Porter’s Generic Strategies

Three strategies to achieve above-average performance: cost leadership, differentiation, and focus

Porter's Generic Strategies

(Source: Flickr)

In order to understand Porter’s Generic Strategies, it is helpful to take a step back and examine the two things which determine a firm’s profitability in the long run.

The first is industry attractiveness, which is determined in any industry by the five competitive forces: the threat of entry by new competitors, the threat of substitutes, the bargaining power of buyers, the bargaining power of suppliers, and the rivalry among existing firms.

Five Forces

Figure 1: Porter’s Five Competitive Forces that Determine Industry Profitability

It is the collective strength of these five forces that determine whether firms in an industry will be able to earn attractive rates of return. In industries where the five forces are favourable, such as the soft drink industry, many competitors have earned attractive returns for many decades. However, where one or more of the forces exerts strong pressure on industry profitability, such as in the airline industry, few firms ever do well for very long.

Understanding industry structure, as determined by the five forces, will inform a firm’s decision to enter or exit an industry, and will also be a key consideration for industry leaders who have the ability to mould industry structure for better or for worse. For example, Coca-Cola is a leader in the soft drink industry and could, if it wanted to, encourage the production and sale of generic unbranded soft drinks. Even if this would increase Coca-Cola’s profits in the short run, it would also threaten the industry structure. Generic cola may increase the price sensitivity of buyers, lead to aggressive price competition, and lower barriers to entry by enabling new competitors to enter the market without a large advertising budget.

In addition to industry attractiveness, the second thing which determines a firm’s profitability in the long run (and this is where Porter’s Generic Strategies comes in) is a firm’s relative position within the industry. That is, can a firm position itself to achieve above average performance within its industry? Or put differently, is it possible for a firm to establish and maintain a competitive advantage?

In his 1985 book Competitive Advantage, Michael Porter explains that there are two basic sources of competitive advantage that a firm can possess: cost leadership and differentiation. A firm can also narrow the scope of its activities to compete in niche segments of the market, and so there are three generic strategies that a firm can adopt to achieve above-average performance: cost leadership, differentiation, and focus.

Porter's Generic Strategies

Figure 2: Three Generic Strategies

Porter’s generic strategies are based on the idea that in order to achieve a competitive advantage a firm needs to make hard choices. Trying to be all things to all people will put a firm on the fast track to mediocrity, and so a firm needs to decide what kind of competitive advantage to pursue and which market segments it should target.

Cost Leadership

As the name suggests, a firm that pursues cost leadership aims to be the low cost producer in its industry. While the strategy involves a primary focus on cost reduction, the cost leader will still need to produce comparable products in order to maintain prices. If a firm can sustain cost leadership while at the same time charging prices at or near the industry average, then this strategy can allow a firm to achieve above average performance.

One danger of the cost leadership strategy is that if there is more than one aspiring cost leader then this can lead to intense competitive rivalry and ultimately destroy industry profitability. If a firm wants to be the cost leader, then its best bet is to get in first in order to deter the competition.

Differentiation

Differentiation is a strategy in which a firm sets out to provide unique value to buyers. This may be achieved in various ways including producing products with unique features, serving buyers through new or different distribution channels, or by creating perceived differences in the buyer’s mind through clever marketing.

If a firm is able to charge a price premium that exceeds the cost of sustaining its uniqueness, then the firm will be able to achieve above average returns. While the strategy involves a primary focus on “being different” the differentiator still needs to manage costs, and will want to reduce costs in any area that does not contribute to differentiation.

Focus

The focus strategy involves narrowing the scope of competition in order to serve certain niche segments within the overall market. By serving these target segments well, the focuser may be able to achieve a competitive advantage in its niche even though it does not enjoy a competitive advantage in the market overall.

Stuck in the Middle

So there you have it, three generic strategies for achieving above average performance: cost leadership, differentiation and focus.

Be warned though, a firm that dabbles in each of these strategies while failing to successfully pursue any of them faces the risk of becoming “stuck in the middle” and being perpetually outperformed by the cost leader, the differentiators and the focusers.

[For more information on consulting concepts and frameworks, please download “The Little Blue Consulting Handbook“.]

Google Bites Off More Than It Can Chew

12.50pm AUGUST 1st and I was trying to make plans for lunch (priority #1).  No problem, I’ll just check my gmail account and use Google Maps to find the address. 

