Times Change and Moats Change With Them

Times change, and we change with them.

—Latin Proverb

Times Change and Moats Change With Them

In his 2005 letter to shareholders Warren Buffett discussed the topic of competitive advantage, or moats in his own words (emphasis added).

Every day, in countless ways, the competitive position of each of our businesses grows either weaker or stronger. If we are delighting customers, eliminating unnecessary costs and improving our products and services, we gain strength. But if we treat customers with indifference or tolerate bloat, our businesses will wither. On a daily basis, the effects of our actions are imperceptible; cumulatively, though, their consequences are enormous.

When our long-term competitive position improves as a result of these almost unnoticeable actions, we describe the phenomenon as “widening the moat.” And doing that is essential if we are to have the kind of business we want a decade or two from now. We always, of course, hope to earn more money in the short-term. But when short-term and long-term conflict, widening the moat must take precedence. If a management makes bad decisions in order to hit short-term earnings targets, and consequently gets behind the eight-ball in terms of costs, customer satisfaction or brand strength, no amount of subsequent brilliance will overcome the damage that has been inflicted. Take a look at the dilemmas of managers in the auto and airline industries today as they struggle with the huge problems handed them by their predecessors. Charlie is fond of quoting Ben Franklin’s “An ounce of prevention is worth a pound of cure.” But sometimes no amount of cure will overcome the mistakes of the past.

Our managers focus on moat-widening – and are brilliant at it. Quite simply, they are passionate about their businesses. Usually, they were running those long before we came along; our only function since has been to stay out of the way. If you see these heroes – and our four heroines as well – at the annual meeting, thank them for the job they do for you.

But, as sure as times change, the same goes for moats. So, if you manage to identify a moat that you may even assess as sustainable, remember that nothing lasts forever, not even wide moats (at least I’d say that’s the most probable and likely outcome if you were asked to make a bet on any given business).

As an example, let’s take a look at the newspaper industry and how it has changed during the latest decades.

Newspapers in the ’70s: Moat-Widening

Thanks to a reader of the blog, I was made aware of an article published back in 1977 in the Wall Street Journal and entitled The Collector: Investor Who Piled Up 100 Million in the ’60s Piles Up Firms Today. In this article the author wrote about Warren Buffett’s taste for cash-generating newspapers with moats:

Warren has been largely restricting himself to companies which he feels offer some protection against inflation in that they have a unique product, low capital needs and the ability to generate cash. Warren likes owning a monopoly or market-dominant newspaper to owning an unregulated toll bridge. You have relative freedom to increase rates when and as much as you want.

To read the WSJ article, click here.

Newspapers Today: Moat-Erosion

Going back through the years and the letters to shareholders written by Warren, we find an extensive discussion about the state of the newspaper industry in his 2012 letter (emphasis added).

We Buy Some Newspapers . . . Newspapers?

During the past fifteen months, we acquired 28 daily newspapers at a cost of $344 million. This may puzzle you for two reasons. First, I have long told you in these letters and at our annual meetings that the circulation, advertising and profits of the newspaper industry overall are certain to decline. That prediction still holds. Second, the properties we purchased fell far short of meeting our oft-stated size requirements for acquisitions.

We can address the second point easily. Charlie and I love newspapers and, if their economics make sense, will buy them even when they fall far short of the size threshold we would require for the purchase of, say, a widget company. Addressing the first point requires me to provide a more elaborate explanation, including some history.

News, to put it simply, is what people don’t know that they want to know. And people will seek their news – what’s important to them – from whatever sources provide the best combination of immediacy, ease of access, reliability, comprehensiveness and low cost. The relative importance of these factors varies with the nature of the news and the person wanting it.

Before television and the Internet, newspapers were the primary source for an incredible variety of news, a fact that made them indispensable to a very high percentage of the population. Whether your interests were international, national, local, sports or financial quotations, your newspaper usually was first to tell you the latest information. Indeed, your paper contained so much you wanted to learn that you received your money’s worth, even if only a small number of its pages spoke to your specific interests. Better yet, advertisers typically paid almost all of the product’s cost, and readers rode their coattails.

Additionally, the ads themselves delivered information of vital interest to hordes of readers, in effect providing even more “news.” Editors would cringe at the thought, but for many readers learning what jobs or apartments were available, what supermarkets were carrying which weekend specials, or what movies were showing where and when was far more important than the views expressed on the editorial page.

In turn, the local paper was indispensable to advertisers. If Sears or Safeway built stores in Omaha, they required a “megaphone” to tell the city’s residents why their stores should be visited today. Indeed, big department stores and grocers vied to outshout their competition with multi-page spreads, knowing that the goods they advertised would fly off the shelves. With no other megaphone remotely comparable to that of the newspaper, ads sold themselves.

As long as a newspaper was the only one in its community, its profits were certain to be extraordinary; whether it was managed well or poorly made little difference. (As one Southern publisher famously confessed, “I owe my exalted position in life to two great American institutions – nepotism and monopoly.”)

Over the years, almost all cities became one-newspaper towns (or harbored two competing papers that joined forces to operate as a single economic unit). This contraction was inevitable because most people wished to read and pay for only one paper. When competition existed, the paper that gained a significant lead in circulation almost automatically received the most ads. That left ads drawing readers and readers drawing ads. This symbiotic process spelled doom for the weaker paper and became known as “survival of the fattest.”

