Ques 2a: Checklists for Competitive Advantage

1. Ques 2a: Checklists for Competitive Advantage • www.jeffreytowson.com

2. Competitive Advantages (1 of 2) • Revenue Advantages – captive customers / control over pricing / repeat purchases • Share of consumer mind and buying habits • Switching costs • Searching costs • Temporary supply-demand imbalance • Production Cost Advantages – proprietary production capability / manufacturing cost advantages • IP or proprietary technology • Labor costs • Lower cost of inputs • Special resource • Location or transportation costs • Economy of Scale Cost Advantages – lower average costs at higher volumes • Manufacturing • R&D • Marketing • Distribution / logistics • Government Advantages • License • Regulation (antitrust, zoning, environment) • Patents • Tariffs and quotas www.jeffreytowson.com

3. Competitive Advantages (2 of 2) • Efficiency of Scale – One dominant company in small market – with high initial capital costs and history of attacking new entrants. • Not a strict CA. But strong disincentive to new entrants. • MSPs and Network Economics Advantages • One-sided network effects – Facebook, Wechat, telephone • Two-sided MSPs and network effects – UnionPay, American Express, Apple App Store • Combos – Tencent multiplayer gaming is one sided and two sided. • Usually not (but not always) a competitive advantage: • Most brands. You can buy a brand with cash. It’s an asset. • Being smarter. This can be copied. • Most expertise. Can be copied over time. • Lower cost of capital – nope. • Lower cost of labor – nope. Transitory. • Most government regulations and tariffs www.jeffreytowson.com

4. Five CA Questions (1 of 5) • Does company (or asset / product / service) have a competitive advantage (a long-term forces view)? • What is it? • Wide or narrow moat? • Is it getting stronger or weaker? Moats have a lifecycle. • 1a. Has a high ROIC – WACC? • Sustained high profitability as measured by return on invested capital (ROIC) • Sustained high market value/book value (replacement value) • Significant, and sustained, differences between the profitability (ROIC) relative to other market participants. • Note: You can have high profits with no CA. Needs to be relative to capital. • 1b. Stable market share? - Entry/Share Stability • High share stability over time (low change in average share among participants) • Few new entrants/failed entry • Local, long-term firm dominance. How long? • Is the market strictly circumscribed? Niche? Better for maintaining CA. Think local (Greenwald). • If in an uncertain period, market share will still be there. But ROIC and earnings can be low or negative. • www.jeffreytowson.com

5. Five CA Questions (2 of 5) • How does CA compare to existing competitors with or without CA? To giants? To dwarfs? How long will it last? • Think about the key competitive relationships (giants to giants, giants to dwarves, both to new entrants). • How long it lasts? 0-1 years, 0-10 years, 10-20 years? • Key to sustainability is usually competitive advantage + sharply proscribed market. Dominate a niche (customer type, geographic, functional) • Compare the existing competitive advantage with the existing resources / assets. • Verizon – a Buffett company with a big competitive advantage based on the economies of scale of their national network (huge capex expenses every year (fixed costs) and a big expensive tangible asset). This is about a tangible asset that is hard to replicate and expensive to maintain and upgrade every year. • Visa – a Buffett company with a big competitive advantage based on two-sided network economics in their global payment network. No real tangible assets or fixed costs (some marketing). They have a big intangible asset (customers, merchant network) that is very hard to replicate. • www.jeffreytowson.com

6. Five CA Questions (3 of 5) • What is the cost and / or difficulty for a Dwarf or a well-funded, well-run new entrant to replicate this or overcome the CA? Think about the tangible and intangible assets that create the competitive advantage (the resources view)? • A CA shows up as high revenue or low cost relative to capital. But is the result of resources / assets or intangibles / capabilities. These things can often be bought so someone can jump the barrier. The key is how must does it cost (tons of capital?) or how difficult (a new railroad approved?). • Replace them on shelves? Convince loyal customers? Build pipeline? Launch a big furniture store? Develop a drug? • Think about entry costs and special entry difficulties versus ongoing costs: • Keeping an existing customer cost (A) << Grabbing a new un-attached customer cost (B) << (C) Taking a customer from a competitor (C). • www.jeffreytowson.com

7. Five CA Questions (4 of 5) • Cheetah Qestion: What is the company superspecialized in? • Relative to a specific market / situation and against a specific competitor. Think Cheetah plus the ecosystem it is in. • Cheetah is specialized for 17 seconds of speed. BUT...this only works when after the gazelle that others cannot catch. Need to be super-specialized against a specific situation? Think what do you give up to do this? • Be extreme at one thing. You usually have to give up lots of things to superspecialize (cheetah is all about acceleration). Costco is extreme low cost retailer. • More powerful is when it is a combination of 2-3 different and intertwined activities. That is very difficult to replicate. • Nascar has stadiums and Nascar media / race teams • Sirius Radio has unique content but also tons of devices in cars. Very different skills to create content and coordinate with car dealerships. • www.jeffreytowson.com

8. Five CA Questions (5 of 5) • 5. Mgmt Behavior Question: Is there unhealthy competitive fighting between companies with CA? • Is this like Coke vs. Pepsi in the 1980’s? • Very common in China. • www.jeffreytowson.com

