Tag Archives: Barriers to Entry

Prof. Bruce Greenwald on the Market Today

Confessions of a Quantitative Easer

We went on a bond-buying spree that was supposed to help Main Street. Instead, it was a feast for Wall Street.
By Andrew Huszar Nov. 11, 2013 7:00 p.m. ET

I can only say: I’m sorry, America. As a former Federal Reserve official, I was responsible for executing the centerpiece program of the Fed’s first plunge into the bond-buying experiment known as quantitative easing. The central bank continues to spin QE as a tool for helping Main Street. But I’ve come to recognize the program for what it really is: the greatest backdoor Wall Street bailout of all time.

Five years ago this month, on Black Friday, the Fed launched an unprecedented shopping spree. By that point in the financial crisis, Congress had already passed legislation, the Troubled Asset Relief Program, to halt the U.S. banking system’s free fall. Beyond Wall Street, though, the economic pain was still soaring. In the last three months of 2008 alone, almost two million Americans would lose their jobs.

The Fed said it wanted to help—through a new program of massive bond purchases. There were secondary goals, but Chairman Ben Bernanke made clear that the Fed’s central motivation was to “affect credit conditions for households and businesses”: to drive down the cost of credit so that more Americans hurting from the tanking economy could use it to weather the downturn. For this reason, he originally called the initiative “credit easing.”

My part of the story began a few months later. Having been at the Fed for seven years, until early 2008, I was working on Wall Street in spring 2009 when I got an unexpected phone call. Would I come back to work on the Fed’s trading floor? The job: managing what was at the heart of QE’s bond-buying spree—a wild attempt to buy $1.25 trillion in mortgage bonds in 12 months. Incredibly, the Fed was calling to ask if I wanted to quarterback the largest economic stimulus in U.S. history.

This was a dream job, but I hesitated. And it wasn’t just nervousness about taking on such responsibility. I had left the Fed out of frustration, having witnessed the institution deferring more and more to Wall Street. Independence is at the heart of any central bank’s credibility, and I had come to believe that the Fed’s independence was eroding. Senior Fed officials, though, were publicly acknowledging mistakes and several of those officials emphasized to me how committed they were to a major Wall Street revamp. I could also see that they desperately needed reinforcements. I took a leap of faith.

In its almost 100-year history, the Fed had never bought one mortgage bond. Now my program was buying so many each day through active, unscripted trading that we constantly risked driving bond prices too high and crashing global confidence in key financial markets. We were working feverishly to preserve the impression that the Fed knew what it was doing.

It wasn’t long before my old doubts resurfaced. Despite the Fed’s rhetoric, my program wasn’t helping to make credit any more accessible for the average American. The banks were only issuing fewer and fewer loans. More insidiously, whatever credit they were extending wasn’t getting much cheaper. QE may have been driving down the wholesale cost for banks to make loans, but Wall Street was pocketing most of the extra cash.

From the trenches, several other Fed managers also began voicing the concern that QE wasn’t working as planned. Our warnings fell on deaf ears. In the past, Fed leaders—even if they ultimately erred—would have worried obsessively about the costs versus the benefits of any major initiative. Now the only obsession seemed to be with the newest survey of financial-market expectations or the latest in-person feedback from Wall Street’s leading bankers and hedge-fund managers. Sorry, U.S. taxpayer.

Trading for the first round of QE ended on March 31, 2010. The final results confirmed that, while there had been only trivial relief for Main Street, the U.S. central bank’s bond purchases had been an absolute coup for Wall Street. The banks hadn’t just benefited from the lower cost of making loans. They’d also enjoyed huge capital gains on the rising values of their securities holdings and fat commissions from brokering most of the Fed’s QE transactions. Wall Street had experienced its most profitable year ever in 2009, and 2010 was starting off in much the same way.

You’d think the Fed would have finally stopped to question the wisdom of QE. Think again. Only a few months later—after a 14% drop in the U.S. stock market and renewed weakening in the banking sector—the Fed announced a new round of bond buying: QE2. Germany’s finance minister, Wolfgang Schäuble, immediately called the decision “clueless.”

That was when I realized the Fed had lost any remaining ability to think independently from Wall Street. Demoralized, I returned to the private sector.

