Competitive advantage needs a winning strategy AND excellent execution

In a world of hyper-competition, rapid change and ever-shortening product lifecycles companies’ competitive advantages are being eroded at a frightening pace. Entire industry business models are being disrupted, which in turn is causing knee-jerk restructurings and frequently fatal blows.

Companies in this hostile environment are shortening their investment time horizon and are tending to overinvest in efficiency and cost-cutting and to underinvest in uniqueness and innovative strategic growth opportunities.

This backdrop has led many to pronounce strategy as dead. For them, superior execution is key to surviving and if lucky thriving. We think such logic is flawed and that it will lead companies to destroy value and result in many more company failures than is necessary.

We believe today’s world requires companies to create innovative strategies that help overcome supposed immutable trade-offs. For example, companies don’t have to be efficient or unique, they can be, and must be, efficient and unique.

Why does strategy underpin companies’ valuations?

Joan Magretta, in her book “Understanding Michael Porter”, does an excellent job of reducing Porter’s work on competition and strategy to its essence. 

A winning strategy comprises a set of integrated choices that lay the foundation for a company to formulate tactics and take actions to create a value proposition that can deliver sustainable and superior customer value relative to the competition. 

For a strategy to increase a company’s value, it must positively impact some combination of a willingness to pay, costs, reinvestment and risk. The strategy must create a durable competitive advantage, which is observable as a return on invested capital (ROIC) that is sustainably above the company’s cost of capital (CoC). For more details on how competitive advantage impacts companies’ valuations, please see our blog The “Six Million Dollar Question” for Valuation and Management. 

Columbia Business School Professor Bruce Greenwald in his book “Competition Demystified” powerfully lays out why when formulating strategies, creating barriers to entry must take centre stage. Even if a company uncovers new and uncontested markets, a novel value proposition or a new business model, without barriers to entry, it will result in only a fleeting period of value creation (ROIC > CoC). 

Since, if competitors can decode and replicate an incumbent’s value proposition and earn a ROIC above their CoC they will invest. Inevitably the incumbent’s ROIC will be driven down to its CoC as new entrants take market share, fixed costs are spread over a narrower base, customer retention costs increase and prices come under downward pressure.

Moreover, the rapid advancement of technology often means that the new entrant has a technological advantage and can hence replicate the incumbent’s value proposition more cheaply. In this case, it will even force the incumbent’s ROIC below its CoC. However, the new incumbent does not have a winning strategy as typically the vicious cycle won’t stop there. Before long the new incumbent will itself be surpassed by another new entrant with a technological advantage. Finally, a new technology is often created that wipes the industry out. For example, such a pattern of events played out with CD manufacturers, before the MP3 player revolutionised how we do things. 

Strategy is the antidote to competitors. A winning strategy prevents competitors from replicating a company’s activity system or creating a new activity system, to deliver superior customer value relative to the company’s unique value proposition. 

The efficiency versus uniqueness value trap

Replicating an activity system with a tailored value chain, trade-offs incorporated and multiple core capabilities that work synchronously together is no easy task. Additionally, the uniqueness of the activity system means that there won’t be best practices to provide a blueprint. In other words, it will take a new competitor considerable time and cost to move down what Boston Consulting Group founder Bruce Henderson defined as the Experience Curve (where unit costs fall with experience).

Additionally, it is hard to model a nested activity system and to create a master strategy from the outset, and almost impossible to do so if customer preferences and the environment are not static, controllable or predictable. Instead, a company must continually make coherent tactical choices that are informed by the intended strategy and then make adjustments based on intricate feedback loops.

Such behaviour fits closely with what Henry Mintzberg observed and defined as Emergent Strategy, where an organisation learns what works best, often benefitting from serendipity, and then incorporates that learning back into its intended strategy. Strategic-learning is difficult to copy as it evolves from a continuous iterative process, which creates deep learning and tacit knowledge that is embedded in a company’s culture, core capabilities, employees and processes.

For example, designer Gills Lundgren who joined IKEA in 1953 as its fourth employee, reportedly had the flat-pack eureka moment when after an IKEA photo shoot in the 1950’s he was taking the legs off a table to put in his car. He looked at this problem through a customer’s eyes and this inspired the self-assembly concept, which is a core pillar of IKEA’s winning strategy. 

Some seventy years later competitors still have not been able to replicate IKEA’s strategy in a way that delivers superior customer value compared to IKEA’s unique value proposition. The reason is simple, competitors must copy the entire IKEA activity system to gain the full magnitude of benefits and this makes IKEA’s strategy as strong as its strongest link!

