Watch the video with Andrew Stotz or read a summary of it below.
Three Types of Competitive Advantage
Strategy is about how a company picks which activities it engages in. It is also about how and where management decides to engage in those activities. Success is when that strategy generates a sustainable, above industry average profit. Porter identifies three generic strategies for competitive advantage:
Cost leadership – Become the lowest cost competitor. Most industries only have one cost leader. And this leadership is usually achieved through economies of scale, technology, or maybe from unique access to raw materials. A company is successful if its costs are lower than competitors and it can charge industry average prices. But if that company sacrifices quality, it may find itself in a downward cost-cutting death spiral. This strategy is hard if competitors are also pursuing it. In that case, this strategy could start the industry on a cost-cutting death spiral.
Differentiation – Develop products or services that provide superior value. This strategy costs more, so the company must be able to charge more than competitors to earn an above industry average profit. To offset these higher costs the company may need to cut costs in less critical, non-core areas. Unlike the low-cost strategy, many competitors in an industry could pursue this strategy.
Focus – Target a specific industry segment, ignoring the rest. Usually, this focus area is where its competitors are weak.
A company should not pursue more than one strategy or Porter says it will get “stuck in the middle”. There are rare cases when the cost and differentiating strategies may work together. For instance, if competing companies are mismanaged or if a company has a major innovation. But a company should not attempt such a dual strategy until it has mastered one strategy.
To decide on a strategy that generates long-term above industry average profit, companies should study Porter’s industry five forces model. The five forces are: the power of suppliers and buyers, the strength of substitutes, the risk of new entrants, and the behavior of existing competitors. This model describes an industry’s profitability and which part of the value chains is most profitable.
To be successful a firm must relentlessly pursue the strategy it chooses; even when some are doubtful that strategy can succeed. In fact, true success comes when a management team sticks to that strategy longer than competitors.
Of course, nothing lasts forever. Cost leaders may lose their advantage if their competitors also cut costs. Differentiators may lose their edge if buyers stop caring about their specific difference. Focusers may find that their strategy is unsustainable if competitors target their niche.
Books talked about in the video:
Competitive Advantage: Creating and Sustaining Superior Performance, by Michael E. Porter
Article by Dr. Andrew Stotz, Become A Better Investor