Where are we today? The Fed keeps buying roughly $85 billion in bonds a month, chronically delaying so much as a minor QE taper. Over five years, its bond purchases have come to more than $4 trillion. Amazingly, in a supposedly free-market nation, QE has become the largest financial-markets intervention by any government in world history.

And the impact? Even by the Fed’s sunniest calculations, aggressive QE over five years has generated only a few percentage points of U.S. growth. By contrast, experts outside the Fed, such as Mohammed El Erian at the Pimco investment firm, suggest that the Fed may have created and spent over $4 trillion for a total return of as little as 0.25% of GDP (i.e., a mere $40 billion bump in U.S. economic output). Both of those estimates indicate that QE isn’t really working.

Unless you’re Wall Street. Having racked up hundreds of billions of dollars in opaque Fed subsidies, U.S. banks have seen their collective stock price triple since March 2009. The biggest ones have only become more of a cartel: 0.2% of them now control more than 70% of the U.S. bank assets.

As for the rest of America, good luck. Because QE was relentlessly pumping money into the financial markets during the past five years, it killed the urgency for Washington to confront a real crisis: that of a structurally unsound U.S. economy. Yes, those financial markets have rallied spectacularly, breathing much-needed life back into 401(k)s, but for how long? Experts like Larry Fink at the BlackRock investment firm are suggesting that conditions are again “bubble-like.” Meanwhile, the country remains overly dependent on Wall Street to drive economic growth.

Even when acknowledging QE’s shortcomings, Chairman Bernanke argues that some action by the Fed is better than none (a position that his likely successor, Fed Vice Chairwoman Janet Yellen, also embraces). The implication is that the Fed is dutifully compensating for the rest of Washington’s dysfunction. But the Fed is at the center of that dysfunction. Case in point: It has allowed QE to become Wall Street’s new “too big to fail” policy.

Mr. Huszar, a senior fellow at Rutgers Business School, is a former Morgan Stanley managing director. In 2009-10, he managed the Federal Reserve’s $1.25 trillion agency mortgage-backed security purchase program.


Emphasis on Global Crossing Case; Good Health

A conclusion is the place where you got tired of thinking. –Steven Wright

Every man who says frankly and fully what he things is so far doing a public service. We should be grateful to him for attacking most unsparingly our most cherished opinions. –Sir Leslie Stephen

Know The Global Crossing Case Cold

I joke while presenting the Global Crossing case, but you should spend time to really understand what happened and why.  Always in these situations there is much noise and hoopla over new technology, massive growth, booming profits, etc. But you have to stand back to listen: http://www.youtube.com/watch?v=1INb5FM_1lE&feature=related.  Obviously, growth does not occur without investment, and growth without profits is DESTRUCTIVE.

….And think strategically. A friend took out margin to buy a huge bundle of out of the money puts on Global Crossing and Level Three (LVLT).   See the chart on LVLT here—the collapse will take your breath away. http://www.scribd.com/doc/77916697/Lvlt-Chart.

I asked him, “Are you out of your $%^&*! Mind? What the heck is the matter with you?” He replied serenely, “Have you ever read The Innovator’s Dilemma: When New Technologies Cause Great Firms to Fail by Clayton M. Christensen and the Disk Drive Industry?” http://www.readinggroupguides.com/guides_i/innovators_dilemma3.asp

“No,” I said, “I am too busy reading the Lehman report on Global Crossing.”

Research by Lehman on Telecom, Fiber Optics and Global Crossing 1998 http://goodbadstrategy.com/wp-content/downloads/LehmanReport.pdf

“Too bad,” he replied. “Because it is the same situation with the telecom companies only worse.  (WHAT is the situation he is talking about____?) Ask yourself what is the WORST industry structure you could possibly design to destroy profits?  Sometimes it is easier to know which companies will face certain death than pick the winners. Also, here is the coup de grace—what happens when marginal costs decline to $0.00!?”

One more time: “Can anyone tell me in two or three words what is the first thing when looking at a company/industry? _____  _____  ______

At the end of the weekend, there will be an analysis of the Global Crossing Case.