Now the world has changed. Stock market quotes and the details of national sports events are old news long before the presses begin to roll. The Internet offers extensive information about both available jobs and homes. Television bombards viewers with political, national and international news. In one area of interest after another, newspapers have therefore lost their “primacy.” And, as their audiences have fallen, so has advertising. (Revenues from “help wanted” classified ads – long a huge source of income for newspapers – have plunged more than 90% in the past 12 years.)

Newspapers continue to reign supreme, however, in the delivery of local news. If you want to know what’s going on in your town – whether the news is about the mayor or taxes or high school football – there is no substitute for a local newspaper that is doing its job. A reader’s eyes may glaze over after they take in a couple of paragraphs about Canadian tariffs or political developments in Pakistan; a story about the reader himself or his neighbors will be read to the end. Wherever there is a pervasive sense of community, a paper that serves the special informational needs of that community will remain indispensable to a significant portion of its residents.

Even a valuable product, however, can self-destruct from a faulty business strategy. And that process has been underway during the past decade at almost all papers of size. Publishers – including Berkshire in Buffalo – have offered their paper free on the Internet while charging meaningful sums for the physical specimen. How could this lead to anything other than a sharp and steady drop in sales of the printed product? Falling circulation, moreover, makes a paper less essential to advertisers. Under these conditions, the “virtuous circle” of the past reverses.

The Wall Street Journal went to a pay model early. But the main exemplar for local newspapers is the Arkansas Democrat-Gazette, published by Walter Hussman, Jr. Walter also adopted a pay format early, and over the past decade his paper has retained its circulation far better than any other large paper in the country. Despite Walter’s powerful example, it’s only been in the last year or so that other papers, including Berkshire’s, have explored pay arrangements. Whatever works best – and the answer is not yet clear – will be copied widely.

In a the recent Politico Playbook interview Warren Buffett shared his bearishness on newspapers.

Buffett is bearish on newspapers:
“Newspapers are going to go downhill. Most newspapers, the transition to the internet so far hasn’t worked in digital. The revenues don’t come in. There are a couple of exceptions for national newspapers — The Wall Street Journal and The New York Times are in a different category. That doesn’t mean it necessarily works brilliantly for them, but they are a different business than a local newspaper. But local newspapers continue to decline at a very significant rate. And even with the economy improving, circulation goes down, advertising goes down, and it goes down in prosperous cities, it goes down in areas that are having urban troubles, it goes down in small towns – that’s what amazes me. A town of 10 or 20,000, where there’s no local TV station obviously, and really there’s nothing on the internet that tells you what’s going on in a town like that, but the circulation just goes down every month. And when circulation goes down, advertising is gonna go down, and what used to be a virtuous circle turns into a vicious circle. I still love newspapers! You’re talking to the last guy in the world. Someday you’ll come out and interview me, and you’ll see a guy with a landline phone, reading a print newspaper.”

The table below shows how advertising revenue has declined between 2003 and 2014. A slide that most likely is going to continue.

As summarized by The 13th annual Pew Research State of the News Media Report about the current state-of-play when it comes to newspapers:

It has been evident for several years that the financial realities of the web are not friendly to news entities, whether legacy or digital only. There is money being made on the web, just not by news organizations. Total digital ad spending grew another 20% in 2015 to about $60 billion, a higher growth rate than in 2013 and 2014. But journalism organizations have not been the primary beneficiaries. In fact, compared with a year ago, even more of the digital ad revenue pie — 65% — is swallowed up by just five tech companies. None of these are journalism organizations, though several — including Facebook, Google, Yahoo and Twitter — integrate news into their offerings. And while much of this concentration began when ad spending was mainly occurring on desktops platforms, it quickly took root in the rapidly growing mobile realm as well.

In hindsight, everything looks pretty clear, right?

The trick is being able to continuously evaluate businesses and industries and identify any data that may indicate a coming, or ongoing, moat-erosion. But that’s some topic for another post.

Even though this blog post was about the past, the key take-away from it is that moats change, and we gotta be aware of this and make the best we can out of it we look into the unknown future. At least if we’re hunting for, and investing in, companies supposed to enjoy sustainable competitive advantages.

“Of all the ‘old’ media, newspapers have the most to lose from the internet.”

—The Economist

Links

Peter Thiel’s Stanford Lecture Nr. 5: Competition is for Losers

«Escaping competition will give you a monopoly, but even a monopoly is only a great business if it can endure in the future.»

—Peter Thiel, Zero to One

Let’s Go to Class: Peter Thiel on Competition

Click here for slide deck.

A transcript of class nr. 5 is available here.

Also, Blake Master’s notes from the Thiel classes can be found here.

* * * * * * * * * * * * * *

«If I do my job right, this is the last class you’ll ever have to take.» 

—Peter Thiel

Additional Reading

FAQs: An Interview with Michael Porter (Part V)

“The underlying principles of strategy are enduring, regardless of technology or the pace of change.” —Michael Porter

Below, the fifth (and last) part of an interview with Michael Porter from Understanding Michael Porter: The Essential Guide to Competition and Strategy. Underlining and bold markings are my own.

V. Leading the Organization

Magretta: What’s your advice on the strategic planning process?

Porter: I am often asked about whether there’s a difference between strategic thinking and strategic planning. My answer is that strategic planning should be a process for doing strategic thinking, but it often becomes a time-consuming ritual that really doesn’t support strategic thinking at all.

