Why do some companies do well, while others struggle? It's a simple question with a large number of potential answers, all depending on the situation. To broadly answer this question, I'd like to briefly discuss the nature of competitive advantage and why it matters so much. Competitive advantage is by far the most important topic in business and is what allows companies to become profitable and thrive over time. When investing in companies for the long-term, it is crucial that one understands what it is that separates their firms from others in the industry and why their firm will continue to produce exceptional results down the road.
Firstly, it should be said that business is about providing consumers with a product/service they do not already have. Many think business is about competition, or being 'better' than rival firms- that's a simple-minded and dangerous approach. As it turns out, the most competitive industries and companies are those which experience the lowest profitability because they have to fight tooth-and-nail for customers and revenues. Exceptional business results rely much more on being different than being better- it is in your benefit to avoid competition. The companies that do well in the long-run are those which provide their customers something different/unique that they care about having, and ensuring that competitors cannot imitate what they produce. Think quickly about some of the best companies in the world- Google, Coca-Cola, Microsoft, Apple- they have hardly any competition and are near monopolies (one firm in the market) or in the case of Coke operate in a duopoly (two firms in the market). If you want to search for information online, you basically have to use Google, you don't have much of a choice. On the other hand, the worst companies are those offering products that all their competitors offer- restaurants, commodity companies such as steel manufacturers and farmers, retailers- all extremely competitive and fighting for survival. Customers can walk into any restaurant they please, or purchase corn from any farmer in the world- it's mostly the same product and brand names aren't very important in those industries. It should be clear that a company offers consumers nothing of value by providing the exact same products that are already available to them.
Being better isn't always relevant in business- it's usually about providing something different. As a quick example of this, consider Southwest Airlines. Is it better than Delta or Emirate Airlines? Both Delta and Emirates offer much more comfortable seats than Southwest and on-board service/amenities which Southwest doesn't offer. Southwest is a pretty no-frills airline with no assigned seating, no special on-board amenities, and relatively short flights to secondary airports- but at a much lower cost. What is better in this case depends on what you care about- if it's flight comfortability you would choose Delta or Emirates, if price then you'd choose Southwest. There's no right answer here, and companies have the ability to offer consumers a different offering based on a wide variety of features and options. A differentiated offering is the basis of competitive advantage.
Another idea many novice investors and business-people have is that by investing in the most innovative companies, or the new companies with products that will change the world, they will do well. This may or may not be the case, and paradoxically it usually doesn't matter what impact the product has on society. Once again, it all depends on whether other companies can offer the same thing. The industries that Warren Buffett uses as examples to explain this concept are automobiles and aviation in the early 1900's. Both cars and airplanes had profound effects on the world, but most investors did poorly as competition and bankruptcies ravaged many of the early competitors in both industries. Feel free to look through the list of defunct automobile manufacturers that went out of business in the early 1900's- there are thousands of them. They all helped change the transportation landscape and form the industry, but most of them exited the industry, to put it politely. Even nowadays, both automobiles and airlines are extremely competitive and difficult industries to compete in. Predicting which ones would prevail would have been a matter of extreme luck, and frankly the few that survived required near flawless execution and timing to survive. I doubt they themselves knew they would be the ones to survive. The same could be said for more recent examples such as social networks, video streaming websites, online retailers, or companies within the solar industry.
As Jeff Bezos has said, innovators must accept the fact that they will almost certainly fail. This makes it extremely difficult for the prudent investor to earn decent returns in new industries in which the major players have not yet been determined. Even after the initial shake-out of a new industry, profitability of the "winners" won't depend on how much the product changes the world, but rather on how competitive the industry is and how easily new firms can enter and compete. Some revolutionary industries will have a small number of tremendously profitable "winners", such as has been the case with search engines, social networks, software developers, and soft-drink manufacturers. Some revolutionary industries, such as automobiles, aviation, and most solar companies will be plagued by competitive conditions and low profitability among many players.