So what happened to my friend? Here he is: http://www.youtube.com/watch?v=mmMS9nvi6eg&feature=related


At the age of 97 years and 4 months, Shigeaki Hinohara is one of the world’s longest-serving physicians and educators. His secrets to a healthy long life:


Podcast on Why We Get Fat by Gary Taubes: http://www.lewrockwell.com/lewrockwell-show/2012/01/11/247-why-we-get-fat-and-what-to-do-about-it/

Strategic Logic Case Study Part 2 Global Crossing


If you think nobody cares about you, try missing a couple of payments. –S. Wright

Everything has been said before, but since nobody listens we have to keep going back and beginning all over again.” –Andre Gide

Part 1 of this case was presented yesterday here: http://wp.me/p1PgpH-hj

If readers don’t grasp the significance of this case then I will QUIT posting and join them: http://www.youtube.com/watch?v=J_kRDcfTKrg

Invest in Global Crossing February 2000

Part 2: You are about to meet the fund manager in 30 minutes to give your recommendation.  Take a glance at Global Crossing’s 10-K. http://www.scribd.com/doc/77824423/Global-Crossing-1999-10-K What’s it worth?  The price is near $61 or about $37 billion in market cap.

Forget the financials you think, after reading Gilder’s Technology Report (background on George Gilder, the Guru of the Telecosm: http://www.wired.com/wired/archive/10.07/gilder_pr.html) on the telecosmic Global Grossing, your confidence increases because growth will double every 100 days.

Since you leave nothing to chance, you call up David Cleevely, the managing director of Analysys, in Cambridge, England. Cleevely is a well-regarded observer of the new telecommunications economics.  He tells you, “The key thing to understand is the huge advantage of the fat pipe (or high-capacity fiber optic channels).  Remember that the cost of laying fiber is mainly the cost of right-of-way and digging or of laying it under the ocean. Recent advances let companies install enormous capacity at no more cost than building a narrow pipe. The economies of scale of the fat pipe are decisive. The fat pipe wins.”

Next you pull a slide from the company’s power point presentation on Where is the Company is Going.

The company will be in a market with EXPLOSIVE growth, competition, capacity on demand, no capital required from telecom carriers, and responsive to market demands.

Your secretary knocks on the door and asks whether you want to read about strategic logic from csinvesing?  You are handed some papers, and you immediately slam dunk the research into the circular file (waste-basket). “Who needs this bullsh@t,” you mutter.


You are thinking of the riches you will make and what you will do with your new car: http://www.youtube.com/watch?v=uo5E-2_2mgg&feature=related

You know that economies of scale are important. The logic seems simple—the fat pipes of the new-wave telecom builders and operators gave them much lower average unit costs (Think about how average cost curves are formed). I sat back and thought a moment about fat pipes, scale economies, and telephone calls. What was the “cost” of moving one telephone call, or one megabyte of date, under the Atlantic Ocean?

But the thoughts of massive wealth kept interrupting my thoughts. “Would putting in a fur-lined sink be in bad taste?” I wondered.

What critical aspect of analysis is missing here? If you need a hint go back to the connection between industry structure and profit.

The time is late February 2000 and with your supporting materials and 10-K you wait here for the big boss to arrive. http://www.youtube.com/watch?v=TulxjdKsROI

Strategy Quiz and Case Study

Change is inevitable….except from vending machines.

A fool and his money are soon partying. –Steven Wright


Dear Readers:

I know the three of you out there will be wondering about replies to your questions. This week requires traveling so please bear with me until I can reply properly.  Meanwhile, continue your work towards completing the Wal-Mart case study and Competition Demystified reading pages 1-110.

This quiz is meant to reinforce concepts you should be thinking about. Whenever you first look at an industry and/or company what should be one of the first questions that you ask______________________?

Research Question

Now, you have been asked to research a new company that has a product where the demand is estimated to increase 10 fold and you must advise your $2 billion hedge fund on Park Avenue, in New York whether to invest.  After two months of 18 hour days, you find out that the research on growth estimates was wrong!  The demand for the service will increase 1000x fold!  You are so excited you can barely wait to speak to the portfolio manager.  How great an investment will this be? What further MAJOR questions should you ask if demand will grow so rapidly. Take five minutes to frame your questions and what you will say to the big boss whom you will be meeting soon.

