Saturday, March 17, 2012

Competition Demystified: Chapter 9

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.

The authors discuss the Cola wars of the 1980s in the context of the strategies described in the last chapter. Clearly, Coke and Pepsi appear to have a competitive advantage. Their market shares have been relatively stable for decades, with high returns on capital.

The authors argue that this is due to a demand preference (very loyal consumers who buy frequently) and economies of scale (advertising and distribution scale allows these companies to spend much more than also-rans, while keeping costs low on a revenue basis). But these companies (especially Coke) managed to erode significant value from themselves in the 70's and 80's before they learned to cooperate and reap the rewards of their competitive positions.

Pepsi was a much smaller player in the decades leading up to the 1970's. Coke's strategy, until then, was to ignore Pepsi. This allowed Pepsi to catch up to a large extent, as a result of heavy "Beat Coke" advertising and innovations (larger-sized bottles for families, selling into supermarkets through DSD etc.).

Not responding at all was a poor decision by Coke, but when Coke finally did respond (in the late 1970's), its decisions remained poor. It initiated a price war to gain market share, and it did so in the worst way possible: it did this in the markets in which it was the strongest. As a result, for every dollar of revenue Pepsi gave up in the price war, Coke was giving up four!

Coke did get lucky with its next move, however. In order to counter Pepsi's reputation for attracting younger and hipper soda drinkers, Coke rebuilt its drink to appeal to this group and ditched the old formula. The new drink was so unpopular (relative to the old Coke) that Coke was forced to bring back it's traditional drink. The situation made the company look pretty poor, but it turned out to be a blessing in disguise: Coke now had a flanker brand, one that could be used to push Pepsi around, while old Coke could keep its prices high and continue to appeal to the current customers.

Because of Coke's new weapon, peace started to prevail. The companies started signalling each other: there was a focus on profits instead of market share, the companies raised debt (suggesting cash flows were of significant importance) and Pepsi dropped its aggressive marketing campaign against Coke (including The Pepsi Challenge taste tests). Both companies started raising prices, leading to improved profitability for both (at the expense of consumers).

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