Helmer is a strategy consultant, teacher and investor. His aim was to distil what he’s learnt into a book about strategy that’s simple but not simplistic. 7 Powers delivers on that goal. It uses the right blend of theory, analysis and examples to teach you what needs to be known about the seven persistent sources of competitive advantage he has identified.
Strategy: a route to continuing Power in significant markets
Power: the set of conditions creating the potential for persistent differential returns
Value: the ongoing enterprise value shareholders attribute to the strategically separate business of an individual firm. The best proxy for this is the net present value (NPV) of expected future free cash flow (FCF) of that activity.
Which can be written as,
This is the Fundamental Equation of Strategy.
The product of M0 and g reflect market scale over time, hence they capture the ‘significant markets’ component of strategy. The impact of competitive arbitrage is expressed in margins and market share simultaneously, so the maintenance or increase of s, while maintaining a positive and material long-term differential margin, provides the numerical expression of Power. In other words,
Potential Value = [Market Scale] * [Power]
The sole objective of strategy is to increase the potential value of the business but it’s worth noting that this potential can only be realized when Power is coupled with operational excellence*.
*This is not to be mistaken with the notion that operational excellence is a Power. Professor Michael Porter of Harvard created quite a stir with his long-ago insistence that operational excellence is not strategy. His reason for doing so, however, completely aligns with the “No Arbitrage” assumption of the 7 Powers: improvements that can be readily mimicked are not strategic, because they do not contribute to increasing m or s in the Fundamental Equation of Strategy, as these are long-term equilibrium values.
Introduction
The arc of any celebrated business is underpinned by decisive strategy choices that are few and typically made amidst the profound uncertainty of rapid change.
Strategy can be usefully separated into two topics:
Statics — i.e. “Being There”: for example, what makes Intel’s microprocessor business so durably valuable?
Dynamics — i.e. “Getting There”: for example, what developments yielded this attractive state of affairs in the first place.
Foundational concepts:
Persistence. The Fundamental Formula of Strategy specifies unchanging m differential margins. Anyone who has done valuation work, M&A or value investing knows well that the bulk of a business’ value comes in the out years. For faster-growing companies, this reality becomes more accentuated. You won’t yield much from a few good years of positive m which then tapers off or disappears altogether.
For example, let’s use a common valuation model: if a company were growing at 10% per year, the next three years would account for only about 15% of its value. Remember, we’ve reserved the term “Power” for those conditions that create durable differential returns. In other words, we are trying to discern long-term competitive equilibria, not just next year’s results. Thus persistence proves a key feature in this value focus, and such persistence requires that any theory of Strategy is a dynamic equilibrium theory—it’s all about establishing and maintaining an unassailable perch.
Dual Attributes. Power is as hard to achieve as it is important. As stated above, its defining feature ex post is persistent differential returns. Accordingly, we must associate it with both magnitude and duration.
Benefit. The conditions created by Power must materially augment cash flow, and this is the magnitude aspect of our dual attributes. It can manifest as any combination of increased prices, reduced costs and/or lessened investment needs.
Barrier. The Benefit must not only augment cash flow, but it must persist, too. There must be some aspect of the Power conditions which prevents existing and potential competitors, both direct and functional, from engaging in the sort of value-destroying arbitrage Intel experienced with its memory business. This is the duration aspect of Power.
Industry Economics and Competitive Position. The conditions of Power involve the interaction between the underlying industry’s economics and the specific business’ competitive position.
Complex Competition. Power, unlike strength, is an explicitly relative concept: it is about your strength in relation to that of a specific competitor. Good strategy involves assessing Power with respect to each competitor, which includes potential as well as existing competitors, and functional as well as direct competitors.
Single Business Focus. The protagonist of Strategy and of a strategy is each strategically separate business by itself, even if they exist within the same corporation, a common occurrence.
Leadership. The notion of Power (and the impact of its lack) is what underlies Warren Buffett’s view that if you combine a poor business with a good manager, it is not the business that loses its reputation. On the other hand, always the domain of Economists, I am a strong believer in the importance of leadership in the creation of value.
My many years of advising companies and making value-driven equity bets has made it crystal clear to me that the ascent of great companies is not linear but more a step function. There are critical moments when decisions are made that inexorably shape the company’s future trajectory. To get these crux moves right, you must flexibly adapt your strategy to emerging circumstances.
Strategy Statics: The Seven Powers
1. Scale Economies
Definition: A business which enjoys declining unit costs with increased business size.
Example - Netflix
A strategy must meet the high hurdle of “A route to continuing Power in a significant market.” Netflix’s DVD-by-mail business made the grade, and it was their Power over Blockbuster that sealed the deal.
But there was a long-term time fuse to this mail distribution business. Why? The physical DVD business would eventually be supplanted by digital streaming distribution. The timing was uncertain, but Moore’s Law, coupled with the meteoric advances in Internet bandwidth and capability, guaranteed this outcome.