OK, scroll down and click on the cases below to learn what happened. Surprised?  Why or why not? Let me know your thoughts.



http://www.scribd.com/doc/77775204/Global-Crossing-A –sorry this had to be placed in the Value Vault under Global Crossing A (36 pages) due to security restrictions. If you do not have a key then email me at aldridge56@aol.com with VALUE VAULT in the subject line.


For a different perspective and more context: http://www.scribd.com/doc/77780615/Bubbles-and-Gullibility-2008

Readers’ Questions: Buffett Compounding $1 Mil. and Why Should an Investor Learn Austrian Economics

Readers’ Questions

Rather than email a reply, I thought sharing with other readers might be helpful.

A reader writes: Your emphasis on capital compounders raises a question in my mind. WEB (Buffett) famously said that if he was running a million bucks, he could get returns of 50% per year. If you reverse engineer this statement, you have to think he would be investing in the following: small caps, special situations, and catalysts.

I don’t think you can get those kinds of return with capital compounders. Thoughts?

My response: Good point. By the way, any future questions that you have for Warren can be answered here: http://buffettfaq.com/.  An organized web-site of all of Buffett’s articles, writings, and speeches organized by subject, source and date–an excellent resource for Buffaholics.  Buffett said he could compound a small amount of money at 50% as he mentions below:

Interviewer to Buffett: According to a business week report published in 1999, you were quoted as saying “it’s a huge structural advantage not to have a lot of money. I think I could make you 50% a year on $1 million. No, I know I could. I guarantee that.” First, would you say the same thing today? Second, since that statement infers that you would invest in smaller companies, other than investing in small-caps, what else would you do differently?

Buffett: Yes, I would still say the same thing today. In fact, we are still earning those types of returns on some of our smaller investments. The best decade was the 1950s; I was earning 50% plus returns with small amounts of capital. I could do the same thing today with smaller amounts. It would perhaps even be easier to make that much money in today’s environment because information is easier to access.

You have to turn over a lot of rocks to find those little anomalies. You have to find the companies that are off the map – way off the map. You may find local companies that have nothing wrong with them at all. A company that I found, Western Insurance Securities, was trading for $3/share when it was earning $20/share!! I tried to buy up as much of it as possible. No one will tell you about these businesses. You have to find them.

Other examples: Genesee Valley Gas, public utility trading at a P/E of 2, GEICO, Union Street Railway of New Bedford selling at $30 when $100/share is sitting in cash, high yield position in 2002. No one will tell you about these ideas, you have to find them.

The answer is still yes today that you can still earn extraordinary returns on smaller amounts of capital. For example, I wouldn’t have had to buy issue after issue of different high yield bonds. Having a lot of money to invest forced Berkshire to buy those that were less attractive. With less capital, I could have put all my money into the most attractive issues and really creamed it.

I know more about business and investing today, but my returns have continued to decline since the 50’s. Money gets to be an anchor on performance. At Berkshire’s size, there would be no more than 200 common stocks in the world that we could invest in if we were running a mutual fund or some other kind of investment business.

  • Source: Student Visit 2005
  • URL: http://boards.fool.com/buffettjayhawk-qa-22736469.aspx?sort=whole#22803680
  • Time: May 6, 2005

So the Wizard of Omaha agrees with you that returns are probably to be found in small caps where greater mis-pricing on the downside and upside can occur. The problem you have is paying higher taxes on short-term (less than one year and a day) gains and reinvestment risk.  Once you sell you have to be able to find other attractive opportunities to redeploy capital.  Special situations like liquidations may give you high annualized returns but the positions may only be held for four months until the investment is liquidated.

Investing in a Coca-Cola may give you high risk adjusted returns but not 50% annual returns because of its side and lack of reinvestment opportunities. Unless you find an emerging franchise which is quite difficult, then if you hold Coke for years, you will eventually earn the company’s return on equity.

This writer organizes his investment world into franchises and non-franchises. With non-franchises you are hoping to buy at enough of a discount to asset value and earnings power value to generate attractive returns. A catalyst like a special situation or corporate restructuring may increase the certainty and lessen the time needed to close the gap between price and your estimate of  intrinsic value. Often, with non-franchises you do not have time on your side. You must buy at a huge discount to have a chance at 50% returns.  These opportunities may be limited to micro-caps with large discounts  partially due to illiquidity issues.

