In Strategic Logic the author talks about the foundations for long-term profitability of companies.
I found Strategic Logic an interesting and informative book with many good real world examples. It provides a useful mental model for analysing companies and their profitability, and it changed the way I look at things like merger announcements. What I liked less is that there is quite a bit of repetition.
Of course, logic does not mean determinism. The logic of the business world, which is the result of the interaction of thousands of human beings (employees, competitors, customers and so on), cannot pretend to the precision of natural sciences such as physics or chemistry which deal with inert materials. The number of variables that act upon the profitability of companies is enormous, and luck should not be ignored. Clear strategic logic, however, can still cast a clear light on business realities.
Of course, the quality of management also greatly affects the final results of specific companies. But the truth is that some business models are more solid than others, independently of any other variable.
[...] every strategy that seems to work against the rules of logic is simply profiting from the ignorance or greed of markets, but logic wins in the end.
[...] all announcements of a "new economy" are deeply suspect, not because innovation isn't constant in the business world, which it is, but because the rules of the game never change. The prophets of the new rules are either self-interested (which consultant or professor does not like to say that the rules of the game have changed and immediately offers himself or herself to explain them?) or, more likely, just ignorant.
The Essential Elements of Strategic Logic
The Basic Principles
[...] if supply can easily follow demand, profitability will be minimal, because competitors, in their desire to capture a demand that's already satisfied, will lower their prices until they reach that equilibrium point where they just cover their opportunity costs.
One of the key points [...] is that the speed with which supply can follow demand in a given business (and therefore, the level of profits) stems from a series of objective, industry-specific reasons, that can be studied a priori. Or, in other words: it is possible to predict the profitability of a business even before knowing its financial situation.
[...] the normal situation in an open economy is that, given a desire, the market takes care of it. But it is not always like that. There are many reasons why a company may find itself in the wonderful position of selling something for which there is plenty of demand but cannot be sold by anybody else. In fact, we have already seen one of the reasons: patents. If a company develops a product that is clearly more desirable than its substitutes, because customers prefer it, and gets a patent on it, it gains a monopoly position. Of course, this is only possible in some industries, where patents are possible, but not in most. There are many other reasons, such as reputation or brand name, why a company may be protected by a de facto quasi-monopoly.
What we are finally saying is that in some businesses, an evident chance for profits (substantial margins, a clear signal of a small supply for the existing demand) does not produce an increase in supply, because there are difficulties in making this happen. These difficulties can be summarized as either the impossibility of actually supplying the demanded product (patents, registered brands) or the difficulty of doing so at a cost that would make the effort worthwhile for a new competitor, given the current market price. These difficulties are objective, in the sense that they don't depend on the effort of the managers involved [...], but on the intrinsic characteristics of the business.
[...] why would a competitor have a consistent cost advantage that the others cannot copy? A new technology, for instance, can lower production costs, but as long as that technology is embedded in machines that anybody can buy, it is not going to be the basis for a sustainable cost differential. As a matter of fact, the seller of the machines will make sure that all potential users realize how essential it is that they buy the new technology, lest they allow a competitor to have lower costs. A real cost advantage must be based on a unique factor to be the basis for long-term profits.
In the end, economies of scale determine how many competitors can survive in a given industry.
[...] if we divide the total market [...] by the minimum efficient scale [...], we obtain the maximum number of competitors that can survive profitably in the industry [...].
Economies of scale, when they are important, determine that only a handful of companies can survive in a given market and act as barriers to entry, which allows incumbent competitors to enjoy good margins. They are also relatively permanent. Until somebody invents a different way to make a product or deliver a service efficiently at a lower volume, the maximum number of competitors is predetermined and fixed.
Nevertheless, we must not forget diseconomics of scale. Every large company is less efficient than a small one, for its coordination and management costs are higher. If economies of scale in a given business are important, a few large companies will dominate it. If not, these large companies will find themselves under attack from leaner, smaller competitors.
[...] it often happens that companies start their success by doing something unique and their success provides them with economies of scale, which protect them when competitors start copying their uniqueness.