I think there are a couple of keys to successful strategic planning. One is that you need to bring together the whole team responsible for a particular business, and they need to do the plan together. You can’t divide up the work and then try to staple it together at the end. Strategy is about the whole enterprise, not the individual pieces. That’s a foundational principle of good strategy. There’s no such thing as a good marketing strategy. There’s only a good marketing strategy in the context of the overall strategy. The danger with sending people off to do their own functional plans is that you’ll end up with a series of unconnected “best practices,” not a coherent strategy. That’s why a strategic plan needs to involve the whole management team working together to think about the industry, the competitors, the opportunities, the value chain, and then ultimately make some choices about positioning and direction. Then, the team needs to develop the implications for action.

I believe it’s beneficial to have a formal strategic planning process because otherwise the day-to-day pressures of the business drive out strategy. There needs to be a process once every year or two, and then quarterly reviews. But you can’t let it be simply about budgeting and making guesses about next year’s growth rate. Planning needs to support thinking rather than drive it out.

Magretta: How do you get everybody in the organization on the same page?

Porter: Communicating the strategy is really important. Strategy is useless if it’s a secret, if nobody else in the organization knows what the strategy is. The purpose of strategy is to align the behavior of everyone in the organization and to help them make good choices when they’re on their own. Those choices happen every day—when your salesman is deciding who to call on and what pitch to give, when the folks in product development are thinking about what sort of new ideas to look at. People are out there, every day, making choices. You want them to make the choice that fits the strategy. So you’ve got to communicate it.

How do you communicate it? Well, you’ve got to find a concise and memorable way to explain your strategy. Really good leaders crystallize the value proposition into something relatively simple. And then they help individual units in the organization translate what that means for every activity. Good leaders are strategy professors, in the sense that they’re teaching strategy all the time. They’re giving lots of little talks about strategy. They start every meeting with the twenty-fifth repetition of the essence of the value proposition. Then it goes on to whatever the meeting is about. The employee dialogues always start with, What do we stand for as a company? What makes us distinctive? How are we unique? And it goes on from there. You’re constantly repeating and you’re encouraging your direct reports to also give the same speech to their organizations. It’s important, if you’re the general manager, to sit in on some of those meetings where your direct reports are trying to explain the strategy, and listen to see how they do, just to make sure that people really understand it.

I’ve seen too many organizations where the understanding of the strategy and the agreement about it are superficial. Everyone can agree at some very high level, but then when you get into the detail, you see that people actually don’t understand, and they don’t agree. They act at cross-purposes to each other. So you’ve got to create an opportunity to really understand the way people think and to confront the issues.

I also believe that you should communicate your strategy to your customers, to your suppliers, to your channels, and to the capital markets. You’ve got to help the capital markets understand how you’re going to be superior and what metrics they ought to be using to see, first of all, how you’re superior and how you’re progressing in your strategy. Don’t assume that stock analysts will figure it out. You’ve got to tell them.

If your competitor hears you give a speech about your strategy, so much the better. Because if you have a clear strategy with trade-offs and choices, the more the competitor knows you’re committed to it, the more likely they are to do something else, to avoid head-to-head competition where they’re not going to be able to win. Ultimately, I think communicating widely is the only way to do it. Now you don’t necessarily want to tell your competitor which machine you’re going to buy and when you’re going to introduce a new product and all the details that might give them some ability to make things difficult for you. But the basic direction you’re going is something else. They’re going to find out anyway, so you might as well communicate it clearly in your own words.

And finally, if there are individuals who don’t accept the strategy, who simply refuse to get on board, they cannot have an ongoing role in the company. That’s a polite way of saying they’ve got to go. You can’t debate strategy among yourselves for very long. You just can’t. It’s too hard to implement well even with a willing management team. I’ve seen too many cases where executives just let the dissenters hang on. The resulting negative energy and confusion and waste of time really damage the strategy. It’s healthy for people to disagree and managers should be given a chance to make their case and to change minds, but there comes a time when the discussion has to end. It’s not about democracy, or consensus, or about making everyone happy. Fundamentally, it’s about picking a direction and then getting everybody really excited about it.

Disclosure: I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company or individual mentioned in this article. I have no positions in any stocks mentioned.

FAQs: An Interview with Michael Porter (Part IV)

“As a multisport athlete, I was always fascinated with competition and how to win. At HBS and later at the Harvard Department of Economics, I was drawn to the field of competition and strategy because it tackles perhaps the most basic question in both business management and industrial economics: What determines corporate performance? —Michael Porter

Below, the fourth part of an interview with Michael Porter from Understanding Michael Porter: The Essential Guide to Competition and Strategy. Underlining and bold markings are my own.

IV. Special Cases: Unattractive Industries, Developing Countries, Nonprofits

Magretta: What if your industry is unattractive? Are you stuck with the five forces, or can you reshape them in your favor?

