Arc of any successful business comes down to a few crux moments where one wrong decision could have spelled defeat
Strategy: study of the fundamental determinants of potential business value
Statics: ‘being there’, how has the business kept this valuable space?
Dynamics: ‘getting there’, what developments has business used?
Alternate definition: route to continuing power in significant markets
Ex: Intel drops memory for microprocessors, which was an excellent business move
Power: set of conditions necessary to create persistent differential returns
Game theory is not enough to determine the best strategy because it often doesn’t lead to Power
Cleverness is also not important, because it is relatively common
Fundamental Formula of Strategy (mathematical definition in book) is composed of two parts:
Persistence: strategy is a long-term game, not a short-term one
You need to be able to determine unassailable perches and figure out a way to get there
Dual Attributes:;
Benefit: creates positive marginal returns
Barrier: prevents other businesses from realizing same benefits
Industry economics and competitive position, complex competition, single business focus and leadership are fundamental in attaining and maintaining Power
Strategy Statics
Scale Economies
Ex: Netflix strategic moves from DVD rentals ⇒ streaming ⇒ own content
By focusing on DVD rentals and streaming, Netflix first acquired huge market shares. This allowed it to pursue gamechanging content with a sizable cash flow, disrupting industry economics
Benefit of scale economies: cost/unit is significantly lower
Enhanced value and lowered cost/unit increases cash flow
Barrier of scale economies: company with largest market share can undercut smaller firms, making it unprofitable to enter market
Definition of Scale Economies: a business in which cost/unit declines as production volume increases
Asides from fixed costs, there are other places where we see scale economies:
Volume/area relationships: production costs closely tied to area but utility tied to volume. Think of milk vats and warehouses
Distribution network density: delivery costs decline as network density increases because delivery is much more economical. Ex: Uber/ UPS
Learning economies: if learning leads to benefit and positively correlated with production levels, then leader will accrue benefits
Purchasing economies: large scale buyers have leverage to lower cost/unit. Think Walmart and Costco
Surplus Leader Margin (SLM) is the profit margin the business with Power can expect to achieve if pricing such that competitors’ profit is zero
SLM = scale economy intensity * scale advantage
First term is referring to economic structure that all firms in market face, while scale advantage refers to the specific company’s scale
Netflix correctly attacked both: originals changed economy and early user acquisition from streaming led to huge scale advantage
Network Economies
Ex: BranchOut, a LinkedIn-esque startup that used Facebook data instead. This startup fizzled out despite its tremendous growth due to low engagement and high churn
Facebook, LinkedIn and BranchOut all use the network effect where the service depends on a large amount of users
BranchOut mainly failed because people wanted to keep their work lives and personal lives separate
Benefit to Network Economies: leaders in the Network Economy can charge higher prices because it inherently has higher value for users
Barrier to Network Economies: unattractive cost in gaining a similar network size
Industries in a Network Economy exhibit the following attributes:
Winner takes all: once a leader reaches a certain tipping point, all other companies basically throw in the towel
Boundedness: boundaries of the network determine the boundaries of the business (eg. LinkedIn is bounded by professional network)
Decisive early product: whoever gets the best product early on gets more users, which is critical for businesses in a Network Economy (growth of users is paramount in the early stages)
Definition of a Network Economy: A business in which the value realized by the customer increases as the installed base increases
SLM=1−1+δ(NS−NW)1
The above is the SLM equation for network economies where:
Delta: benefit accrued by user when one more individual joins network divided by variable cost per unit of production (industry)
N_S: installed base of leader (competitive advantage)
N_W: installed based of follower (competitive advantage)
Delta is the key: by increasing this, you increase the relative effect of the network
For industry leaders, you always need to have a large differential from followers to ensure that you can make som margin
If you are starting a new Network Economy, you must scale faster than anyone else: whoever reaches the tipping point wins
A major problem with entering a Network Economy is that you have no guarantee that you can reach the potential N_S but you still need large capital to scale quickly
Remember, when a brilliant businessperson enters a bad economy, it is the reputation of the businessperson that suffers
Indirect network effects:
If a business has important complements and complements are exclusive to each offering, then a leader will attract better complements (ex: you cannot enter the smartphone OS market because better OS have already taken all apps)
This increases the value prop to the user and the network effect continues
Counter-Positioning
This is the strategy to use to defeat incumbents whose strength seems unassailable according to conventional metrics for competitive advantage
Ex: The rise of Vanguard in equity mutual funds: it simply tracks the market, reducing commisions considerably
Essentially, this strategy comes down to a totally new, heterodox business model which can challenge incumbents and paralyze them into inaction
Benefit of counter-positioning: superior to incumbent’s business model because cost is lowered/ability to price higher
Barrier of counter-positioning: collateral damage; businessness see a huge cost in changing to the new business model. It’s not a lack of thinking, but actually a product of a lot of thinking
Definition of counter-positioning: a newcomer adopts a superior business which the incumbent does not mimic due to anticipated damage to existing business
Why does collateral damage occur?
