3. The Fundamental Equation of Strategy. Value = M0 g s m
Commentary. The interpretation of this is that Value = Market Size * Power. M0 is the current market size, g is a discounted growth factor for the market, s is long-term average market share and m is long-term average differential margins (the profit margin above that needed to return the cost of capital). I have found that the explicit tying of Strategy concepts to the exact determinants of the net present value of free cash flow puts to rest a lot of fuzzy thinking about the relationship between Strategy and value. It has also helped me as an active equity investor. It is important that s and m are long-term equilibrium values. Short-term movements in these have little impact on fundamental value.
4. The Mantra. A route to continuing Power in significant markets.
Commentary. If you only take one phrase away from reading this book, I hope it is this one. It is a complete statement of the elements of a strategy. It maps directly to the Fundamental Equation of Strategy and is inclusive of Dynamics. The word “continuing” is included, even though Power implies sustainability, to encourage ongoing layering on of different sources of Power as a business progresses.
5. The 7 Powers.
Commentary. To the best of my knowledge the seven Power types positioned on this chart are the only strategies available to a company. If you do not have at least one of these for each competitor (current and potential, direct and functional), you cannot satisfy The Mantra and hence are lacking a viable strategy. In the 200+ strategy cases I have led over my career, these seven were sufficient. This is also true of all the cases studied by my students, probably another 200 or so.
Aside from being exhaustive, two additional characteristics of the 7 Powers enhance its usefulness:
Small set. The key strategic questions for you are: (1) “What Power types do I now have?” and (2) “What Power types do I need to worry about establishing now?” The 7 Powers informs you that there are only seven possibilities for (1) and usually you can quickly rule out several. The Power Progression informs you that at any given growth stage the maximum number of new Powers that you might explore is 3. This focusing is very valuable. If you cannot see a route to one of these 7, your strategy problem is not yet solved.
Observable ex ante. The potential for these Power types is usually evident long before detailed forecasting is possible. What I have found working with early-stage companies in Silicon Valley and working with mature companies considering new directions is that it is possible to have meaningful conversations about the potential for Power at quite an early stage.113 My investment results are also indicative of this ex ante transparency.
6. “Me Too” Won’t Do. The first cause of a strategy is invention.
Commentary. Tectonic changes in value take place when Power is first established with an acceptable level of certainty. Looking at the seven Power types we can see that this always involves an invention, whether that be an invention of product, business model, process or brand. Eventually such inventions lead to a Benefit as expressed in a product attribute, be that features, price or reliability. The marker for sufficiency of such a Benefit is usually “compelling value,” eliciting a “gotta have” response. There are three paths to achieving compelling value: Capabilities-led, Customer-led and Competitor-led. These each present distinctly different tactical imperatives.
My view is that there is an important welfare implication in these relationships as well. Not only is invention the gateway to Power but also the possibility of Power (and the associated durable success) fuels invention. For example, if there were no prospects for Power then I doubt that Silicon Valley would have come to be. So from a static viewpoint, the search for Power may seem like a zero sum game of preventing gains flowing to consumers. But from a Dynamics viewpoint, it is the possibility of Power that is a critical motivator of invention. An invention only gains traction if customers flock to it. This take-up is of course a sure marker of increases in consumer welfare—they are voting with their feet. This Dynamics perspective is of course the one that should motivate policy makers.
7. The Power Progression.
Commentary. Different Power types present the opportunity for first establishing a Barrier at different times in the development of your business. Knowing when this window is open and when it shuts is valuable in recognizing and seizing the opportunity. The break between takeoff and stability is when unit growth falls below about 30%–40% per year. This is a business stage framework and should not be confused with the product stages of Introduction/Growth/Maturity/Decline of the Product Life Cycle which have dramatically different points of phase separation. Origination can include pre-product periods which are not covered in the Life Cycle model, and the Growth stage in the Life Cycle model includes takeoff and parts of stability in the Power Progression. These differences really matter in assessing the availability of Power.
Appendix 9.2: A graphical representation of the tools of Power Dynamics and their relationship.
Appendix 9.3: Power Dynamics Glossary
Term
Description
Strategy
Strategy (with a Capital S) is the intellectual discipline sometimes called Strategic Management. I define it: the study of the fundamental determinants of potential business value.
Power
The set of conditions needed for persistent differential returns. Power requires both a Benefit, something that materially increases cash flow, and a Barrier, conditions such that all the value to the firm of the Benefit is not arbitraged out by competition.
strategy
Strategy (with a lower case s) is the path to potential value for a strategically separate business. I define it: a route to continuing Power in significant markets.
value
The fundamental enterprise value of an activity. This is reflected ex post as generation of accessible returns to an owner (free cash flow). It is investors’ expectation of the stream of these returns discounted over time that determines value ex ante.
Strategy Dynamics
The study of strategy development over time.
