“Unfair advantages” come in many forms. They tend to fall into three major categories—marketing advantages, production advantages, and research. In years past, when research was more than a commodity item, proprietary technology was often an unfair advantage. This is less-often true today. Sometimes, unique technology still can provide an unfair advantage.
Unfair advantages in marketing come in many forms. One is simply a better knowledge of how to motivate customers. This is quite common. Joe Blow spends his early years in the savings and loan industry. Later he leaves the S&Ls to start selling products or services to them. Nothing could really be simpler. When he wants to learn about something new, he approaches the contacts in his “buddy-buddy” network. He quickly discovers what is going on
in the market, while other salespeople may get stopped at the purchasing-agent level. The others aren’t often in situations where the key, high-level decision makers let their hair down. Joe Blow crosses this threshold easily. It is not only that he knows them but also, to a large extent, he thinks as they do.
Consider Dataquest, the famous information services com- pany, now a subsidiary of A. C. Nielsen. Its semiconductor industry service in its early years was a success, in large part because it was run and marketed by Jim Reilly. Reilly had come out of Signetics, Intersil and Fairchild with a long and successful career in market- ing in the semiconductor industry. When he called to sell Dataquest services to bigwigs in the semiconductor industry, he could get in doors and attract the attention of people that others couldn’t. Within a very short period, the semiconductor service became far and away the biggest part of Dataquest’s operations.
Let’s focus further on the so-called unfair advantage. Some types of advantages include:
Distribution advantages and the ability to fan out a product base, cost base, or technology base into different markets. Economies of scale by advertising closely aligned
products. Trade secrets. A lengthy time lead.
Lower-cost production techniques.
A quality image for which customers will pay a premium. The list goes on and on. The point is to look for an unfair advantage as a key determinant to whether or not your investment would earn above-average future margins. Determine if there are sound reasons to believe the company can maintain its advantage over competitors.
High Market Share Can Be an Unfair Advantage
High market share is a long-recognized form of unfair advantage. The Boston Consulting Group brought this concept into the realm of modern margin analysis, popularizing it as a key to determining potential profitability.
The concept was intuitively understood by many decades earlier. In its extreme, this concept gave birth to the aged Sherman and Clayton antitrust acts. The government thought extremely high market share to be so unfair they made it illegal. Market share is forever apt to hold its place, in the rationality of business schools, as a key tool for understanding future profitability. Just why market share is so important to future margins should be obvious.
The issue is a little like the chicken and the egg. The Super Company builds market share over time and comes to dominate an industry. Then, through its market share, it is able to: (1) maintain high margins and, thereby, (2) finance the developmental expenses to perpetuate its dominance.
Relative Market Share Is More Powerful Still
Consider why. Generally, a 30 percent market share is considered a high share. Is it really the market share that counts? Market share is important, but the relative market share is most important. Below are three companies, all in different industries. Each has a 30 percent share of its market:
Company A Company B Company C
Market share 30% 30% 30%
Market share of its largest
competitor 50% 30% 12%
Market share of its next
largest competitor 20% 15% 7%
Total number of competitors 3 9 18
In spite of the fact that each of these three companies has a 30 percent market share, their relative shares are all different. Therefore, differences are implied for their potential profitability. Company C is likely to be in the best position by far. It has a dominant position in its industry. It is likely to have the lowest per-unit produc- tion costs since it spreads costs over a larger volume of units pro- duced. It will be able to afford development costs and market studies due to its volume: items its smaller competitors must forgo. In a weak economy, it probably can cut prices further than industry stragglers.
The only time high market share is liable to move against Company C is if a rapid change takes place in production technology. Huge fixed investments in plants with old processes, for instance, may work against the market-share leader. High market share never protected U. S. Steel from competitive inroads by foreign steel and domestic minimills in the 1960s and 1970s. Japanese and other for- eign steel producers built new technology plants to compete against aging U. S. Steel plants, many of which were still using old, open- hearth technology.
More damaging, but less well known, is the effect of the U.S. minimills. In only 10 years, domestic minimills—employing con- tinuous casting and other innovations—swept the market away from the big steel companies in rods, flats, re-bars, angles, and other long, thin shapes. A bed frame or oil rig tower, formerly made of USS steel, is now made of steel by Chapparel, Florida Steel, Georgetown, Nucor, and others. These were real-life Davids slaying Goliaths.
On the other hand, if consumer preferences change and Company C is not responsive, it can lose market share. General Motors and Ford lost market share as they disregarded America’s shift in preference in the 1960s and 1970s toward smaller cars. Theoretically, the market-share leader ought to be able to spend much more than competitors studying markets and understanding shifts in consumer preferences. Companies may not always take advantage of the potential that exists in their unfair advantage of high market share. Management may fail to be responsive to mar- ket changes or simply fail to produce efficiently. Still, the potential power of high market share is great.
Company B is in worse shape. Still quite strong relative to the industry, it has all the inherent muscle that Company C enjoys in its industry. Unfortunately for Company B, its chief competitor has just as much muscle. They both have the natural potential to inflict great damage on one another. This is a little like Muhammud Ali against Joe Frazier—both clearly champions in their own right, but after 15 rounds against each other, both are a bit done in. There is no obvious reason why one should do particularly better than the other. The outcome is largely the result of personal factors.
Now consider Company A with a high absolute market share but a low relative market share. Its share is low compared to the
industry leader. It is obviously not in a strong position—vulnerable to the whim of its larger and more powerful competitor. In an industry like this, with few competitors and each having a respectable market share, all are likely to have good margins in times of prosperity as profitability becomes foremost in their minds. This is likely to promote informal meetings of the minds to avoid strenuous price competition in what, in the early 1970s, Dow Chemical called “statesman-like pricing.” Statesmanship is likely to fade when prosperity does. In a poor economic environment, these companies are likely to slug it out to the fullest in price wars. Company A is then liable to feel the full wrath of its larger competi- tor, who has many of the same advantages over it that Company C has over its competitors.
Another factor further complicates things—growth. Each firm will find itself in quite a different situation if its industry is in a strong demand—growth environment—than if the industry suffers from shrinking demand. This should be intuitively obvious to the most casual observer. If Company C is in an industry widely perceived to have rapid growth prospects, it may find new and increased competition from smaller competitors who have been able to raise additional equity and debt financing.
If, instead, the industry were shrinking, it would be unlikely these smaller firms would find anyone to provide the financing. Look at the differences. First, you have numerous high-technology firms being formed and financed with venture capital and public equity offerings at high Price Sales Ratios. Then you have their counterparts in the auto and related industries, which have been shrinking in relative importance for years. Growth doesn’t eliminate the validity of the market-share argument by any means. It just alters it somewhat.