Gmail, Google Maps, Google.com, Google.com.au and Google.com.hk failed to respond (for at least 20 minutes).  

There is some chance that there is just a problem with the internet connection, but that would prevent me from publishing this post, so the internet connection must be fine.

Perhaps the internets [sic] is broken?  Typing “bing.com” into the web browswer and pressing enter loads Bing instantly.  A few sample searches confirm that the internets [sic] is still out there and seems to be working just fine.

The only logical conclusion is that the Google server must have crashed today.  I have not experienced this before and (after spending my lunch hour writing this post) it makes me much more inclined to use Bing in future. Even though it was a 20 minute abberation, down time is not what we have come to expect from Google. 

Perhaps this problem only affected myself or the Hong Kong metro area (let me know if you experienced similar difficulties!).  Or maybe it was something more significant: the roll out of Google+ has stretched Google’s global server capacity to breaking point. 

But let’s not run away with ourselves. 

This post is not intended to be a Google bashing.  However, my experience today raised a couple of interesting and important questions relevant to any consumer orientated company operating in an industry with low switching costs:

  1. How much tolerance should we (as consumers) have for a company that fails to perform as we expect? 
  2. How can a company that offers an increasingly homogeneous product build consumer loyalty?
  3. How concerned should shareholders be that a momentary failure to perform could disillusion millions of consumers and cost the company hundreds of millions of dollars ($$$)? 

The switching cost of moving across to Bing is zero after all … time for lunch.

Understanding the Competition

“Know your [competition], know yourself and you can fight a hundred battles without disaster.”
~ Sun Tzu

YOU are running a company, advising companies or would one day like to be.  A company needs to understand its competition, and here are 11 points to help you do that.

1. Identify the competition

Who are the company’s major competitors? Taking Cadbury as an example, some of its major competitors are Lindt, Ferrero, Nestlé, Hershey and Mars.

2. Segment

Are you able to segment the competition in a meaningful way? You may be able to segment by distribution channel, region, product line, or customer segment. For example, the FOX Broadcasting Company may want to segment its competition by region. In America, some of its major competitors include PBS, NBC, CBS and ABC. In Australia, its competitors include Channel 7, 9 and 10 as well as ABC and SBS.

3. Concentration

What is the concentration of competitors in the market? That is, are there lots of small competitors (a low concentration industry) or a few dominant players (high concentration industry)? Examples of high concentration industries include oil, tobacco and soft drinks. Examples of low concentration industries include wheat and corn.

4. Size

What is the sales volume and market share of the major competitors?

5. Growth

What are the historical growth rates of the competition?

6. Performance

What is the historical performance of the competition? Relevant indicators of performance include profit margins, net income, and return on investment.

7. Competitive Advantage

What is the competition good at? What are the competition’s capabilities? How sustainable are these advantages?

What are their weaknesses? How easily can these weaknesses be exploited?

8. Competitive strategy

What are the competition’s strategic priorities? What motivates them? What are their plans? How can these plans be upset?

9. Competitive response

How will the competition respond to the company’s actions?

10. Substitutes

Are there any other products that people can use that are as good or almost as good as the company’s products? These substitute goods represent a form of indirect competition, think Coke and Doctor Pepper, Vegemite and Nutella, coffee and tea, pizzas and hamburgers, tennis and basketball. Not the same, but it may be a decent substitute.

11. Barriers to entry

Are there barriers to entry that would stop competitors from entering the market? If the market has low barriers to entry then we can expect that the market, if not already heavily contested, will soon be filled with a large number of competitors.

Finding Yourself

THIS post was initially going to be called “finding your competitive advantage”, but I think it goes further than that.

Here are 8 factors to get you thinking, and to help find what you’re looking for:

  1. Why do you do what you do every day? What makes you tick? What do you believe in? These are things that you are not willing to compromise on for any reason.
  2. How do you provide value for others? Why do people ask you to help them solve their problems?
  3. Are you remarkable? That is, are you doing something that is worth people making a remark about.
  4. Where do you source your raw materials? Your ideas, your circuit boards, your fabrics, your fresh fruit, or whatever it is that you use to do what you do every day. Where do you get that from? Are they the best materials you could be using?
  5. Do other people talk about you in a positive way? Do you talk about yourself in a positive way?
  6. What are your key strengths that allow you to do what you do best? Are you using them?
  7. Are you in a stable financial position? (hint: lots of debt may stop from experimenting, from exploring, from discovering, and from becoming remarkable).
  8. If a customer or work colleague had to name three things about you, what would they say? What would you like them to have said?

Porter’s Six Steps of Strategic Positioning

There are six strategic principles which are relevant to any company that wants to be profitable online

Porter Six Steps

IN AN article entitled “Strategy and the Internet” published in the March 2001 edition of the Harvard Business Review, Michael Porter outlined six principles that he believes companies need to follow if they want to establish and maintain a distinctive strategic position in the market place.

Since the internet is a business platform with low barriers to entry, these six strategic principles are particularly relevant to any company that wants to be profitable online:

1. Stand for something

In order for a company to develop unique skills, build the right assets, and establish a strong reputation it is important to define what the company stands for so that the company will have continuity of direction.

2. Focus on profitability

This point seems obvious, however many internet based companies have instead focused on “unique visitors” and “page views” as measures of performance. At the end of the day, sustainable profits will only be possible where goods or services can be provided at a price which exceeds the cost of production.

3. Offer consumers a unique set of benefits

Good strategy involves being able to provide a distinct set of benefits to a particular group of consumers. Trying to please every consumer will not give a company a sustainable competitive advantage.

4. Perform core activities differently

If a company is able to establish a distinctive value chain by performing key activities differently from its competitors, then this will help the company establish a sustainable competitive advantage.

5. Specialise

There is no competitive advantage to being a jack of all trades and a master of none. Porter recommends making trade-offs.  By focusing on certain activities, services or products at the expense of others a company can establish a unique strategic position.

6. Ensure that all activities reinforce the company’s strategy

All of a company’s activities are interdependent and, as a result, they must be coordinated so as to reinforce the company’s overall strategy. A company’s product design, for example, will affect the manufacturing process and the way that products are marketed. By coordinating all of its activities, a company makes it harder for competitors to imitate its strategy.

[For more information on consulting concepts and frameworks, please download “The Little Blue Consulting Handbook“.]

GE-McKinsey 9-Box Matrix

The GE-McKinsey 9-Box Matrix offers any decentralised corporation with multiple business units a systematic approach to help it decide where to invest its cash

GE-McKinsey 9-box matrix

IN SEPTEMBER 2008, the McKinsey Quarterly published an interactive audio presentation on the GE-McKinsey 9-Box Matrix

An outline of this framework is provided below, but I highly recommend watching the original presentation.

1. Background

The 9-Box Matrix follows in the footsteps of Boston Consulting Group’s growth share matrix which was introduced in 1968.

The 9-Box Matrix was developed as part of work that McKinsey did for GE in the early 1970s. At that time, GE had around 150 business units and was faced with the challenge of how to manage such a large number of business units profitably.

The 9-Box Matrix was developed as a result of the realisation that it is important to separate the ability of a business to generate cash from the decision about whether to put more cash into the business.

2. Purpose

The 9-Box Matrix offers any decentralised corporation with multiple business units a systematic approach to help it decide where to invest its cash.

The 9-Box Matrix solves the problem of trying to compare potentially very different business units: one might be capital intensive; another might require high advertising expenditure; a third might have economies of scale.

Instead of relying on the projections provided by the manager of each individual business unit, the company can determine whether a business unit is going to do well in the future by considering two factors:

  1. attractiveness of the industry; and
  2. the business unit’s competitive strength within that industry.

3. Using the matrix

GE-McKinsey 9-box matrix

(Source: McKinsey Quarterly)

Placing each business unit within the 9-Box Matrix offers a framework for comparison between them.

In order to keep things simple, the framework offers only three investment strategies:

  1. Invest/Grow;
  2. Selectivity/Earnings; and
  3. Harvest/Divest.

Allocating one of these investment strategies to each business unit is a necessary first step. However, it is important to note that two business units that have been given the same strategy will not necessarily be treated in the same way. For example, a strong unit in a weak industry is in a very different situation than a weak unit in a highly attractive industry.

After placing a business unit into one of the nine boxes, there are at least two questions that are worth asking:

  1. If a business unit is in one category, say “selectivity/earnings”, is there anything that can be done to change its position? That is, would it be possible to move a business unit from the “selectivity/earnings” category and into the “invest/grow” category by making any kind of strategic investments?
  2. If a business unit is to receive money, what should it do with that money? It is important that money is given with a purpose in mind because the best use of money will vary depending on the industry and on the business unit. For example, advertising to enhance the brand might work for one business unit, whereas investing to increase research and development might work for another.