Strategy Statics
The study of strategic position at a single point in time.
industry
The group of businesses whose products have a high degree of substitutability.
business
A strategically separate economic activity. By strategically separate I mean that its Power position is largely orthogonal to the Power position of other activities the firm pursues.
market
The revenue attributable to all firms in an industry.
industry economics
The economic structure of a particular industry. For example, with fixed-cost-driven Scale Economies, this is measured by the magnitude of the fixed cost relative to the company’s overall financials.
competitive position
A characterization of a company position in the metric relevant to Power. For example, with Scale Economies it is relative scale compared to the largest competitor.
Surplus Leader Margin
The profit margin a Power holder will achieve if pricing is such that a competing firm with no Power has zero profits. This is not necessarily an expected equilibrium but rather is a good marker of the leverage possessed by the Power holder. This would equal m in the Fundamental Equation of Strategy if the firm without Power experienced competitive arbitrage that resulted in its earning just its cost of capital and that the cost of capital for the firm with Power was equal to the cost of capital of the firm without Power.
ACKNOWLEDGMENTS
This book distills what I have learned about Strategy over decades of consulting, investing and teaching. Throughout the years, I have interacted with, and benefited from, so many thoughtful people that I am at a loss to name them all. I will mention some, but for those left out, I ask forbearance.
First I must thank my Stanford co-conspirator on this project, Pai-Ling Yin. Pai-Ling is a deeply thoughtfu
l Strategy scholar, and our many fascinating conversations greatly advanced my thinking. At one time, she signed on to serve as co-author of this book, and even developed early drafts of three chapters. Unfortunately, her work demands required that she back out of the project. Even still, her many insights have left a lasting impact on the effort.
My editor Blair Kroeber has been with me every step of the way—there is not a paragraph in this book which he hasn’t carefully reviewed. Always a pleasure to work with, he has proven quite extraordinary in his ability to polish my prose while preserving my voice and remaining true to my logic. This would have been a different book without his help.
I owe an intellectual debt to the numerous consulting clients I have served over the years. The problems they posed have been foundational to my understanding of Strategy. During these decades of work, there are some individuals who stand out in my memory as being exceptionally stimulating and congenial: Denis Brown of Pinkerton, Derek Chilvers of John Hancock, Bruce Chizen and Bryan Lamkin of Adobe, Bill Hanley of Galileo Elector-Optics, Reed Hastings of Netflix, Greg Hinckley of Mentor Graphics, John Meyers of Hewlett-Packard, Jim Putnam of Markem, Mark Thompson of Raychem, and Bob Wilson of Southwall Technologies. Each has been such a pleasure to work with. Their on-the-ground experience and their probing intelligence focused my thinking in ways otherwise impossible.
The acuity, hard work and enthusiasm of my many accomplished Stanford students have provided constant inspiration to me. I especially want to thank David Sheu for his careful analysis of Cornered Resources. The challenge of conveying the complex discipline of Strategy to my students has considerably sharpened my concepts. Further, many participated in research teams I organized on topics germane to this book. Their efforts have made a real contribution to the understandings presented in 7 Powers. It has been my great pleasure to be their teacher.
The Economics Department at Stanford has been unusually supportive as well. Unlike my talented colleagues there, I did not follow the path of an academic Economist; nevertheless, my course has been openly welcomed within the Department, and I have been given the freedom to teach it the way I see fit. I want to especially thank my Yale classmate John Shoven, who first introduced to Stanford the idea of my teaching there. John recently retired as the Director of SIEPR, but the legacy of his leadership there is profound. I also wish to thank Larry Goulder, who was Department Chair when I first began teaching at Stanford. Larry got me off to a great start with his thoughtful support and general openness to my approach.
I was fortunate enough to work for Bain & Company right out of graduate school, and that’s where my lifelong passion for Strategy ignited. Nowadays such a career track isn’t all that unusual for an Economics Ph.D.; back then, however, it was completely untrod. Bill Bain placed a bet on me, and for that I am forever in his debt. During my initial job interview, I discussed with him a concern I had heard from other interviewers—namely, that I lacked an MBA. His counsel: “Don’t worry, I don’t have one either.” Bain & Company quickly proved a perfect place for me to work. Surrounded by sharp peers, guided by more experienced hands, I was able to immerse myself in one fascinating problem after another. My current Strategy Capital partner, John Rutherford, served as an especially thoughtful guide in those early days.
Yale has a world-class Economics Department, but it’s also an inordinately humane and welcoming institution. While there, I was privileged to count Bill Parker as my friend, mentor and eventual thesis committee chair. Bill was a deep humanist, blessed with a penetrating wry wit—heaven help the pompous around Bill Parker! I am also grateful to know Bill Brainard, whose Microeconomic Theory course I took during my first term at Yale. His brilliance and compelling teaching were inspirational to me then, and remain so to this day, even though I now possess only the barest recall of bordered Hessians.