For Netflix, the crucial insight didn’t snap into focus until 2011, fully four years after they started streaming. Up till then, Netflix had negotiated with content owners (film studios being the chief example) for streaming rights. But these content owners were very savvy about monetizing their properties—they sliced and diced these rights by geographical region, release date, duration of the agreement, and so on. Ted Sarandos, Netflix’s Chief Content Officer, came to believe that it was vital the company secure exclusive streaming rights to certain properties. Here now Netflix finally made a radical move: a major resource commitment to originals, starting with House of Cards in 2012.
Exclusive rights and originals made content, a major component of Netflix’s cost structure, a fixed-cost item. Any potential streamer would now have to ante up the same number of dollars, regardless of how many subscribers they had. If, say, Netflix paid $100M for House of Cards and their streaming business had 30M customers, then the cost per customer was three dollars and change. In this scenario, a competitor with only one million subscribers would have to ante up $100 per subscriber. This was a radical change in industry economics, and it put to rest the specter of a value-destroying commodity rat race.
Theory
So we see that Scale Economies satisfy the sufficient and necessary conditions for Power.
Dual Attributes:
Benefit: Cash flow is improved by (1) enhancing value (enabling higher pricing) and/or (2) lowering cost, ceteris paribus.
Barrier: A competitor fails to arbitrage out the Benefit because (1) they are unable to, or (2) they can, but refrain from so doing because they expect the outcome to be economically unattractive.
This situation creates a very difficult position for smaller players like Netflix’s smaller-scale streaming competitors. If they offer the same deliverable as Netflix, similar amounts of content for the same price, their P&L will suffer. If they try to remediate this by offering less content or raising prices, customers will abandon their service and they will lose market share. Such a competitive cul-de-sac is the hallmark of Power.
The sole objective of a strategy is to increase the potential value of the business. Netflix’s share price chart shows how they fared after creating Power in their streaming business. If you look at Netflix’s share price trajectory, it is instructive:
First, the payoff for their successful strategy was enormous. Over the six years from Feb 2010 to Feb 2015, Netflix’s stock price increased six-fold compared to a doubling of the market.
Second, we can observe that this outperformance was not monotonic—2010 to 2013 was a roller coaster, and later years were no walk in the park. Regarding this volatility: In situations of high flux, it often takes time for cash flow to reliably reflect Power, so investor expectations may move up and down.
Power Intensity
The Barrier in Scale Economies comes from a follower’s rational economic calculation (often learned) that, despite the attractive returns being earned by the leader, attack carries an unattractive payoff.
A productive way to more formally calibrate the intensity of the scale leader’s Power is to assess the economic leeway they have in balancing attractive returns with appropriate retaliatory behavior to maintain share. The greater this leeway, the more attractive the longer-term equilibrium is likely to be for the leader.
To do this, let me introduce the notion of Surplus Leader Margin (SLM). This is the profit margin the business with Power can expect to achieve if pricing is such that its competitor’s profits are zero. If the fixed cost = C, then:
The first term of this equation indicated the relative significance of fixed cost in the company’s overall financials, while the second term shows the degree of scale advantage.
Namely, the first term is tied to the economic structure of that industry (the intensity of the scale economy), a condition faced by all firms. The second term reflects the position of the leader relative to the follower.
For Power to exist, both of these terms must be significantly positive. For example, even if there exists strong potential scale economies (C is large, relative to sales), the leader margin will still be zero (no Power) without any scale differential, because that second term was still zero, too.
2. Network Economies
Definition: A business in which the value realized by a customer increases as the installed base increases.
Theory
Network Economies occur when the value of a product to a customer is increased by the use of the product by others.
Dual Attributes:
Benefit. A company in a leadership position with Network Economies can charge higher prices than its competitors, because of the higher value as a result of more users.
Barrier. The barrier for Network Economies is the unattractive cost/benefit of gaining share, and this can be extremely high. In particular the value deficit of a follower can be so large that the price discount needed to offset this is unthinkable. For example, “What would BranchOut have had to offer users for them to use BranchOut rather than LinkedIn?” I think most observers would agree that every user would have required a non-trivial payment, so the total spend for BranchOut would have been colossal.
Industries exhibiting Network Economies often exhibit these attributes:
Winner take all. Businesses with strong Network Economies are frequently characterized by a tipping point: once a single firm achieves a certain degree of leadership, then the other firms just throw in the towel.
As powerful as this Barrier is, it is bounded by the character of the network, something well-demonstrated by the continued success of both Facebook and LinkedIn. Facebook has powerful Network Economies itself but these have to do with personal not professional interactions. The boundaries of the network effects determine the boundaries of the business.