By the way, I am a big fan of small cap special situations, and I plan to post my library for readers, but we have to go step-by-step in posting material.

The reasons I want to focus on franchises are the following:

  1. A study of franchises will teach us about investing in growth which is difficult to value.
  2. Studying competitive advantages will hone our skills in business analysis making us better investors.
  3. Knowing that a company is not a franchise is also important, because–then with no competitive advantage–the company must be managed efficiently. We know what to look for in management activity. Diversification would be a warning signal, for example.
  4. Investing in franchises can be quite profitable if bought at the right price. Say 3M (MMM) at $42 back in 2009 was purchased, then you would be receiving today about a 5.5% to 6% dividend with growth in cash flows of 8% to 10% or more, then in a few years you will have a 14% dividend yield leaving out any rise in share price. You compound at a low base while you defer taxes and reinvestment headaches. I think Buffett receives double in dividends each year more than the original purchase price of Washington Post.  MMM_35
  5.  The biggest gap today in industry and company research is the lack of interest or knowledge in analyzing competitive advantage. Rarely do you ever see an analyst focus on barriers to entry in their valuation work. My hat is off to Morningstar, Inc. because their stock research is geared toward franchises. Many managements have no idea what are structural competitive advantages are. Often, they say their company’s competitive advantage stems from “culture.”
  6. Finally, you want to avoid Hell. Hell is paying a premium for growth for a non-franchise company. Look at Salesforce.com (“CRM”) as an example for today. Full disclosure: I have held short positions in CRM.   Thanks again for your question.

Another reader:

First I would like to thank you for the quality work you are doing. I am new to Austrian economics and I would really appreciate if you can walk us on how to get started and how is it different from other Keynesian and mainstream economics. I, also, want to know why Austrian economics would be more valuable to value investors than other schools. I also wonder why we have not been taught about Austrian economics in school and why it’s not taught.

My reply: Oh boy, you are asking for an all-night discussion. I came out of school having studied Keynesian economics (Samuelson’s text-book, http://en.wikipedia.org/wiki/Paul_Samuelson) because that is what American Universities taught back then and still do about economic theory. Imagine studying geography and being told that the world was flat, yet once in the real world ships were circling the globe.  What I experienced in real life (raging inflation with high unemployment in the late 1970s) completely contradicted Keynesian theory.  Also, the conceit of central planning, having the government intervene, made no sense. How could bureaucrats in Washington, DC allocate resources in Alaska better than an entrepreneur, say, in Alaska?  The only economists that predicted the Great Depression and the collapse of the Soviet Union and Eastern Europe BEFORE the events occurred were the Austrians, von Mises and Hayek. So I read, Human Action by von Mises, and became hooked. The world of booms and busts, inflation, deflation and capital formation started to make sense. But I had to UNlearn a lot of nonsense.

See how flawed Keynesian prediction has been vs. American history: http://www.youtube.com/watch?v=6XbG6aIUlog. Bernanke in 2005 discussing housing vs. the Austrian view. http://www.youtube.com/watch?feature=endscreen&NR=1&v=x2qr5cSln3Q. Bernanke’s confident ignorance is terrifying.

As an investor you must understand how man operates in an economy allocating scarce resources to better his condition or lesson his unease. Only Austrians–from what I know–have a coherent theory of the business cycle and the structure of production. But then you may ask, “If Keynesianism is such a repeated failure, then how come it is still prevalent today?” Think of human motivation. If you are a politician, what better cover to weld power than Keynesian theory?   Constant intervention to “help” is your guide.

Successful investors who are considered Austrians because they study/follow the precepts of Austrian Economics): http://www.dailystocks.com/forum/showtopic.php?tid/2623

Noted investors who use Austrian Economics:

George Soros is the legendary investor who started Quantum Fund in the 1960s and is a multi-billionaire as a result of some winning macro trades. Soros’ prescription for healing broken economies cannot be mistaken for Austrian Economics, but Soros’ analysis of markets as expressed in his books seems to borrow a lot of influence from the Austrian Economists.