The book was improved by a number of readers who were kind enough to look over portions of it and offer their suggestions: Blake Grossman (the prior CEO of Barclays Global Investors) and Mike Latham (the prior COO of iShares) for my chapter on Counter-Positioning; Jeff Epstein (the prior CFO of Oracle) for my chapter on Switching Costs; Larry Tint (the Chairman of Quantal International) for my appendix to Chapter 8; Pete Docter (Pixar feature-film director) for my chapter on Cornered Resources; Wally Rhines (CEO of Mentor Graphics) and Bill Mitchell (Portfolio Manager of Spinoff & Reorg Fund) on Intel; Reed Hastings (CEO of Netflix) for the Introduction; Daphne Koller (Co-Founder and past President of Coursera) for overall book comments. While I cannot hold them responsible for any errors I might have made, their insights improved the content of these pages.
I have had an exemplary production team for this book: 1106 Design for the overall layout, Rebecca Bloom for copy-editing, Irene Young for cover design and web layout and Katherine Evers (one of my Stanford students) for developing displays. They have conducted themselves with grace and professionalism throughout the book’s long gestation period.
This book opens with a dedication to my family and so it should end with an acknowledgement of them. First, my wife Lalia, who constantly encouraged me during the lean years in which I established my consulting firm, and who has fully supported my single-minded commitment to advancing Strategy concepts. We have never taken a vacation in which she didn’t make a point of confirming that the potential venue included a quiet place for me think—in fact, I concocted the 7 Powers construct while on a tranquil beach in Mexico! My three children have also contributed materially. My daughter Margaret cast her eagle eye to the overall visuals of the book, and brought her aesthetic insights to bear on it throughout. My son Edmund offered advice on graphics and suggested the subtitle of the book. My son Andrew carefully read over the whole book, flagging numerous typos, but also helping to refine the reasoning in several spots. I have been blessed with their love and support.
BIBLIOGRAPHY
There has been a great deal of fine work in the academic world on Strategy, or Strategic Management, as it is called in those circles. If the reader wishes to explore that work, these excellent bibliographies offer a good jumping-off point:
http://global.oup.com/uk/orc/busecon/business/haberberg_rieple/01student/bibliography/#m
http://www.nickols.us/strategy_biblio.htm
https://strategyresearchinitiative.wikispaces.com/home
I have been especially influenced by the compelling scholarship of Professor Henry Mintzberg of McGill University (http://www.mintzberg.org/resume), Professor Michael Porter of Harvard University (http://www.hbs.edu/faculty/Pages/profile.aspx?facId=6532) and Professor David Teece of the University of California at Berkeley (http://facultybio.haas.berkeley.edu/faculty-list/teece-david).
CHAPTER NOTES
Introduction
1 Originally called NM Electronics.
2 This isolation of the “failure” of competitive arbitrage is a primary assumption of the field in Economics known as Industrial Organization, which examines violations of perfect competition.
3 This phrase was coined by Paul O’Donnell while working for me at Helmer & Associates.
4 I very much resonate with Saloner’ s conclusion that perhaps the most important contribution of Game Theory to Strategic Management is “metaphorical.” By metaphorical, he meant that the fundamental assumption of Game Theory—the presence of a variety of well-informed, properly motivated players, all trying to do their best—must serve as a foundational assumption. Saloner, Garth. “Modeling, Game Theory, and Strategic Management.” Strategic Management Journal 12: Issue S2 (1991): 119–136. Print.
5 The observed market cap would be this plus any “excess” capital (for example unneeded cash on the balance sheet), and then adjusted to reflect current levels of pricing in the stock market in order to move from absolute value to relative value. If the NPV formulation includes the initial capital needed as a negative term, then this would ha
ve to added back as well.
6 A quick summary of FCF: https://en.wikipedia.org/wiki/Free_cash_flow#Difference_to_net_income
7 There are some acceptable simplifying assumptions to derive this formula. The derivation is in the Appendix to the Introduction. The simplifying assumptions are called out explicitly in that appendix.
8 Differential margins is the more important variable since, unlike market share, it is not constrained by being ≥ 0. However, there can be subtle trade-offs. For example, a company might improve its differential margin for quite a period if it accepted steadily diminishing market share—the impact of an unprotected price umbrella.
9 The Fundamental Formula of Strategy simplifies by assuming m and s are constants over the period in question, a hallmark of Power. Fundamental enterprise value at any point in time is the result of expectations regarding future free cash flow. As Intel moved forward in time, the prospect of withering arbitrage became clearer and the expectations for s and m changed accordingly.
10 In developing a strategy, it is essential to not just consider existing competitors, but also potential ones. This approach has a long history in Economics as well. Baumol, William J., Panzar John C., Willig, Robert D., Bailey, Elizabeth E., Fischer, Dietrich. “Contestable Markets: An Uprising in the Theory of Industry Structure.” The American Economic Review, Vol. 72, No. 1, (Mar., 1982): 1–15. Print.
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