Decisive early product. Due to tipping point dynamics, early relative scaling is critical in developing Power. Who scales the fastest is often determined by who gets the product most right early on.
Power Intensity
As before, I use Surplus Leader Margin to calibrate the intensity of Power: “What governs the leader’s profitability when prices are such that the challenger makes no profit at all?”
In the case of Network Economies, I assume all costs are variable (c), so the challenger’s profit is zero when the price equals these variable costs. The value the leader offers is greater than this by the differential network benefits it offers, and I assume they can bump up price to account for this.
δ is a measure of the intensity of Network Economies: how important the network effect is relative to industry costs.
[SN–WN] is the leader’s absolute advantage in installed base. As you would expect, as this approaches zero, the Surplus Leader Margin also approaches zero, even if the industry has strong Network Economies.
This equation also makes evident the tipping point outcome of Network Economies. As the installed base difference gets large, the pricing such that the follower has zero profits results in very large leader margins (100% at the limit). This means a leader can price at very attractive margins while still pricing well below the breakeven point for the follower. The result is that a follower would have to price at a significant loss to offer equivalent value. As pointed out earlier, in BranchOut’s case it would not surprise me if users would have had to be paid (a negative price) to switch from LinkedIn.
Again, I have parsed the intensity of a Power type into separate components: one reflecting industry economics (δ, the degree to which network economies exist in a particular business) and the other competitive position [SN–WN] within that structure.
Some final comments on Network Economies:
There can be positive network effects but no potential for Power.
The network effect δ needs to be large enough relative to the potential installed base and the cost structure for there even to be one profitable playeras this fulfills the Benefit condition.
If homogeneous network effects are the only value source, then if N δ < c, a firm cannot reach profitability. This is the problem I see often in Silicon Valley. If one supposes Network Economies then the strategy imperative is to scale much faster than anyone else—if another firm gets to the tipping point before you, then the game is over.
However, ex ante it is often very difficult to have much assurance in sizing potential N and δ. So you are left with a situation that sometimes requires significant up front capital but an uncertain ability to monetize. This for example has plagued Twitter. Usually management gets the blame but we are back to Buffett’s observation: “When a manager with a reputation for brilliance tackles a business with a reputation for bad economics, the reputation of the business remains intact.”
3. Counter-Positioning
Definition: A newcomer adopts a new, superior business model which the incumbent does not mimic due to anticipated damage to their existing business.
Example - Vanguard
Creating something really new in business is challenging in the best of times. Vanguard was no exception; its gestation period was attenuated and its birth painful. Bogle traces its roots as far back as his Princeton senior thesis, penned twenty-five years before, in 1950. In 1969, when Wells Fargo began pioneering index funds, Bogle took note. He also drew inspiration from foundational academic work, in particular Paul Samuelson’s seminal 1974 piece for The Journal of Portfolio Management, in which the Nobel Laureate in Economics envisioned a fund that would enable investors to simply track the market.
Vanguard’s inauspicious starting capital was followed by modest growth in assets. A merger with Exeter helped, and bit by bit the company achieved respectable scale, as the chart below indicates. Still, more than a decade would pass before Vanguard reached full escape velocity. Once it did take off, however, the upward arc was stunning with assets under management exceeding $3T by the end of 2015.
To understand the ascendancy of Vanguard, I must first note these characteristics:
An upstart who developed a superior, heterodox business model.
That business model’s ability to successfully challenge well-entrenched and formidable incumbents.
The steady accumulation of customers, all while the incumbent remains seemingly paralyzed and unable to respond.
These elements were not unique to Vanguard—they were pieces of an oft-repeated story. Think of Dell vs. Compaq, Nokia vs. Apple, Amazon vs. Borders, In-N-Out vs. McDonalds, Charles Schwab vs. Merrill Lynch, Netflix vs. Blockbuster, etc. But nearly always, these featured the same outcome: the incumbent responds either not at all or too late.
Theory
Dual Attributes:
Benefit. The new business model is superior to the incumbent’s model due to lower costs and/or the ability to charge higher prices. In Vanguard’s case, their business model resulted in substantially lower costs (the elimination of expensive portfolio managers, as well as the reduction of channel costs and unnecessary trading costs) which then translated into superior product deliverables (higher average net returns). Due to their business structure of returning profits to their fund-holders, they realized value from market share gains (s in the fundamental equation of strategy), rather than ramping up differential profit margins (m).
Barrier. The barrier for Counter-Positioning seems a bit mysterious. Freqently in such situations, naïve onlookers castigate the incumbent for lack of vision, or even just poor management. Often, too, they level this accusation at companies with prior plaudits for business acumen. In many cases, this view is unjust and misleading. The incumbent’s failure to respond, more often than not, results from thoughtful calculation. They observe the upstart’s new model, and ask, “Am I better off staying the course, or adopting the new model?” Counter-Positioning applies to the subset of cases in which the expected damage to the existing business elicits a “no” answer from the incumbent. The Barrier, simply put, is collateral damage. In the Vanguard case, Fidelity looked at their highly attractive active management franchise and concluded that the new passive funds’ more modest returns would likely fail to offset the damage done by a migration from their flagship products.