On the other hand, think of some boring and stagnant industries such as hand soap, shampoo, bubble gum, soft-drinks, and beer. The firms in those industries have been around for a very long time and they have for the most part been quite profitable. It is because innovation and the pace of change is very low in these industries and the barriers to entry are very high. It is unlikely that a new competitor could make a bubble gum comparable to Wrigley's at a reasonable price, or a bottle of shampoo comparable to Old Spice at a reasonable price. Thus, companies in these boring industries sell the same products year in and year out at very high profit margins for decades without much competition. Of course, all types of volatile and highly technological industries can be highly profitable, but the point is that innovation and profitability are not necessarily correlated.
For small local companies it is possible to simply out-compete one's rivals. If you are a small retailer, maybe you have access to cheaper products by having a good relationship with a wholesaler, are in a better location, have better selection, have a cleaner store, and have better customer service. All of these things could result in you 'beating' your competitors and doing quite well. Outcompeting your rivals however, relies on your rivals being inefficient- something that is much more common in small owner-operated companies than large corporations. If however, a better owner decided to open up a shop near yours and was just as good at customer service, marketing, and providing a good store environment with a wide selection of products, it is possible that they could infringe upon your business and steal your customers. Excluding customer habit, there wouldn't be much to stop them.
Having a competitive advantage however, essentially means that no matter how capable your competitors or potential entrants, your product would be difficult or impossible to replicate. Having a differentiated offering doesn't necessarily give you a competitive advantage or ensure that competitors cannot copy what you make. For example, if I were the first company to ever make balloons with smiley faces on them, and I did well because the balloons were unique and my customers loved them, it probably wouldn't be too difficult for another manufacturer to copy that design and slap a smiley face on theirs as well. There must be barriers to entry and imitation so that your product would be near impossible to replicate at a similar price.
There are a variety of potential reasons this may be the case, and I would like to summarize a few of them below. This list is in no way all encompassing, and the main idea here is that anything which makes it so that your product is uniquely valuable to consumers and ensures competitors can't copy you will bring high profits and great returns to owners.
1. Your product/service must be unique and provide something different than that of your competitors
This is a prerequisite for competitive advantage and good performance. A company is merely a group of people using a group of assets to provide a product or service to the public. I personally like to think of firms with a competitive advantage as tailoring these people and assets to maximize a certain outcome. I think of well-run companies as systems that are designed to produce a certain product in a certain way.
I'll use Southwest Airlines as an example of a well-designed system. Southwest understands that most airline travelers care most about price. Most consumers would much rather have a cheap flight than a comfortable flight- so they get rid of everything that customers don't require and that increase costs. They exclude reserved seats, they don't serve meals, they don't fly internationally, they use the same type of planes throughout its network so that pilots have to be trained to fly only one model of plane and so that their mechanics have to know how to repair only one model of plane, and they use the same repair parts for each plane as a result, and finally they have a highly productive workforce which is focused on minimizing turn-around times to ensure their planes are in the air. Southwest understands that to minimize cost, they must make sacrifices in quality and other features. Most of their competitors can't and won't do this, as they serve business travelers and others who desire to fly in class and style.
To sell tickets at the same price as Southwest, competitors would have to do all of the same things- they couldn't just copy a few parts of the system, they'd have to replicate it in its entirety. This requires massive trade-offs in quality versus price. Similarly, a high quality airline such as Emirates and others would rather focus on offering comfy and spacious seats and beds, meals, tvs, games, wi-fi, and other on its planes to cater to those willing to pay more for an excellent flight experience.
The idea, as originally developed by the strategy theorist Michael Porter, is that many trade-offs must be made in order to develop a system that maximizes a particular feature of a product. In Southwest's system, it caters all of its elements and decisions to minimizing price. Even if a competitor tried to imitate the system, it is not certain that they would be able to copy every particular trade-off- so the more trade-offs that must be made, the better.
A simple math equation explains this idea. If there is a 90% chance that a competitor will be able to replicate any trade-off you have made, then if only 3 trade-offs have been made in your system, the chance of imitation is = 90% x 90% x 90% = 0.9x0.9x0.9 = 0.9^3 = 0.729 or 72.9%.
