You are on page 1of 6

LECTURE #1 Greenwald Strategy Class

These notes may be used to supplement your readings in Competition Demystified. If you look at many strategy and consulting books, your brain will turn to goo. Try to understand the concepts behind the jargon. Strategic Decisions: The real distinction which will apply in this class is: When you talk about strategy, introducing the new product, going into a new business, it is the nature of those decisions that the outcome depends on the reaction of other agents to your decisions. (Think of chess). It is the function of the external economic environment. Then you consider the consequences of those decisions, you are going to be looking outward. When you think of tactical decisions like cost reduction, the outcome is in the control of the company itself—it is inwardly focused. This is a course in external plans. Formulating or analyzing strategy often gets applied in the context of a business plan. Price, entry, competitive response, margin—a lot of assumptions in the outside world are in those numbers. No one ever sees a negative NPV, but as you can see from AOL/Time Warner merger, there are a lot of negative NPV decisions out there. See a discussion here: http://www.nytimes.com/2010/01/11/business/media/11merger.html?pagewanted=all Before you do these financial numbers in a business plan, look at the world from a broad perspective. How do I avoid investing in the South Bronx (Declining Business) of the Investing world? Five Forces from M. Porter--it is not clear--you want to start with one (Barriers to Entry). When we look at external competitive interactions, they are dynamic and complicated. We have to analyze simply. There is no best solution, no formula. You need to analyze each segment of a business and think strategically. Develop a sensible approach. What are the elements of a sensible approach? 1. First, given the nature and complexity of these problems, you will get no place unless you simplify. Start with 1 premise. Go from simple to complicated one step at a time. 2. Second, there is no unique in-depth approach. Look at the problem (elephant) from a variety of different perspectives of which only some are presented in these cases. 3. Third, you want a broad understanding first. Know whether other alternatives are stupid. You are going to start with an idea of what is going on, ask yourself first, how do I measure and know if that is, in fact, true of the particular, real world situation you find yourself, Then you are going to look at broader, qualitative implication, and then you are going to compare that to the available historical data. The sad thing about life is—all you have is historical data. You have to base your decision on historical information. Once you compare your original conjectures, suitably refined, so that they
www.csinvesting.wordpress.com Studying/Teaching/Investing Page 1

LECTURE #1 Greenwald Strategy Class

lead to measurable prediction, against the actual history, you find out if you are wrong or right— then you can refine your theory of how the world works. One step at a time, multiple impressions, broad understand and an iterate process of doing things. There are two ways to describe what we are going to do in this class. A. We are going to make a sequence of simplifying assumptions and each of those simplifying assumptions is going to lead to an approach, the kind of analysis that we can do. B. The first is an industry analysis. It is an army of the ants’ problem (http://www.youtube.com/watch?v=DXaaTQztoI0). The industry that you are operating in---there are many competitors who are after broad profit opportunities and they can’t be manipulated by you. There is no conscious, direct interaction in that environment. What will determine profitability in that environment? Always ask, “Is there competitive advantage (“CA”) and barriers-to-entry (B-t-E)? There is one force of unreasoned competitive drive that most business organizations seem to have. That is not subject to manipulation. If there are B-t-E and limited competitors, there are opportunities for mutual interaction, conscious interaction, what can you say about that? The general solutions don’t get you very far. There are small number of interactions that if you manage them well, you will do well. They will cover 95% of the situations. They are like a Prisoner’s Dilemma problem (see http://pespmc1.vub.ac.be/PRISDIL.html) We are talking about playing in those games and those competitive situations. Finally, you will step back and say that suppose this industry were run by a cooperative council, which organized things efficiently—how would that work? It is possible. Even if it is not possible, you want to think that way, because it will point you in the direction of possibilities for collaboration, or possibilities of non-collaboration. Your survival depends on others in that industry not getting together. We will go through and develop alternatives to particular situations. The first questions about competitive interactions—are the cast of characters limited? Are the characters identifiable or are there an unlimited supply of global competitors? If it is unlimited global competitors, then don’t worry about interactions. Then where profits are driven out by competition, you must be the most efficient producer or more efficient than your competitors. If the situation is a level playing field, then you must be the most efficient producer/operating in that environment.

