Thursday, November 21, 2019

Strategic Advantage

Once when I was lecturing in Moscow, French chess grand master Joel Lautier was in the audience and he asked me about strategic advantage: “There may be many possible business strategies," he said. "How do we know which strategy is best?” I replied that Mr. Lautier himself illustrated the key to strategic advantage by his own example. The best strategy depends on you, because it is the strategy that plays to your strengths.

Let me explain: Several years earlier, Lautier had been brought onto a team advising Vladimir Kramnik as he prepared for his tournament against chess icon Garry Kasparov. The team were all wiz kids, each a chess master in his own right. No one person could fully prepare alone for the many possibilities of a match at this level. So Kramnik had advisors each assigned to work out the best solution to a particular situation that might arise. Lautier was on the team because he is one of the few to ever beat Kasparov.

Lautier’s job was key: Formulate Kramnik’s best “black” opening. Many readers will know about the most well-known chess openings. But, in fact, there are many more possible openings than the common ones, and Lautier was tasked to find a way to improve Kramnik's chances in the games where he started as “black”- second - since those games would favor Kasparov’s famous attacking ability.

Lautier formulated an unusual approach for Kramnik, one rarely used at that time. The opening was not ideal, but it might work given Kasparov’s strengths relative to Kramnik. It involved an odd series of moves quickly leading to the trading of queens, an approach known as the "Berlin" defense. The opening would leave Kasparov with his players in slightly better places on the board. But it would hurt Kasparov too, by skipping the complicated “mid game” where he had an advantage. The strategy worked. The opening shifted the edge enough for Kramnik to draw games that he would have otherwise lost, and nicely illustrates how strategic advantage results from pursuing a strategy that plays to your strengths.

Strategic Alignment

Barnett says "do what you are good at." That may sound obvious, but then why do so many companies seek to imitate "best business practice"? Here in Silicon Valley, executives come from far and wide to tour the campuses of Google, Facebook, and Apple. They come to Stanford and ask "what is the Silicon Valley's secret to success?" These efforts are premised on the idea that there exists an ideal strategy. But in fact the ideal strategy depends on the company. Some businesses are well suited to take a low-cost strategy, while others are adept at marketing products and services with greater perceived quality. Still other companies are good at a time-to-market strategy, and some thrive at technological innovation. In short, don't seek out "best business practice." Instead, follow a strategy that plays to your strengths.

Of course, doing what you are good at is only half of the strategic advantage story. The other half is your company's environment: the markets (including customers, suppliers, labor, and financial markets) as well as the political and social forces that affect your company. A company good at low-cost manufacturing will thrive only if it operates in an industry where low-cost products and services are valued by customers. The same goes for high quality producers, those who are good at time to market, and innovators. Strategic advantage happens when you do what you are good at - in an environment that rewards what you do. This happy outcome is sometimes called strategic alignment: when a company's strategy, organization, and environment are all aligned with what the company does well.

The Basis of Advantage

To align with the environment, you need to understand what is rewarded in that environment. Otherwise, you could excel at execution but still under-perform because you are playing the wrong game, like a well-run cab company losing to competition from ride-sharing services. In short, what it takes to have a strategic advantage depends on the basis of advantage.

For instance, early on the computer storage company Seagate excelled at low cost manufacturing, but had trouble turning a profit. When Steve Luczo took over as CEO in the late 1990s, he shifted the company to compete on the basis of time-to-market rather than purely on manufacturing costs. The consequence of this shift was a dramatic increase in financial performance, since Seagate's customers were willing to pay a premium to get better storage devices sooner. Luczo's transformation of Seagate changed many things, but the most important change was to align Seagate's strategy and organization to compete on the basis of advantage favored in their markets. To paraphrase leadership sage Peter Drucker, strategic advantage is not about doing things right, it is about doing the right things.

Straightforward though it seems, there is a great deal of muddled thinking when it comes to  the basis of advantage. Perhaps the biggest source of confusion comes from denying that trade offs must be made. For example, there is a trade off between cost and quality. If a company does everything possible to minimize costs, it is the extreme low-cost producer. Of course, it should also produce at the highest quality possible given its low costs, but the extreme low-cost producer makes no cost trade offs to increase quality. By definition, if it now chooses to increase quality, this will have to come at the expense of greater costs. Similarly, the extreme high-quality producer makes no quality trade offs to lower costs. It wants to minimize costs, but only if this does not come at the expense of quality.

These two strategies - the extreme low cost producer and the extreme high quality producer - can be thought of as the extreme points on the cost-quality "frontier". The cost-quality frontier illustrates the various combinations of low cost and quality that are possible. At any point along the frontier, you can improve your costs, but only if you are willing to make a trade off against quality (and vice versa). 