Now let's say the system requires 10 trade-offs to be made, in which case the chance of imitating the entire system becomes 0.9^10 = 35%. The more trade-offs that must be made, the harder it is to copy the system. In reality, it is likely that the chance of imitating any particular trade-off is lower than 90% for most systems, ensuring that the chance of imitation of a well-designed system will be remote.
To summarize, if different customer segments within an industry have differing needs, companies can develop differing systems to optimize their product offering to that group of customers, at the expense of other customer groups. It requires making trade-offs, understanding the sacrifices, and knowing that developing the 'optimal' product to your desired customers requires giving up other customers with different needs. Tough choices will be made, but the benefits if executed well can be massive.
2. Supply-Side Economies of Scale
Supply side economies of scale (usually just called economies of scale) are both immensely powerful and magical. It is a very simple mechanism which allows large companies to offer products at a much lower cost than smaller companies. It is even possible (and in fact likely) that the large company will have both a better product at a lower price- clearly a high barrier to get over for any new entrant. It involves spreading a large fixed cost over the number of units sold, and if all firms require the same fixed costs then the firm which sells the most units will have the lowest fixed costs per unit sold. This is explained in plain terms below.
A simple example will explain the basics of economies of scale:
Consider two shoe companies. The first is Sadidas Inc., a company which has been selling and designing athletic footwear for decades. The second is Lab brands, a new entrant which would like to offer shoes to the same type of customer. Let's say that to make shoes, you have to open a shoe factory and that a shoe factory costs $1 million to open. So both companies have to pay $1 million to open their shoe factories- it's the cost of entry in the shoe business. Sadidas, being a large and established company, sells 1 million pairs of shoes a year. Lab brands, being an upstart company, only sells 100 pairs of shoes a year.
We are going to exclude all other costs of business besides the factories for now. So for each shoe sold, the factory costs Sadidas only $1.00 ($1 million factory cost / 1 million shoes sold). This means that Sadidas can sell its shoes at any price over $1.00 and be profitable. Lab brands on the other hand, has a factory cost per pair of shoes of $10,000 ($1 million / 100 shoes sold) - so because Lab only sells 100 pairs of shoes a year but has the same factory costs as Sadidas, they have a much, much higher total cost per unit sold. For Lab brands to make any profit from its shoes, it would have to sell each pair at a minimum of $10,000, which is exactly 10,000 times the price of a pair of Sadidas.
Now couple this higher price of Lab's shoes with the fact that Sadidas has been designing and perfecting its footwear for decades for elite athletes, while Lab is inexperienced and just starting to figure out how to design comfortable and safe shoes that perform well. The result is that Lab's shoes are likely not as flashy or attractive, not as safe, will not perform as well, and are priced 10,000 times higher than Sadidas' shoes.
All of the above combine for a near impossible barrier for Lab brands to overcome. For Lab to survive, their customers will have to be willing to pay a much higher price for each pair, meaning Lab's shoes will have to be attractive in some way that Sadidas' aren't. Maybe they can achieve profitability by marketing to a different (likely smaller) customer base with unique shoe needs, and design their shoes in a much different way than Sadidas to best meet those unique needs. In any case, they are at an extreme disadvantage and would have to think deeply about how they would ever be able to compete with the existing shoe companies. If they provide a similar product to what Sadidas offers, they will not survive.
Economies of scale apply to any fixed costs required in business, and even any costs that may be semi-fixed, such as advertising. Advertising is usually seen as a variable cost, but can act to provide economies of scale. Consider television advertising- it is expensive on a national scale and the same concept applies. If a national television ad costs $1 million, and if firm A sells 1 million units from running that ad, and firm B only sells 100, then the advertising costs per unit sold are far higher for firm B. This is the reason large consumer product industries had incredible barriers to entry in the mid to late 1900's- they had massive economies of scale from both factory and advertising costs. There were only a few national television channels, and so an ad ran on television would reach a huge percentage of the American population. If you were a large consumer products company, you could reach most Americans on a daily basis with TV ads, and have a tiny ad cost per unit sold- helping to keep the industry highly concentrated with only a few major, large players. This is still true today, but not to the same effect, as there are many methods of advertising and as TV is far more decentralized.
