Ahead of the Curve (21 page)

All her life up to then, she said, she had been following a formula for success, and doing so very effectively. What was unnerving about choosing the fashion house was the reaction of those closest to her. They were baffled, and their bafflement stoked her insecurity. It was as though she had dropped the veil on a hitherto secret part of her soul. Was she crazy? Or self-indulgent? How many people would kill for the opportunity she had to succeed on Wall Street? Why would she have made all these decisions to get to this point and then make this one? It was exactly what I had felt when I left my job in Paris. People asked what was wrong with me. How could I leave such a great job? Why had I even bothered getting to that point in my career only to walk away and start afresh? But as Annette had just found out, when you know, you know.

Business is the activity of making things to sell at a profit—decently.

—EDWIN GAY,
SECOND DEAN OF
HARVARD BUSINESS SCHOOL

Despite the onslaught of recruitment, there was still a course of academic study to pursue. Besides more finance, the second semester would introduce us to strategy, negotiations, entrepreneurship macroeconomics, and business ethics. Strategy was taught by a Swiss professor, Felix Oberholzer-Gee. He looked like the quintessential academic, with round glasses, hair brushed forward, and an absentminded gaze when he walked across campus. But he had spent five years in the injection-molding business in Switzerland and then another five in the economics department of an investment bank. He brought a wry worldliness to the classroom and quickly became a favorite of the section.

Harvard prided itself on its strategy department, not least because it was the core of the general management program. Establishing and executing a strategy was precisely what a general manager did. We were not being trained to be excellent financiers or operations managers but rather good generals. We were learning how to marshal disparate forces and resources to pursue the goals of creating and capturing as much value as possible. Strategy was not about filing the right accounts or making sure the machinery worked. It dealt with the big picture: building and managing a business to make superior returns over the long term.

The first thing to understand about strategy, we learned, is that it is not operational efficiency. You could run the best laundry in the world, but if what you were doing was quite simple and thousands of others could do it, you were not going to make any money. You lacked, as Felix liked to say, “a great strategy.” A beautifully run restaurant with the greatest chef in the world could be an economic disaster, while owning a few grubby fast-food franchises could make you a millionaire. Being very good at doing something was absolutely no guarantee of financial success. I recalled Steenburgh in marketing telling us, “A good product alone won’t get you there.” So the first challenge for the strategist was picking the right thing to do.

Felix showed us a graph of the distribution of returns on equity of major American companies over the past twenty years. Most returned between 10 and 15 percent a year. But a few had returns on equity over 20 percent. What were they doing that enabled them to do this? The most profitable companies year after year tended to be in a few sectors: pharmaceuticals, high-technology, financial services, discount department stores, and oil. The worst major industry to be in was airlines. There were exceptions, such as Southwest, which had done phenomenally well. But even Southwest, we had to assume, would eventually struggle to escape the broader trends of its industry. Picking the right industry, one with a sound structure, where your chances of making a profit were highest, was where good strategy began.

In 1980, a Harvard Business School professor called Michael Porter published an article, “What Is Strategy?,” that laid out the five forces he believed determined a company’s ability to capture value. They are: barriers to entry, supplier power, customer power, substitutes, and rivalry. Understanding the five forces allowed you to see why the well-run laundry or the wonderful restaurant floundered, while a shoddily run muffler store flourished. The five forces are the cornerstone of modern strategic thinking.

Take the laundry. The barriers to entry are relatively low. It does not require highly skilled labor, and almost anyone could buy a small Laundromat with a bank loan. This is why so many immigrants run laundries. When you are new to the country, laundries are simple businesses to acquire and run. If you speak little English, have a little money, and are prepared to work hard, laundries make sense as a first entrepreneurial endeavor. But you must expect a lot of competition from people with the same idea and the same access to the opportunity.