There is a dynamic to CP: As the challenger cannibalizes the incumbent’s customer base, two parts of the incumbent’s negative attribution lessen: (a) the incumbent’s original business shrinks, and (b) the uncertainty surrounding the viability of the challenger’s approach diminishes. As this scenario plays out, the risk-adjusted size of expected collateral damage declines. At some point, a rational incumbent, our hypothetical CEO, will then find the collateral damage insufficiently off-setting—an investment is warranted. Such delayed entry happens frequently, and while some may characterize it as incumbent foot-dragging, it is often simply a rational response to the circumstances.
A competent Counter-Positioned challenger must take advantage of the strengths of the incumbent, as it is this strength which molds the Barrier, collateral damage.
For Counter-Positioning, the Competitor Position element of Power is simply binary: you have adopted the heterodox business model. The Industry Economics aspect of Power refers to the central characteristics of this model: it must be superior, and it must cause the expectation of perceived collateral damage.
4. Switching Costs
Definition: The value loss expected by a customer that would be incurred from switching to an alternate supplier for additional purchases.
Theory
Switching Costs arise when a consumer values compatibility across multiple purchases from a specific firm over time. These can include repeat purchases of the same product or purchases of complementary goods.
Dual Attributes:
Benefit. A company that has embedded Switching Costs for its current customers can charge higher prices than competitors for equivalent products or services. This benefit only accrues to the Power holder in selling follow-on products to their current customers; they hold no Benefit with potential customers and there is no Benefit if there are no follow-on products.
Barrier. To offer an equivalent product, competitors must compensate customers for Switching Costs. The firm that has previously roped in the customer, then, can set or adjust prices in a way that puts their potential rival at a cost disadvantage, rendering such a challenge distinctly unattractive. Thus, as with Scale Economies and Network Economies, the Barrier arises from the unattractive cost/benefit of share gains for the challenger.
Switching Costs can be divided into three broad groups:
Financial. Financial Switching Costs include those which are transparently monetary from the outset.
Procedural. Procedural Switching Costs are somewhat murkier but no less persuasive. They stem from the loss of familiarity with the product or from the the risk and uncertainty associated with the adoption of a new product. When employees have invested time and effort to learn the particulars of how to use a certain product, there can be a significant cost to retraining them in a different system.
Relational. Relational Switching Costs are those tolls which would result from the breaking of emotional bonds built up through use of the product and through interactions with other users and service providers. Often a customer establishes close, beneficial relationships with the provider’s sales and service teams. Such familiarity, ease of communication and mutual positive feelings can create resistance to the prospect of severing those ties and switching to another vendor.
Switching Costs are a non-exclusive Power type: all players can enjoy their benefits. IBM and Oracle are competitors to SAP, and they also benefit from high customer retention rates and Switching Costs.
As a market matures, the Benefit of Switching Costs becomes transparent to all players and they are able to calculate the value of an acquired customer. More often than not this leads to enhanced competition to grab new customers, which arbitrages out the Benefit for new customer acquisitions. So the major value contribution comes from capturing customers before such value-destroying pricing arbitrage transpires.
Switching Costs offer no Benefit if no additional related sales are made to the customer. To assure that such additional sales take place, one tactic might be to develop more and more add-on products.
I should note that such advantages can be swept away by tectonic shifts in technology. ERP firms know well this lesson; that’s why SAP and Oracle are presently doing their best to make certain they are not leapfrogged by cloud-based applications.
5. Branding
Definition: The durable attribution of higher value to an objectively identical offering that arises from historical information about the seller.
Theory
How is it that Tiffany can successfully charge a substantial price premium over other sellers of what is a demonstrably identical offering?
Fuller described it this way: “You got exactly what they said you were getting. Anything that is brand-name and has developed a reputation that Tiffany has developed, they’ve earned it over the years for quality control. You can go there and you don’t have to think twice about your purchase. And you pay for that.”
Branding is an asset that communicates information and evokes positive emotions in the customer, leading to an increased willingness to pay for the product.
Dual Attributes:
Benefit. A business with Branding is able to charge a higher price for its offering due to one or both of these two reasons: (1) Affective valence. The built-up associations with the brand elicit good feelings about the offering, distinct from the objective value of the good. (2) Uncertainty reduction. A customer attains “peace of mind” knowing that the branded product will be as just as expected.
