The term strategy has acquired a certain ‘Humpty Dumpty’ quality: “it means just what I intend it to mean, nothing more, nothing less”. Before we explore what strategy is, we should be clear around the purpose of strategy.
The purpose of strategy is to create a sustainable competitive advantage (SCA). It is useful to distinguish the essential terms: ‘sustainable’ and ‘competitive advantage’.
Competitive advantage is the capacity to deliver more value at the same cost, the same value at lower cost, or more for less. This is the genesis of Porter’s now famous dictum that there only two generic strategies: low cost or differentiation (putting aside the choice of a ‘narrow’ versus ‘broad’ target market).
There are just two pathways to competitive advantage. Relative to its competitors, an organisation must either:
- undertake different activities within its value chain (or ecosystem); or
- do the same activities differently.
It takes a certain arrogance to imagine you can do the same as your competitors and somehow sustain a competitive advantage. Let’s illustrate these two options in practice.
Consider Zara, one of the world’s most profitable fashion houses. Traditional fashion houses have embraced a model where fashion houses design and sell, but manufacturing is entirely outsourced. By contrast, Zara undertakes a lot of manufacturing in-house[i]. Different activities within the value chain.
What about the same activities done differently? BHP chose years ago to market its portfolio of minerals products through an integrated marketing centre in Singapore. By contrast, Rio maintained a product centric marketing structure, wherein each product group was responsible for marketing their individual products. The same activities done differently.
But it is the sustainability of competitive advantage that is the holy grail of strategy. Warren Buffett describes this as a building a moat:
“The most important thing to me is figuring out how big a moat there is around the business. What I love of course, is a big castle and a big moat with piranhas and crocodiles”
It is this ‘moat’ that stops someone from imitating your competitive advantage. Absent some ‘structural’ barrier to imitation, ‘excess’ profits guarantees that competitors will copy your model.
Some experts challenge the traditional view of SCA. Rita Gunther McGrath[ii] argues that today SCA is the exception rather than the rule.
What can we say about sustainable competitive advantage?
Firstly, as McGrath acknowledges, SCA still exists. The value being generated by some companies suggests there are still plenty of moats which have not been bridged . For example (numbers are Q3 FY2017 unless otherwise shown):
· Apple … $9.5B free cash flow (FCF) from $52B revenue
· Google … $7B FCF from $20B revenue
· Microsoft … $8.7B FCF on $23B revenue
· BA Tobacco … £2.8B FCF on £8.1B revenue (6 months to EODec 2016)
Firms could not produce these results without large moats around them.
Secondly, data from McKinsey and elsewhere suggests that around 20-25% of firms earn economic profits[iii] across 5-year timeframes. So, we can reasonably presume these firms have a level of competitive advantage which they’ve been able to sustain beyond 5 years. The more complex question is how long is the ‘competitive advantage period’ (a construct developed by investment analysts).
Finally, we understand industry cycles well. The early stages are characterised by competition for the dominant design. As this battle matures, the competitive focus shifts to product innovation, as players seek to take their offering to the next level. In turn, the innovation shifts to process and efficiency innovation. And McKinsey data show that through this process the degree of strategic differentiation within an industry is reduced.
This results in the Red Queen effect[iv]:
“It takes all the running you can do to keep in the same place … if you want to get somewhere else, you must run at least twice as fast as that” …
Lewis Carroll (Through the Looking Glass)
Gary Hamel once quipped (apropos Avis): “we try harder might be a great customer slogan, but as strategy it sucks”. I think ‘running twice as fast’ falls into the same category.
Despite McGrath’s own observation that sustainable competitive advantage is becoming the exception rather than the norm, her research into growth outliers found:
“Although these companies are nimble and adaptive, their leadership, strategy and values are very stable”
My advice: keep your sights set on building a sustainable competitive advantage, but recognise every day someone else is trying everything they can to challenge that advantage. And remember the advice of Andy Grove, the former CEO of Intel: only the paranoid survive.
[i] Zara’s differentiation in business model is far more sophisticated than this simple difference, but that’s for another post
[ii] Author of The End of Competitive Advantage; acclaimed expert on strategy and innovation
[iii] Economic profit means their cash flow return on investment is greater than their weighted average cost of capital
[iv] Beinhocker (1997). Strategy at the Edge of Chaos. McKinsey Quarterly