Jim Rogers is acknowledged as one of the most successful investors of all time. Making an early start when he was in his twenties, he was able to build a huge fortune with an initial investment of just $600 by the time he was 37. A firm believer in Austrian economics, he advocates investing in China, Uruguay and Mongolia.

Marc Faber was born in Switzerland and received his PhD in Economics from the University of Zurich at age 24. He was Managing Director at Drexel Burnham Lambert from 1978-1990, and continues to reside in Hong Kong. He is famed for his insights into the Asian markets, and his timely warning about market crashes earned him the name of Dr.Doom. In 1987 he warned his clients to cash out before Black Monday hit Wall Street. In 1990 he predicted the bursting of the Japanese bubble. In 1993 he anticipated the collapse of U.S. gaming stocks and foretold the Asia Pacific Crisis of 1997-98. A contrarian at heart, his credo has always been: “Follow the course opposite to custom and you will almost always be right.”

James Grant, a newsletter writer who publishes “Grant’s Interest Rate Observer” is also a follower of Austrian Economics. He is a “Graham & Dodder” too. Go to www.grantspub.com

Ron Paul, a Republican Congressman for the Texas State, is also a believer of Austrian Economics.

Interestingly enough, Howard Buffett, the father of Warren Buffett is also an Austrian Economics follower. His son, Warren, however, seems to be more inclined to the Keynesian method of healing broken economies as opposed to the strict and rigid ones espoused by Austrian economists. Warren Buffett did acknowledge in a recent TV interview that one will have a hard time finding a paper based currency that appreciates in value over time. (All fiat currencies have been debased to worthlessness.)

Austrian Economics vs. Keynesianism

What is Austrian Economics http://mises.org/etexts/austrian.asp

http://mises.org/daily/4095   Hayek vs. Keynes Rap video and discussion. http://mises.org/daily/3465    The Austrian Recipe vs. Keynesian Fantasy.

A recent civil debate between an Austrian economist and a New Age Keynesian.  http://board.freedomainradio.com/forums/t/32178.aspx

Free School in Austrian Economics

If you REALLY want to learn Austrian economics, the lessons couldn’t be laid out better for you than here: http://www.tomwoods.com/learn-austrian-economics/.   Start with Economics in One Lesson by Hazlitt.

And if you want to interact with professors you can go to the Mises Academy here: http://academy.mises.org/.   Don’t go by what I say, but by what YOU think after delving into the material. Does it make sense? Forget political labels of Right-wing, Democrat, Liberal, and Conservative; think of how the world works.  I hope that helps partially answer your question.

The same reader asks another question:

I have another question related to Bruce Greenwald book, Competition Demystified. In his book he mentioned that if the company has no competitive advantage then strategy is irrelevant and the course of action should be efficiency. However, following this argument, investors would have avoided many companies during the journey to become industry dominant player.

Correct me if mistaken, but I don’t think you have read the entire book yet. Greenwald will talk about entrant strategies from the point of view of the incumbent (crush an entrant) to an entrant (how to gain a foothold profitably against an incumbent). Greenwald will also talk about cooperation between incumbents.

If you want a more detailed description of emerging franchises–though I suggest you read it after Greenwald’s book–read Hidden Champions of the 21st Century by Hermann Simon.

I can promise you that one of the reasons for Buffett’s success is his amazing understanding of competitive advantages in his investments.  As a business person understanding strategy is critical.

Here is a question.  You own a chain of very profitable movie theaters within a 150 mile radius of a major city. These theatres are spread about 5 to 20 miles from each other and are nicely profitable. You have economies of scale in hiring, securing first-run films, buying condiments, etc.  You awake one morning to find that another large regional theater chain from 800 miles away wants to open a theatre near one of your 29 theatres.  What response might you offer to send a strong message not to enter this market?  A paragraph is enough.

Thanks for your questions, you make me work hard.

Discussion of Strategic Logic (Kodak) Part 1

Part 1

Remember the cardinal rule of market analysis and investing: Those that know don’t say and those that don’t know have the floor to themselves.

You won’t find any great market or investment tips here.  What we can do is learn investment principles, strategic logic, and tools and techniques to become better investors. 99.999% percent of your success will be in applying your own thinking to the opportunities in front of you.