www.csinvesting.wordpress.com

Studying/Teaching/Investing

Page 2

LECTURE #1 Greenwald Strategy Class

If you are the only one there--Wal-Mart—no competitors in its local market. How do you take advantage of your competitive advantage? When there are CAs and they are shared among a number of competitors (six or less) then you need cooperation amongst firms. You can use classical game theory when more than six firms involved. Cooperative analysis. http://www.law.yale.edu/documents/pdf/holler.pdf And http://faculty.lebow.drexel.edu/McCainR/top/personal/ncoopcoop.pdf This (what we learn in this class) is not the only approach at looking at these strategic situations. The Brandenberger book, Co-opetition, will show you that things don’t turn out as expected. They have a different way of looking at situations. Go here: http://mayet.som.yale.edu/coopetition/ Coke has customer captivity, demand advantage (Things go better with Coke: Gladys Knight and the Pips) http://www.youtube.com/watch?v=lcAr6gBRG9E&feature=related Customers buy out of habit. Mercedes-Benz doesn’t have such customer captivity. Other companies sell Lexus and Cadillac, so other companies compete on a level playing field. Also, the customer is making an infrequent purchase so the opportunity to even capitalize on customer captivity is less. Note with a complex product or service: it is riskier to go to a different plastic surgeon—a complex product has higher search costs. DEMAND competitive advantages—these have to be competitive advantages for your firm. Thing you can do that others can’t do. Cost structure if you have the technical advantage, captive customers that others don’t have. This is not product differentiation. B-t-E and CAs are the same. B-t-E are incumbent advantages. So that the entrants are at a disadvantage. Is it the person who comes in with the latest generation of tech that does best? Not necessarily. You can enter against MSFT. You have to support that technology. Entry advantages intensity competition (TELECOM). A bad industry. Two natural sources of B-t-E and profitability: Proprietary technology and Captive Customers. Competitive Advantage (CA): These others can’t compete at my stage of production; a steadily declining AVERGE COST CURVE in the relevant market is ECONOMIES OF SCALE (“EOS”). This pertains to size in the relative market—not declining average costs depending upon the amount of production. If you are a refrigerator manufacturer and this

www.csinvesting.wordpress.com

Studying/Teaching/Investing

Page 3

LECTURE #1 Greenwald Strategy Class

is your cost per unit, then it doesn’t help you to get more auto sales. Different markets have different sets of Fixed Costs (“FC”). The underlying fixed cost spread over more output means lower per unit costs than your competitors. Also, you need some customer captivity to help guarantee greater demand. If you are an incumbent and you start out with a high demand and your competitor entrant enters with a low demand, you can match the entrant on price. On a constant or lower price, you will beat your competitor. Your fixed costs are only that amount and they are lower per unit than your competitor. What about the entrant? His/her sales are low and with his higher per unit fixed costs than you, he/she loses. (Think of K-Mart competing on price against Wal-Mart). The underlying fixed costs are spread over more output mean lower per unit costs than your competitors. Also, you need some customer captivity to help guarantee greater demand. You (incumbent) are further down the cost curve than he is. Go to any micro-economics text book to see this or go here: http://economics.fundamentalfinance.com/micro_atc_mc.php As marginal costs decline, average costs decline until the lowest point on the average cost curve where marginal costs have started to rise. Are EOS alone a CA? NO! EOS must be combined with customer captivity. If there is difference in access to customers between entrant and the incumbent facing that downward sloping AVC, how should the market be divided? The market will divide equally. Same demand curve for both. If you can’t defend your scale of advantage or your temporary greater access to customers, then the advantages will dissipate. There has to be a temporary advantage. EOS magnifies customer captivity (“CC”) Plus and active defense of the incumbent’s market share, will lead to a large difference in profitability even with the same basic costs. These are the most common sources of profitability. Notice the position of the entrant. There is a big difference in the avg. cost structure. Suppose the market went global? What happens as demand curves move out—what happens to average costs? That is why globalization is the enemy of profitability since economies of scale are eroded for incumbents. As the scale get bigger, the fixed costs get smaller and smaller as a percentage of the market, a bigger market supports more competitors. Once that happens the EOS is never restored. The fixed costs also have to be large relative to the scale of the
www.csinvesting.wordpress.com Studying/Teaching/Investing Page 4