Barrier. A strong brand can only be created over a lengthy period of reinforcing actions (hysteresis), which itself serves as the key Barrier. Again, Tiffany has cultivated its brand name for more than a century. What’s more, copycats face daunting uncertainty in initiating Branding: a long investment runway with no assurance of an eventual path to significant affective valence. Efforts to mimic another brand run the risk of trademark infringement actions as well with their attendant costs and unclear outcomes.
Challenges and Characteristics:
Brand Dilution. Firms require focus and diligence to guide Branding over time and ensure that the reputation created remains consistent in the valences it generates. Hence, the biggest pitfall lies in diminishing the brand by releasing products which deviate from, or damage, the brand image.
Counterfeiting. Since it is the label, not the product, that bestows Branding Power, counterfeiters may try to free-ride by falsely associating a powerful brand with their product.
Changing consumer preferences. Over time, customer preferences may vary in a way that undermines the value of Branding.
Geographic boundaries. The affective valence may apply in one region but not another. For example, for many years, Sony enjoyed a Branding advantage with its televisions in the United States. In Japan, however, it enjoyed no such advantage, thus preventing it from enjoying premium pricing over rivals such as Panasonic.
Narrowness. To clear the high hurdle of Power, Branding in the context of Power Dynamics is a much more restricted concept than in marketing. For example, even if “brand recognition” is very high, there may not be Branding Power.
Non-exclusivity. Note that Branding is a non-exclusive type of Power. Indeed, a direct competitor might have an equally impactful brand that targets the same customers (e.g., Prada and Luis Vuitton and Hermès).
Type of Good. Only certain types of goods have Branding potential (more on this in the Appendix on Surplus Leader Margin) as they must clear two conditions:
Magnitude: the promise of eventually justifying a significant price premium.
Business-to-business goods typically fail to exhibit meaningful affective valence price premia, since most purchasers are only concerned with objective deliverables.
For Branding Power derived from uncertainty reduction, the customer’s higher willingness to pay is driven by high perceived costs of uncertainty relative to the cost of the good. Such products tend to be those associated with bad tail events: safety, medicine, food, transport, etc.
Duration: a long enough amount of time to achieve such magnitude. If the requisite duration is not present, the Benefit attained will fall prey to normal arbitraging behavior.
Power Intensity
In the case of Branding, I assume all costs are marginal, so the zero challenger profit price equals marginal costs. The value the leader offers is greater than this by the brand value it offers, and I assume they can charge a higher price.
As a consequence:
SMargin = 1 – 1/B(t)
Where,
B(t) ≡ brand value as a multiple of the weaker firm’s price
t ≡ units of time since the initial investment in brand
Industry economics define the function B(t) and determine the magnitude and sustainability of leverage. Time (t) represents the competitive position that S has relative to W in developing brand power.
6. Cornered Resource
Definition: Preferential access at attractive terms to a coveted asset that can independently enhance value.
Example - Pixar's Brain Trust
Pixar’s artistic success early on was extraordinary. Their first 10 films had an average Rotten Tomatoes score of 94%, with only Cars coming in below 90%. Eight Pixar films have been awarded an Academy Award for Best Animated Feature, and two of their films have been nominated for Best Picture, an impressive achievement for an animated film. Their commercial success has been no less impressive. On average these films achieved a gross profitability nearly four times that of the average of all other theatrical releases or all non-Pixar animated films.
This Power type is given a name in Economics: Cornered Resource. The services of this cohesive group of talented, battle-hardened veterans were available only to Pixar; they had it cornered.
Theory
Dual Attributes:
Benefit. In the Pixar case, this resource produced an uncommonly appealing product — “superior deliverables”— driving demand with very attractive price/volume combinations in the form of huge box office returns. No doubt—this was material (a large m in the Fundamental Equation of Strategy). In other instances, however, the Cornered Resource can emerge in varied forms, offering uniquely different benefits. It might, for example, be preferential access to a valuable patent, such as that for a blockbuster drug; a required input, such as a cement producer’s ownership of a nearby limestone source, or a cost-saving production manufacturing approach, such as Bausch and Lomb’s spin casting technology for soft contact lenses.
The Barrier in Cornered Resource is unlike anything we have encountered before. You might wonder: “Why does Pixar retain the Brain Trust?” Any one of this group would be highly sought after by other animated film companies, and yet over this period, and no doubt into the future, they have stayed with Pixar. Even during the company’s rocky beginning, there was a loyalty that went beyond simple financial calculation. In Pixar’s case, the Barrier was personal choice. In the case of spin casting technology, it is patent law, and in the case of cement inputs, it is property rights. Our general term for this sort of barrier is “fiat”; it is not based on ongoing interaction but rather comes by decree, either general or personal.
The Power hurdle for Cornered Resource is high: to qualify, an attribute must be sufficiently potent to drive high-potential, persistent differential margins ( m >> 0), with operational excellence spanning the gap between potential and actual.