4. Axes of the matrix

The 9-Box Matrix places “industry attractiveness” along the vertical or y-axis, and “competitive advantage” (otherwise known as competitive position, or competitive strength of the business) along the horizontal or x-axis.

4.1 Industry attractiveness

Industry attractiveness refers to whether the industry is going to do well in the future. Are most players in the industry likely to do well? How easy will it be for the average company in the industry to make profits over the long run?

There are a number of different factors that affect industry attractiveness and those factors will vary in importance from industry to industry, for example: long run growth rate of the industry, current profitability, etc.

The Structure Conduct Performance model or, its more popular simplified version, the Porters Five Forces model both provide a formal approach to look at industry attractiveness.

4.2 Competitive advantage

According to Coyle, the first formal definition of “sustainable competitive advantage” was not determined until the mid-eighties.

In the early days of the 9-Box Matrix, analysts used proxies for sustainable competitive advantage:

  • Is the business unit’s market share growing? Maybe we can infer from this something about its competitive advantage.
  • How strong is the business unit’s brand equity? That is, how much of a price premium can it charge?
  • Is the company more profitable than its competitors?

A business has a competitive advantage when it is able to achieve profits that exceed the industry average. Competitive advantage may be established by offering consumers greater value by way of:

  • lower prices;
  • differentiated goods or services that justify higher prices; or
  • establishing a market niche and achieving a narrow, rather than an industry wide, competitive advantage.

5. Available strategies

5.1 Invest / Grow

A business unit will be in the “invest/grow” category if the prospects for the industry as a whole are attractive and the business unit’s position in the industry means that it is likely to do better than most of the other firms in the industry.

A business unit in this category should be given as much money as it needs regardless of whether it can generate those funds itself.

5.2 Selectivity / Earnings

Business units in this category are given second priority to those in the “invest/grow” category. So, the amount of money spent on business units in the “invest/grow” category will determine how much money is left over for business units in this category.

When allocating money to a business unit in this category, it is important to be selective about where the money is spent and monitor earnings closely. With the right combination of strategies, it may be possible to move the business unit into the “invest/grow” category.

In this part of the matrix it is a good idea to be careful. If the business unit doesn’t improve then it may be best to invest money elsewhere.

5.3 Harvest / Divest

A business unit will be in the “harvest/divest” category if it is in an unattractive industry and its competitive position is weak.

There are two suggested strategies:

  1. sell the business unit (divest); or
  2. increase short-term cash flows as far as possible, even at the expense of the business unit’s long term future (harvest).

[For more information on consulting concepts and frameworks, please download “The Little Blue Consulting Handbook“.]

Warren Buffett on long term value investing

BACK IN 1998, Warren Buffett gave an inspirational talk to a group of MBA students at the University of Florida, College of Business. In the speech, Buffett gives his perspective on investing, in which he outlines the need to understand the underlying economics of the businesses that you invest in, and the need to stick to disciplined principles of business evaluation without being swayed by passing investment fads.

Here are 15 of the most interesting and insightful points made by Buffett in his speech about successful long term investing, as follows:

1. Return on equity is key

Return on equity is fundamental. In general, there is no point to investing, just because of the availability of cheap financing, if a business has a low return on equity. It’s hard to earn much as an investor when the business you’re in doesn’t earn very much money. Buffett elaborates that when he started out as an investor he would sometimes purchase very ordinary stocks at prices way below the value of working capital. This is what Buffett calls the ‘Cigar Butt’ approach to investing. You look around for a cigar butt (i.e. really cheap company), you find one that is old and soggy. You get one free puff out of it, and then you throw it away and try to find another one. If you’re looking for a free puff then this approach to investing works, but these are very low return businesses. By investing in a wonderful business with a high return on equity then, even if you initially pay a little too much, you’ll do well if you stay in for a long time.

2. Ownership of a stock is partownership of a business

Ownership of a stock is part ownership of a business.  With that in mind, the investors should not pay attention to the day to day stock fluctuations.

