Friday, April 6, 2012

Competition Demystified: Chapter 15

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 now describe three separate industries where companies either successfully cooperated with each other, resulting in strong profitability thanks to barriers to entry, or failed to cooperate, resulting in needless losses.

Nintendo dominated the home video-game industry in the late 1980s. It benefited from certain advantages including high household penetration of its system, which created network effects for games (for which Nintendo received licensing fees) and dominant retail space. But instead of cultivating its relationship with game makers and retailers, Nintendo took advantage of its industry position to squeeze its partners for all it could. When competing systems came along, these partners were all too pleased to encourage the competition and receive a bigger slice of the pie. Nintendo lost its position because it did not cooperate along its value chain.

The gasoline additive business was an industry in decline from 1974 onward. Environmental hazards resulted in legislative action that effectively made it clear that the industry would soon no longer exist. But despite the overcapacity that results when demand starts to fall in high fixed-cost industries, the companies in this industry made a profit to the end. Some of the techniques they used to protect themselves included uniform pricing (so companies wouldn't be tempted to offer discounts to some customers and reduce profits), advanced notice of price increases (allowing other companies to match, and if they didn't, a rescinding of the price increase), and joint sourcing (allowing one company to buy production from another, resulting in the idling and identification of the most inefficient plants).

Sotheby's and Christie's, the two leading auction houses, actually colluded illegally. But the authors offer an alternative for how these firms could have cooperated that would have resulted in no jail time and no fines for its officers. These houses simply had to specialize in certain types of art, and thereby avoid competing directly. Each house could have concentrated on a particular period or type of art, and would then have monopoly pricing power on all works that fall within their purview. Instead, they each tried to do it all, and fought each other on price to lower profitability.

No comments: