|This is an excellent book for understanding how companies have a STRUCTURAL competitive advantage. I am now re-reading it.|
Financialization of the US Economy Why Wall Street will have to shrink over time.
|This is an excellent book for understanding how companies have a STRUCTURAL competitive advantage. I am now re-reading it.|
Financialization of the US Economy Why Wall Street will have to shrink over time.
Published: Monday, 2 Jul 2012 |
I was shocked: http://www.youtube.com/watch?v=HqVBKO_QM3o
Lessons to be learned
There are several lessons:
- First, this is an example of why you must discount/haircut the value of the EXCESS CASH on Microsoft’s balance sheet.
- Second, the importance of the ability of management to invest outside their circle of competence; in other words, how management allocates capital.
- Finally, what strategic logic did Microsoft violate? Hint: Google has 65% of the search market.
Hint: If I wanted a job at Microsoft or an investment bank servicing technology companies, I would do an intensive analysis showing why there would almost always be failure due to faulty strategic logic. You may not get the job, but I guarantee you would do better than submitting countless resumes. Say you saved MSFT $6 billion plus the money that could have been earned on that amount–what percentage would be fair compensation? Not a bad payday.
Microsoft admitted its largest acquisition in the Internet sector was effectively worthless and wiped out any profit for the last quarter, as it announced a $6.2 billion charge to write down the value of an online advertising agency it bought five years ago.
The announcement came as a surprise, but did not shock investors, who had largely forgotten Microsoft’s [MSFT30.56 -0.03(-0.1%) ] purchase of aQuantive in 2007, which was initially expected to boost Microsoft’s online advertising revenue and rival Google Inc’s [GOOG580.47 0.40(+0.07%)] purchase of DoubleClick.
The company’s shares dipped slightly to $30.35 in after-hours trading, after closing at $30.56 in regular Nasdaq trading.
Microsoft said in a statement that “the acquisition did not accelerate growth to the degree anticipated, contributing to the write-down.”
Editor: Discuss MSFT’s flawed strategic logic.
The world’s largest software company bought aQuantive for $6.3 billion in cash in an attempt to catch rival Google Inc. in the race for revenues from search-related advertising. It was Microsoft’s biggest acquisition at the time, exceeded only by its purchase of Skype for $8.5 billion last year. But it never proved a success and aQuantive’s top executives soon left Microsoft.
As a result of its annual assessment of goodwill – the amount paid for a company above its net assets – Microsoft said on Monday it would take a non-cash charge of $6.2 billion, indicating the aQuantive acquisition is now worthless.
The charge will likely wipe out any profit for the company’s fiscal fourth quarter. Wall Street was expecting Microsoft to report fiscal fourth-quarter net profit of about $5.25 billion, or 62 cents a share, on July 19.
In addition to the write-down, Microsoft said its expectations for future growth and profitability at its online services unit – which includes the Bing search engine and MSN Internet portal – are “lower than previous estimates.”
Again, through your lens of strategic logic what obvious flaw did management make and WILL make again if it doesn’t understand what?
The company did not say what those previous estimates were, as it does not publish financial forecasts.
Microsoft’s online services division is the biggest drag on its earnings, currently losing about $500 million a quarter as the company invests heavily in Bing in an attempt to catch market leader Google. The unit has lost more than $5 billion in the last three years alone. Even though its market share has been rising, Bing has not reached critical mass required to make the product profitable.
Before rolling out Bing in June 2009, Microsoft’s Windows search engine had 8 percent of the U.S. Internet search market, compared with Yahoo’s 20 percent and Google’s 65 percent.
In the three years since then, Bing has almost doubled its market share to 15 percent, but that has been mostly at the expense of Yahoo, which has had its share whittled down to 13 percent. Google now has almost 67 percent, according to research firm Comscore.
Another generous reader contributed riches to the value vault. This book is a great supplement to Competition Demystified. I rate the book as a great way to improve your understanding of analyzing businesses.
We are all fortunate:Strategic_Logic
I intend to live forever – so far, so good–Steven Wright
Let’s test our comprehension of the reading.
What competitive advantages does Microsoft enjoy in the operating system industry?
Why have “box makers” not been able to establish a competitive advantage over other competitors? Why was the enormous growth in the market for PCs such a problem for Compaq specifically? Did it have any alternatives that might have worked out better than its chosen strategy? Did Apple?
A lot of companies have chosen to downsize, and maybe that was the right thing for them. We chose a different path. Our belief was that if we kept putting great products in front of customers, they would continue to open their wallets.
A lot of people in our industry haven’t had very diverse experiences. So they don’t have enough dots to connect, and they end up with very linear solutions without a broad perspective on the problem. The broader one’s understanding of the human experience, the better design we will have.