3. Invest in businesses that you understand

As Buffer jokes, this significantly narrows down the number of companies that he has to look at. You need to look for a simple business which is easy to understand, and which has honest and able management. Buffett says that this lets him understand where a company is going to be in ten years time. If he can’t see where the company will be in ten years, he won’t buy it. Buffett says that “investing is putting out money now, to be sure of getting more money back later at an appropriate rate. To do that you need to understand the business.” Buffett says that he wouldn’t invest money in a new internet business because he doesn’t understand that business and couldn’t say where it would be in ten years time. In his early years he would conduct extensive industry research. For example, by asking every CEO in an industry “if you could buy the stock of one other company in the industry, which one would it be and why?”

4. Invest within your circle of competence

The nice thing about investing is you don’t need to learn anything very new. Buffett says that he learnt about Wrigley’s chewing gum 40 years ago, and still understands that industry today. As a result, you will develop a pool of knowledge about different industries that builds up over time. Interestingly, Buffett says that most of his deals get completed in a matter of hours. If you don’t know enough about a business instantly, you won’t know enough in a month or two.

5. Invest based on solid reasoning

If someone told you about a company at a cocktail party or the charts look good, that’s not good enough. Paying a little too much for a wonderful business, you’ll do well if you stay in for a long time. You buy a lousy business for a good price; you stay in for a long time you’ll get a lousy result. If you’re right about the business, you’ll make a lot of money.

6. Invest for the long term

Buffett recommends buying businesses that you would be happy to own forever. It may happen that you have to sell for one reason or another, but you should, at the time you buy, want to be buying a company that you’ll own forever.

7. Strong businesses need a durable competitive advantage

A strong business needs a durable competitive advantage. Buffett says that although he wants to understand the businesses he goes into, he doesn’t want a business that is easy. You want a business with a moat around it with a duke defending the castle. That moat might be low cost operations, quality of products, service, patents, real estate location, or share of mind (Buffett explains that thirty years ago, Kodak’s moat was as wide as Coke’s moat. Kodak had share of mind, forget about share of market. They had something in everybody’s mind that said, “Kodak is the best”).

8. Feel strongly about the products

You want a business that has products that are not price dependant. Disney and Coca-Cola have developed a favourable impression in the mind of consumers that allows these companies to charge more for their products and sell more of them than other companies in the same industry.

9. Don’t borrow money that you don’t need

Buffett says that he never borrows money. He loves his job and was doing the same thing when he had $10,000 and when making $1,000 was a big deal. He recommends taking a job that if you were independently wealthy you would take. “If you think you’re going to be a lot happier if you have 2X instead of X, then you’re probably making a mistake.”

10. You only have to get rich once

Risking what you have and need to get what you don’t have and don’t need is foolish. Buffett gives the example of Long Term Capital Management. This hedge fund was run by smart people, with extensive experience and with their own money invested. To make money they didn’t have and didn’t need, they risked money they did have and did need. Buffett says, “if you risk something that is important to you for something that is unimportant to you, that decision just doesn’t make sense.”

11. Be patient, think carefully and avoid over stimulation

Buffett says that, in his opinion, the best way to think about investments is to sit in a room and just think. The problem with being in a market environment is that you get the feeling that you have to do something everyday, you get over stimulated. You want to be away from any environment that stimulates activity. Get one good idea a year, and ride it to its full potential.

12. Professional investors should not diversify

Buffett believes that if you are not a professional investor, which is ninety nine percent of people, then you should extensively diversify your investments and not trade. However, once you decide that you are going to bring an intensity to the game and start evaluating businesses and bring the effort, intensity and time involved to get that job done, then Buffett believes that diversification is a terrible mistake. In his opinion, if you really know businesses then you shouldn’t own more than 6 of them. “Very few people have got rich on their seventh best idea.”

13. Business size is not the important consideration

When investing, business size is not the important consideration. Small, medium and large cap stocks can all represent good investment opportunities. It doesn’t matter about the size of the business; it’s the certainty of the returns that counts. The relevant questions are:

  1. Can we understand the business?
  2. Do we like the people running it?
  3. Does it sell for a price that is attractive?

14. Only worry about what is important and knowable

Anything that is unimportant or unknowable, you should forget about it. Buffett outlines that market predictions do not affect his investment decisions. “I have no idea where the market is going to go.”

15. Make investment mistakes

Buffett says that the mistakes that he has actively made have been far less costly than his mistakes of omission. He reflected that the times where he understood a business, saw an opportunity and sat on his hands and did nothing have cost him tens of billions of dollars.