Five tests of a cornered resource:
Idiosyncratic. If a firm repeatedly acquires coveted assets at attractive terms, then the proper strategy question is, “Why are they able to do this?” For example, if one discovered that Exxon was able to persistently gain the rights to desirable hydrocarbon properties, then understanding their path to access would be the more crux issue. Perhaps their relative scale allows them to develop better discovery processes? If so, their discovery processes are the Cornered Resource, the true source of Power, and it would be misleading to simply cite only the acquired leases.
Examining the Pixar Brain Trust through this lens, then, proves highly informative. In particular, you might notice one striking aspect of the Brain Trust: it is largely restricted to a specific set of individuals. As a first indication, consider that every one of their first eleven films was directed by one of this group (except for Brad Bird, discussed below). Further, Pixar’s record shows that simple inclusion into the group will not preternaturally endow newbie directors with the “Brain Trust process.” Such directors frequently fail, as evidenced by the replacement of Ash and Colin Brady on Toy Story 2, Jan Pinkava on Ratatouille and Brenda Chapman on Brave. I believe the Brain Trust is more than a combination of individual talents; rather it is the foundational members’ shared experience in the early trial years that has yielded one success after another.
Non-arbitraged. What if a firm gains preferential access to a coveted resource, but then pays a price that fully arbitrages out the rents attributable to this resource? In this case, it fails the differential return test of Power. Consider movie stars. A turn by Brad Pitt would probably advance box office prospects, therefore proving “coveted,” but his compensation captures much or all of this additional value and so fails the Power test.
Transferable. If a resource creates value at a single company but would fail to do so at other companies, then isolating that resource as the source of Power would entail overlooking some other essential complement beyond operational excellence.
Ongoing. In searching for Power, a strategist tries to isolate a causal factor that explains continued differential returns. There’s a contrapositive to this, too: one would then expect differential returns to suffer should the identified factor be taken away. Clearly this perspective has bearing on the identification of a Cornered Resource. There may be many factors that proved formative in developing Power but whose contributions then became embedded in the business.
Sufficient. The final Cornered Resource test concerns completeness: for a resource to qualify as Power, it must be sufficient for continued differential returns, assuming operational excellence.
7. Process Power
Definition: Embedded company organization and activity sets which enable lower costs and/or superior product, and which can be matched only by an extended commitment.
Example – Toyota’s NUMMI production process
In 1984 GM established NUMMI, a joint venture with Toyota, which would utilize Toyota production techniques to produce compact cars at a Fremont, California plant. GM accepted Toyota as the expert here, and the Fremont workers were sent to Japan for training. The joint venture got off to a fast start, and the low defect rates of NUMMI cars quickly approached those of Toyota in their Japanese facilities.
GM had high hopes that the lessons learned from this endeavor would be readily transferable to their numerous other plants around the world. But it was not to be. Although Toyota offered full transparency regarding NUMMI practices, GM just couldn’t replicate the NUMMI results in its own facilities. This was not merely incompetence—the inability to mimic the TPS was shared by many, as noted in a Harvard Business Review article: “What’s curious is that few manufacturers have managed to imitate Toyota successfully even though the company has been extraordinarily open about its practices. Hundreds of thousands of executives from thousands of businesses have toured Toyota’s plants in Japan and the United States.”
Here’s the rub: the TPS is not what it seems. On the surface, it consists of a fairly straightforward variety of interlocking procedures, such as just-in-time production, kaizen (continuous improvement), kanban (inventory control), andon cords (devices to allow workers to stop production and identify a problem so it can be fixed).Observing all this, GM workers naturally assumed you could clone TPS by copying these procedures. It turns out, though, that these production techniques merely manifest some deeper, more complex system,
The TPS exemplifies a rare Power type: Process Power.
Theory
Dual Attributes:
Benefit. A company with Process Power is able to improve product attributes and/or lower costs as a result of process improvements embedded within the organization. For example, Toyota has maintained the quality increases and cost reductions of the TPS over a span of decades; these assets do not disappear as new workers are brought in and older workers retire.
Barrier. The Barrier in Process Power is hysteresis: these process advances are difficult to replicate, and can only be achieved over a long time period of sustained evolutionary advance. This inherent speed limit in achieving the Benefit results from two factors:
Complexity. Returning to our example: automobile production, combined with all the logistic chains which support it, entails enormous complexity. If process improvements touch many parts of these chains, as they did with Toyota, then achieving them quickly will prove challenging, if not impossible.
Opacity. The development of TPS should tip us off to the long time constant inevitably faced by would-be imitators. The system was fashioned from the bottom up, over decades of trial and error. The fundamental tenets were never formally codified, and much of the organizational knowledge remained tacit, rather than explicit. It would not be an exaggeration to say that even Toyota did not have a full, top-down understanding of what they had created—it took fully fifteen years, for instance, before they were able to transfer TPS to their suppliers.
