Bruce Greenwald and Judd Kahn outline a simplified approach to business strategy, in their book Competition Demystified.
It wasn’t until Michael Porter’s publication, Competitive Strategy, in 1980 that strategic thinking came to acknowledge the importance of interactions among external economic actors.
“…Identifying the many factors in Porter’s complex model and figuring out how they will play off one another has proven to be frustratingly difficult.” Greenwald & Kahn
Greenwald and Kahn propose a simpler approach, agreeing that the five forces – Substitutes, Suppliers, Potential Entrants, Buyers and Competitors within the Industry – can affect the competitive landscape but not all to equal degrees.
“Clearly one is more important than the others.” Greenwald & Kahn
Greenwald and Kahn propose that ‘Barriers to entry’ – the same force underlying Porter’s “Threat of new entrants” is the one force that outweighs the others.
A company with large barriers to entry can prevent new entrants entering their market. We’ll refer to a company with large barriers to entry as exhibiting competitive advantages and as Warren Buffett commonly refers to as a ‘castle with a moat running around it.’
The other three forces – bargaining power of suppliers, bargaining power of buyers and the threat of substitutes, play a larger role when no company has a competitive advantage thus no barriers to entry exist in the market, allowing new entrants to easily enter the market.
“Life in an unprotected market is a game played on a level field in which anyone can join. These markets, often but mistakenly identified as ‘commodity’ markets, [where] only the very best players will survive and prosper, and even they have to be continually on their toes.” Greenwald and Kahn
A level playing field requires little to no strategic planning as the competition within the market is so large that it would have no effect on other identifiable competitors.
A level playing field initially attracts many competitors all seeking profitable opportunities for investment and are usually attracted to unusually high returns on invested capital. But as the competition become fierce among competitors product prices fall.
A characteristic of a level playing field is low returns on invested capital. As new entrants are attracted to the initial high returns on invested capital earned by the current dominating firms they begin flooding the market with competing differentiated products thus driving the return on invested capital down to eventually below the cost of capital.
The products sold on a level playing field are essentially differentiated commodities products.
The Differentiation Myth
“Strategic thinking often starts with this admonition: Do not allow yourself to be trapped in a commodity business. Fledging business majors are taught that the essential first step in formulating any legitimate business plan is to differentiate your product from that of the competition. But on its own, differentiate as a strategy to escape the woes of commodity businesses has one major flaw – doesn’t work.” Greenwald and Kahn
Porter proposed that the differentiation strategy is one of two generic business strategies for outperforming other organisations in a particular industry. Porter’s differentiation strategy suggests that an organisation’s ability to produce and market unique and superior quality products. It focuses on product uniqueness, brings brand quality, emphasis on marketing and research and has superior after-sales service. Porter’s examples included BMW, Mercedes-Benz and Alfa Romeo in the auto industry.
“Differentiation may keep your product from being a generic commodity item, but it doesn’t eliminate the intense competition and low profitability that characterise a commodity business…the damage to profit persists because the problem is not lack of differentiation, but the presence of barriers to entry.” Greenwald and Kahn
Porter used the prestige automakers as an example, so let’s look at Mercedes-Benz.
Mercedes-Benz is admired by many and seen as a status symbol of wealth.
“If you go down Fifth Avenue everyone has a Mercedes Benz in front of his house, isn’t that the case?” he said. “How many Chevrolets do you see in Germany? Not very many, maybe none at all … it’s a one-way street.” Sigmar Gabriel’s response, early this year, to U.S Presidents Trump suggestion of tariff on German, imported cars into the U.S.A.
Branding is proposed as the primary tactic for product differentiation, and Mercedes-Benz is a globally recognised symbol of quality in the marketplace. Just Check out their impressive Annual Press video.
Greenwald and Kahn describe how Cadillac once had the equivalent position in the United States. Yet, despite their recognition and association with quality, both have not been able to translate the power of their brands into exceptional profitable businesses.
“Their economic performance is not distinguishable from those mundane commodity businesses everyone tries to assiduously avoid.” Greenwald and Kahn
The years after World War II, Cadillac and Mercedes-Benz dominated their local markets and made exceptional profits, which those same profits attracted other companies to enter their markets.
Let’s apply the return on invested capital test to find out if the differential strategy actually works for Daimler AG.
In figure 1. Daimler AG needs their Return on average Equity adjusted, we need to strip out their most profitable division which is financing. The financing division earned 17.5% on outstanding loans, impressive considering the banks on average earned 2-3%. Once deducting the financial liabilities the total debt to equity ratio falls and thus reduces return on average equity downwards in line with the return on investment at 6%. Well below their cost of capital.
The only way a company can survive is to employ an operational effectiveness tactical approach. Operational effectiveness is often thought of as a strategy, but as Porter correctly identified, operational effectiveness is doing what rivals do but doing it better and cheaper, and it is an internal organisational matter.
A Strategy is focused on the long term direction of the organisation and the external interactions between players, whereas tactical issues are internally focused like operational effectiveness.
For example in the 1970’s, the Japanese automotive firms started flooding the US market at the same time the Detroit majors GM, Chrysler and Ford had mounting problems, from faulty cars to the oil crisis.
The Japanese firms had implemented the practice Kaizen (meaning Continuous Improvement) which incorporated the Just in Time (JIT) production system. The JIT production system aimed to eliminate non-value added activities of all kinds and an emphasis in control/management of the quality process. While the Detroit majors had grown complacent as Jeremy Clarkson explains in this short clip.
The only strategic decision companies make on a level field is made when they decided to enter the industry.
In Part III we will discuss barriers to entry and the various competitive advantages – demand, supply and economies of scale, plus two tests – market-share and high return on capital to confirm their existence.