Saturday, February 25, 2012

Competition Demystified: Chapter 3

The author of the excellent book for beginners, Value Investing: From Graham to Buffett..., is back, this time with a book about how to understand and analyze competitive advantages. Investors interested in better understanding what gives a company a competitive advantage must give this book a read.

In addition to the two types of competitive advantages discussed in the last chapter, the authors discuss a third advantage in this chapter: economies of scale.

But economies of scale can be eroded. Therefore, firms enjoying such advantages must defend market share. It's also important for defending companies to recognize that size is not the same thing as scale. The relevant market (either geographic or product) is the market in which the fixed costs exist, and this is where the advantage lies. For example, a retailer concentrated in one geography has an advantage (through distribution, marketing etc.) over a spread-out retailer with higher national market share. Finally, market growth actually hurts advantages based on scale. This is due to the fact that as a market grows, fixed costs (which are fixed) become a smaller percentage of total costs (as variable costs grow), reducing the advantage of scale.

As a result and somewhat counterintuitively, economies of scale are easier to achieve in smaller rather than larger markets. For example, consider an isolated town with a population of 50,000 that can support only one large discount store. An incumbent store gets to enjoy a monopoly as a result, since a new entrant would not be able to achieve satisfactory profits. A large city on the other hand would support a number of large discount stores, removing the advantage of the incumbent.

The authors therefore lay out the strategies imperative to maintaining an advantage due to scale. The best strategy is to match the aggressive competitor, whether it be in price cutting, adding products/services and/or entering new niches. In this way, relevant market share is held firm, and profitable niches (whereby competitors could build scale) are not conceded.

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