Professor Michael Porter of Harvard created quite a stir with his long-ago insistence that operational excellence is not strategy. His reason for doing so, however, completely aligns with the “No Arbitrage” assumption of this book: improvements that can be readily mimicked are not strategic, because they do not contribute to increasing m or s in the Fundamental Equation of Strategy, as these are long-term equilibrium values.
But aren’t the step-by-step improvements that drive Process Power exactly what much operational excellence is all about? Yes, they are, but this represents only the Benefit side, which brings us to an important point of caution about Process Power. The type of Benefit it cites—evolutionary bottom-up improvement—stands at the heart of operational excellence; as such, it is quite common. The rarity of Process Power results from the infrequency of the Barrier: an unyielding, long-time constant for the improvements in question. No matter how much you invest or how hard you try, the desired improvements are constrained by a boundary of potential that is tied to time, as seen in the NUMMI experience of GM.
Visual Summary of the Seven Powers
Dual Attributes. The benefit and barriers mapped for all 7 Powers.
The determinants of Power Intensity for all 7 Powers.
Strategy Dynamics: How & When to Establish the 7 Powers
How
Let’s take a step back, reexamine all seven types of Power and ask the Dynamics question “What must you do to get there?”
Scale Economies. With this first Power type, you must simultaneously pursue a business model that promises Scale Economies (industry economics), while at the same time offering up a product differentially attractive enough to pull in customers and gain relative share (competitive position).
Network Economies. Here the needs are similar to Scale Economies, except that installed base, rather than sales share, is the goal.
Cornered Resource. You must secure the rights to a valuable resource on attractive terms. This often comes from having developed that resource in the first place and then gaining ownership of it, the most common avenue being a patent award for research developments.
Branding. Over an extensive period of time, you make the consistent creative choices which foster in the customer’s mind an affinity that goes beyond the product’s objective attributes.
Counter-Positioning. You pioneer a new, superior business model that promises collateral damage for incumbents if mimicked.
Switching Costs. With Switching Costs, you must first attain a customer base, meaning the same new-product requirements demanded of Scale and Network Economies factor in here as well.
Process Power. You evolve a new complex process which renders itself inimitable within a reasonable period and yet offers significant advantages over a longer period of time.
You will notice a common thread: the first cause of every Power type is invention, be it the invention of a product, process, business model or brand.
So if you want to develop Power, your first step is invention: breakthrough products, engaging brands, innovative business models. But it can’t be the last step. Had Netflix invented the streaming product without introducing originals, they would have been left with an easily imitated commodity business. There would have been no Power and little value in the business.
In the midst of invention, you need to be ever watchful for Power openings. The 7 Powers framework focuses your attention on the critical issues and increases the odds of a favorable outcome.
By looking through the lens of the 7 Powers, we have come to a vital insight: Power arrives only on the heels of invention. If you want your business to create value, then action and creativity must come foremost. But success requires more than Power alone; it needs scale. Recall the Fundamental Equation of Strategy:
Value = [Market Size] * [Power]
There are three distinct paths to creating compelling value. Each has different tactical needs, so it is instructive to think of them separately.
First is Capabilities-led compelling value: when a company tries to translate some capability into a product with compelling value.
But here’s the uncertainty of such a capabilities-led initiative: the customer need is unknown, making such efforts profoundly risky. So risky, in fact, that they should probably be undertaken only if an assured Barrier appears early on.
Success requires that a company stay in the game, appropriately morphing to suit the requirements of the situation. Typically, this takes a long time—five years, in Adobe’s case—and involves many twists and turns.
A second path to compelling value is customer-led compelling value. In this case, many players spy an unmet need, but no one knows how to satisfy it. The uncertainty in this case is technical: “Can we invent it?”
The third and final path to compelling value is competitor-led. In this case, a competitor has already brought to market a successful product, and the inventor must produce something so much better (in whole product terms) that it elicits the “gotta have” response.
In cases of competitor-led compelling value, the uncertainty is two-fold: (1) Will the new features be differentially attractive enough to drive share gains? And (2) will the existing competitors be sufficiently delayed in their response?
Competitor-led origination often requires gut-wrenching big bang commitments up front. The time constants are less, and competitive response far more imminent. Often, you must make formal arrangements with providers of complements ahead of time—they will not sign up without such commitments. For example, in the case of the PlayStation, Sony had to make such commitments to independent game companies to ensure they would create games for the platform in the first place. In the case of the iPhone, it was telecommunication giants.
7 Powers as an investment strategy
Does this mean that utilizing the 7 Powers can result in alpha for investment in any company?