Now enter muddled thinking. Often you will here pundits say that "quality is free", or that making trade offs comes from the "tyranny of the or." These experts will give you examples of where a company increased quality and lowered costs at the same time. Well, this just means that the company in question was inefficient. It was inside the frontier - meaning that it was producing at a lower quality than it should have, given its costs. By improving the way it organizes, the company is able to improve both quality and costs. If it keeps improving, at some point it will reach the frontier. Once on the frontier, any further improvements in quality will require greater costs (and vice versa).

Low cost and perceived quality are just two bases of advantage. In practice, a variety of bases determine strategic advantage across the many markets that exist in the world: authenticity is the basis of advantage for ethnic restaurants; innovativeness determines strategic advantage in pharmaceuticals; responsiveness to market trends is the basis of advantage for popular music producers; and the list goes on. Strategic advantage is evaluated according to different criteria, depending on what markets you operate in.

What's more, in most markets companies face multiple bases of advantage, and different companies will compete on different combinations of criteria. Hotels are evaluated according to service quality and price, with different companies competing with many distinct combinations of service and price. And in some markets, companies must first satisfy a basic entry criterion, after which they may compete on various dimensions. Airlines, for instance, must all be seen as safe to fly at all, after which they can then balance service, route access, and cost. Because different bases of advantage often matter in a given market, business leaders must be very clear about the bases of advantage on which they are trying to compete.

Positional Advantage vs. Capability Advantage

Speaking of strategic advantage, what university would you say has the best geography department in the world?

If you answered "Harvard," you are not alone. Harvard often ranks well when people are asked this question. But Harvard does not have a geography department.

In fact, the field of geography is still reeling from Harvard's decision, decades ago, to disband its geography department, since this decision led to similar abandonments at Yale and elsewhere. To find classes in geography at Harvard today, you have to find courses that sneak into the curriculum masquerading as Earth Sciences, Environmental Studies, Anthropology, and the like.

The success of Harvard's nonexistent geography department is an example of positional advantage. An advantage is positional when it is based on who or where you are, not what you do. By contrast, a capability advantage is based on what you do. Brand reputation - essentially status - is at the heart of Harvard's advantage. But there are many other forms of positional advantage besides reputation.

One of the most common positional advantages is the incumbent scale advantage, where an existing firm ("incumbent") enjoys economies of scale - making it difficult for new rivals to enter the market. New rivals might enter even though an incumbent enjoys scale advantages, of course, but the newcomer will not immediately attain scale, putting them at a competitive disadvantage. 

The incumbent scale advantage is especially strong when the minimum efficient scale in an industry is about the same size as the market. (Minimum efficient scale is the smallest size one can be and still enjoy economies of scale.) In those cases, the incumbent firm will probably end up a monopoly.

Note that incumbent scale economies might be either supply side scale economies or demand side economies. Either way they give the incumbent a positional advantage. On the supply side, increasing scale leads to decreasing average costs - typically because of a large fixed cost such as a factory or refinery. On the demand side, scale economies exist where increasing the number of users makes a product or service more valuable, as with the so-called "network effect." But either way, scale economies give an incumbent a positional advantage over newcomers.

The first-mover advantage is also positional, because it depends only on your order of entry to a market. Research demonstrates that first-mover advantages are not common, but they do exist in some cases. For instance, a firm that owns intellectual property, such as a critical patent, may enjoy strategic advantage (at least until the patent expires). Similarly, if a firm's product or service becomes a de facto standard before others can get established, this will serve as an advantage. This was the advantage that kept Microsoft dominant in the computer industry for a number of years.

Strategy professors and investors love positional advantage. They wax metaphorical about not needing to compete, preferring for companies to find "blue oceans" and "moats" where position alone is enough. The problem here is that no positional advantage is forever. If there is money to be made, somebody else will find a way across the moat. Once that happens, you will wish you had been improving your capabilities.

By contrast, capability advantage continues to improve as your company continues to learn. A company that is good at getting products to market, or at delivering great customer service, or at last-mile logistics - or at whatever capability - can continue to reinforce its source of advantage by continuing to improve that capability. As a result, capability-based advantages remain strong when a competitor shows up. By comparison, a positional advantage may feel safe, but by its nature it depends on avoiding competition.

Ideally, your strategic advantage will result from both capabilities and position, but this need not be the case. When companies enjoy positional advantage, they continue to attract business regardless of whether their capabilities measure up. This fact often leads to the problem of the "lazy monopolist," where leadership of a dominant firm allows its capabilities to lapse (because they can).