Saturday, March 3, 2012

Competition Demystified: Chapter 5

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 explore the idea of "local" economies of scale with a couple of examples. A number of reasons have been set forth explaining why Walmart has been so successful. The authors discuss some of these, and explain why they have had none or only small effects on Walmart's business. The strength of Walmart came instead from its local economies of scale, according to the authors.

As Walmart grew out of Arkansas and its neighbouring states, it had much greater local market share than its competitors (e.g. Kmart) even though many of its competitors were national. But national coverage makes distribution, advertising, and management supervision much more expensive.

At a tenth of the size of Kmart, Walmart actually benefited more from economies of scale than its larger competitors. Its stores were within 300 miles of its distribution centres, allowing its trucks to service distribution centres and stores in the same day. Its high local market share allowed for lower advertising costs as a percentage of its sales, and its managers were able to spend more time in stores rather than requiring travel time and additional layers of management.

Coors is in a completely different business than Walmart, but once again the concept of local economies of scale is demonstrated as an explanation for why Coors was so profitable in 1975, and why that profitability eroded in the ensuing years. In 1975, Coors was a regional brewer, with a national market share of 8%. Ten years later, it still had a national market share of 8%, but now it was a national player. Distribution and advertising costs increased as a percentage of sales because though its national market share was the same, it no longer had the local economies of scale. The authors argue that Coors did not identify its advantage, and therefore its expansion strategy did not focus enough on defending this advantage, causing it to lose local share to competitors.

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