Of course not. In nearly all cases, both the potential for Power and the size of the market are sufficiently evident to astute investment professionals. In particular, they can often be found in the markers of historical financials. Alpha depends on exceptions to the semi-strong form of the Efficient Market Hypothesis: you need material informational advantage. In these cases the 7 Powers offers no such advantage. The only places one might expect alpha from applying the 7 Powers are those situations in which such transparency is not the case—opacity in other words—and that such opacity is penetrable by the 7 Powers.
A primary driver of opacity is high flux: if a business is in a fast-changing environment, then the information facing investment pros tends to have much higher uncertainty bars regarding future free cash flow. But high flux also attends the sort of conditions which orbit the “value moment.” So if the 7 Powers can lead to alpha by identifying Power in these situations ex ante, it also promises to be useful in doing the same for those inventors on the ground trying to find a path to satisfy The Mantra.
When
As a strategist and value investor, I cringe every time a CEO or CFO says they are pleased by the entrance into their market of a well-heeled competitor, insisting it “validates the market.” In 1981, at the introduction of the IBM PC, Apple had the temerity to run a large ad in the Wall Street Journal: “Welcome, IBM. Seriously.” They did not understand the nature of Power attainment in the takeoff stage: you and your competitor are in a race for relative scale, and there can only be one winner. Intel’s experience imparts a crucial “When?” lesson: the takeoff period represents a singular time. Only then can you initiate three important types of Power: Scale Economies, Network Economies and Switching Costs.
The Power Progression maps when Power must be established by Power type. It indicates at what point the window is open.
Given the critical importance of takeoff for establishing Power, the clock for calibrating the acquisition of Power should be parsed into three time windows—before, during and after takeoff:
Stage 1: Before—Origination. This occurs before a company clears the compelling value threshold, at which time sales rapidly pick up pace. For microprocessors, the entire Busicom period, including Intel’s efforts up until the release of the 8080, constituted the Origination stage.
Stage 2: During—Takeoff. This is the period of explosive growth.
Stage 3: After—Stability. The business may still be growing considerably, but growth has slowed from “explosive” levels, with 30–40% per-year unit growth as a workable choice for the cutoff. Above this rate, the market doubles in two years, sufficiently fluid for market leadership swaps without value-destroying counter-moves.
Power results from the simultaneous presence of a Benefit and a Barrier. Both of these play a pivotal role in Dynamics but as I have discussed throughout this book, Benefits are common, and they often bear little positive impact on company value, as they are generally subject to full arbitrage. The true potential for value lies in those rare instances in which you can prevent such arbitrage, and it is the Barrier which accomplishes this. Thus, the decisive attainment of Power often syncs up with the establishment of the Barrier.
This pulls into focus another Dynamics insight: each of the four generic Barriers is specific to stage. This results from the nature of those barriers:
Hysteresis. The Barrier here? A structural time constant facing all players. It makes sense, then, that all Powers relying on hysteresis would only become available in the stability stage, as the takeoff stage is relatively short-lived and does not usually provide sufficient time to build up the Benefit, constrained as it is by the time constant.
Collateral Damage. Here it is the economics of the challenger’s business model which threatens collateral damage to the incumbent. But, the initiation of this business model is what gets the challenger off the ground so it must occur in origination.
Fiat. The critical issue here concerns whether the “right” protected by fiat is fully priced. As the business proposition involving the Cornered Resource develops during takeoff, the resource’s value becomes more widely known, substantially reducing the probability that it will be materially underpriced, and it must be underpriced to qualify as a Cornered Resource.
Cost of Gaining Share. Of course, the whole notion of gaining share carries no meaning in the origination stage, as sales have not yet materialized. When the business takes off, there are many factors which determine which company can scale most rapidly: channel position, product features, communication approaches, location, production constraints, etc. As a consequence, the “price” of share usually does not reflect its intrinsic long-term value. Upon reaching the stability stage, the most effective modalities become better known and accessible to many players. There the customer’s focus turns from “Can I get it?” to “What is the best deal?” In this situation, each player grasps the value of share and will game accordingly, usually arbitraging out its value. Hence, generally speaking, only in the takeoff stage can a player gain share on attractive terms; otherwise it is too costly to be worthwhile.
Closing thought on Leadership
As a value investor, I consider Warren Buffett one of my heroes. I previously mentioned his insight that good managers can rarely reverse the course of a bad business, i.e. one without Power. Over and over, I have witnessed Buffett’s axiom play out in the press, with business leaders castigated for poor management ability in the face of seemingly impossible circumstances. Yahoo, Twitter and Zynga come to mind here. That said, when it comes to establishing Power in the first place, make no mistake: leadership is fundamental. Operation Crush would never have happened were it not for Andy Grove’s implacable, aggressive leadership. Going back further, the company would not have even pursued microprocessors were it not for the leadership of Bob Noyce. In summary, when you step back to consider how Power is established in the first place, there are a lot more parts to the puzzle: leadership, timing, execution, cleverness and luck can all play decisive roles.
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