Porter: The structure of any industry is heavily influenced by some underlying economics. The real profit killer for the airline industry has been the highly unusual combination of low entry barriers and high exit barriers. That’s a very rare configuration of forces. So it’s not all that hard to start a new airline, but if the company goes out of business, the airplanes don’t go away. Airplanes are what we call fungible assets, that is, they can be used by any carrier, on almost any route, at any time. So the plane can change ownership, but the capacity never leaves the market until the plane literally falls apart. If you’re running an airline, once you’ve acquired your planes, hired your staff, and set a schedule, then the fixed costs are enormous and the variable costs are low. Therefore there’s intense pressure to fill the plane, and pressure on discounting to do so.
These elements define the underlying economics of the industry and they are reflected in the industry structure. If larger planes have lower operating costs per passenger, that will push the industry toward larger aircraft. That’s fundamental economics. Sometimes these basic economics do change. Imagine if someone invented a different kind of airplane engine that changed the economics, that someone lowered the penalty for flying smaller planes. That would relax the economic constraints. That’s what happens when you have a new technology that upends the economics.

But some aspects of industry structure result from choices that industry leaders make that lead you down one path or another. There was nothing foreordained in airlines that required the industry to embrace yield management, setting different prices for the identical seat on a flight because of the exact time you bought the ticket. It must have seemed like a smart way to fill seats, but it has, in fact, been a disaster for the industry, creating permanent price competition that has devastated industry profitability. The customer has been trained to shop for the lowest price. Travel sites have emerged to help them do just that. The industry created a profit-devouring monster. Yield management was a choice. It wasn’t an inevitable outcome of the industry’s economics. So you’ve got to separate the aspects of industry structure that are truly inherent from those that result from choices you make, choices that could be modified by leadership.

And, stay with me because this is a subtle point, if you are trying to change industry structure, you want to lead the whole industry in a given direction. When you’re going for competitive advantage, you’re trying to be unique. When you’re trying to change the industry structure, you want everyone else to follow you.

Consider how Sysco transformed the food distribution industry. This was an industry with fragmented customers and powerful suppliers, often the big branded food companies. Barriers to entry were low. Rivalry historically had been on price because basically the distributors were all distributing the same products. That’s a bad structure. But some of the industry leaders—Sysco, for example—wanted a different kind of competition. They started doing private label to mitigate the power of the suppliers. They ramped up their IT investments, which served as an entry barrier to the small distributors who would be unable to afford those investments. They started to provide value-added services to their customers such as menu and nutrition planning, inventory management, and inventory financing. This shifted competition to dimensions other than price alone. And here, imitation was a good thing. As others followed Sysco’s lead, the industry became more attractive.

Magretta: Is strategy important for companies operating in a developing economy? Do the same strategy fundamentals apply?

Porter: Companies in developing economies typically have lower factor costs, such as labor, and this might let them compete for a time with rivals outside the country even if they are behind in OE and their products are not distinctive. But factor cost advantages tend to diminish over time, and eventually companies in developing countries will need to address both of those issues.

First, they have to close the OE gap. They have to overcome deficits in workforce skill levels, technology, and management capabilities. Where companies face a business environment full of obstacles such as poor physical infrastructure and complex regulations, it’s a challenge to reach world-class standards in OE and to improve performance in cost and quality.

Second, they have to begin to develop real strategies. Eventually these businesses will have to compete with the multinationals—and it is highly unlikely that a local company will win on operational effectiveness alone. That’s a lesson which Guatemala-based Pollo Campero has taken to heart. Pollo Campero competes successfully in the Central American fast food market against giants such as McDonald’s, Burger King, and Pizza Hut. It does so by adapting its value proposition and its value chain to meet local Central American needs. It has also taken the next step, expanding to serve those same needs for a growing Hispanic market in the United States.

Companies in developing economies must eventually transition away from being very reactive and opportunistic to become more strategic, to focus on building a unique position, on developing something distinctive in the market. This means shifting the focus so you’re not just relying on a cost advantage, but you’re thinking in terms of value, ideally of unique value in the marketplace.

And geographic scope is a real issue. If you look at the data in Turkey, to cite just one example, companies are still much too domestic, much too focused on their own market, even though it is growing. The future is to be international, and that often starts by looking at the region. This often presents a tremendous opportunity, which local companies may be uniquely positioned to serve.

One of the problems I see in developing and emerging economies is that people tend to be too focused on Europe and the United States, and really don’t see the opportunity of selling within their region, often because that wasn’t possible in the past. The region was closed, and every country was protected, and so the only way you could export was to export out to the advanced economies. But that’s changing. There’s really a historic opportunity for companies in developing and emerging middle-income economies to start to be middle-income economies to start to be international today. Because they can penetrate regional markets, they don’t have to penetrate only the advanced markets.

Another problem I see is that companies tend to be very diversified. They still compete in lots of businesses that are very different. It’s important to recognize when the time comes to put that model aside, and to move to greater focus in your business groups, where you can put together businesses that can leverage each other, which can enhance your competitive advantage, which can make your position more unique. That’s an important transition for companies in emerging economies if they hope eventually to realize their full potential. What has to change is not the quality of the people, but the mind-set, the approach to thinking about how to build a business, in short, about strategy.

Magretta: Do nonprofits need strategy? Nonprofits focus a lot on raising money, on their mission, on serving their clients. But they don’t spend much time on strategy. Should they? What is strategy for a nonprofit organization?

Porter: Strategy is necessary for any type of organization that serves customers or meets needs. Good strategy for any organization starts with defining appropriate goals. The fundamental goal for a business is superior long-term return on investment. Performance against that goal tells you whether or not the company is creating value. For a nonprofit, there is no directly comparable metric, so you’ve got to create one. A major challenge for every nonprofit is to define its goal or goals in terms of the social benefits it seeks to create. And then it must develop a value metric that looks at the results achieved versus the costs required to achieve them.