[...] a company cannot earn more than it "deserves". A company, no matter how leading, that sets too high a price [...] will not earn more, but less, because too high a price will simply invite competitors, helping them to enter the business profitably, in spite of their disadvantages. Of course, the leader may think that if there is entry, it will confront it, for it has the best margins, thus being able to do more advertising, more product development and, in the end, lower its prices, but this is rarely a sound strategy. If the company attracts too many competitors, the market will fragment and volumes will diminish, even for the leading company, perhaps hurting its cost position.
The best way to avoid competition is to try to prevent entry, not to try to expel competitors from the market. And the best way to prevent entry is to set a price that, from the beginning, makes it clear to potential entrants that they will never be able to obtain a decent return on their investment. This price [...] is more of a concept than a reality, as knowing it would imply, among other things, knowing the costs of all our potential competitors.
In general, whenever there are switching costs there is a profit opportunity, for buyers will be willing to pay extra to their current supplier to avoid the switching costs. Of course, that profit opportunity will be proportional to the importance of the switching costs.
In general, when a business has mostly fixed costs and variable demand, there will be price wars. A restaurant does not get into those wars, for an important part of its costs is variable: if it cannot sell the steak tonight, it will try to sell it tomorrow, something an airline or a hotel cannot do with its empty seats or rooms.
[...] we can say that a company cannot make money in a business where some competitors are ready to lose it, for they will always lower their prices until they can snatch customers away. That's why a company must consider the situation carefully before entering a market with high barriers to exit, even if it has serious reasons to consider itself the most competitive firm in the business. It can find itself surrounded by companies that are less efficient, but able to steal customers nonetheless, as they will stay in business even while losing money.
[...] the fact that the prices of raw materials go up or down does not affect an industry's margins in the long term. Of course, in the short term, margins are the difference between the price and the cost. But what determines how high the margins are, are the barriers to entry. If barriers to entry don't change, margins will not change, no matter how much costs go up or down: prices will simply reflect the new level of costs.
In essence, strategy is about finding ways to make something better and/or cheaper than competitors, in a sustainable way. Everything a manager can do, from hiring people to firing them, internationalizing operations or merging them with another company's, is only useful in as much as it lets the company raise its prices (do something better) or lower its costs.
The Nuclear Unit of Strategic Analysis
[...] economies of scale (or any other entry barrier) do not apply to the sector in its entirety, but rather to some of its activities.
In short, the golden rule of analysis is that any economic activity that is conceptually separable from the rest (such as owning a property and managing a restaurant on it) is in fact a distinct business. Furthermore, it is a distinct business in the strongest sense of the word, for it has a profitability structure that is distinct, as distinct will be the appropriate strategy to earn money at it.
[...] the decision as to which activities a company will perform and which activities it will leave to others, is possibly the most important a manager can make, since it consists, in short, of deciding in which business the company is going to be and, therefore, what is, a priori, its profit potential.
[...] a company that is capable of organizing the activities in a more efficient way than others, and in a non-copiable way, will obtain an extraordinary profitability, even if the profitability of the activities themselves is the same.
The first step towards understanding what is going to happen in an industry in transformation (and this includes, sooner or later, all of them) is to understand the present situation and how it has come about. [...] Once this is done, we must study what factors can modify the current profitability of each of the activities. As we know, the profitability of the activities is supported by some market imperfections. Hence, we must be capable of anticipating how these imperfections are going to change.
[...] any change affects the strategy, whenever it affects the characteristics that make an activity more or less singularizable, that is, those characteristics that make some competitors able to carry out the activity with costs sustainably lower or with some degree of differentiation. If the changes in the scene do not affect this "capacity of singularization", they do not truly affect the strategy: although the change can produce short-term imbalances, the strategic equilibrium will reassert itself.
Technological change [...] is only important from the strategic point of view when it changes the possibilities of singularization of the industry, and this can occur only when it alters the cost structure or the real possibilities for differentiating the product.
[An] activity has a given minimum efficient size, determined by its technology, that is, by the most economic way to carry it out. This efficient size then determines how many competitors fit into the sector, which normally influences the profitability of the activity. In principle, this is a structural, or permanent, reality. But, once in a while, someone invents a new way of doing things that makes them cheaper. [...] If this cheapening of the production is attainable by all competitors (for example because it consists of a new machine that is on sale to everyone), it will have no impact on the profitability of the sector: the rivalry between competitors will make the savings go directly to the clients. Profitability will continue to be as it was, since entry barriers have not changed. But if the new technology implies that the MES [minimum efficient size] is greater, because it implies large investments and optimizes its costs at a higher level of output than the previous one, then it produces a phenomenon of concentration in the industry [...].