Strategic Logic

Studying strategic logic will be an important part of building a mental model for investment success.

I will discuss the Kodak case from here: http://csinvesting.org/2011/11/22/industry-analysis-kodak-strategic-logic-quiz/

I chose Kodak’s demise and Bill Miller’s loss to highlight several points.  Don’t follow market mavens off a cliff, make your own mistakes. You can’t lose when investing—either you make money or you learn. But to learn you must think systematically about your process, record your investments and think about your successes and mistakes.  Secondly, unless you have mental models (thanks Mr. Munger) to understand reality, you will become lost.  Mr. Miller and his team of 10 analysts including Michael Mauboussin might have been caught up in a turnaround story, the personality of a new CEO, the iconic brand name of Kodak or a plunging stock price—I don’t know—but they never asked a simple question—what competitive advantage would Kodak have in its new endeavor?

Let’s take a break to assess what is “Strategic Logic” or analysis of competitive advantages.

Strategic analysis should begin with two key questions: in the market in which the firm currently competes or plans to enter, do any competitive advantages actually exist? And if they do, what kind of advantages are they?

There are only three kinds of genuine competitive advantage:

Supply. These are strictly cost advantages that allow a company to produce and deliver its products or services more cheaply than its competitors. Sometimes the lower costs stem from privileged access to crucial inputs, like aluminum or early recoverable oil deposits (Saudi Arabia). More frequently, cost advantages are due to proprietary technology that is protected by patents (Pharmaceuticals) or by experience—know how—or some combination of both.

Demand. Some companies have access to market demand that their competitors cannot march (Ebay’s network effects). This access is not simply a matter of product differentiation or branding, since competitors may be equally able to differentiate or brand their products. These demand advantages arise because of customer captivity that is based on habit on the costs of switching, or on the difficulties and expenses of searching for a substitute provider.

Economies of scale. If costs per unit decline as volume increases, because fixed costs make up a large share of total costs, then even with the same basic technology, an incumbent firm operating at large-scale will enjoy lower costs than its competitors.

Beyond these three basic sources of competitive advantage, government protection or, in financial markets, superior access to information may also be competitive advantages, but these tend to apply to relatively few and specific situations. The economic forces behind all three primary sources of competitive advantage are most likely to be present in markets that are local either geographically or in product space. Pepsi loyalists have no particular attachment to Frito-Lay salty snacks, any more than Coke drinkers prefer movies from Columbia Studios when that was owned by Coca-Cola. Nebraska Furniture Mart, the store Warren Buffett bought for Berkshire Hathaway one afternoon, is a dominant player in Omaha and its hinterland, more powerful there than Ethan Allen or other large national furniture retailers.

Most companies that manage to grow and still achieve a high level of profitability do it in one of three ways. They replicate their local advantages in multiple markets, like Coca-Cola. They continue to focus within their product space as that space itself becomes larger, like Intel. Or, like Wal-Mart and Microsoft, they gradually expand their activities outward from the edges of their dominant market positions. (Source: Competition Demystified by Bruce Greenwald)

Think simply about competitive advantages. Morningstar categorizes economic moats in five ways.

Efficient Scale: when a company is effectively serving a limited market, rivals may have no incentive to enter. Some businesses are simply natural monopolies. This classification also applies to rational oligopolies. Think International Speedway for NASCAR races (geographic) or WD-40 in product space.

Network Effect: The value of a network is correlated to the number of connections. Large networks are most attractive for users, and it may be nearly impossible for upstarts to attain critical mass (Chicago Mercantile Exchange or CME).

Cost Advantage: Companies that thrive on being the low-cost provider in a commodity industry can offer lower prices to customers and still make a profit (Compass Minerals or Vulcan Materials). These companies create difficulty for higher-cost competitors.

Intangible Assets: Some companies have an advantage over competitors because of unique nonphysical assets such as intellectual property rights (patents, trademarks, and copyrights), government approvals, or brand names.

Switching Costs: If a company sells products that customers can’t get elsewhere—at least not easily—it has high customer switching costs. This creates a situation in which customers are willing to pay higher prices for products because of convenience.