The suppliers to the laundry are the companies that make laundry machines and cleaning products. There are plenty of both, which keeps down prices and provides you with options should you decide to change. The bad news is your customers. In big cities, there tend to be laundries on almost every street corner, offering identical services and prices. If one laundry wrecks your shirts, you can easily go to another. The only cost of switching from one to the other might be a slightly longer walk. The main substitute for a laundry service is the washer-dryer at home. In Manhattan, many apartment buildings do not allow people to have washer-dryers in their homes, which forces them out to laundries. If that rule were to change and everyone were permitted a washer-dryer, the laundries would be in deep trouble. The degree of competitive rivalry among laundries is stoked by all of these forces—low barriers to entry, weak suppliers, powerful customers, and substitutes in the market where the business is located.

Since Porter came up with his five forces, a couple more have been added. Complements are those products that might enhance your own. In the computer business, complements to a PC include software and printers. Better software or printers make the PC more desirable. Beautiful shirts and ties are the complement to well-made suits. Nurturing these complementary businesses can have a positive effect on your own business. For some businesses, especially those that are highly regulated, government is the seventh force. No major media company, for example, can ignore the workings of the Federal Communications Commission.

The five-forces analysis provides a good idea of a firm’s competitive advantage over its rivals, and hence its chances of relative success. But first we had to understand the notion of competitive advantage. It came in two flavors: either you had a cost advantage, whereby you made things cheaper and sold them cheaper, or you differentiated your product somehow, either by making it better than your rivals or by designing it differently to appeal to a different group of people. These two forms of differentiation were known as vertical or horizontal: vertical meant better or worse; horizontal meant different. If you had two cars and one had a better engine, brakes, and interior than the other, they were vertically differentiated; one was simply better than the other. But if you had two identical cars, but one was pink and one black, they were horizontally differentiated, appealing to different kinds of customer. One nightmare for a business is to have no advantage, to be neither the cheapest to produce nor clearly differentiated. This was to be “stuck in the middle.”

A competitive advantage exists in the gap between a company’s costs and what consumers are willing to pay for its product. If your gap is wider than that of your competitors, you have the advantage. If you can keep that advantage over time, despite all the usual competitive pressures, the advantage is sustainable. Building sustainability is the strategist’s next challenge. If you are profitable, rivals will come after you. Success tends to breed complacency, which is why Bill Gates keeps a photograph of Henry Ford in his office. It reminds him that however pioneering and successful you are, you have to keep innovating and protecting your competitive advantage or else a rival will defeat you, as General Motors eventually defeated Ford. The pace of technological change has also shrunk the life cycle of successful business models. When you think you own the very latest cell phone, a new one comes out to trump it, offering entirely new services and features. This is why so many companies, however well they start out, eventually revert to the mean. Very few maintain outstanding returns for any decent length of time, and these are the jewels. Building a durable competitive advantage is the goal of any manager. Finding the companies that achieve it is an investor’s dream.

Having established the goal of sustainable competitive advantage, the strategist’s next task is to develop and integrate a consistent set of mutually reinforcing activities. The aim is not to have the greatest marketing department in the world but, rather, the best marketing department for your company. You want to build a system in which every activity, including marketing, supports the others. It is the difference between having great individual players and a great team. Wal-Mart’s magic is not just in its low costs and low prices. It also has a frugal corporate culture, low store-construction costs in rural and suburban locations, limited advertising, a stellar logistics operation, no unions, a stranglehold on suppliers, who depend on it to sell colossal volumes of their product, and top-notch technology and inventory tracking. It is the integration of all of this that makes Wal-Mart successful and so hard to replicate. And the more it does what it does, the better it gets, making life for its rivals all but impossible.

To make their advantage sustainable, all companies should try to develop a pattern of causes and effects that over time becomes an irresistible flywheel blowing away competitors. Procter and Gamble, for example, sells a lot of toothpaste. This means it produces a lot of toothpaste. Producing a lot of toothpaste makes Procter and Gamble a better toothpaste maker and allows it to use its toothpaste factory, employees, and marketing more efficiently. It can then set a lower price, without reducing its profit margin, and sell even more toothpaste. Its rivals may be able to make toothpaste, but because they do not have the scale advantages or marketing muscle of Procter and Gamble, they struggle to compete. The notion of “the more you practice the better you get” is known as the learning curve and was first observed by business academics during the Second World War. The more factories produced military aircraft, the faster the planes came off the production line and the better they were. Companies that move up the learning curve fastest tend to do better than their rivals.