[...] a technological change that introduces a new way of doing things that is advantageous for the clients (and which, therefore, ends up prevailing) can also involve a change in the structure of the sector: by increasing the minimum efficient size without the market growing, the maximum number of competitors that can exist successfully decreases. Those companies that position themselves rapidly will survive and those that take longer to react find themselves on the wrong side of the new entry barriers.
Even if the costs of producing a certain good do not change, changes in the transportation costs may make it possible to sell the product farther away in a competitive fashion, thus in fact altering the competitive equilibrium in favour of larger companies.
In short, forecasting industry evolution is a question of seeing whether the foreseeable technological changes in the way an activity is carried out will tend to reduce or increase competition in it, through a different minimum efficient size, or an increased (or decreased) capacity for differentiation.
The constant reduction in costs to which many companies are dedicated can be a necessary condition for earning money, since they cannot have costs higher than those of their competitors, but it is not a sufficient condition: if costs go down by 10%, but those of the competitors also decrease, profits will not improve.
[...] it often happens that when a sector consolidates, for whatever reason [...], the suppliers to this sector see themselves pushed towards a certain consolidation, to withstand the pressure of stronger buyers, as well as respond to the business opportunity to serve the larger clients, who frequently require larger suppliers.
[...] the profitability of a company will not depend, in the medium term, on the demand for its products, but on the market imperfections that make it difficult to satisfy that demand by a more or less unlimited number of competitors. Thus, there are businesses that have enjoyed excellent demand, but have ended just the same in bankruptcy.
[...] it is fundamental, of course, to ask if there will be a demand for the new product. It is fundamental, but insufficient. If there are no entry barriers, success will be ephemeral, since the competitors will take care of lowering the margins to the point where profits disappear, regardless of how valuable the product may be for the buyers.
Total novelty is rare; since, in reality, something new almost always comes to be a substitute for something else, although it may look like a very different product.
If the economies of scale are not significant, there is no reason why dozens, hundreds or thousands of competitors cannot coexist, as long as a technological change does not demand increased economies of scale, something that may never happen. In an industry of these characteristics, an investment in obtaining volume by lowering prices never receives it reward: costs do not go down as foreseen and competitors do not leave, thus making it impossible to recover the investment.
Being first has advantages (and is, therefore, worthy of investment) only when it bestows some sustainable competitive advantage. In those businesses with large economies of scale, it is evident that being first to develop a high volume establishes a solid cost position that will let the company survive the necessary consolidation and enjoy its fruits. But if this is not the case, it is much better to be second.
In general, a competitive position based on the network effect is only lost by a radical change in technology, or after many years of very mediocre management.
[A] very important point is not to confuse growth with structural profitability. In effect, when the product or service is new and there is a strong demand, all participants tend to earn money, since demand exceeds supply. But if there are no entry barriers, supply will not take long to reach demand, and profitability will greatly decline. This phenomenon of "maturing" provokes serious strategic errors in companies that, seeing the profitability of a certain product, decide to enter the competition, only to realize that they have arrived late, and the business suffers significant deterioration of margins. Of course, if there are factors that favour uniqueness (economies of scale, network effects and so on), some of the competitors will continue to be profitable once growth disappears. This is why it is essential to understand what the ultimate source of observed profitability is: pure growth effect, or the existence of factors that protect uniqueness.
An Analysis of Company Development
From the Activity to the Enterprise
[...] vertical integration: ownership, by the company itself, of the means necessary to carry out different activities.
Companies decide which activities to carry out based on a series of reasons. One can be that the company does not find an adequate supplier, for reasons of quality or volume. Another can simply be a desire to grow: incapable of increasing sales because competitors make it difficult, the company decides to add more value by beginning to do something itself that it used to buy, or selling directly to the final buyer, skipping the distributor [...]. Finally, another reason for integrating can be the desire to keep secret the method of manufacturing something, which would have to be communicated to an external supplier, compromising perhaps important information in competitive terms.
In any case, what is important is not so much why the companies integrate, but rather in which cases the integration follows strategic logic: can we, thanks to integration, make something better or less expensively than our competitors?