LECTURE #1 Greenwald Strategy Class

market for EOS to provide CA. Even with CA, these advantages still have to be defended. (Kill the baby in its crib—attack entrants early). What is the difference between Coke and Mercedes Benz? Coke has customer captivity. If Mercedes-Benz matched their competitors on price and quality, they might have maintained their market share. What undermined the profit of Cadillac? The globalization of the auto market, which allowed (entrants) Toyota and European Auto-makers like Fiat to develop economies of scale to compete and to enter the market on level terms. What about Coke? They have the secret formula. Could you compete with a small share of the market? Coke has the huge share of a majority of the market and small shares in other markets. You have to have local competitive advantage, EOS. Coke must have a local bottler and local trucks to deliver. Coke has EOS in local market and customer captivity. If you don’t have the scale to support that bottling and distribution infrastructure in local market, then you will not be competitive. Coke has EOS in local markets all over the world and it has customer captivity (“CC”)—the essence of the power of its brand. Two things that determine long-term profit: 1. CC, habit effect, repetitive purchases and are there 2. EOS that magnify these effects? The habit effect, switching cost effect. When you talk about EOS, what determines the degrees of the EOS? Nebraska Furniture Mart has 60% of the Omaha, Neb. Market. It has EOS in advertising and delivery. Do their same EOS apply to NYC? No, because the fixed costs of storage, distribution and advertising only apply to their local market. Those fixed costs would have to be duplicated in the NYC market. You are not moving down the cost curve, you are adding fixed costs. It is scale in a well-defined, local market that counts. You will learn about regional EOS in detail. In product line it matters if you are concentrated: In Cancer Centers of America, there are certain specialties when you have the fixed costs, connection with local doctors, experience and reputation, that you have EOS in a specific specialty. EOS specific to the market that supports those specific fixed costs. Reputation. Does it help when Amazon goes from books to Housewares? No, not really. Aetna with 20 million patients and 10% of patients in New York or Oxford Health Care that has 45% of the patients and Doctors in NY? Which one will you get better EOS? There are three basic competitive advantages (CAs): 1. Cost advantages by technology 2. Demand advantages 3. Customer captivity combined with economies of scale

www.csinvesting.wordpress.com

Studying/Teaching/Investing

Page 5

LECTURE #1 Greenwald Strategy Class

The last question you want to ask about any Barrier to Entry (B-t-E). To what extent are those B-t-E sustainable? Start with static cost advantages. If you are a venture capitalist, will you ever see sustainable technology advantages? No. Everybody has access eventually to new technology. It is a race. Virgin technology and looking for new tech, eliminates CA. What does that mean as technological change begins in which you have a CA dies, your CA dies too. So in high tech industries, are tech advantages by themselves a CA? NO. In low-tech industries with high-tech? No. Even though the technology may last a long time, over time other people will acquire this technology as well. Does sustainability and/or product advantages, cost advantages are mostly restricted to a middle range of industries. Static demand advantage? Customer captivity for fashion. Does ANF have customer captivity? Yes, teenagers have peer pressure to buy ANF. How sustainable is that advantage? Not long-term. Where does that CC die? Students grow up and change their tastes. Even though McDonald Restaurants captures kids while they are young, those customers grow up and graduate to eat elsewhere. McDonalds’ must recruit a new generation of customers. CC dies with the population of customers to be sustainable CA have to exist in the arena of EOS. If Intel has EOS and a small predisposition of PC manufacturers using their chips, then how much can they afford to spend in acquiring the next generation of chips of technology? If Intel which does $20 million in sales and uses 10% of sales in R&D against AMD, which as $3 billion in sales, how much will it outspend AMD in the development of new chips? Probably 5-7 to 1. And AMD can’t afford to compete. Who will win that race in developing generation after generation of new ships? If there is EOS in brand creation, advertising and customer recruitment, then that is an advantage which will extend to new customers. That will extend the CA. Are there proprietary technologies, are there captive customers and most important for sustainability are there EOS with CC? Those are the things that will create B-t-E and sustain profitability. Forget all the other crap you learned.

END.

www.csinvesting.wordpress.com

Studying/Teaching/Investing

Page 6