Once the nonprofit has a clear handle on what it’s trying to do, then all of the other strategy principles apply. What “customer” are you serving? What’s the unique value you will deliver? What needs will you meet? How is your value chain tailored to best serve those needs? Are you making trade-offs with alternative approaches? Do you know what your organization will not do?

Making trade-offs often turns out to be harder for managers in nonprofits. If you don’t have clear value metrics to guide you, then it is easy to see almost everything you do as contributing to “good.” Because the funder is often not the customer, this can lead to a misalignment between funding and value. Businesses that get paid by customers for what they deliver are powerfully anchored to value. Nonprofits lack that kind of an anchor. Funders, in fact, are sometimes a major source of the distraction. Nonprofits are prone to mission creep when their funders are more willing to support new programs and initiatives than they are to provide operating funding to help you scale what you already do. It’s a common strategic challenge facing many nonprofits.

Disclosure: I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company or individual mentioned in this article. I have no positions in any stocks mentioned.

FAQs: An Interview with Michael Porter (Part III)

“Strategy explains how an organization, faced with competition, will achieve superior performance.” —Joan Magretta, Understanding Michael Porter

“…if you’re creating something that’s truly valuable, don’t kid yourself that no one will follow you.” —Michael Porter

Below, the third part of an interview with Michael Porter from Understanding Michael Porter: The Essential Guide to Competition and Strategy. Underlining and bold markings are my own.

III. Strategy and Innovation

Magretta: Industry boundaries seem to change so fast these days. Does industry really still matter?

Porter: There are two answers to your question, Joan. One is purely empirical. When you look at the data on industry profitability, it tells you that relative profitability differences across industries are remarkably durable. You can look at the data over five years, ten years, even fifteen years, and what you see is that the rank order of industries by their profitability simply doesn’t change very much. The airline industry has been down near the bottom of the list for decades. IT software has been up near the top. Those relationships are quite stable. So the data tells us that industry differences are pretty slow to change.

But we also know that industries do undergo structural change and there are discontinuities that sometimes shift industry boundaries and structure in ways that impact profitability. Those things happen. But they are the exception and not the rule. And even when shifts like that do happen, they unfold relatively slowly. The Internet was transformational in changing industry boundaries and structure in a few industries. But even in the Internet space, the great majority of industries were able to embrace the Internet and move on. Even in information-intensive industries like maintenance, repair, and operations distribution, where the Internet was profound, the competitors didn’t change, the fundamental structure didn’t change.

The second answer to your question about whether industry still matters is this: Even where industry boundaries are changing, the same tools are used to analyze the significance of the change. So the five forces still matter. We have been through a historic period of deregulation, globalization, and technology advances. Some industry boundaries have blurred or shifted. But that doesn’t change the fact that every industry has its distinct structure, and its peculiar configuration of the five forces drives the nature of competition in that industry.

You see that one or more of the forces have been significantly affected by some factor—a change on the buyer side, on the supplier side, some discontinuity in the entry barriers, for example. So the same tools apply at any moment in time. If you’re trying to understand which trends are going to be important in your industry, look to see how those trends might change some fundamental aspect of structure.

People who believe that industry structure no longer matters are likely to be the same people who see every new technology or management innovation as “disruptive.” But you’ve got to be careful because the data simply doesn’t support that view.

Magretta: What is a disruptive technology? Where does it intersect with your thinking about strategy?

Porter: This is a really useful and compelling idea, but it is badly misused and misunderstood to refer to any and every competitive threat. It would be more helpful for managers to use the term only for the far less common situation of real game changers.

A disruptive technology is not any new technology. Many new technologies are not disruptive. Nor is it any big technological leap, because many big leaps are not disruptive. A disruptive technology is one that invalidates value chain configurations and product configurations in ways that allow one company to leap ahead of another and/or make it hard for incumbents to match or respond because of the existing assets they have. So a disruptive technology is one that would invalidate important competitive advantages.

The Internet offers a classic case. It was disruptive where the mechanism for delivering information was fundamental to the product or service, where the business, in essence, was the delivery mechanism. Travel agents, for example, or the recorded music business. But in other cases, the Internet wasn’t disruptive because it was simply one more channel for communicating with customers or suppliers. In those cases, established companies with the best product sets and brands were simply able to incorporate the new technology. It wasn’t incompatible or inconsistent with anything they were doing.

Two questions will tell you whether you’re dealing with a disruptive technology or not. First, to what extent does it invalidate important traditional advantages? Second, to what extent can incumbents embrace the technology without major negative consequences for their business? If you stop and ask those questions, you’ll see that true disruptions are not so common. If you look over a decade, for example, at the hundreds of industries that make up the economy, I would guess that less than 5 to 10 percent would be affected by a disruptive technology.
Having said that, managers should of course be on the lookout for potentially disruptive changes. The advice they get tends to focus on just one form of disruption: a simpler and less costly technology is improved and gets good enough to serve a need that’s currently met by a more complex and more costly technology. So most managers look for the threat to come from below, from some upstart you’ve been dismissing as being irrelevant to your business. And then you learn to your horror that for a lot of customers, the upstart is good enough. To use my value proposition terms, the customers’ needs were being overserved by the “old” technology. The new one meets just enough of their needs at the right price. Disruption from below is an example of a focus strategy. If you focus on the customers who don’t need all the special bells and whistles, you can establish a beachhead. A focuser with a disruptive technology can enter your industry and ultimately grow to occupy a major position. This is the Southwest Airlines story.