[...] it is fundamental to understand one point: the fact that one company is the owner of two links in the chain does not improve, in itself, the profitability of any of those links and, therefore, does not improve the profitability of the company. Only if there were some additional advantage [...] in having a common owner would the integration be a source of benefits.
[...] vertically integrating implies having to confront the entry barriers that protect all businesses. If these are low, the business (the activity) cannot be profitable and integration will provoke a decrease in the average profitability of the company (although the margin goes up, the investment will go up even more). If, on the other hand, the activity is profitable (the supplier or the distributor whose activity is absorbed is consistently profitable), we can be sure, as strategic logic tells us, that there will be very serious entry barriers to the business which will deny profitability for anyone else who wants to enter.
Two reasons – the integrating company's inexperience in the new activity, plus all the efficiencies commanded by the usual supplier, which normally produces for various clients – explain why, in fact, the prices of the external supplier are almost always lower than the costs of the company that integrates.
The first way to lose efficiency is to carry out the activity with less efficiency than the habitual supplier (or distributor). This can easily occur because the company does not have enough volume to use all possible economies of scale.
An evident practical problem is that all integration increases the fixed costs with respect to the variable ones, since we go from being supplied externally [...] to manufacturing ourselves, which always requires fixed investments. This implies greater operational risk, since every decrease in activity will be accompanied by a more than proportional decrease in profitability.
If a company buys outside, and new technology appears that provides lower costs or better quality, a company can go to those suppliers that adopt this technology. But if it has decided to integrate, it will have to choose between getting rid of a suddenly obsolete means of production, or accepting another source of inefficiency. For this reason, vertical integration makes more sense in very mature markets, where it is not probable that the technology will change suddenly.
Another reason for which efficiency can diminish in the long term is that in many vertically integrated companies we find ourselves with "internal monopolies". Clearly, the company competes in the market with its products, but it can have entire internal divisions that are isolated from the pressure of competition, since they "sell" their production to a captive client, that is, to other divisions of the company. At first, this situation can be efficient, since it avoids marketing expenses [...]. In the long term, however, it develops all the characteristics typical of monopolies: the managers in charge of these internal monopolies can end up developing an attitude similar to that of the directors of any monopoly, where efficiency and service are not the fundamental objectives, but rather fulfilling a production quota, or even the preservation of the status quo in general.
[...] it is much easier to control an external supplier than an internal unit of the company. The threat of substitution, even implicit, is very clear in the relationship with a supplier, and non-existent inside the company, except in extreme cases.
[...] there are three main reasons that vertical integration can be profitable: a decrease in costs for technological reasons (if the joint performance of two activities lowers their total costs); protection of a profitable activity, or learning about it; and the lowering of transactions costs. In most other cases, not integrating will probably be the best strategy.
If the manufacturing of the product in question is a determinant of a unique quality, or can be in the medium term, subcontracting the activity will be "exporting profitability".
Very frequently, the decision to "buy or make" is made as a pure short-term cost problem: companies analyse how much it would cost to make the product, look for the best possible price (internal or external) and decide on the less expensive. This is correct, of course, in the short term, but it does not take into account the evolution that the activity will have. This is important, since in many cases the decision to integrate will require a series of investments that make it irreversible at least for several years.
In short, it is a question of going beyond the static consideration of a comparison of costs and evaluating the decision for what it is: entering, or not, a given business. This decision has to adapt to strategic logic: it is a good idea to enter the business if it offers good future profitability, which implies that it is protected by some type of barrier (of course, we must be able to enter it without too much of a penalty). If these barriers do not exist, the investment will not be a good one in the long term, although in the short term it may appear that we are saving money by not buying from an external supplier.
[...] the decisions taken around vertical integration are absolutely crucial for the profitability of a company, because they determine in reality to what it is dedicated, because each activity is, although it may not seem like it, a completely distinct business from the others. The special difficulty in making such decisions is that many of the problems that may occur only appear in the long term.
Only if the company has some reason why it would be more profitable than others in the new activity (that is, its barriers to entry would be lower than average) will vertical integration make sense.
The Globalization Process and The Enterprise
[...] globalization means the progressive interpenetration of world economies, that is, that companies act increasingly in countries other than their own, whether as buyers, sellers or investors.
