My Thoughts on Competitive Advantage

I’ve always been a bit unimpressed by studies of business management. I can’t get through the writings of Peter Drucker without feeling like I’m reading a list of Benjamin Franklin-like truisms, just loaded up with modern business jargon. “An apple a day keeps the doctor away” becomes “companies utilizing preventative management systems have proven to be a net reducer of future operating costs,” and so on.

I’m reminded of fluffy TED talks that are long on anecdotes and iffy on data. Is a horizontal structure better than a vertical one? Beats me. I suppose it depends. Whatever works, works, and I don’t see the need to spin some grand theory out of it.

With the ideas of Harvard professor Michael Porter, the leading guru on strategy and competitiveness, I take a more nuanced view. I’m inclined to think there are solid ideas in Porter’s work, but they’re buried under an overly mechanistic ideology (the five forces of this, the four corners of that).

To me, Porter’s key insight is that the economist’s view of business is all wrong. Supply and demand and EMH are all fine and good for the textbooks, but a business is first and foremost concerned with differentiating itself and keeping competitors out. Perfect competition is for the birds.

Ideally, you want to have a business with high barriers to entry and low barriers to exit, and you want to differentiate yourself with whatever it is you do. You can do that by exclusivity or by price. That’s your competitive advantage. Once you get that, then you get better managers, better advertising and a stronger brand name. But it starts with a competitive advantage.

I think people often have difficulty with the concept of competitive advantage because they want to see sinister forces at work. And make no mistake: I do believe the tempering forces of free enterprise can sometimes break down and give a particular firm a lasting advantage that has nothing to do with its own inherent merit. It could be that they were in the right place at the right time.

For example, many years ago, the Japanese government gave AFLAC a monopoly on selling cancer insurance, and this translates into a huge market share today. Naturally, this is unsettling to those of us raised on the idea that the world wants a better mousetrap. But the truth is, it doesn’t. It wants the one it’s heard of. Just like in politics, the incumbent holds a lot of power.

Now I feel I must address the concept of First-Mover Advantage. This was a huge idea in the 1990s, and I think it served as unrecognized fuel for the Tech Bubble. The idea also goes by the name Winner-Take-All. (That was the name of a book in the 1990s, and the phrase turned up in Bill Clinton’s campaign speeches.)

The idea is that an early entrant could establish an industry standard which remains in place simply because it’s already there. It’s not better—it’s just there. I can’t tell you how many times I was told that some Internet stock was just like the QWERTY keyboard. In the 1990s, Microsoft was an obvious example of a first mover that became enormously successful, but investors wanted to see were the next standard would be. There was even a magazine called the Industry Standard. Wikipedia tells us that “in 2000, it sold more ad pages than any magazine in America.” Unfortunately, the magazine achieved room temperature in August 2001.

While being a first mover can certainly give one a competitive advantage, it doesn’t mean it will last. It’s also a bit more complicated than being first. For example, it’s nice to have lots of upgrade cycles.

One of my friends who works with the U.S. Navy explained to me that there are only a handful of shipyards left that are capable of building modern, large-scale ships for the Navy. These shipyards have become, in effect, government sponsored quasi-monopolies. I doubt anyone wanted that to happen, but things turned out that way.

This is an important point that Warren Buffett has often discussed. Nowadays, Buffett is the “aw shucks” face of nice-guy American capitalism, but it wasn’t always this way. In the 1970s, he and Munger bought the Buffalo Evening News. The Buffalo Courier-Express, a rival newspaper, did everything it could to make them seem like evil out-of-town capitalists. Buffett was beat up hard in the press, and I think that episode has stayed with him ever since.

In the court case that followed, the opposing lawyer used Buffett’s words against him:

Warren Buffett once said that owning a monopoly newspaper was like owning an unregulated toll bridge. His words were, “…in an inflationary world, a toll bridge would be a great thing to own if it was unregulated.” When he was asked for his rationale, he said, “Because you have laid out the capital cost. You build the bridge in old dollars and you don’t have to keep replacing it.” He was then questioned whether he used the term “unregulated” to mean the ability to raise prices. Buffett said, “That is true.”

It sounds rough, but that’s about the best description of a competitive advantage I can think of. Investors should be on the lookout for these kinds of opportunities, but beware—a competitive advantage can be fleeting.

Posted by on July 10th, 2014 at 1:29 pm

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