A Super Company must have a competitive superiority over all current or potential competitors. This usually involves being the lowest-cost producer and/or having established a unique or semi- proprietary position in at least a major portion of its product lines.
Above my desk hangs a small sign that reads, “All I really want in life is an unfair advantage.” Something proprietary or unique gives a company an advantage over others that allows
for potentially large gross margins.2 These margins allow for the
internal generation of enough profits to fund rapid future growth. It is essential in a Super Company.
The unique advantage may come in different forms. The advantage may be more obvious in some businesses than in others. In mining, for instance, the advantage may be merely better reserves in the ground. In consumer items, a trade name or patent may be sufficient. Lower-cost production through better produc- tion techniques is a common and, at times, absolutely necessary form. Marketing and research teams that work well together in product development may provide the advantage by helping to keep one step ahead of the competition.
The ultimate test of research is whether the product can offer the desired feature with a cost low enough to allow a reasonable gross margin. When marketing gives a product idea to top management, the proposal includes those specific features the product needs to satisfy customers. Marketing also will supply estimates of necessary product pricing.
With these product features and prices assumed, marketing will provide specific volume forecasts over time. Accordingly, engi- neering needs to work within these constraints. The product must be designed to be producible with the specified features in the right
volumes with a sufficiently low cost per unit.
The largest single area where research efficiency plays a cre- ative role is in this area of design-to-cost considerations. There is no other function that plays so important a role for the future prof- itability of the product and yet is so completely determined by the engineering effort. Can we cut on costs here? Can we skimp over there? Should we be extra careful not to cut costs on this feature? The design-to-cost function is one where businesses frequently get off on the wrong foot with products. It is the major impact that research efficiency has on gross margins and subsequent net margins.
Once a product is designed with inherently high costs, it is dif- ficult to alter that deficiency. It is likely never remedied. Products that start off with poor gross margins tend to stay that way forever.
2Gross margin means gross profit divided by sales. Gross profit is sales
minus cost of goods sold. Cost of goods sold are those direct production-oriented costs associated with making the product.
IBM is not my idea of a Super Stock, yet many believe it to be a Super Company. It is certainly a Super Competitor—with a lot of advantages. One from which they never cease to benefit is the IBM name. Everyone in the computer business knows that an IBM sales- person can get in doors that remain closed to others. Customers react with favor to the name IBM. Customers react with favor to most forms of supplier advantage.
The financial community easily accepts the notion of a propri- etary advantage among technology companies. Since investors accept the notion that technology companies offer something unique, they are often prone to bid up the stock to high levels.
It is easy to devise a list of companies with unique advantages in technology. Still, low-technology or no-technology examples abound. Warren Buffett, the legendary Omaha investor, is fond of newspapers having a “local business franchise”—another way to describe a business advantage. McDonald’s (“Does it all for you”) and Toys-R-Us created advantages through exploiting catchy mar- keting logos.
Sometimes companies create an advantage in economies of scale generated by acquisitions in related fields. (See Chapter 10 to discover why profit margins often are tied to market share.) To have a Super Stock, you must have at least a Super Company. A Super Company will have an unusual competitive advantage that allows it to make outstanding profitability, expressed in gross and net margins.
Nucor Corporation developed its competitive advantage in the extremely mundane steel industry. They developed processes with costs low enough to compete with foreign steel, while still making outstanding returns. Continuous casting has been well understood in the steel business for years. In the late 1960s, Nucor pioneered coupling continuous casting—fed by cheap scrap steel— with a local minimill concept.
By the mid-1970s, Nucor’s mills were so efficient that steel never stopped moving from the time it was first hot until it was a finished piece of inventory. The process improvements Nucor developed reduced energy requirements, capital costs, and labor per ton of steel produced. Nucor created a cost structure that allowed good profits and continued plant expansion in depressed times (1977 and 1982) when the rest of the U.S. and foreign steel industries were losing money.
A Super Company receives numerous benefits from the advantages it maintains over competitors. These ought to generate the basis for superior market share. It doesn’t have to have the mar- ket share at the time of the investment. When I first invested in Nucor, for example, it had low market share in most product lines. A Super Company ought to be able, if it has a true advantage over competition, to gain market share or at least to keep market share to the extent it desires. The analyst’s standard question, aimed at find- ing intermediate to long-term goals, should be: “What are you doing now to make margins better in the future?” This is often the same as asking: “What are you doing to increase your future market share?”
There are a lot of wrong answers to these questions. Manage- ment may explain it is cutting various forms of selling and admin- istrative expense. It may even be cutting research. All of that may be fine, but the real solution has to lie at the gross-margin level.3Better
to ask: “What are you doing to improve gross margins?” What a company does to improve gross margins tends to be the same things that allow it to improve market share.
Profitability and market share are so closely wed that it often becomes futile to invest long-term money in anything other than an industry’s market-share leader. The only good long-term invest- ment in a company with low market share is when you expect it to eventually upset the leader and take the leading market-share posi- tion away (see Chapters 10 and 11).
Does the Customer Get the “Best Bang for the Buck”?
An advantage is often achieved through product differentiation in the eyes of customers. By designing a product that addresses a slightly different market niche or by offering price performance advantages with unique features, a company can often command a premium price. Marketing excellence enables a company to identify which product characteristics are most important to customers. In stressing these features while trimming costs in other areas, it
3Gross margin means gross profit divided by sales. Gross profit is sales
minus cost of goods sold. Cost of goods sold are those direct production-oriented costs associated with making the product.
is possible to give the customer the most “bang for the buck.” (The introduction of portability to personal computers is a perfect example.) This almost always pays off for all concerned. Market share may be defined in this case in terms of the so-called market niche. Size differentiation falls into this category and is one of the most useful analytical tools for staying out of trouble. (It is so important that a substantial portion of Chapter 9 is devoted to size differentiation.)