First of all, stand-alone unattractive is not counter positioning. That is, switching to the new model as a stand-alone business does not provide any power to the incumbent is NOT collateral damage
Ex: Kodak. Kodak could have switched into making digital cameras, but it had no strengths to help take power over digital.
Attributes
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New superior approach is developed
Products from new approach seem to overtake products from old approach
Incumbent has little Power for new business either due to industry economics provide no power (commodity) or attaintment of power is unlikely due to competitive position
Milking: Going to the new model of business will lead to losses regardless of potential increase in gain. However, the incumbent DOES have the ability to attain some power, it will just be incredibly Pyrrhic
Ex: Fidelity Investments vs Vanguard
Called milking because business decides to ‘milk’ existing business model as much as they can
Eventually, the cost of moving over will decline and we usually see ‘delayed investments’ into new business model from incumbents
History’s Slave (Cognitive Bias):
Challenger’s approach is too new and existing business model is successful.
Despite having a positive margin of switching over to new business model, incumbents don’t want to because they are deluded
Job Security (Agency issues):
Upending a business creates a lot of turbulence, which may make senior management extremely wary.
Kind of like sunk cost bias. Not mutually exclusive to cognitive bias!
Counter-positioning vs disruptive technologies: note that there is a difference between the two. DT may provide conditions for CP, but doesnt not by itself give Power
This is a very relative type of Power: it does not apply if other firms start to apply same business model
We can induce cognitive biases of competitors by not trumpeting the benefits of the new business model
In contrast to Scale and Network Economies, many companies in same market can employ counter-positioning
Counter-positioning is very hard to counter, so try not to end up in this position
Usually, people in this position are pressured to do something while not destroying their existing business, so they resort to dabbling, which doesn’t actually address the challenge
CP is usually the cause when the challenger is making strong share gains and strong profitability while incumbent experiences share loss, cannot counter moves, management shakeups and late capitulations
Usually, challenging an incumbent is a loser’s game, but if you are confident that even at the best game the incumbent can be swept off the board, then commit to CP
Take advantage of the incumbent’s strength to create a Barrier
Mathematic model is binary:
Competitive position: you have adopted new business model or you didn’t
Industry economics: must be superior and must cause expectation of collateral damage
Switching Costs
Ex: HP and SAP;
SAP has terrible service, but it has made itself into such a lynchpin that people don’t want to switch from SAP. Good example of sunk cost bias
When HP tried to switch from SAP to another software, it resulted in a $160M financial hit due to unforeseen technical challenges
Once a customer is bought in, they are hopelessly hooked, giving them the power to raise prices if need be
Switching costs arise when a consumer wants compatibility of multiple purchases from a specific firm over time
Benefit: A company that has embedded switching costs can charge higher prices than competitors. Only works for current customers
Barrier: Competitors need to account for the switching costs to take market share, which is unattractive in terms of cost
Definition: the value loss expected by a customer that would be incurred from switching to an alternate supplier for additional purchases
Types:
Financial: transparently monetary (eg. buying new databases, total of all applications)
Procedural: stem from loss of familiarity of product or risk of adopting new product
Ex: people in organization know how to create reports on SAP. By switching away, you create discontent as that skill is now useless
Relational: breaking of emotional bond (eg. customer loses a terrific relationship with service team
Non-exclusive Power type, as multiple competitors can use Switching Costs. As a market matures, this benefit is slowly gone as everyone starts to use it. Thus, the major value is to acquire customers before everyone else does
Benefit is gone if you don’t do additional sales, so develop more add-on products (like SAP) or acquire interesting companies (like Intuit)
Advantages can be swept if technology swiftly changes
Branding
Ex: Tiffany can charge more for diamonds than Costco can, but the quality of the diamonds are almost the same
Tiffany has built a reputation for high-quality jewelry → strong differential margins
Benefit of branding: business with branding can charge higher prices than competitors for two reasons
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Affective valence: built-up associations with brand elicit good feelings (ex: Safeway cola vs Coke)
Uncertainty reduction: product is consistent and high quality (ex Bayer aspirin vs. Kirkland aspirin)
Barrier of branding: strong brand can only be created with lengthy period of reinforcing actions. Copycats are not sure if they can create this branding
Mimicing brands simply leads to unclear outcomes and possible law violations
Definition of branding: durable attribution of higher value to an objectively identifcal offering that arises from historical information about the seller
Challenges of branding for the company:
Brand dilution: have to maintain an extremely high quality of products
Counterfeit: some people will free-ride their products and associate with brand because its the brand that causes differential returns, not the product itself
Changing consumer preferences: a good example is Nintendo failing to adapt to a growing market share of adult gamers. It has developed a brand for child video games
Geographic boundaries: affective valence may only apply in certain regsions
Narrowness: its not just about brand recognition
Non-exclusive: several players in the same market can enjoy branding
Certain goods enjoy branding. They must exhibit the following criteria:
Magnitude: promise of eventually justifying a significant price premium
Consumer goods associated with identity are often great for branding
Duration: long enough time to achieve such magnitude
Marginal profit:
mP=1−B(t)1
B(t) is the brand value as a multiple of a weaker firms price (created by industry economics). t or time is the competitive position
Cornered Resource
Ex: Pixar’s incredible success from Toy Story and beyond. More incredibly, Pixar was able to maintain their success well into 2010s
Why did they succeed? Pixar had an amazing leadership team comprised of Steve Jobs on business, John Lasseter on creative, and Ed Catmull as technical
Only Pixar had the resources of these three. They had it cornered
Benefit of a cornered resource: offers unique benefits
Barrier of a cornered resource: comes down to fiat, usually a personal choice
Definition: preferential access at attractive terms to a coveted asset that can independently accrue value
5 screening tests:
Idiosyncratic: its very unique and its not easy to replace
Non-arbitraged: the resource’s value >> cost in acquiring the resource
Transferable: you can put the resource somewhere else and it would lead to the same value
Ongoing: if you were to take away the resource at any point, differential returns would soon end
Sufficient: having the resource is sufficient in creating potential for differential returns
Process Power
Ex: Toyota Production System is somehow unable to be copied. GM even started a collaboration with Toyota but they couldn’t replicate it’s efficiency
TPS is not just a series of kaizen maneouvers, just-in-time production and other interlocking steps. It’s a huge system.
Benefits: able to improve products and/or lower costs as a result of improvements in the organization
Barrier: difficult to replicate and can only be achieved through long-term evolution. Results from two factors:
Complexity: if process improvements affect many parts of the chain of production, it will be near impossible to mimic
Opacity: its unclear to many, even the creators (ex: Toyota knows that no other company can mimic them because much of their success is created by tacit factors)
Definition: embedded company organization and activity sets which enable lower costs and/or superior product, and which can be matched only by an extended commitment
This power is rare precisely because it is difficult to make process improvements that are not easily replicable in other organizations
Strategy Dynamics
The Path to Power
All power starts with invention, which propels market size
Take the example of Netflix: Netflix had iterated many times, from DVD rentals, exclusives to finally originals. This enabled it to create a competitive position and change industry economics
How to use invention to achieve power:
Scale Economies: pursue a business model that promises scale economies while creating something that is differentially attractive from competitors in order to gain market share
Network economies: much of the same things, except user base is the goal, not sales
Cornered resource: Secure the rights of a valuable resource at an attractive position. Usually involves developing the resource itself
Branding: make consistent design ideas that makes the product create an affinity that is beyond its objective attributes
Counter-positioning: pioneer a new, superior business model
Switching costs: need a user base first
Process power: evolve a complex process that is not easily replacable and offers crazy benefits
Adage ’ “Me Too” won’t do” will help here. Cannot rely on planning to get you to the goal
Elements of how invention creates power:
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Flux: creates new threats and opportunities. For Netflix, this was decline in DVD-mail orders and increase in streaming capabilities
Fits and starts: Need to invent something new
Find a route to Power through continuous experimentation
Always be vigilant for Power opportunities
You need to create a product that evokes a ‘gotta have’ reaction among consumers. This is known as ‘compelling value’
Capability-led value: company tries to translate some capability with product into value (ex: Adobe Acrobat). Highly based on Jobs quote: people don’t know what they want unless you show them.
Customer-led value: many players know about a customer need, but no one knows how to solve it correctly (ex: fiber optics)
Competitor-led value: a competitor releases a product so you need to release an even better product to evoke the ‘gotta have it’ response (ex: Playstation)
Often requires big bang commitments and involves a lot of uncertainty whether features are differential enough in terms of coolness
Power Progressions
Most power moves done in the takeoff period, but these are very short! Only short periods of time where you can take advantage of high market flux to establish Power
Just because another competitor has also joined you in the takeoff stage doesn’t mean that your idea is validated; it also means that you need to act quickly to establish power
At takeoff, you can primarily begin Scale Economies, Network Economies and Switching Costs (think of Intel microprocessors)
Three steps:
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Before (Origination): occurs before product-market fit and where sales aren’t widely taking off
During (Takeoff): Explosive growth
After (Stability): Stability with some mild growth, but nowhere near explosive growth levels
Types of power avaliable in the origination phase:
Cornered resource: protect something that no one else can copy. For example, Intel had secured its rights to the microprocessor patent before releasing it
Counter-positioning: create a vexing business model that creates a ‘damned if you do, damned if you don’t’ cul-de-sac for industry incumbents
Types of power availiable during stability phase:
Process power: requires time to develop
Branding power: same as above
Leadership and operational excellence, while not a true power source, are important in navigating power dynamics