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Toasters are toast

Created:
1 July 2008
Written by:
Mr Bearbull

In the long run, everything is a toaster, Bruce Greenwald tells us in Competition Demystified, his book about what makes some companies great, yet most unexceptional. And that's bad because any company that makes toasters condemns itself to returns that, at best, barely cover its cost of capital. It's not that toasters are all the same. Some can be pretty funky even if none has yet to match the existential toaster in TV's Red Dwarf that tells Dave Lister, "So you're a waffles man." The trouble is that any company can make and market toasters, and too many already do. That's why returns on toasters are so poor - there are no competitive advantages to making them, no barriers to entry that give incumbents excess returns while deterring would-be competitors.

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And barriers to entry are crucial. As Mr Greenwald, professor at New York's Columbia Business School, tells us: "No other feature of the competitive landscape has as much influence on a company's success as where it stands in regard to these barriers." They are what made the likes of Coca-Cola, Microsoft and WalMart great. And their erosion is what turned, say, General Motors, RCA and Westinghouse from winners into losers.

As to the test of whether a company enjoys a competitive advantage in its chosen area, that's simply defined - being able to do what rivals cannot. Figuring out what sort of a company can carve out a powerful franchise and how it should protect it is the trickier part.

Mr Greenwald simplifies by distilling competitive advantages into three categories: first, supply advantages; second, demand advantages; and third, advantages created by economies of scale.

Supply

Of these three, supply advantages tend to be the weakest barriers. While they are present, they allow a company to supply its products or services either exclusively or, at least, at a price that its competitors can’t match. At one extreme, government licences or patents make the barrier. More often, it's an X factor that allows a company to beat its rivals - for example, the technological superiority that allowed RCA to be the Microsoft of the 1920s or, briefly, Cisco to dominate routers in the 1990s.

The problem is that the brute force of events undermines this superiority. So, when the patents on Zantac ran out in the late 1990s, GlaxoSmithKline found that it was just another pharmaceuticals group. And when the technological know-how that made RCA special became ubiquitous - in other words, when radios descended to the technological level of toasters - the company's glory days were over.

Demand

Dominance based on demand tends to be more powerful. It's where customers choose to buy goods or services from a particular company. They don't have to - they want to. Reasons for this can be the irrational habit formation that keeps smokers loyal to one brand of cigarettes or Coca-Cola drinkers loyal to Coke but not to Pepsi. It's irrational because the very same consumers will show little brand loyalty to beer, for example. A guy who normally drinks Bud will happily sink a Peroni when it's on offer.

Companies can reinforce the demand barrier by making it difficult for customers to switch to rival products. Sometimes there is a natural barrier, anyway. For example, often there can be big costs - and dangers - for a company to switch its software systems. Similarly, many branded drugs which continue to generate healthy sales have gone off-patent because doctors feel comfortable prescribing them. But fine-tuning a product so that it becomes complicated for a customer to make comparisons helps keep him captive. Which is one reason why providers of products as far apart as life insurance and motor cars add on so many bells and whistles. Customers get confused and stick with the same supplier.

Yet Mr Greenwald also warns that making a product different simply to escape the dismal returns of a commodity-type business won't work. Take the cost and effort that goes into making Vauxhall's models different from Mazda's, from Peugeot's and so on. But does it make any of these marques any more profitable?

Economies of scale

Then there are those advantages created by the economies of scale. These imply a good level of customer support in the first place, which permits a level of sales to be built from which the economies flow. The great benefit of a barrier built on the economies of scale is that, so long as the company behind the fortress does not mess up, it cannot be undermined. Essentially the incumbent has the power to match anything that its rivals do but - crucially - at a lower unit cost.

However, this exposes one particular business myth - that the best markets are the ones that show the strongest growth. They may provide a hunting ground for lots of hungry predators, but they won’t provide the excess returns and quasi-monopoly profits that are evidence of truly exceptional companies. The difficulty with fast-growing markets for market-leading companies is that they soon offer a sufficient quantity of sales for smaller companies to absorb their fixed costs. So high-fixed costs are no longer a formidable barrier. In response, market leaders must do all they can to raise fixed costs - for example, by advertising heavily, or by accelerating product-development cycles.

All of which leads me to wonder, which UK companies have the best barriers to entry. The markets would have to be niche, and the proof would be a longish record of high and stable returns. It also requires more work. But I'll tell you one thing - the chosen companies won't make toasters.

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