Now the advantage of economies of scale of course depends on the assumption that new firms will have the same fixed costs as the existing firms. If instead, a revolutionary manufacturing process was developed that reduced the cost of a factory to only $1,000, then the entrants would be in a much better place.
The higher the cost of investment required to enter the industry, the more powerful the economies of scale are and the more difficult it will be to compete with larger firms. In summary, economies of scale are powerful barriers to entry for existing firms in industries where high fixed costs are required to compete. If no fixed costs are required, economies of scale will not exist.
3. Economies of Scope
Economies of scope are very similar to economies of scale, but instead of operating in a single product-line, it implies the sharing of a fixed-asset for a variety of products. This allows for both high quality and low costs across these products which share the fixed asset. An example will clear this cloudy sentence up for us:
Although Honda is known for making cars, its advantage comes primarily from its superior engines. Honda puts these powerful engines in not only cars, but also aircraft, motorcycles, and power equipment such as lawnmowers and generators. So this does two things for Honda. Firstly, if Honda makes awesome engines (which it apparently does), it can put these great engines in a variety of products which require engines, allowing it to produce a wide range of products at high quality. Secondly, if these engines are the same, or very similar, they could be made from a small number of factories which would give Honda the same lower fixed cost per unit effect as described in the economies of scale section with shoes above. This gives Honda both lower prices and higher quality products because all of its products use a similar engine.
Starbucks does something similar with its coffee products. It basically uses the same high-quality beans in all of its drinks (drip coffee, cappuccino, macchiato, frappuccino, iced coffees, and more). By using the same beans in all its products, Starbucks can make a wide variety of coffee-type drinks at high quality.
4. Brands
Brands matter. For the most part, I don't believe that they in and of themselves provide a competitive advantage to a firm, but if a differentiated and/or high quality product/service is combined with a strong brand and unique marketing, it could produce a powerful effect. This seems to work best in industries where consumers develop strong habits- Coca-Cola being the best example. Despite the public conception, there are many more reasons for Coke's great performance over the decades than simply its branding, but no doubt the addictive nature of its product combined with a powerful brand helped it dominate the soft-drink industry. Consumers will almost always purchase the products they are comfortable with, and won't try a new product and accept that 'risk' unless they truly feel they need to. Many of these products have economies of scale, so firstly a new product wouldn't be capable of matching the existing brand's price, but even if it could offer a similar product at a lower price, consumers probably wouldn't be willing to switch. The new product would have to be demonstrably different and/or better in some way. Nearly all blind-taste tests show that Pepsi is far more popular in terms of taste than Coca-Cola because it is much sweeter, but nobody seems to care. Most people feel better when drinking Coke- the brand has a measurable effect on their willingness to pay for Coke and they come to believe that Coke is better while their unbiased tongues would say otherwise.
5. Patents
Developing a complex product, or one which requires significant research and development costs usually allows one to file for a patent. As we all know, patents are given to those products which display some form of technological, biological, or other advance and grant the owner a monopoly over a certain period of time in exchange for information on how the product is created. Having a government-enforced monopoly on your product is clearly a great way to achieve competitive advantage, but you must be sure that the product cannot be manufactured in a similar but slightly different manner or that anyone will be able to infringe upon your patent until it expires. If you are a start-up, expect large companies to attempt to infringe upon your patent and take you to court as you may not be able to afford the legal fees to impose your legally granted monopoly. Whenever the patent expires, massive imitation will ensue if the product is at all in demand.
6. Demand-Side Economies of Scale (Network Effects)
Demand-side economies of scale, or more often known as network effects, are extremely powerful- so much so that they usually create industries in which the winner takes all. The basic explanation of network effects is that as the number of customers or users of a product increases, the value of that product to each user also increases. Unlike in industrial firms, the companies that benefit from network effects usually provide a free service and so differentiation based on features of quality versus price isn't as relevant- the firm that provides the "best" option usually will take an enormous chunk of market share (70%+). The winner in this case would be the firm that is able to best fulfill the average user's needs. Generally this requires user needs to be relatively homogeneous.