But other forms of disruption play a role in strategy. The threat can come from above. You can have an advanced technology or a richer approach that performs at a high level but that can be simplified or streamlined to meet less sophisticated needs at much lower cost. We don’t have good evidence on which form is most prevalent, but both exist. Disruptive technology is compelling as a metaphor, but managers need to be rigorous about what’s creating the disruption. How does it impact the value chain? Relative price? Relative cost? The strategy fundamentals definitely apply here.

Magretta: The term “business model” gets a lot of attention in the business press, especially in the context of innovative new businesses. Is a business model the same thing as a strategy?

Porter: The term “business model” is widely used, but it’s not precisely defined. So as with the word “strategy,” it unfortunately can mean a lot of different things to different people. But here’s where I think the concept can be useful. If you’re starting a new business and you’re not yet sure whether or how it’s going to work, the business model concept helps you to focus in on the most basic question of all: How are we going to make money? What will our costs look like? Where will our revenue come from? How can this business be profitable? There are different ways of getting revenue and different ways of managing costs, and the business model lens can help you to explore those.

But the business model doesn’t help you to develop or to assess competitive advantage, which is what strategy aims to do. Strategy goes beyond the basic viability question, Can we make money? Strategy asks a more complicated question, How can we make more money than our rivals, how can we generate superior returns, and then, How can we sustain that advantage over time? A business model highlights the relationship between your revenues and your costs. Strategy goes an important step further. It looks at relative prices and relative costs, and their sustainability. That is, how your revenues and costs stack up against your rivals’. And then it links those to the activities in your value chain, and ultimately to your income statement and your balance sheet.

So the business model is best used as the most basic step in thinking about the viability of a company. If you’re satisfied with just being viable, stop there. If you want to achieve superior profitability (or avoid inferior profitability) and stay viable, then strategy—as I define it—will take you to the next level.

Magretta: How do you do a five forces analysis if you’re an entrepreneur starting a new business in a completely new market space? Is strategy even relevant when there’s no existing industry or when conditions are still so fluid that there is no discernible industry structure and no direct competitors?

Porter: Strategy is relevant for any organization at any point in its trajectory. How to develop and sustain a competitive advantage is the core question that every organization has to answer if it’s to be successful and to prosper. In emerging industries there’s a lot of experimentation. What will the product ultimately look like? What will the distribution system look like? Will the product or service scope produce a stand-alone industry, or will this new idea become part of a larger or existing industry?

There’s more uncertainty about the shape of things, but the five forces exercise is fundamentally the same with one big exception: instead of analyzing what already exists, you’re forecasting. And you probably know quite a lot about all of the five forces but one. You know the customers you’re targeting. Are they likely to be price sensitive? You know who your suppliers are or who they are likely to be. How powerful will they become? You know the substitutes and can identify the likely entry barriers. What you don’t have yet are actual rivals. That’s where you need to think through who those might be. Will the rivals most likely come from adjacent industries? Or from companies that already exist in other countries? Or will the likely rivals be new start-ups? How would each of these rivals be likely to compete? So even when you’re inventing new market space, you probably already know more about the five forces than you realize.

Doing such analysis is important because if you’re creating something that’s truly valuable, don’t kid yourself that no one will follow you. There is no such thing as a market where competition is irrelevant, as nice as that might sound. The idea that innovation allows you to ignore competition is a fairy tale. So you have to have a hypothesis for how the industry might take shape once there is an industry.

Early on, there are many paths the evolution can take, many choices you can make that will have an important impact on how attractive the industry will become. Decisions you and others make over time will begin to lock in the basic economics, making industry structure less fluid. So it’s crucial to see different paths for how the industry might evolve, and to ask the basic questions about the five forces, so that you can make choices that will put the industry on the best possible path.

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Disclosure: I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company or individual mentioned in this article. I have no positions in any stocks mentioned.

FAQs: An Interview with Michael Porter (Part II)

“Strategy is about making choices, trade-offs; it’s about deliberately choosing to be different.” —Michael Porter

Below, the second part of an interview with Michael Porter from Understanding Michael Porter: The Essential Guide to Competition and Strategy. Underlining and bold markings are my own.

II. Growth: Opportunities and Pitfalls

Magretta: The capital markets pressure managers to grow. But you’ve observed that this pressure can have a perverse effect on strategy. How do you grow a business without undermining your strategy?

Porter: This is a huge problem. The pressure to grow is among the greatest threats to strategy. And I’m referring here to growth within a business, not diversification, which is equally challenging. Too often, companies believe that any growth is good growth. They have a tendency to overshoot, by adding product lines, market segments, or geographies that blur uniqueness, create compromises, reduce fit, and ultimately undermine competitive advantage.

My advice is to concentrate on deepening and extending a strategic position rather than broadening and ultimately compromising it. Here are some thoughts about how to grow profitably without destroying your strategy.

First, never copy. Companies always are confronted with opportunities for new products, new services, or moving into adjacent customer groups. How should you think about that? If your competitor has a good idea, learn from it, think about what that innovation accomplishes, but don’t just copy it. Figure out how the idea could be adapted and modified in order to reinforce your strategy. Is it relevant to the needs you’re trying to serve? Could it be used to reinforce what makes you unique? You don’t have to jump on every trend. But if the trend is relevant, tailor it to your strategy.

