A Primer on Competitive Advantage — How to build a Winning Business
Note: Republishing this post I shared on the Medium paid subscription a few years ago. This was originally written in January 2015.
This Edition is based upon 6 books, 8 posts, and 4 videos. See all of the resources and previous Editions in the Evergreen Business Library [coming soon].
Remember, these are designed to feel like short books, you’re meant to meander and spend ~3 hours on this topic this week. Save some of these links and read them throughout the week. Immerse yourself in this topic and leave the week smarter than you started it!
Introduction to Competitive Advantage
A dude named Michael Porter, an HBS professor, initially coined ‘Competitive Advantage’ in 1979, in a paper called “How Competitive Forces Shape Strategy.” This paper and its ideas went over well and launched Porter into (academic) stardom. [Here’s a 90-second, too-simple summary]
“Among academics,” writes Joan Magretta in Understanding Michael Porter, “he is the most cited scholar in economics and business. At the same time, his ideas are the most widely used in practice by business and government leaders around the world.
To understand Porter’s core ideas, these two videos [Part 1, Part 2] are a hilariously old-school way to hear Porter’s lecture about this paper. As a bonus, you can laugh at his comically awkward body language. For the full immersion, Porter wrote a relatively large book as well.
Thanks to Nathan Bashaw for contributing these videos and Porter as a foundation of this topic.
A contrarian on Porter’s Ideas
A dissenting opinion from the classic strategies of creating ‘Sustainable Competitive Advantage’ comes from Professor McGrath, a professor at Columbia Business school. A Forbes piece written by Steve Denning explores her new sensationally-yet-misleadingly-titled book, The End of Competitive Advantage.
Dr. McGrath’s first point is refreshingly obvious: ‘Sustainable’ is a naive concept in Competitive Advantage. The environment is constantly changing.
“Strategy is stuck,” Professor McGrath’s book tells us. “Virtually all strategy frameworks and tools in use today are based on a single dominant idea: that the purpose of strategy is to achieve a sustainable competitive advantage.
We must understand two assumptions, which explain why this is the mindset: 1) Industry selection matters most. 2) Once achieved, advantages are sustainable.
It should be relatively obvious that both of those are somewhat bullshit. Which pulls the rug out from under much of the classic strategy gospel. In addition, pursuing Sustainable Competitive Advantages can have nasty side effects. From Dr. Mcgrath:
Think about it: the presumption of stability creates all the wrong reflexes. It allows for inertia and power to build up along the lines of an existing business model. It allows people to fall into routines and habits of mind. It creates the conditions for turf wars and organizational rigidity. It inhibits innovation. It tends to foster the denial reaction rather than proactive design of a strategic next step… A preference for equilibrium and stability means that many shifts in the marketplace are met by business leaders denying that these shifts mean anything negative for them.
Thanks to Lexi Usgaard for contributing Dr. McGrath’s article—we love to feature the dissenting opinions!
To sum up: We have Porter’s classic ideas. We have Professor McGrath contributing the idea of the transience of Advantages, and a warning to be aware of the dangers of over-reliance on classic strategic plans. Luckily for us, applications of these ideas are not mutually exclusive.
Now for some Real People’s Ideas
Let’s take a look at some non-academics (finally) and how they think about and act upon Competitive Advantages.
Thiel on Creating Monopolies
Peter Thiel (a founder of Paypal and Palantir) has been on a rampage recently expounding on his ideas about how a business can only be in one of two states: Perfect Competition or Monopoly. (The difference being a meaningful competitive advantage). Thiel also points out the important difference between the size (created value) of the business and it’s profitability (captured value).
He’s been prolific recently, so depending on your preference you can get these ideas from his book, lecture, podcast [Lecture 5], or blog post.
In his fantastic book, Zero to One, chapters 3, 4, and especially 5 are strikingly counterintuitive opinions on competition and competitive advantages, or as Thiel speaks of it, ‘creating a monopoly.’ His book lists 4 characteristics that can create Monopoly conditions: Proprietary Technology, Network Effects, Economies of Scale, and Brand.
Zero to One is worth buying for ~900 reasons, but chapter 5 is some of the best reading out there on competitive advantage. Thanks to Blake Robbins for suggesting this piece and throwing Thiel’s ideas into the mix.
World’s Best Investor on Competitive Advantage
One can only become the greatest living investor by having an incredible understanding of Competitive Advantages, or as Warren Buffett calls them, ‘Economic Moats.’ Watch this 2-minute video of Buffett explaining Moats as a Competitive Advantage.
A few wise words from the Oracle of Omaha
Let’s look at Buffett’s most famous investments for their Competitive Advantages. Coca-Cola has a Trade Secret and one of the best brands on earth. Geico was a low-cost producer as the first centralized, digital insurance provider. The Washington Post exhibits Network Effects, where larger circulation leads to more ad dollars, enabling larger circulation, etc.