Again, you can’t connect the dots looking forward; you can only connect them looking backwards. So you have to trust that the dots will somehow connect in your future. You have to trust in something – your gut, destiny, life, karma, whatever. This approach has never let me down, and it has made all the difference in my life.
An iPod, a phone, an internet mobile communicator… these are NOT three separate devices! And we are calling it iPhone! Today Apple is going to reinvent the phone. And here it is.
And it comes from saying no to 1,000 things to make sure we don’t get on the wrong track or try to do too much. We’re always thinking about new markets we could enter, but it’s only by saying no that you can concentrate on the things that are really important.
(contact: Aldridge56@aol.com with VALUE VAULT in subject line for the key)
I uploaded 21 videos of 2010 value investing lectures into a sub-folder in the VALUE VAULT. The VAULT seems cluttered so unless anyone objects, I will place non-videos into folders with sub-categories for easier searching. I will choose a quiet time to work on the vault—probably Sunday.
If you are having trouble opening the folder, please contact www.yousendit.com customer service at 888-535-9442 or (outside the USA) 1-408-385-8491 and email me if the problem has or hasn’t been fixed. I will #$%^&*! find out the problem. I am having no issues accessing the folder or videos so far.
If anyone has an idea for a more accessible storage option, let me know.
I’ve just started digging into the Competition Demystified PDF (in VALUE VAULT) and came across this passage (also mentioned in the “Strategy is Local” PDF) and couldn’t help but wonder what’s changed:
“Apple’s experience stands in stark contrast. From the start, Apple took a more global approach than Microsoft. It was both a computer manufacturer and a software producer. Its Macintosh operating system anticipated the attractive features of Windows by many years— “Windows 5 = Macintosh 87,” as the saying goes. Yet its comprehensive product strategy has been at best a limited and occasional success, especially when compared to Microsoft’s more focused approach.”
This strategy of controlling everything (operating system, hardware, software licenses/developers, content delivery, etc.) is, according to Greenwald, a competitive liability, yet today, as Apple is the most valuable company in the world and the most successful tech company, it is the very reason given for their massive success, and the “special genius” of the recently departed Jobs.
What gives? Is Apple just a fad? Is Greenwald making stuff up? Or is there some other piece of this puzzle I am not considering?
The Reader follows up with: “I thought of another strategic element for Apple. I read this somewhere a few months ago, don’t remember where, but Apple basically made exclusive contracts with its various suppliers such that they guaranteed them large volume up front in return for them not taking orders from competitors, essentially (some arrangement like that).
This resulted in two things:
First, conferred a competitive advantage in supply to Apple because they were able to achieve lowest cost in production.
Second, accomplished the strategic goal of totally denying their competitors access to suppliers of similar quality/cost. This meant that the only way a competitor could create something of Apple quality would be to pay (and charge) a lot more for it. But Apple commanded a brand premium in the market place while the competitors did not. This would be a good example of the Jarillo principle of the premium company charging less than they could, forcing competitors who don’t command a premium to price near cost.
I think normally the issue of “what suppliers do we use and how do we contract with them?” would be tactical. But because Apple interfered with their competitors’ ability to compete by working with suppliers the way they did, this seems to be a strategic consideration as well.
My reply: Like a lecturer before an audience, I was hoping no one would notice that my fly was unzipped. The reader is mentioning the elephant in the room–did Steve Jobs read Prof. Greenwald’s Competition Demystified and just do the opposite–Apple has a closed system for hardware and software. Has Apple been successful?
There are a number of possible answers:
Who said strategic thinking would be easy. Let’s take our time to look at a problem from all sides and go through our strategic logic process. We will soon discuss the Coors case study and then move on to Chapter 6: Compaq and Apple in the Personal Computer Industry or pages 113-136 in the book. Once we have finished the book and all the cases, let’s circle back and study Apple’s current success.
One question that should slap you in the face, “Why does Apple have such a low multiple of earnings and cash flow?” Perhaps the market does not believe that Apple can have real growth and/or the genius of Steve Jobs will no longer drive Apple’s future.
We all have our prejudices. Here is how to deal with them.
Sensitivity Training: http://www.youtube.com/watch?v=iliNaspGVDg&feature=related
More posts to follow…………
The book that discusses this case: http://www.amazon.com/Strategic-Logic-J-Carlos-Jarillo/dp/1403912599/ref=sr_1_1?ie=UTF8&qid=1322071768&sr=8-1
Most new technologies do not create a new business, but rather a substitute for the old way of doing things. Thus, the strategic impact of a new technology will depend on how it affects the market imperfections that protected the older way of doing things. And this impact can be important. Take the case of photography, which turned to digital. You do not have to be a genius (written in 2003) to realize that the traditional business of Kodak is in danger, since every time someone buys a digital photographic camera, he or she is renouncing the future purchase of photographic paper and the products necessary for development, products on which Kodak has a high margin supported by its patents and economies of scale. There are only two important competitors in the world, Kodak and Fuji, along with a few secondary actors.