Second, deepen your strategic position, don’t broaden it. A company can usually grow faster—and far more profitably—by better penetrating needs and customers where it is distinctive than by slugging it out in potentially higher growth arenas in which the company lacks uniqueness. So the first place to look for growth is to deepen your penetration of your core target of customers. The common mistake is to settle for 50 percent of your target segment when 80 percent is achievable. You can shoot for true leadership when the customer target is properly defined not as the whole industry, but as the set of customers and needs that your strategy serves best.

Going deeper allows you to leverage all your advantages and improve profitability. Deepening a strategic position in this way involves making the company’s activities more distinctive, strengthening fit, and communicating the strategy better to those customers who clearly benefit from what you uniquely do. Gaining 10 percent share in another segment where you have no advantage will often damage your profitability.

Third, expand geographically in a focused way. If you’ve penetrated your strategic opportunity at home, there’s always the rest of the world.

Magretta: Any further advice about tackling foreign markets?

Porter: When you go to a foreign market, remember that you’re not trying to serve the whole market. You’re looking for the segment that values what you do. So when you go to Spain, don’t try to compete like existing Spanish companies. Go find those customers who are in your sweet spot. They might not be a big part of the market initially, but can be built up over time. The wonderful thing about geographic expansion is that you can grow with the same strategy. You don’t have to serve customers at home whose needs you don’t meet very well.

But you have to be really focused, because the tendency in geographic expansion is to get too caught up in the differences present in the new market. Find the part of the new market that responds to what you do rather than try to adapt to all the differences.

Another key characteristic of successful internationalization is that you’ve got to get direct contact with the customer. It’s hard to work through somebody else’s distribution channels. You’ll never understand the customer needs, you’ll never be able to differentiate and distinguish yourself. If somebody else is representing your product and listening to customers, how can you have a strategy?

And be especially careful when making and integrating acquisitions. You buy a Spanish company and all you’re going to hear from them is how things are done in Spain. Economists have been studying mergers for twenty years and they find that the seller gets most of the value, not the buyer. Foreign acquisitions must be forcefully repositioned around your strategy, not allowed to continue theirs (unless, of course, theirs is better!).

But geographic expansion can actually be a very powerful way of leveraging and growing your strategy if you do it the right way.

Magretta: And what do you do if none of those approaches to growth are feasible?

Porter: That’s an important question that too few managers are willing to face. Sometimes, at the end of the day, the answer is that there are few opportunities to grow rapidly with your strategy and do it profitably. You’ve got a strong position in your space, and no good way to expand it significantly. Here, the huge mistake is to deny that reality and to try to turn lead into gold. Instead, you should simply make a good ROIC, pay good dividends or otherwise return capital, and enjoy creating value and wealth.

I think many more companies should pay higher dividends rather than take enormous risks trying to grow beyond the capacity of their strategy and their industry structure. Don’t set yourself up for failure.

Paying dividends fell out of favor years ago. It became a signal that the management team had no imagination. And that’s what gives rise to AOL Time Warner and so many other value-destroying growth plans and deals. The nice thing about dividends is that they’re aligned with economic value. You can’t pay a dividend unless you create economic value and that’s a sign you’re actually making good choices about how to compete.

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Disclosure: I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company or individual mentioned in this article. I have no positions in any stocks mentioned.

FAQs: An Interview with Michael Porter (Part I)

“Strategy explains how an organization, faced with competition, will achieve superior performance.” —Magretta, Joan, Understanding Michael Porter

Below, the first part of an interview with Michael Porter from Understanding Michael Porter: The Essential Guide to Competition and Strategy. Underlining and bold markings are my own.

I. Common Mistakes and Obstacles 

Magretta: What are the most common strategy mistakes you see?

Porter: The granddaddy of all mistakes is competing to be the best, going down the same path as everybody else and thinking that somehow you can achieve better results. This is a hard race to win. So many managers confuse operational effectiveness with strategy.

Another common mistake is confusing marketing with strategy. It’s natural for strategy to arise from a focus on customers and their needs. So in many companies, strategy is built around the value proposition, which is the demand side of the equation. But a robust strategy requires a tailored value chain—it’s about the supply side as well, the unique configuration of activities that delivers value. Strategy links choices on the demand side with the unique choices about the value chain (the supply side). You can’t have competitive advantage without both.

Another mistake is to overestimate strengths. There’s an inward-looking bias in many organizations. You might perceive customer service as a strong area. So that becomes the “strength” on which you attempt to build a strategy. But a real strength for strategy purposes has to be something the company can do better than any of its rivals. And “better” because you are performing different activities than they perform, because you’ve chosen a different configuration than they have.

Another common mistake is getting the definition of the business wrong, or getting the geographic scope wrong. There has been a tendency to define industries broadly, following the influential work of Theodore Levitt some decades ago. His famous example was railroads that failed to see that they were in the transportation business, and so they missed the threat posed by trucks and airfreight. The problem with defining the business as transportation, however, is that railroads are clearly a distinct industry with distinct economics and a separate value chain. Any sound strategy in railroads must take these differences into account. Defining the industry as transportation can be dangerous if it leads managers to conclude that they need to acquire an airfreight company so they can compete in multiple forms of transportation.