Another great look at Competitive Advantage from an Investor’s perspective is this post by Bill Gurley: All Revenue is Not Created Equal: Keys to the 10x Revenue Club. Companies are valued at differing Revenue Multiples, largely based on the evaluation of their Moats. This post is a fantastic dissection of what dynamics can earn massive valuation. Thanks to Nathan Bashaw for this fantastic suggestion. Great read and valuable unique perspective.
Using a hypothetical investor as a mental test to evaluate the Competitive Advantages of your business can shed new light on a decision. Whether you’re starting a company or joining one, that’s an investment decision. Would Buffett invest in that company too? Does it have a durable moat? Is that moat widening or shrinking?
Types of Competitive Advantage
Porter originally coined two sources of Competitive Advantage: Low Cost and Differentiation (with a focus axis included as well). We can add Thiel’s list of monopoly-makers: Proprietary Technology, Network Effects, Economies of Scale, and Brand.
Buffett spoke of Talent as a Competitive Advantage, in addition to Echoing Low Cost advantages. This list from Seth Godin misses Proprietary Technology, but includes the important addition of Ownership of scarce resources. (For example, owning all of the real estate in a college town. Or being the only guy with mining rights to a comet).
Godin also mentions the creation of Switching Costs. While switching costs are inherent in some industries, (switching CRM software, for example, is a massive pain in the ass), it can always be exacerbated by companies (ever try to switch Cable or Cell phone companies?) Thanks to Aaron Wolfson for recommending Seth Godin’s contributions to the topic!
Let’s organize this mess:
Low-Cost Operator: For some reason, often Innovation, Operational Excellence or Economies of Scale, a company has the ability to produce comparable products for a lower cost than competitors, winning them customers (Amazon, P&G).
Brand: A company has created a relationship with their customers that earns them loyalty, trust, word-of-mouth, and profits. (Coke, Prada)
Proprietary ‘Technology’: This could be based on a scientific discovery (Google Search Algorithm), but could also apply to Trade Secrets (Coke), Trademarks (Disney), or Patents.
Network Effects: Think about Economies of Scale affecting Quality rather than price. The more customers, the better the product, which earns it more customers and the market develops into a natural Monopoly (Newspapers, Facebook, Ebay).
Talent: An organization that has developed or recruited talents that competitors cannot compare to. (McKinsey, Mayo Clinic)
Scarce Ownership or Access: A very obvious advantage is ownership of a scarce resource, such as real estate. This could also apply to specialized access to data (Polk has exclusive rights to Gov’t data) or resources (Mining rights).
Don’t forget about the Lollapalooza effect. This is the idea that extreme results occur when multiple independent forces act in the same direction. More than one of these Competitive Advantages are present in many companies. We need to understand whether the way they interact is additive, multiplicative, or even Exponential. Every confluence of effects is different, and it’s important to consider the extremity of those situations.
Before starting a company, starting at a company, or investing in a company run down this list and see what Competitive Advantages you can identify. If there’s not any, ask yourself why this company will thrive over the next 10 years.
Creating, Evaluating, & Maintaining CAs
Now we’re getting into Strategy. We’ll get to that another week. To be sure you get to be a part of it, join now for future Editions of Evergreen Business Weekly.
Kings of Competitive Advantages
Wal-Mart: The best execution of the Low-Cost strategy of our Lifetimes. Sam Walton was a small-town merchant who was simply better at fighting down prices for customers. He took Economies of Scale and a talent for low-cost execution farther than anyone else. His book, Made In America, is a simple story written by the man himself about how he pulled it off. He’s a humble, hard-working guy with a fascinating story. Sam Walton is a guy who knows how to take a simple idea, and take it seriously. Thanks to Bo Fishback for suggesting this book as a prime example of how to create an absolutely dominant Low-Cost Competitive Advantage.
Coca-Cola: Created in 1886, Coke has an indisputably dominant world-wide brand based on a secret formula with a hypothetically indefinite lifespan. The best piece I’ve ever read about branding is based on Coca-Cola, written by Charlie Munger. Read this to understand how powerful the Branding strategy can be when executed correctly. You’ll also see why Coca-Cola may be a Trillion-Dollar company within a few decades.
Proctor & Gamble: Based on talent, they’ve created an organization that can be relied upon to create proprietary technologies in household items, then build incredibly strong brands upon them, for a confluence of Competitive Advantages that’s kept them in homes all over the world for 178 YEARS. The book Playing to Win, written by AG Lafley, former Chairman & CEO, shows how their strategy builds and maintains Competitive Advantages in multiple product lines and consumer segments. Thanks to Bo Fishback for suggesting this book, which is one commonly recommended by Meg Whitman, CEO of HP, previously of Ebay.
Apple: An obvious one, and commonly exemplified, it’s worth talking about in this context because of the Lollapalooza Effects. Apple has created the most valuable Brand on Earth. Proprietary Technology is coming out of their ears. Their software, development ecosystem, and third-party apps ALL exhibit Network Effects. Switching costs are high and increasing quickly as Apple sells more types of devices and increases the benefits of their complementary devices. Clearly, their scale earns them some very unique Economics in production, and they’ve got some of the most talented engineers and designers in the world. That’s some kind of moat. Like a moat made of lava with irritable Dragons chilling in it.