In short, the focus that strategic logic suggests is not accepting globalization as a given, to which one must respond by internationalizing a company's operations, but of carefully studying what are the structural changes that are occurring, if they are occurring, and how to take advantage of them in order to improve the profitability of the company.
[...] where economies of scale in production are very significant, and the costs of distance (transportation, adaptation, management and so on) are small, we will see companies with global reach, as the manufacturing of passenger airplanes can be. When the economies of scale are moderate and costs of distance high, we will see local, or at the most, national companies.
The first case [...] in which internationalization makes sense is when these three conditions are met: the local market is saturated; there are still available economies of scale (that is, a greater volume will generate lower costs); and the costs of internationalization are less than the savings in production costs. Operating in several countries can also contribute to lowering the risk of the company: instead of diversification by products, we have geographical diversification. [...] In other cases, the reason for internationalization has nothing to do with costs, but with client service. [...] Sometimes, it can happen that clients value the fact that a supplier is present in various countries.
Finally, internationalization may mean not selling more products, but buying them: instead of markets, the company looks for resources, shifting production or purchasing activities to countries with lower costs. As long as those inexpensive resources are in principle available to all competitors, however, we cannot expect a sustainable competitive advantage, but it is always better to be first in lowering costs. Again, the advantages gained must compensate for the added costs, and these can be substantial: different countries, different standards of work (quality, productivity) and so on. What looks like a great opportunity (labour ten times cheaper) may not be so, once the differentials of productivity, costs of distance and the necessary "learning fee" are taken into account.
If going international does not imply a decrease in overall costs (perhaps through economies of scale), or an improvement in the prices the company can charge (because clients prefer an international supplier), overall profitability will go down. This is so if everything works out as expected, not taking into account the typical start-up problems [...].
It is appropriate to insist that if all a company is looking for is to continue growing, but its international expansion is not supported by solid competitive advantages, going international will result, at best, in a decline in profitability and, at worst, in serious problems.
The argument that "we can no longer grow in our home market and, therefore, we should expand", is silly: it is better not to grow and stay profitable than to grow ruinously [...].
[...] the truth is that companies do not diversify to reduce risk, but to continue growing, whatever they may say. The basic reason is that all businesses sooner or later reach their saturation point. Faced with this situation, managers interested in maintaining a rhythm of growth for the company basically have three options [...]: they can attack foreign markets within their company's traditional business; they can integrate more activities into the company's business system; or they can remain in their country but enter different businesses [...]. Thus diversification is, in practice, one more way for a company to grow, to which strategic logic must be applied in the same way as to the other two.
[...] we will understand diversification as the entry into businesses where the most important characteristics, from a strategic point of view (technology, brand, channels of distribution), are really different.
In short, adding businesses, like adding countries or activities, does not create value in itself, rather it tends to destroy it. Only when growth contributes a specific value, in terms of better prices or lower costs, does it really create value.
In general, a specialized company has much less operational risk than a diversified company since, by definition, it knows its own business better. And this includes, of course, the general management who must determine the company's strategy.
[...] a large company is always more expensive to manage than a small company; if the synergies are not real, the diversified company will be less profitable than a collection of specialized companies.
Logic in Action
The Search for Growth: Mergers and Acquisitions
A merger/acquisition only makes sense if it creates value, that is, if the resulting company is more profitable than the sum of the two previous companies.
The first logical reason is to grow to reach the minimum efficient size, since a merger is without question the fastest way for a company to get there.
A second reason can be to gain not so much size as reach. A company that wants to expand geographically can choose [...] to open its operations in a new country from scratch, or it can acquire a local company already in operation. Evidently this is a rapid way of internationalizing a company, at the same time obtaining the desired assets and the local personnel necessary to run them.
The third strategic reason that can make sense for a merger is one of which protagonist companies do not usually speak in public, but which is behind many of the operations that are observed, although the reasons given in public are different: it is simply a question of reducing the installed capacity.
In many cases, a merger that is presented as an attempt to obtain economies of scale is, in reality, a relatively simple way of withdrawing capacity from the market. The problem is not that the merged companies were too small but rather, paradoxically, they were too large for the real size of the market. A merger permits them to eliminate an important part of the installed capacity, optimizing the result. Of course, these mergers provide an added advantage: not only do they reduce installed capacity, but also the number of competitors, which [...] is one of the determinants of the intensity of competition in a sector.