9. When confused: • Identify the key activities (content, mktg,distribution) and ask "what doing that others cannot?". That is the barrier. • “Could a well-funded and well-managed company enter this business? What would it cost? Cost vs. difficulty to jump the barrier? • www.jeffreytowson.com

10. 1. Revenue Advantages - Checklist • For Share of Consumer Mind / Customer Buying Habits: • This is often aout brand power and intangible assets. It shows up as repeat business or willingness to pay more. Frequency of purchase usually matters. • Example: Coca-Cola, Starbucks • Aging consumer population is often the problem. • For High Switching Costs: • Switching means cost, hassle and/or time. Switching can also be perceived as risk. Customer will ignore lower price and better product if big switching costs. • Best is a low cost item with high perceived risk. Such as airbag pellet in car. Not worth switching. • For High Searching Costs: • This is similar to switching costs. You tend to stay with what you know if it’s complicated for evaluating quality. The devil you know. • Example: doctor, lawyer, accountant, management consultants. • Another example is limited shelf-space in stores. Leading companies are amplified as 1 of 5 available in Walmart or 7-11. This is especially powerful for Heinz as stores only carry 1-2 ketchup. Try to find another ketchup or beer to buy. • www.jeffreytowson.com

11. 2. Production Advantages • If a company has manufacturing or production advantages, it has a cost structure that other companies cannot duplicate. A company with a cost advantage will be cheaper or more profitable than its rivals at any volume • Four main types of competitive advantages on production side: • Proprietary technology (often new technology) • Example: Software, trading • Process advantage and learning curve – that is hard to replicate • Example: BYD • Lower cost of inputs – such as bargaining power with suppliers • Example: Managed care / United Healthcare • Special resources • Example: Saudi Aramco • Location and transportation costs • Example: granite mine in town, Carlsberg • www.jeffreytowson.com

12. 2. Production Advantages - Checklist • For Proprietary Technology: • Technology can be for lots of activities (call center, etc.) but we are looking at production costs. • Example: manufacturing technology, drilling tech, software • New or disruptive technology shows up as a cost advantage. Like Netflix DVDs against blockbuster. Allows a new entrant. But it can usually be copied fast. So new entrant needs to get big and build a real competitive advantage asap. • For Process Advantage and Learning Curve: • This is rare. Hard to have process that can’t be replicated. • Learning curve / cumulative experience can be a real cost advantage. Unlike economies of scale which is in a set period of time, this is about time it takes to capture low costs.. • Example: BYD, McKinsey? • www.jeffreytowson.com

13. 2. Production Advantages – Checklist (cont) • For Lower Cost of Inputs – and Bargaining Power with Suppliers: • Low cost labor, low cost energy, low cost capital and other factors tend to be fleeting cost advantages. Almost never more than just efficient. • However, bargaining power with suppliers is important and durable. • Example: Health insurers (vs. doctors) • Ques #5: What discount are you getting relative to competitors? What % of costs is this? • Ques #6: Are suppliers consolidating? • For Special Resources: • You have access to Lithium, oil, or other. Planet has limited resources so geological resources can matter. Can be other things. • Ques #7: Do you have unique or lower cost resources? What % of costs is this? • For Low Location and Transportation Costs: • Transportation is important cost. For products with low value / weight ratio. • Example: beer, furniture, granite mine, railway versus trucks • Ques #8: Do percent of costs are transportation for you versus competitor? • www.jeffreytowson.com

14. 3. Economies of Scale Advantages • Lower cost than competitors when at higher volumes. So can undercut on price or keep price the same and make larger profits. • Do you have lower per unit costs than your competitors at higher volumes? • Economies of scale provide a company with a lower average cost curve because of high fixed costs and greater production volumes than others. • The company’s advantage translates into a lower per unit cost for a certain volume - that other vendors cannot duplicate. For economies of scale to be in effect they must result in lower per unit manufacturing costs as volume increases. But this effect reverses when volume hits certain point. • Look at fixed costs in Sales/Marketing, R&D, manufacturing, distribution and other. Is about being big in a local market, relative to others. Need to bash small competitors. For Sales / Marketing, R&D and local promotion, you spend them into the ground. For manufacturing and distribution, you cut your prices cause they cannot match your cost per unit at higher volumes. • Need sharply prescribed market (local, local). Need to keep others small. Almost all local. Few are national. Need market of certain size to get economies of scale - but if too big cannot get. • Usually also need customer captivity. otherwise new entrants chip away at your size advantage over time. (greenwald) • www.jeffreytowson.com

15. 4. Government Advantages • Depending on the type of regulation, governments can explicitly or effectively limit entry into specific markets. This barrier can help to provide the existing firms with a competitive advantage which would be sustainable for as long as the regulations stays in place. • Sources of governmental advantage: • Licenses and regulations • Patents • Presence of strategic SOEs • Government impacts that are not competitive advantages but can influence competition: • Regulation (antitrust, zoning, environment) • Tariffs and quotas • Subsidies and taxes • Contracting and purchase preferences • Government-related assets and capabilities • www.jeffreytowson.com