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Hope you and your families are safe. This is the 5th post of the strategy series. So far, this is what we have covered in strategy:
Law of competitive exclusion — Over the long-term, out of multiple companies competing for the same market need, only one will survive.
The litmus test of good strategy — The opposite of a good strategy shouldn’t look stupid.
The paradox of strategy — To succeed, you have to commit to a singular strategy. Committing to a singular strategy increases the risk of failure, which means either you will have large gains or large losses.
Choices in strategy — Strategy, like life, is all about making choices. What generic choices are available for a product strategy.
We have now arrived at a place where we can dive deeper into where strategy makes a lot of difference for a business.
If we ask a room full of people — what's the ultimate objective of a business? This will warrant a long and varied discussion. Some will say growth; others will content with creating an impact and doing good for humanity. Few will also say the benefit to shareholders, which loosely translates into stock prices.
The ultimate objective of a business is to 'generate profits over longer periods. Every business strives to do so even if they aren't optimizing for this in the short run. Amazon is usually quoted by a lot of people on how the focus on profits shouldn't be the goal. 'Not in the short run' is often the missed clause. Amazon didn't optimize for profits in its first 20 years of operations and focussed on cash-flows. Its operating income (trailing 12 months) crossed > $ 500 million in 2015 and is $27 B in Mar '21. Look at the market cap growth before 2015 and after that. The market understands and rewards companies it believes can generate profits over the long run.
What Creates Profits
Strategy thinkers have devoted a long amount of time studying what generates profits. They have gotten some answers. All these answers constitute the strategy.
There are only two key things that affect profits — competition and consumer preferences. Consumer preferences change over time, and that affects demand. Remember Fidget Spinners in 2017? Marketed as a helpful toy for kids dealing with attention deficit hyperactivity disorder, anxiety, and autism, fidget spinners quickly became popular. They were basically the most popular toy of the decade.
And then kids moved on! The consumer preference changed, and the sellers can't do much about it. Lack of demand could mean lower pricing to increase demand and hence lower profits. The changes in consumer preferences are usually slow. But sometimes, the preferences change rapidly especially in trends like the rise of fidget spinners.
The second thing that affects the profits is competition. Competition plays a major role in eroding profits. Competition creates alternatives, better products, substitutes, etc. All of these affect the demand and hence profits. Most of the strategy is, therefore, focused on how to beat the competition.
From the first post on strategy —
“If you know the enemy and know yourself, you need not fear the result of a hundred battles. If you know yourself but not the enemy, for every victory gained you will also suffer a defeat. If you know neither the enemy nor yourself, you will succumb in every battle.”
In the absence of competition, the strategy would lose its relevance. So it's important to understand it well.
Probably the best writing around competitive strategy in the last 50 years has come from Michael Porter. He wrote books such as Competitive Advantage and Competitive Strategy in the 1980s, and these books revolutionized the field of strategy over the coming decades. In fact, most of the strategy books I have read so far (20+ or so) have been a derivative of Porter's work in some form or other.
Porter wrote about five forces (more on this later) that shape an industry to understand an industry and competition. Porter's five forces are taught across business schools/ case studies to understand competition. Many of you may be familiar with it.
There is a reason this framework is still relevant today — it's all about the fundamentals. The fundamentals hardly change over time.
The Fundamental Equation
Profit margin = Price - Cost
Porter mentioned there are five forces at work that affect profit margin:
Here is a good explainer on these if you haven’t been through them before.
Here is an explanation of how profitability is affected by the five forces.
What's so special about these five forces? As we talked about earlier, they are fundamental to all industries and provide a pretty good framework to understand and analyze.
Why not keep the Internet as one of these forces? Internet age companies like Amazon have created a big competition against Barnes and Noble. However, the Internet may not be a fundamental force. It affects some of the forces. Let's take the book business, for example.
If you think carefully, the Internet creates options for book readers, hence increasing buyer power. A buyer can now buy books from anywhere in the world on Amazon, and businesses across the world will be competing on prices.
The Internet also creates supplier (publisher) power. Publishers can now directly advertise and sell on Amazon.
It creates strong rivalry since the cost of running an online business is lower than a brick-and-mortar business.
The Internet also creates knowledge of substitutes that were not available earlier. An ideal world would be where consumers are aware of all substitutes, but in reality, that was not possible for a person sitting in Tier 3 city in India 20 years back. Because of smartphones and the Internet, they can do a quick search on google and see the substitutes. Access to information increases substitutes.
Building the Competitive Advantage
Once we have understood the industry, it's time to create a competitive advantage.
The competitive advantage is all about the difference in the ways a company does activities like design, produce, sell, market, service, etc., across the value chain. These differences determine the relative cost and pricing as compared to the competition.
We discussed Southwest Airlines in the last post. Let’s revisit that. Southwest Airlines performs different activities across the board. From the post,
Making choices across the value chain leads to lower costs. Southwest does it by
Using secondary airports reduces the cost of landing there
Using only one aircraft type reduces training for pilots, skills required of mechanics and spare parts bank required to remain operational
An intelligently put together schedule, with short turnaround times and routes that maximize the airtime of every aircraft in the fleet
Short, in-demand routes operating at a high frequency
By choosing to do different activities and cutting on the costs, Southwest has a lower relative cost and can offer a lower relative pricing, becoming the competitive advantage.
There are two secret ingredients of competitive advantage that we will discuss in this section:
Various activities should fit across the chain — Connection across choices making them interdependent is crucial to ensure it becomes harder for anyone to copy your strategy. Let's take Apple as an example. Apple has created an end-to-end supply chain to ensure quality premium products. The software (OS) and hardware for Apple are tightly integrated. It becomes more distinctive when they offer a sophisticated sales force, premium assistance, and support in Apple Stores. It will be very hard to copy Apple end-to-end since one will have to copy the activities across the board.
Stable strategy over time — Changing strategy frequently confuses employees and consumers both. Continuing with the current strategy is for a reasonable amount of time provides ample time and opportunity for the company to evolve itself without throwing everything in chaos. An example of this is Microsoft. Microsoft didn't invent much between 1995 and 2010, partly because of anti-trust issues. The core office business bought Microsoft the time. It could afford to miss capitalizing on certain trends like Smartphone OS and browsers. In the last 6-7 years, Microsoft has changed itself and made huge progress on AI, cloud, and even acquiring professional community products like LinkedIn and Github.
What’s Different about Internet Firms?
The rules of business and strategy have changed over the last 20 years. Even if we can apply Porter's frameworks to analyze the internet industry, it isn't enough. The modern strategy has to take data network effects, attention economy, platforms, etc., into account. We will discuss this in detail in the next post.
Stay safe and see you next week,