The Power of Focus and A Sustainable Comparative Advantage

The concepts of focus and diversification are diametrically opposed, but both are crucial concepts in finance.  As investors, we are wise to diversify, to not put all of our eggs in one basket.  As one extreme, employees of Enron who also invested their personal assets in the fast rising company lost both their wealth and their income when the firm collapsed.

For companies (and for individuals considering career options), the opposite is true, and much research has found that those companies that focus on their core competencies are those that prosper.  Companies, like people, have distinct advantages at certain things - but not at everything.  Effective strategic leadership requires defining and honing a sustainable comparative (competitive) advantage.  Let's consider that phrase more fully:

• Comparative (competitive) Advantage means that you can deliver a service or product more effectively, or with higher quality or more inexpensively than your competition.  Now whether you focus on quality or cost is another major decision that we leave for later discussion, but the choice comes down to knowing your marketplace, to understanding customer wants and needs. But as my colleague Joe Rizzi points out, make sure your advantage is comparative: "Having smart people doesn’t mean anything if all your competitors have smart people as well."

• Sustainable - means you will continue to enjoy this advantage for at least the next several years.  This is why Warren Buffett and other great investors talk of finding companies with moats protecting them from competition.  The moat may be in the form of a superior product that cannot be duplicated -  perhaps due to technological knowledge, but more likely due to patents.  It could be from regulatory advantages or political alliances. It could also be from brand capital - the reputation of your firm in the marketplace.  A moat could also exist because of natural barriers to entry like regulation or other legal structures or because the business requires intense capital or other requirements, not easily copied.  There are many more ways to build a 'moat' but the concept is the same, find a way to stay ahead of the competition - a way that is not easily duplicated.

Note that managements can have moats built around themselves as well - a highly undesirable characteristic.  Moreover, management can be so enamored with the size of their empire that they forget the need to focus.  When this happens, external forces - takeovers or activists - step in to correct the situation.  Indeed, the need to focus, to find the sustainable competitive advantage is at the heart of much recent activist activity.  See Joe's recent post discussing Yahoo, Darden, Ebay, Hewlett Packard and DuPont (Royalists Vs. Governistas).  

You can think of sustainable comparative advantage as overlapping circles.  One circle contains the set of all things a company is good at - another partially overlapping circle contains the set of things the market will reward.  The intersection of these circles is the sweet spot where businesses (and people) can prosper.  For businesses and individuals with a sustainable competitive advantage, the sweet spot exists for a longer period of time, but even here the circles are continually moving as technology, consumer tastes, regulation, political climates and other catalysts shift the circles.  It is essential to stay ahead of the shifts.  

Note: for individuals considering career choice, I'd add a third circle consisting of things you enjoy doing.  If you find the intersection of those three circles in your life you are indeed fortunate, doing something you like, that you are good at, that the market values. 

All the best,

Ralph

Responding to Low T

The T in question is the Competitive Advantage Period and not testosterone. It is time in which a firm can invest at returns exceeding its cost of capital. T, or moat as used by Warren Buffett, is the driving factor underlying tech firm high valuation multiples. It is based on strategic barriers including technology, First Mover Advantages and regulation. (Also, see our previous post: Find your sustainable competitive advantage.)

It has a dramatic valuation impact as it declines when firms or industries mature. T eventually fades for most industries as they experience Regression to the Mean due to competitive forces such as new entrants and substitutes. Firms like Apple can have several years of remaining T; whereas, firms like Hewlett Packard’s T is largely gone. This fact is reflected in their widely differing valuation multiples. In fact, you can view T as the number of years a firm has before it undergoes a fundamental corporate change like a LBO, recapitalization or sale.

The current flurry of tech related deals presents insights into how firms are handling the rapid changes in T. These firms are based upon rapidly changing technology life cycles, which can be measured in terms of dog years. Firms can respond this development in two distinct manners. The first is to accept and mature gracefully and increase shareholder distributions as IBM has done. 

Alternatively, you could try to adapt by either developing new products like Apple or acquiring new products and technologies as is Facebook –see Crisis. The acquisition approach is to be distinguished from weak acquirers such as Hewlett Packard seeking to hide declining performance.

Tech firms like Google are investing in strategies which just happen to be executed thru acquisitions. Unlike Cisco which pioneered this strategy, these new transactions are much larger. 

The transactions have two objectives. The first is to acquire skills and technologies faster and cheaper than could be internally developed. The second to pick technology winners early and help them develop early as Facebook is doing with its Oculus Acquisition. In these efforts Real Option Valuation is used to supplement traditional Discounted Cash Flow analysis.

There are many risks involved with the acquisition approach. For example can you the right targets? Can you properly execute the transactions? Can you grow the acquired technology fast enough and large enough? How will your competitors respond?

The jury is still out on how this plays out. It is fascinating to watch.

J

Find Your Sustainable Competitive Advantage

“In business, I look for economic castles protected byunbreachable ‘moats’.”

Warren Buffett

Famed investor Warren Buffett is known to favor companies with a 'natural moat', a built in protection that gives companies some protection against competition.  Economists call this a sustainable competitive advantage.  The idea is simple, find what you do well, better than anyone else - that is your competitive advantage.  But you need more.  It isn't enough to have a competitive advantage - you need a sustainable competitive advantage.  If someone can start up a new business tomorrow, delivering the same product and service as your company, you don't have a sustainable competitive advantage. 

Sustainable competitive advantages come from many sources.  In some industries, larger companies benefit from economies of scale making it hard for smaller companies to enter. Other advantages are created through access to supplies or raw materials.  This can occur naturally from the physical location of a company or access many be driven by relationships - familiarity with a particular country, etc.  Intellectual benefits occur when a company has a particular patent or copyright that others cannot duplicate.  

On an individual level an example of an intellectual benefit combined with relationships would be the economist Larry Summers, a leading contender to be next chairman of the Federal Reserve.   Obviously a very smart individual, Summers has honed his personal competitive advantage through a career of challenging positions and a myriad of political contacts.  Of course, competitive advantages in politics are often unsustainable, and it is not assured that Summers will be chosen for the Fed post.  Nevertheless, the comparative advantage will serve him well in multiple pursuits and the intellectual capital and connections are indeed sustainable.

In developing business (and personal) strategy, look for situations where barriers of entry exist, or create a sustainable advantage by differentiating your product in ways that are hard to reproduce.  Soft drinks are a good example.  Coke and Pepsi are trademarks that are known throughout the world.  Other soft drink companies come and go - but none have risen to the level of Coke and Pepsi.  Those two brands are the go-to soft drinks of the world.  

This doesn't mean that companies with well established brand names are immune from competition.  Just think of Kodak.  A dramatic catalyst  can easily change the fortunes of a company - or an industry. For Kodak it was technology.  Other catalysts include regulatory shifts, demographic changes, political events, and changes in consumer tastes.  Which brings us back to Coke and Pepsi.  Noticing a shift away from colas, Coke has broadened its product line to include drinks like Dasani water, Powerade and Minute Maid and non-drink products like Dannon that can still benefit from the company's distribution and promotional expertise.  Excellent companies adapt to keep the competitive advantage sustainable.