If both companies were already sufficiently large before the merger to obtain the lowest possible prices, it is clear that, by definition, the merger cannot lower those prices. And this is very common. In fact, it is difficult for two large companies that merge to be able to really improve their costs through economies of scale. The idea that they have to be larger to compete is simply false when the companies have already reached the necessary volume, The merged companies are larger, but not necessarily more profitable. Yet they still face the added problem that [...] large companies are costlier to manage than small ones. Therefore, if they do not obtain new economies of scale, but incur new management costs, the net result is negative.
In short, the problem with visions is that, frequently, they are hallucinations. Unfortunately, because it would all be more fun, strategic success is almost never (note the "almost") in a brilliant idea, but rather in the work of many years of finding positions in the market that are, at the same time, attractive for the clients and competitively defensible.
It is also relatively frequent, however, that a merger/acquisition, conceived with respect for the rules of strategic logic, ends up not bringing the company the expected results. This can be due to two further problems: the execution of the operation is defective or the price paid is too high.
In the buying/selling of companies there is what economists call "asymmetric information": the seller knows the product much better than the buyer. No matter how much due diligence is done, it is often after the acquisition that buyers really get to know the acquired company. As is to be expected, negative surprises are much more common than positive ones.
A last source of problems when putting the mergers into practice is the enormous amount of management time they absorb. When two companies merge, or an important acquisition occurs, the attention of the entire management is absorbed by the operation. First, because of its importance and, second, because of the unexpected problems [...]. But this concentration on the merger/acquisition is made at the expense of the daily management of the business. Sometimes, a merger/acquisition opens an extraordinary opportunity for competitors to improve their position, since the merging company loses its competitive edge, at least for a few months, distracted by its own internal problems.
But even when the idea is good and things are done right, mergers often destroy value. The reason is simple: if one company pays too much for another, it will never recover the investment, no matter how well things go.
Deals in which there is a purchaser and a clear purchased tend to be easier to manage than mergers of equals. The reason is that the latter usually produces a long period of political instability, in which the two organizations try to impose their ways of doing things, and individual managers try to ensure their positions. As soon as a merger between equals is announced, there is only one idea in the minds of all second-level managers: to save their job against their equivalent who comes from the other company. This, of course, does not lead to an easy and harmonious optimization of operations, or maintaining the focus on the customer or the competition.
For a merger to be successful, it has to meet the following conditions:
- It must follow strategic logic.
- There must be clear authority from the beginning.
- The price has to include the possibility of the synergies being much lower than forecast and, above all, that they may be achieved with a delay of up to two years.
Some Hints on How to Design a Strategy
The sought-after profitability will never come from the adoption of best practices that can be easily copied by all, because the same consultants who help one company help the rest. Profitability only comes from original strategic approaches that are difficult to imitate.
[...] the objective of strategy is to ensure, as far as possible, that the company obtains a profit on its invested funds above the cost of these funds, adjusted for risk. Everything else is value destruction, and if managers charge a salary (paid by shareholders), it is to do just that.
[...] companies frequently carry out important operations whose net result is growth in the volume of the business but not in its profitability. In fact, in many companies, growth is considered as something valuable in itself, independent from profitability.
The goal of strategic analysis is to find activities (or new ways of carrying out activities) that improve the intrinsic profitability of the company.
Each activity of the company must be analysed to see which ones are really profitable and why, and what can be done to emphasize these more and lessen those whose profitability is below average.
In fact, the old marketing tool known as "market segmentation" is a fundamental ally of strategic thinking. It is extremely likely that there will be a part of the market where the specific characteristics of the company can be translated into entry barriers. Even [...] when the company faces a perfectly competitive market, there will often be segments with special needs that can be the basis of higher profitability. However, to find them, managers need at least three things: profound knowledge of the business; creativity in finding solutions to problems that perhaps the buyer himself does not know how to solve; and a strong dose of strategic logic to know in which cases the investment will be profitable in the long term, and in which it will be copied by competitors.
Conclusion: From Logic to Practice
[...] the importance of the quality of management is in inverse relation to the entry barriers that protect the business.
Of course, management that is capable of putting into practice, for example, the best operational techniques in less time than their competitors will achieve a slightly higher profitability. Experience shows, however, that, with very few exceptions, this excellence in management is very difficult to sustain, since it depends on specific persons, who come and go.