Book Review - Competition Demystified: A Radically Simplified Approach to Business Strategy
I found that this book lives up to its subtitle. It argues that Michael Porter got it mostly right, but only one of the five forces really matters - barriers to entry. Bruce Greenwald and Judd Kahn then break down what to do if you find yourself (or a company you are analyzing) in a market with or without barriers to entry, and provide some examples of historical failures and successes to illustrate the simple point that without barriers to entry, it's very difficult to earn a sustained rate of return above the cost of capital.
I'll be upfront that, on the whole, I didn't find this book compelling. I thought the main assertion was unique and useful, but all the original and important information is contained in the first 50 or so pages - and the next 325 are mostly examples and case studies. I think it would have been more digestible as an essay or even a podcast interview.
That said, the central premise is worthwhile, so here's what I took away from it:
Porter's Five Forces - buyers, suppliers, substitutes, potential entrants, and competitors - was a robust and helpful framework for looking at interactions between any economic actors. However, it's clear that one of the forces, potential entrants (rephrased as barriers to entry) is overwhelmingly more important than the others.
Without barriers to entry, most of the other forces can be ignored because you will have enough on your hands dealing with all the new competitors vying for the same prize. This phenomenon is well understood - returns above the cost of investment are eventually competed away unless there is a moat in between you and the competition. If there is enough demand for a single firm to earn an attractive return, other firms will recognize the opportunity and enter the same market. The demand is now split among several competitors, fixed costs are spread among fewer units, prices fall, and margins narrow until the point where it no longer makes sense to be in business.
Barriers to entry can be thought of as a necessary but insufficient precondition for high returns. Rival firms competing away profits is too strong a force to overcome. A great firm (and a great investment) must be the, or one of the, dominant players in a market with barriers to entry.
The book then asserts (again radically simplified) that there are only three kinds of genuine competitive advantage: supply, demand, and economies of scale.
Supply - strictly a cost advantage that allows a firm to deliver products or services more cheaply than competitors. Sometimes these cost advantages stem from privileged access to crucial inputs like raw materials, but more often they are due to proprietary technology that is protected by patents, specific knowledge (know-how), or a combination of the two.
Demand - access to market demand that competitors can't match based on customer captivity. This can come from habit (branding) or high switching costs.
Economies of scale - cost per unit declines as volume goes up because you spread your fixed costs over a higher number of units. Even with the same technology, a sub-scale competitor will not be able to match the prices of an incumbent at scale.
One nugget on economies of scale I found useful:
"pure size is not the same thing as economies of scale, which arise when the dominant firm in a market can spread the fixed cost of being in that market across a greater number of units than its rivals. It is the share of the relevant market, rather than size per se, that creates economies of scale."
Counterintuitively, most real advantages based on economies of scale are found in local niche markets. In smaller markets, fixed costs are more substantial as a percentage of sales. The higher the fixed costs/sales ratio, the more attractive the advantage of scale. As market size increases and sales go up, this ratio decreases and scale advantages are less meaningful. In other words, economies of scale depend on your size relative to competitors, not your absolute size. This dynamic helps explain why Walmart was so successful - they were able to replicate their scale advantage in each individual new geography, and local retail and grocery was dominated by small, local players not equipped to compete on scale. It also didn't matter that Kmart was a much larger operation nationally as long as they didn't have a competing store in each town Walmart was entering.
Two telltale signs that barriers to entry / competitive advantages exist in an industry:
Stability of market share among firms - if companies regularly capture market share from each other, it's unlikely that any of them are protected by a competitive advantage.
Profitability of firms within the segment - without competitive advantages, new entrants will eventually eliminate returns above cost of capital. Persistent excess returns are usually a sign of barriers to entry.
This flowchart is repeated frequently.
It basically says:
If there are no competitive advantages in a market, the only thing that matters is operational efficiency, the competition is brutal, and the returns are meager.
If there are competitive advantages with multiple dominant firms, you go into some complicated game theory in order to eke out a return. The majority of the book is spent here.
When there is a dominant firm, that firm has to carefully manage its advantage and ward off assailants.
tl;dr
Barriers to entry are a necessary but insufficient precondition for high returns in a competitive market. Don't overthink competitive advantage, it comes from 3 places - cost advantages on your supply, captive demand, and economies of scale. The "scale" in economies of scale refers to a firm's size relative to its competitors in a given market, not its absolute size.