A similar flywheel effect can be set in motion for willingness to pay. The more people bought Apple’s iPods, the more people wanted them. To reach this audience, music companies made their entire catalogues available on iTunes. Consumers downloaded more and more music, making their iPods even more precious. When rival device makers tried to enter the market, they found they were not just competing on the quality of their device but also taking on the entire ecosystem that Apple had created. Cheaper devices of equal quality failed in the market because people were ready to pay more for an iPod for its familiarity, the cool brand association, and its compatibility with iTunes and other Apple products. Apple had built a sustainable competitive advantage.

After integration, the strategist must next consider the reactions of his company’s competitors. If I do this, what will my rival do? At HBS we were introduced to game theory as a means of analyzing the consequences of a competitive situation. In its simplest form, game theory involved understanding the financial consequences of a decision for two parties. If Bill opens a new store to compete with Bob, what should Bob do? Should he close his store or compete with Bill? What will be the costs to Bob of competing versus closing? What will be the costs to Bob if Bill decides to stick around? Mapping out these options and applying values to their consequences offers an aid to decision making rather than a specific answer. It is another means of making the best decision with incomplete information, the main goal of our two-year course.

Finally, we moved to issues of scope. What should our business do? What should it own? Where should it operate? The value test, we learned, should be applied when considering whether you or someone else is better off owning a particular business. General Electric demands that its separate businesses be ranked one or two in whatever sector they operate. If they are ranked lower and cannot be improved, GE assumes it is not the best owner for that company and sells. The ownership test asks whether your business needs to own a certain asset to create value. McDonald’s decided long ago that it was far better off selling franchises and then servicing them than owning millions of parcels of real estate. A fashion designer does not need to own the factories that produce her clothes, provided she can be sure the clothes will be made to her specifications. Sound contracts and long-term relationships, Felix explained, could be far less hassle than ownership.

With so much fevered discussion of globalization, the ownership and value tests were more relevant than ever. Could an American company with global ambitions adapt to new countries and cultures and run businesses better than local firms? If a product or service worked well in one country was there any reason to believe it would work well in another? Did global growth allow you to reduce your costs? What were the realities of doing business overseas—developing manufacturing capacity, training employees in uncertain political environments, and risking your intellectual property in markets that might not respect it?

One of the most remarkable companies we studied was called Li and Fung, which was founded in 1906 in Canton as a trading company, helping English and American merchants get access to Chinese factories. Based in Hong Kong, it now managed the supply chains for many of the world’s largest retailers and manufacturers. In 1976, Victor Fung, the grandson of the founder and a professor at HBS, returned to Hong Kong to take over the firm. He and his younger brother, William, a Harvard MBA, decided to expand the scope of the company’s operations. Instead of being an intermediary between foreign companies and Hong Kong suppliers, Li and Fung built relationships throughout Taiwan, Korea, Singapore, and eventually deeper into China. It went from simply fulfilling customer requests to developing unique production programs that allowed manufacturers to create products of a quality and cost they never thought possible. If you wanted shirts made in Asia, Li and Fung would know separate places for cotton, buttons, and stitching and be able to move the unfinished product from one place to another and still deliver it cheaper than if you had picked a single factory. They called what they did “dispersed manufacturing,” and their staff, “little John Waynes,” because they spent their days “standing in the middle of the wagon train, shooting at all the bad guys.” By the time we studied Li and Fung, the firm was working with 7,500 suppliers in twenty-six countries and owned none of them. It organized design, engineering, and production planning, material sourcing, physical production, quality control, and global shipping for hundreds of well-known clients and yet it owned almost no physical assets. Unless you were in the industry you would never have known its name. At the end of our class discussion of the firm, the projector screen dropped down and Victor Fung appeared via satellite linkup from Hainan Island in China to take questions. He talked about the fragmentation of the global supply chain, how even the tiniest step was becoming the preserve of specialists, and how Li and Fung helped customers find their way through the maze. Margret had decided she wanted to see a class and this happened to be the one she sat in on. Afterward, I asked her what she thought. I had found it riveting but worried she might have been bored.