Why can some businesses generate vast amounts of profits while others can't, even with comparable products and services? How can a manager ensure that his business can maintain healthy profit margins for extended periods of time without having those profits eroded by competition? How can an investor identify companies likely to generate healthy returns on capital?
If these questions interest you, Hamilton Helmer's 7 Powers: The Foundations of Business Strategy might be the most important book you've never heard of. Unlike most business books, its 210 pages are packed with valuable insight and clear explanations.
This is a book on business strategy, and it addresses the topic at a foundational level. It aims to provide the reader with a "strategy compass". For the manager of a business operation the strategy compass is a guide on navigating the trials of the business world to arrive (with some luck) at an attractive strategic position such that the business can command healthy profit margins and yet be protected from the arbitraging effect of competition. For the investor, the strategy compass provides a means of identifying strong and high-potential businesses that may not have been discovered yet.
Jeff Bezos famously said "your margin is my opportunity". This quote captures the dilemma for everyone who operates a business. A new venture starts by identifying a need for its customer base that has not been met. A solution is developed for this need and the business is off to a great start. Soon enough, however, others take notice and copycats emerge. They also want a piece of the pie, and what better way to compete with the pioneer than by undercutting their prices? Before long, the attractive profits enjoyed by the pioneering venture have been eroded by competitors.
Yet some businesses are immune from this effect. In spite of years of developing competitive (or superior) technologies, AMD could never dethrone Intel as the dominant supplier of chips for PCs. What's the difference between businesses that are immune to competition and those that are not? Helmer's answer is that there are seven strategic positions (powers) that allow businesses to command high profits and keep them protected from competition.
So what are the seven powers?
- Network effects: Any product that improves as more people use it benefits from network effects. Facebook is the most uniquitous example of this. A social network is only as good as the friends you have on it. Facebook established itself as the dominant social network. This position was so powerful that in 2011, even $200B Google couldn't challenge Facebook's dominance with its Google+ offering.
- Scale economies: Some products cost too much unless they're made for a sufficiently large number of customers, such that the cost per each customer comes down. Microprocessors are a perfect example. They're incredibly expensive to develop. Once Intel raced ahead in its market size, it became increasingly difficult for AMD to challenge them because Intel could outcompete AMD by spreading its costs across the larger customer base.
- Switching costs: Some products make it incredibly difficult for customers to switch once they have adopted the product. For example, a complicated piece of entreprise software requires expensive installation process. Then the workforce needs to be trained on the new software. Then the software needs to be supported on an ongoing basis. Each of these phases makes it less likely that the customer will consider an alternative vendor in the future. High installation costs are a deterrent. The need to re-train the workforce is another deterrent, and the personal relationships forged with the personnel of the existing vendor are yet another deterrent.
- Counter-positioning: Sometimes, it's possible to challenge an incumbent by offering a unique angle on an existing product. The example Helmer provides is Vanguard. Its founder was thought insane by existing active money managers who charged large fees for their management services. Vanguard offered index funds with low fees and no active management. Even once the new approach proved popular and profitable, the incumbents had an institutional aversion to embracing it because it meant canibalizing their existing profitable businesses.
- Branding: This one is pretty obvious. Brands are incredibly powerful and command loyalty from their base. However, they're also one of the most elusive power types because they require persistent investment over a long period of time.
- Cornered resource: A company can sustain high profit margins if it has exclusive control over a valuable resource. Here, "resource" can refer to anything from patents (as in the case of pharmaceuticals) to talent (as was the case of Pixar's "brain trust" consisting of Ed Catmull, John Lasseter, and Steve Jobs).
- Process power: This is the most rare of the powers. A company can develop a process that delivers superior results that cannot be copied by others. Helmer provides the example of the Toyota Production System. The company spent decades trying to optimize its manufacturing. When it became clear that Toyota was building superior cars, it even allowed staff from GM to observe its factories and question its staff. Still, GM could not reproduce Toyota's success.
These are the seven powers. Companies that don't enjoy at least one of these powers are bound to fall into a race-to-the-bottom as competitors erode their profit margins. For the interested reader, Helmer also shows mathematically the impact of each power type on the bottom line.
Each of these powers include a benefit enjoyed by the winning business. Equally crucially, they create a barrier that makes it undesirable for others to compete with the winning business. This combination of benefit and barrier is what leads to power.
Helmer calls these the "strategy statics". These are desirable destinations for any business. How to reach these destinations is what Helmer calls "strategy dynamics". These are my main takeaways on dynamics:
- Strategy is not made in a vaccum, it is crafted. As Helmer puts it in the book, "the rudder only works when the ship is moving". Nobody can invent a winning strategy in isolation. It requires the business leaders to be intimately familiar with every aspect of their business and their market. They need to keep their eyes on the seven destinations above and use their feel of their organizational capability and the market landscape to navigate to those destinations.
- "The first cause of every Power is invention ... of product, process, business model, or brand."
- The opportunity for invention arises out of external conditions. When these are ripe, the company uses its existing resources and capabilities to invent in any of the axes specified above to bring compelling value to market - value that is not currently offered by incumbents. Without the right combination of external conditions and invention, power can't be achieved.
- An invention that brings compelling value to market, creates or significantly expands the market.
- There are three ways to bring compelling value to market:
- Capabilities-led. The company uses its capabilities to invent. The risk here is that there may not be a market for the invention.
- Customer-led. The company starts from the needs of the customers to invent. The risk here is that it may not have the right capabilities.
- Competitor-led. Sometimes a competitor has successfully brought a compelling product to market but the company can invent a superior or adjacent product that expands the market.
Additionally, Helmer points out that each of the seven powers need to be achieved in different phases of the company lifecycle. It does not make sense, for example, to invest heavily in the branding of a fledgling startup. Similarly, the time to achieve sufficient market share is during the early growth.
So that's a quick summary of Helmer's strategy compass. I highly recommend you read the book if you're interested in business strategy. I also recommend reading Henry Mintzberg's "Crafting Strategy" article that Helmer references. The notion that strategy is not designed but crafted rejects some approaches to strategy where managers who are distant from the business can get in a room and think their way to a strategy. It highlights the fact that ultimately, strategy comes down to judgement, which in turn comes down to an intimate familiarity with every facet of the organization, the customer base, and the industry. With this knowledge, good judgement, and a little luck, the manager can use Helmer's strategy compass to navigate the business to one of the desirable destinations above.