In this article I will review the book "The End of Competitive Advantage," by Rita Gunther McGrath, published by the Harvard Business Review Press in 2013.
I like to think of myself as a "value investor." That is, I believe that I invest in quality companies that are underpriced. In terms of the quality of the organizations I like to invest in, I look for firms that have established a competitive advantage in their industries and are earning at least a 15% return on equity, after taxes. To judge the quality of management and its staying power, I look for those organizations that have a sustainable competitive advantage, defined as earning a 15% return on equity, after taxes, for a period of five to eight years. And, to capture the fact that a stock may be underpriced, I look for a low price/earnings ratio.
Other factors that have been important in my analysis are the industry share the company achieves and protects and the stability of this share over time. Of course, these are the quantitative factors and must be supplemented by other factors, such as an examination of management, industry make-up, and governmental factors that might contribute to firm performance.
Well, starting right here, Dr. McGrath starts to eat away at this picture. For one, she argues that industry boundaries are no longer that important. She argues that "arenas" are more crucial in the modern environment. The important thing in today's world is that there are connections between "the outcomes that particular customers want (the jobs to be done)" and "the alternative ways those outcomes might be met" (page 10). Industry lines are not the determinants of what products one should be producing and what markets they should be sold in. Thus, don't just look to the competitors that fit nicely into the definitions of what a particular industry does.
This opens up a can of worms. Competition can come from anywhere at any time. So nice, comprehensive definitions of what competitive advantages are all about just go down the drain. The criteria I expressed above about sustaining a 15% return on equity over a five- to eight-year time period become much more complex. Achieving such a result depends on a management structure that is much more aware of market changes, has a sustainable pipeline of alternative products/services, has a flexible approach to how physical capital and human capital are allocated, and that is willing to "let go" of products/service lines when they are in decline.
The argument here is based on the reality that the interval between when an innovation is introduced to the market and when a competitor comes in with a competitive product is being reduced to a very short span of time. This interval was estimated to be 32.75 years in the 1887-1906 time period. In the 1967-86 time period, the interval was estimate to be 3.40 years. You can bet that this time span has fallen even further in recent years.
McGrath argues that competitive advantages cannot be sustained in the way they once were. Although sustainable competitive advantages may be achieved in some arenas in the economy, fewer and fewer arenas are capable of this kind of stability. This is what a firm faces and it is what an investor must be aware of in order to value invest in today's market. To operate in such an environment, McGrath emphasis that managements must use a "real options" approach to their creation of new opportunities and must be brutal when it come time to disengage from a specific product.
The real options approach to the development of possible future offerings means that the firm invests small amounts in many potential projects. If the projects seem to be promising, more investment is made in them. If the projects do not seem to be going anywhere, then get rid of them at as soon as this fact is observed. And this continues all along the development cycle.
In terms of cutting off a product line, McGrath indicates that brutal honesty is needed along with the will to "disengage" from the product line as soon as possible. This is so important to her that she discusses "healthy disengagement" in chapter three, whereas most authors put the topic near the end of their work. This just emphasis the fact that in today's world, businesses just cannot continue to live off of products/services that have been "winners" in the past. Between these two extremes, the launch of a product/service and the disengagement from a product/service, there lies the period where the product/service can be "exploited," where competitive advantages exist and exceptional returns can be earned. Of course, this is where the management works to attain all it can from its creative efforts.
Dr. McGrath has studied numerous firms she calls "outliers," which have been able to produce exceptional results in the face of transient competitive advantages and she presents them in a way that is easily understandable and insightful, with lots of examples. To her, the success of these "outliers" is dependent upon achieving the right combination of stability and agility to the culture of the firm. This requires leadership that is insightful and "hard-headed," but, surprisingly to McGrath, understated. That is, the leaders are not always trying to grab the spotlight.
The sources of stability seem to embedded in the creation of a culture that wants to succeed, is given to building this cultural identity into everything it does, and to spreading this culture by educating, training, and incenting employees to grow and accept the change that is constantly occurring around them. Since disengagement is a regular component the environment, "smart companies recognize that continuous training and development is a mechanism to avoid having to firm people when competitive conditions shift, and they invest in training even as they pursue deployment."
Agility is achieved by allocating resources "flexibly and on an ongoing basis." Budgeting plays a big role in attaining this, but the budgeting is done on a more frequent basis, and is fast and flexible. Adjustments are made within short horizons not waiting for an "annual review." And, innovation is accepted as the norm, not the exception.
I believe that this is a valuable book for investors to read because it really tackles the needs of the modern business organization. Although it is written for people interested in management leadership and business strategy, the author gives us an understanding of what we should be looking for in a business and a management to help us separate good companies for the others. I believe investors should still look for exceptional returns, companies that achieve at least a 15% return on equity after taxes. But investors need to understand that in today's environment, sustaining this kind of return over a five- to eight-year period is more connected with continuous adjustment of what the firm is doing, and less and less connected with maintaining a competitive advantage that one just sits back and protects.
One company Dr. McGrath mentions in the book is BlackBerry (NASDAQ:BBRY). When McGrath wrote the book, the company was in the early stages of understanding its problems. It had assumed it had a sustainable competitive advantage and grew complacent in this knowledge. Then, Apple (NASDAQ:AAPL) entered the scene -- a computer maker, no less, and not of BBRY's industry. At the time she wrote the book she argued that BBRY was "at risk for its very survival." And we've heard in the last week or so that BBRY could be on the market. That's a lesson smart investors need to heed.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.