Facing this ‘announced death’ of its main business by the invasion of a new technology, Kodak seems to have a straightforward strategic solution: enter into digital photography. Kodak has been investing the important cash flow produced by its traditional operations in the new digital technologies. However, profits are not arriving and never will. The reason is that the competitive structure of traditional (chemical) photography and that of digital photography (electronic) are very different, the second being much less attractive than the first.
Traditional photography is based on a fairly specific chemical technology, on which Kodak has an important number of patents and specialized knowledge, accumulated over more than 100 years. Moreover, not only research but also most production processes are subject to important economies of scale. In addition, Kodak’s brand, advertised for a century, and its worldwide distribution reach are two more barriers that protect the company’s profits. A further positive for the manufacturers is that the price of the cameras is relatively unimportant compared with that of the consumables, such as photographic paper and developing products. Each person who buys a camera, no matter how inexpensive, ends up leaving a lot of money in Kodak’s till. For all these reasons, the business has traditionally been very profitable, with very little competition. Kodak has been able to push the rest (Agfa, Ilford) that did not have its competitive advantages from the market. The only exception has been Fuji, which shares the market with Kodak.
This competitive structure, however, has nothing to do with the business of digital photography. To start with, there are no significant consumables: digital photos are taken with a digital camera, which does not use rolls of film, and are seen on the computer screen, without consuming film. Some, perhaps, are printed on the printer, on paper that is more normal than photographic paper and is not protected by entry barriers.
The technology of the cameras is also different, based on electronic light sensors, produced by several companies: all those that have significant capability in photo-electronics can manufacture them, and there are many. Finally, because we are dealing with a digital product, company brands such as Sony, Panasonic, HP and so on come into play, as they have credibility with consumers in this area. In short, we find a business that will be structurally less profitable than that of traditional photography, since its entry barriers are lower and the degree of competition, logically, is higher.
That is why Kodak’s effort to transform itself into a digital photography company is headed for failure. Even if it succeeds, it will find that the business is not as profitable as the traditional one. And there is not much that it can do about it: The shift from chemistry to electronics is a technological change that destroys the profitability of the traditional photography business, just as the microcomputer destroyed the profitability of large computers. If IBM has become profitable today, it is not by selling PCs, but by doing other different activities. It is a question of accepting strategic logic: the profitability of a company depends in the first place on the possibilities of singularization that exist in its business, and if these change to become higher or lower, then profitability will change to become better or worse.
 Singularization means that the company can charge a higher price or produce at a lower cost or some combination thereof than its competitors or potential entrants.
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.
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.
This a report on the US housing market. Whether you agree with the author’s assumptions or not, he carefully lays out his thesis. Also, his research shows the difficulty in investing in cyclical industries. The future is unknown, but if you can find a skewed risk reward opportunity then pursue it.
Kodak Case Study in Strategic Logic
Value-Line on Kodak: http://www.scribd.com/doc/73498449/EK-VL. Note the high returns on capital pre-2000.
50-Yr. Chart: http://www.scribd.com/doc/73498399/50-Yr-Kodak-SRC Note how the stock price of Kodak (EK) begins to underperform the stock market back in 1973/74. Back then (1972) the digital camera was invented. Coincidence or every picture tells a story doesn’t it? (Rod Stewart).
The history of the digital camera: http://inventors.about.com/library/inventors/bldigitalcamera.htm
Digital imaging also had another government use at the time that being spy satellites. Government use of digital technology helped advance the science of digital imaging, however, the private sector also made significant contributions. Texas Instruments patented a film-less electronic camera in 1972, the first to do so. In August, 1981, Sony released the Sony Mavica electronic still camera, the camera which was the first commercial electronic camera. Images were recorded onto a mini disc and then put into a video reader that was connected to a television monitor or color printer. However, the early Mavica cannot be considered a true digital camera even though it started the digital camera revolution. It was a video camera that took video freeze-frames.
Bill Miller bought Kodak near $60 and then many years later sold at $1. He said to a reporter that Kodak was his biggest mistake. He underestimated the need for a cultural change to turn the company around. Do YOU agree with his assessment of his mistake? Not to pick on Mr. Miller, but using strategic logic what questions would you ask if Kodak was transitioning from film photography to Digital? What might you do if you were the CEO?
