prof Porter says “the real point of competition is not to beat your rivals. It’s to earn profits”
Porter developed a five force which basically tells how the industry works and creates and shares value. What are these five forces, just the names now:
Force 1: Threat of New Entrants
Force 2: Bargaining Power of Suppliers
Force 3: Threat of substitute products or services
Force 4: Bargaining Power of Buyers
Force 5 or Core Force: Rivalry among existing competitors
Few misconceptions which we also keep singing day in and day out:
Same forces works for all industries, their relative strength may be different.
_Industry structure determine profits- there is nothing called high growth or low growth _
industry, high tech or low tech, heavy or light regulations. Structure trumps these factors.
Industry structure is surprisingly sticky.
What is industry structure?
Just to repeat five forces framework explains the industry’s average prices and costs and therefore the average industry and profitability we are trying to beat. To know more about Porter five force google, you may get more than a billion pages.
More powerful the force it will exert more pressure on prices and costs both which will make industry less attractive. The hear of business equation remains that is profit!Profit comes after deducting expenses from income, isn’t it? Think expenses are resources used in competing including finance costs, this will transform the industry to create a value. Income reflect how customers value our offering and compare with alternatives.If we don’t create values for customers our income will never costs. Now if a industry creates a lot of value structure becomes critical in understanding who can capture it. A lot of value for customers and suppliers may leave the companies earn little for their efforts.
Joan Margarita of Bain and Company brilliantly expanded once in her speeches, book and article:
When threat of entry goes up, profitability goes down because incomes goes down and expenses goes up.
When supplier exerts more power, profitability goes down because expenses goes up.
When buyers exerts more power, profitability goes down because income goes down and expenses go up.
If substitutes become plenty profitability goes down because income goes down and expenses goes up.
When rivalry becomes intense profitability goes down because income goes down and expenses goes up.
If you look at statements suppliers are only force having an impact on expenses. All others work on dual levers i.e. cost and profit or income and expenses.
Understanding your customers
If you have powerful buyers they will use their clout to pull down prices and demand. Now guess I am selling tooth paste , buyers are limited either Colgate, HUL or few others which will dictate the pricing, thats what they do actually. Most of soaps for HUL is manufactured by small players, pricing and branding is done by HUL; this leaves mark up pricing for small player. If you put the situation on HUL side, it can bully any small time players.
Understanding channels as to how products are delivered can be important to understand customers powers more so when these channels influence customers. For example investment advisor have enormous power in influencing a common man as to which financial products to buy. You can understand now how investment banking are making a moolah.
We might come across cases where segments of customers are less negotiating particularly when they are price sensitive. And this works when products are undifferentiated, expensive to their income. For example you are buying an airline ticket , how does it matter to you which company to use. Or you are buying a LED which is a important decision and substantial investment, we all become price sensitive.
Now take the reverse situation, you are going to buy toilet cleaner; will you bother about cost? Or you want to buy an Apple product, you wont mind paying as you think Apple itself a prestige for many.
Sometime the product becomes mission critical, for example you cant build a house without electric switches,even if switches cost a fraction of apartment cost.So Havells keeps adding teaser price, you continue to ignore them.
Understanding the suppliers
Suppliers can charge higher prices and ask for favourable terms. Hence suppliers capture more value from industry leaving less for others. Example would be perhaps Intel who keep on bull dozing lap top guys. Even the bargaining power of labourers like trade union can be dangerous. That’s why software is a preferred investment decision than tea or sugar.
How do we know the suppliers exerting power?
Check whether suppliers are large and concentrated in industry in terms of percentage?
Whether supplier needs industry or industry needs supplier? For example for guys like Premco Global who makes elastic they need Jockey to survive not other way.
Switching costs are costs (financial and non financial) when you choose one products or services over the other which you are already using.
Switching cost tied to suppliers, for example products like ERP where so many things are interconnected its not easy to switch. One of them is need and investment, I wrote sometime back, here is the link:
Anywise we will cover some of these key terms in detail later as well.
Now If I am a soap manufacturer then I have to sell it through like someone HUL or Godrej.
I don’t have a choice but to accept, as people recognise soap with them. This is called differentiation which can be real (technology) or even perceived (brand).
Also HUL decides to manufacture its own soap, this creates more panic with small guys and prices further fall.
Substitute products or Services
If a product meets same basic need of another product it can put a cap on industry profitability. For example Tax preparation software can hit practising CA’s, but we will continue to use jargons in income tax even software wont understand! 
Substitutes are not direct rivals, they may be unrelated and come from unexpected corners. Sometimes we don’t spot it easily, example IPOD knocked off Sony Walkman with fan fare , little it realised all mobile phones are giving one music player as package. Of course Apple has it’s own share via IPHONE but nevertheless IPOD became unattractive.
Some substitutes have a catastrophic effect, imagine petroleum is gone and everyone started using Algae. The entire auto industry, engines, infrastructure, ancillary have to change their cars, equipments and so on.
But the substitute must offer an attractive value or else it doesn’t look like trade off. Like online video library for renting are much cheaper than buying a movie.
Substitutes works wonderful on both frequent usage and casual usage. Say you get another Gillette at lesser price or say even after you watched a movie utility is over. Both way it works!
Substitute may not be cheap always, for example luxury bus services even higher will be preferred for short distance as it offers saving of hassles, comfort and last mile connectivity.
Switching costs have a role in substitution, cigarette smoking is a such strong habit people wont even switch with lower price.
We covered three forces, two more to go. We will touch upon then Blue Ocean (contrary to what Mr Porter said) and move to what investors made out of these strategy more importantly Mr Pat Dorsey. Finally we will end competitive advantage as surveyors, how do we hunt them from financials and other places.
Thanks once again for giving me an opportunity to write. I hope you do enjoy as I am enjoying by writing, checking and collating.