In recent years finance has become myopically focused on increasing companies’ ROIC by stripping out costs, outsourcing, minimising variance and lowering capital usage. These are all important but in our opinion finance wrongly views creating uniqueness, agility and innovation as a cost, instead of as a strategic opportunity to create a durable competitive advantage. 

Strategy can help to create modern companies that are unique, efficient, agile and engaging communities where creativity and innovation flourishes and durable competitive advantages emerge. Such modern companies will be far harder to replicate than traditional ones, which are overly controlled, innovation sapping and have rigid hierarchies that prevent ongoing strategic renewal.

Inditex’s competitive advantage stems from a winning strategy AND excellent execution 

As far back as the early 1980’s Inditex’s José María Castellano, who became CEO in 1984, developed, tested and implemented a system that revolutionised the time between design, production and garment display in stores. This innovative business model remains at the core of the company today. 

The founder Amancio Ortega, who owns 59% of the company, knew only too well that focusing on costs and efficiency without also focusing on speed would cut the heart and soul out of the company’s competitive advantage. Despite the Siren’s cost-cutting and efficiency song he stuck to his guns and in August 2018 he was the 5th wealthiest person in the world!

Zara’s relentless focus on speed enables it to prototype new styles in as few as five days and to achieve a design, production and time to store turnaround in as short as fifteen days. 

To promote speed, Zara is willing to incur extra costs. For example, about sixty per cent of manufacturing takes place locally and is in small batches, its design team is twice the size of other rivals, it has its own fleet of trucks and it delivers ironed garments that are ready to be hung in stores. Additionally, its stores are in prime locations. 

If we looked at Zara’s value chain solely through an efficiency and cost lens, it could be significantly improved.  For example, Zara could lower costs if it chose to manufacture its garments in China. However, the long supply chain and large batch production would increase the time to store by many multiples and destroy its speed competitive advantage. In this case, Zara would have to predict fashion trends, rather than be ready to surf the frequent but unpredictable fashion-waves. 

The benefits of Zara’s business model greatly outweigh the negatives. Zara’s customers continually have garments that are the height of fashion, at a reasonable price and are attractively presented in prominent locations. Customers know that if they don’t buy now, it won’t be there in a few weeks. As a result, Zara only has to mark down about half as many garments as the industry standard. The company also doesn’t really advertise as the buzz of a continual supply of new and unique fashion ranges at prime locations has led to customers behaving more like fans. Hence, in stark contrast to other fashion retailers, Zara is able to omit the sizeable marketing cost from its income statement!

When looking at Inditex on an activity by activity bases, many choices appear suboptimal, but they make perfect sense when looking at the whole company’s activity system. Its stunning financial results bear this out. Inditex has grown sales nearly five-fold since 2000, from c.€5bn to c.€25.3bn in 2017, which is a compound annual growth of c.10%, and in 2017 it had eye-popping operating margins for a retailer of 17%. 

Wouldn’t all competitors want to replicate such performance? Of course, but, so far Inditex’s strategy has created a durable competitive advantage that has prevented competitors from replicating its activity system, or developing a new activity system, to create a value proposition that provides superior customer value than Inditex. Key to this is the fact that competitors must replicate Inditex’s entire activity system to reap the same benefits.

Key takeaways

Moreover, these companies don’t have a proprietary technology or patent advantage that prevents competitors from copying them. Instead what prevents them is an innovative strategy that drives seamless implementation and activity systems that competitors must copy in their entirety in order to meaningfully compete. 

Using backwards-looking measures of financial performance, analysing companies activity by activity instead of looking at the entire activity system and a short-term focus can cause an overemphasis on cost-cutting and efficiency and underinvestment in uniqueness and innovation. 

Such behaviour is a value trap, as over the long-term it turns companies into commodities that are relatively easy to replicate. Once a company can be replicated its ROIC will gravitate to or below its CoC over the medium-term.

To help IVC’s clients avoid such value traps and to uncover fresh opportunities we leverage our Strategy to Valuation Multidisciplinary (SVM©) model to analyse how their entire activity system operates to create, deliver and capture value. 

Our SVM© model enables us to dissect clients’ businesses and their industries value creation process as it provides us with a specialised toolkit that draws on tried-and-tested techniques from finance, strategy, value investing, behavioural economics and the work of leading experts from other disciplines. 

Moreover, the model provides the foundations for us to develop, deepen, quantify and visualise strategies; ensuring they are adaptable, resilient and deliver superior customer value relative to the competition.

For details on the SVM© model and how we add value to our clients please see www.ivconsulting.co.uk.  

By Hugh Page

MD Integrated Value Consulting (IVC)

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