Similarly, there has been a tendency to define industries as global when they are national or encompass only groups of neighboring countries. Companies, mindful of the drumbeat about globalization, internationalize without understanding the true economics of their business. The value chain is the principal tool to delineate the geographic boundaries of competition, to determine how local or how global that business is. In a local business, every local area will require a complete and largely separate value chain. At the other extreme, a global industry is one where important activities in the value chain can be shared across all countries.

Reflecting on my experience, however, I’d have to say that the worst mistake—and the most common one—is not having a strategy at all. Most executives think they have a strategy when they really don’t, at least not a strategy that meets any kind of rigorous, economically grounded definition.

Magretta: Why is that? Why do so few companies have really great strategies? What are the biggest obstacles to good strategy?

Porter: I used to think that most strategy problems arose from limited or faulty data, or poor analysis of the industry and competitors. To say it differently, I thought the problem was a failure to understand competition. This surely does happen. But the more I have worked in this field, the more I have come to appreciate the more subtle and more pervasive obstacles to clear strategic thinking and how challenging it is for companies to maintain their strategies over time.

There are so many barriers that distract, deter, and divert managers from making clear strategic choices. Some of the most significant barriers come from the many hidden biases embedded in internal systems, organizational structures, and decision-making processes. It’s often hard, for example, to get the kind of cost information you need to think strategically. Or the company’s incentive system rewards the wrong things. Or human nature makes it really hard to make trade-offs, or to stick with them. The need for trade-offs is a huge barrier. Most managers hate to make trade-offs; they hate to accept limits. They’d almost always rather try to serve more customers, offer more features. They can’t resist believing that this will lead to more growth and more profit.

I believe that many companies undermine their own strategies. Nobody does it to them. They do it themselves. Their strategies fail from within.

Then there is the host of strategy killers in the external environment. These range from so-called industry experts to regulators and financial analysts. These all tend to push companies toward what I call “competition to be the best”—the analyst who wants every company to look like the current market favorite, the consultant who helps you benchmark yourself against everyone else in the industry, or who pushes the next big thing, such as the notion that you’re supposed to delight and retain every single customer.

Let’s take this last idea as an example. If you listen to every customer and do what they ask you to do, you can’t have a strategy. Like so many ideas that get sold to managers, there is some truth to it, but the nuances get lost. Strategy is not about making every customer happy. When you’ve got your strategist’s hat on, you want to decide which customers and which needs you want to meet. As to the other customers and the other needs, well, you just have to get over the fact that you will disappoint them, because that’s actually a good thing.

I also believe that as capital markets have evolved they have become more and more toxic for strategy. The single-minded pursuit of shareholder value, measured over the short term, has been enormously destructive for strategy and value creation. Managers are chasing the wrong goal.

These are just some of the obstacles. Cumulatively, they add up. Having a strategy in the first place is hard. Maintaining a strategy is even harder.

Magretta: Would you elaborate on how the capital markets impact strategy?

Porter: This is a multifaceted problem. Let’s start with the way financial analysts and the investor community evaluate companies. For any industry, analysts tend to settle on a set of relevant metrics. If it’s retailing, for example, it’s same-store sales. In another industry, it might be revenue per employee. Of course, it’s good to try to find measures that tell you what’s going on in a company. But the problem for strategy is that the same metrics are applied to all companies in the industry. One of the important lessons about strategy is that if you’re pursuing a different positioning, then different metrics will be relevant. And if you force everybody to show progress on the same metrics, you encourage convergence and undermine strategic uniqueness.

At another level, at any moment in time there’s a tendency for the players in the capital markets to identify a “winner.” Typically it’s the company that seems to be doing well, maybe because it’s growing a bit faster, or its profitability the last few quarters has been better. For the analysts, this becomes the gold standard, and then all the companies in the industry are pressured to replicate what the current industry favorite is doing. If the favorite is Pfizer, and Pfizer has been making acquisitions, then everyone else in the industry is pressured to make acquisitions. Follow Pfizer. Do some deals.

Now it often happens that the current favorite eventually falls out of favor, but usually not before the analysts have herded everyone down the same path. And, of course, in strategy there is no one best path. The essence of strategy is to create your own path. You want to run your own race to reach a distinctive endpoint, which is the way you choose to create value. So in this way the capital markets reinforce the mind-set of competition to be the best. And they set themselves up as the arbiter of what “the best” is.

At a third level, the weight of activity in the markets has gravitated toward short-term trading versus long-term investing. People move in and out of stocks quickly, trying to profit from small gaps and discontinuities. But strategy needs a longer time horizon. Building out a unique position in the market takes a series of investments over time. So what are the consequences of this mismatch? If it’s going to take a few years to build earnings, but only a few months to buy them, then why not take the quicker path, especially if you can conveniently forget about the intangibles you’re writing off after the deal closes. There’s a strong bias for doing deals. At the broadest level, then, there’s a mismatch between the market’s focus on near-term performance and the longer time horizon that would support investment in building a strategic position.

The whole emphasis on shareholder value over the past couple of decades has focused managers on the wrong thing when they should really be focusing on creating economic value sustainably over the long term. The capital markets are better at driving OE, better at keeping pressure on companies to improve efficiency and profitability and to use capital better—these are positive influences. But I have no doubt that the markets damage strategy, even if the impact is subtle and mostly unrecognized.

Disclosure: I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company or individual mentioned in this article. I have no positions in any stocks mentioned.