In 2002, Fortune described the quandry Kodak faced in this article: http://money.cnn.com/magazines/fortune/fortune_archive/2002/02/04/317510/index.htm
Kodak: In The Noose
Andy Serwer February 4, 2002
(FORTUNE Magazine) – When I was a boy, my grandfather gave me a few shares of Eastman Kodak. I never got a chance to talk to him about it, but I’m sure his thinking was, “Taking pictures is a great business. People will always take pictures, and Kodak is the big fish in that pond.” Well, for years my grandfather was right, and Kodak was a fair, though by no means stellar, stock. Now, however, it seems that only the first part of Grandpa’s axiom holds true. Everyone still takes pictures, but increasingly Kodak isn’t the big fish in the photography business.
Despite all of Kodak’s best efforts, this grand old American brand could very well go the way of Wang and Xerox. Which is to say the company may be hanging around for years, but for all intents and purposes, it’ll just be twisting slowly in the wind.
EK is under siege. On one side, Fuji and others are chipping away at Kodak’s very profitable consumer film business. On the other, the digital image revolution (i.e. digital photography) is hitting critical mass. Yes, Kodak is a big player in that arena, but even if it succeeds there–which is far from clear–that’s a much less profitable business than those little yellow boxes.
Take a look at the numbers. In 1991, Kodak had $19.4 billion in sales. Last year, it’s expected to have done just a bit over $13 billion. And while net income hit close to $1.4 billion in 2000, that’s about what it earned in 1988. The company has recorded “nonrecurring” losses in ten of the past 12 years. Kodak’s dividend is now $1.80 per share, but some analysts don’t think the company will earn that this year. The stock, which hit $94 in 1997, now trades for $27. (How long, you might ask, before the good people at Dow Jones do what they did to Woolworth, Bethlehem Steel, and Union Carbide, and throw EK off the DJIA?)
But there is an even more disturbing figure for EK shareholders: Sales of digital cameras climbed an estimated 30% last year, to 5.5 million units. Now, Kodak makes digital cameras–in fact, it recently became the market share leader. But (1) Kodak’s digital camera business isn’t profitable, (2) every time someone buys a digital camera he is no longer a customer of the company’s high-margin film business, and (3) to succeed, Kodak must compete with the likes of Sony and Canon.
Kodak says it’s hurting because of the recession and the slump in travel since Sept. 11. (“Why then,” asks one short-seller, “is its medical imaging business also slumping?”) As for digital photography, the company says that it’s not only selling cameras but also high-quality paper and other digital photo-finishing services. Again, though, margins there are nothing like those in film. The other problem with digital photography is that consumers seem to print far fewer images. Why bother? You just store ‘em on a disk or PC and print out the few you want when you want ‘em.
Management at Kodak has long been considered–to quote one knowledgeable Wall Street source–“entrenched, inbred, and unresponsive.” (And one key outsider, COO Patricia Russo, just left to head up Lucent.) I doubt, however, that any manager could “turn around” Kodak. What’s happening doesn’t lend itself to a restructuring. To exaggerate only slightly, we are talking buggy whips here. Film for Kodak is somewhat like long distance for AT&T: a mature, still profitable business that’s very much in decline. One thing to do would be to take Kodak’s film operation and turn it into some sort of master trust that pays out cash to shareholders. But that would probably require a level of fortitude that only an outside-raider type like Carl Icahn possesses.
Sure, film will be around for years, but let’s be real: Digital cameras are totally changing how we take pictures. Here’s a story: Friend of mine told me about a woman who mostly uses a digital camera. One day she had her old SLR instead. Her daughter looked in the back of the camera after a shot and asked Mommy where the picture was. “This camera doesn’t let you see the picture,” Mom said. “Then why are we using it?” the kid asked. Get the picture?
You answer should be no more than a few sentences. Bill Miller is an intelligent, well-read investor but he failed to think strategically (yes, easy to point fingers with hindsight bias). But you can take the same analysis of entering the digital photography market and apply it to investing in Salesforce, Inc. (CRM) today. If you were to invest in CRM, what questions must you ask?
If you have trouble with this case, I have started a training camp to teach strategic logic. Watch a clip of a recent training day: http://www.youtube.com/watch?v=6eXFxttxeaA
Let’s test our business IQ.
A restaurant owner who owns a building in New York City where he serves some of the best Spanish food (Tapas, Paella) seeks your advice. He nets about $30,000 a month. This is, apparently, an excellent income for a small individual owner. He wants to expand to another location. Should he and how would you advise him?
Please, no more than a sentence or two. How would you need to look at his restaurant business?
Correct answers are required to receive any more value videos (just kidding; power goes to my head.)