Wednesday, June 11, 2014

Understanding Michael Porter

Michael Porter is one of the legends of corporate strategy. Most of you are likely familiar with the Five Forces model which has his name associated with it, but he didn't stop there even though that's as far as most people go with respect to Porter. In her book Understanding Michael Porter, Joan Magretta has full access to him, including his papers, transcripts of his speeches, and interviews with Porter himself. She summarizes Porter's thoughts on strategy and competition.

I think this is a great book for those of you who are starting out in trying to learn more about corporate strategy and what companies should try to do to get better and more profitable. I don't know anything about Porter's investing style, but he sounds like a value investor when he discusses companies. For instance, he discourages growth for the sake of growth (often at the expense of profits), which is a theme that is very familiar to value investors.

The topics ranged from elementary to rather advanced, in my opinion. One of the more interesting topics that came up again and again in different examples in the book was how companies can avoid commoditizing their products. It's easy to say that, but it's less clear how to do that. Competitors are in a race to be the best, and in doing so they tend to copy each other and improve the same features such that returns are driven down to the cost of capital. This makes sense in other settings, like say sports, where the rules are fixed so that only one person or team can win. But in business, more than one company can win in any industry, because each can play a different game. Furthermore, companies can tailor their activities (including processes, where they are located, how they market, what kind of hires they make etc) to their segment of customers, which then becomes impossible to copy, since the competitor would sacrifice his own customers if he were to try.

One example is in the car rental business. Hertz grew by appealing to travelers needing car rentals. Rather than go head to head, Enterprise focused on intra-city customers who were in accidents. In so doing, Enterprise marketed to insurance companies, acquired cheaper locations (that didn't have to be in expensive areas near airport terminals), emphasized different features and generally had a set of other activities that would have been hard to copy.

If a number of your activities are tailored to your customer segment, it becomes much harder to copy. For example, if a competitor can replicate one of your activities (e.g. good, cheap locations) with a 90% probability, his probability of replicating five of your activities drops considerably (.9*.9*.9*.9*.9 = 59%). The more strategic activities you have that are tailored to your segment of customers, the more insulated you are from the competition.


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