A few well-known examples follow:
The example closest to our hearts- Facebook. Of course, the value of a social network to its users depends on the total number of users. If a social network has only 50 members, it probably isn't very valuable. If it has over 1 billion members, it will become extremely valuable to most users and users wouldn't have much of a reason to leave for another social networking site- unless of course the alternative is by far superior in some major way.
Myspace at one point benefited from network effects, just as Facebook now does. The problem? Myspace was primarily focused, as the company name suggests, on the users' personal profile. Facebook understood that to do well in social networking, it had to create a far more immersive and inter-connective experience. I could be wrong in my analysis below, but in my opinion there are a few main factors which allowed Facebook to thrive and dominate in this industry.
Firstly, Facebook required all users to upload photos of themselves and to use their real names. This made it so that users were not simply anonymous users, but real people. Secondly, the Facebook timeline where you can see your friends activity massively increased user connectivity. Facebook members almost certainly interacted at a much higher level than Myspace users because of it. Of course, if users on your network are more active with each other, then the network effects are more powerful. If you create a social network where massive interactivity isn't crucial, then the number of total users doesn't matter as much to the average user. Thirdly, Facebook allowed users a wide range of benefits which would increase activity with one another, including the upload all types of content, the creation of pages and groups, games, and the ability to search for one another much easier than one could on Myspace. Since Facebook provides much of what the average internet user requires of a social network, and since most internet users have a Facebook profile, there is with few exception no need to move to another social network.
Next example- Google. When looking for a search engine, all of us consumers and seekers of information really care about is the relevancy of that information to our needs and the speed at which we can find it. By optimizing its search algorithm, Google has managed to create what is by far the best search engine in terms of providing relevant information to users.
Google is a multi-sided platform. This means that it has two groups of users- consumers looking for information, and companies willing to advertise to those consumers of information. It is a similar system to that of newspapers in the mid 1900's which dominated their local cities- except Google operates on a global scale. It is basically the gatekeeper of all information searched for on the internet, and as a result it has become one of the best companies in history. Consumers need no second search engine, and so Google is the only search engine on which most advertisers are willing to buy ads. The more users that use Google, the more advertisers are willing to pay Google for ads. These network effects are tremendous. Google controls over 80% of the search industry, and that is with Bing currently paying users to search through its engine. If you are paying people to use your product, and they still choose your competitor's offering instead, it should be clear that you are in a bad position.
The last example I'd like to mention to illustrate network effects is a physical network. A physical network doesn't always increase in value to its users as the number of users increases, but it might. The advantage of a large physical network is a mixture of supply-side economies of scale and network effects. Let me explain:
Consider the two largest private logistics firms in the U.S. - UPS and Fedex. They have facilities worldwide which sort and distribute packages. Now, imagine you are a new delivery company and you'd like to send packages to and from customers across the U.S. just like Fedex and UPS. How would you go about doing this? You couldn't just build a facility in one location, because you'd have nowhere to send packages to. You couldn't really just place buildings in a handful of locations either, because then you'd only be able to send packages between a few select locations and your customers need to send packages to all sorts of locations around the country. The answer is that you'd basically have to replicate the entire network at once, which is obviously a daunting and immensely expensive task. Now let's just say you somehow came up with the funds to construct buildings so you could send packages all over the world, just like UPS and Fedex. The problem here is that you still have no customers, and so your cost per package sent will be much, much higher than that of UPS or Fedex, causing your prices to be much higher as well. Why would anyone want to use your delivery services at a higher price? It's an incredible catch 22 in which you need the physical network to get customers, but to build the network you need a lot of customers. All in all, this semi-network effect combined with economies of scale create a near impossible barrier to entry.
Amazon seems to be attempting to bypass this catch 22 by slowly building its delivery facilities to service its large base of customers. I will discuss this in a future blog post, but just know that the capital expenditures required to replicate such a physical network would be overwhelming for even the largest of firms.
7. Complicated Processes- the Learning Curve
If a complicated process is required to provide a product/service to customers, it may be hard to imitate by competitors. As a quick example, I'll use UPS and Fedex again. In order to send packages all around the world, a new competitors in the delivery business would have to figure out how to take those packages, sort them, and send them to their end destinations in a timely manner. Some packages require different pickup times, some require different delivery times, some are urgent, some are fragile and need extra care, and some are very heavy, but they're all going to different locations around the world. Providing all of the above services require meticulous and complicated procedures and planning on a constant basis. You also have to ensure that this is done in an efficient and cost-effective manner. It requires years of experience, learning and planning to perform at a reasonable level.
With any task, we get better as we repeat it and do it over and over again. We pick up on how to save time without affecting the outcome, how to improve the outcome, and more. The same goes for large companies- it's called the learning curve.
8. Vertical Integration
This is one that business novices feel will always help a firm dominate an industry. It is thought that if you buy your suppliers, and your customers if they are companies, you can run the entire supply chain from beginning to end-customer. While vastly overvalued in most cases, vertical integration can sometimes be very powerful. Usually the benefits don't come from cutting out middle-men and saving costs, because in most cases these middle-men provide something of value that must be done to the product. If you cut them out, you'll have to perform that same activity, so you won't save much and it may even cost you more. Vertical integration usually benefits firms by providing them with a much higher quality source of supply than they otherwise could have. It may also allow them to keep their entire production process secret.
Starbucks is a good example of a company that is vertically integrated. It buys beans from farmers in certain areas of South America which produce the best quality beans. It then has its own proprietary process for roasting its beans which allow for a much bolder and unique flavor than its competitors. It then uses these beans for all of its coffee drinks worldwide. These drinks are of course sold in the company-owned stores which provide for great atmosphere and customer service. Starbucks integrated backwards into bean roasting, because their process allowed for much bolder and better tasting beans. They also decided to control the retailing of coffee, so they could use the beans in all their drinks and control the setting in which their coffee was sold. Integrating back even further into farming likely wouldn't help them and would only add complexity. The lesson from successfully vertical integrated firms? Only integrate forwards or backwards if you can provide something unique and different to the activity that will benefit your product offering.
9. Regulation
The last major topic I can think of that provides for competitive advantage is regulation. A few quick examples to explain this are below:
After the initial airline shake-down in the very early 1900's when it was a new industry, the government implemented regulations on entry into the industry. This allowed the established players some comfort in pricing because entry and competition was limited. In 1978, the industry was de-regulated, and firms began entering the industry en-masse which ruined industry profitability for the next few decades.
Another more recent example is that of marijuana retailers in U.S. states where it is currently legalized for recreational use. Since marijuana is a basic commodity, nearly anyone can grow and sell it, so growers are largely unprofitable and sell their produce to wholesalers and retailers for whatever they can (which as expected, is increasingly at a lower price as more people grow the plant).
Retail stores which are licensed to sell marijuana to consumers are for now quite profitable, and for one big reason- in these states the number of retail licenses is limited. In Washington state for example, only a certain number of licensed retailers can exist at any time (and the number is quite small), so after that number, entry is impossible. This means that the established retailers have what may be the best barrier to entry imaginable- the government disallows all new firms from entering the industry and competing. Of course, this makes retail prices of marijuana higher than they would be in a free-market scenario and as a result these retailers are highly profitable. If and when the industry is de-regulated to the point where anyone could open a marijuana retail shop, the industry would change dramatically. As with most other local retail stores, there would be almost no barriers to entry. The entrants would compete profits away, and marijuana shops would be about as profitable as coffee shops (maybe slightly more because it requires higher product selection and more product knowledge, but either way- not a great business when fully deregulated).
If your firm is doing well, it is likely that it benefits from one or a few of the above effects. The above summary is not all-inclusive and I may certainly be forgetting a few things, but hopefully it provides a basic mental framework for those looking to understand how companies do well, both for their customers and themselves.