Management Buzzwords Explained: Competitive Advantage

This is the fifteenth in a series of essays that addresses management topics. The first ten explored "hot button" issues; the next ten satirize management "buzzwords." I base these essays on countless provocative lectures and irreverent discussions as a nutty professor of Business Administration.

I can't seem to watch television for ten minutes without watching fifteen minutes of commercials. Inevitably, one company or another brags about its product/service that gives it a "competitive advantage." Since I quickly get disgusted watching the instrument that has already exposed me to over one million commercials, I often turn to reading a weekly business magazine. Before I've read three articles, however, a company has bragged about its product/service that gives it a - sigh -- competitive advantage.

A bit fed up, I might assuage my guilt for being so passive, and turn to grading student papers, that provide analyses of an assigned company. Within another fifteen seconds, I always come across one that explains why the company has a competitive advantage assuming, I guess, that I'm going to be dazzled by the term. There goes that "A."

The only thing I can control about the situation is to deliver, or re-deliver, my lecture on the meaning of competitive advantage the next day in class. Well actually, I can share the basics of that lecture here, too, and at least know that I'm trying to get this buzzword used a little less often, or a little more correctly as the case may be.

First, follow this logic. If every firm claims to have something that sets it apart from the pack, is anyone really that different? If so, if each and every firm could possibly be so clever, how much of an advantage can one firm have over all the rest? Of all the firms that can really claim an "advantage," not too many can have the one that matters. In a sense, only one firm can be truly different in such a profound and correct way.

But assuming that each and every firm can be truly different in the way it really matters (see how dumb that sounds?), how long can one firm's advantage last against being copied, imitated, or obviated by another tactic? If I can understand a stupid commercial, so can that firm's competition and any advantage has already started to erode.

Let's start over. What does "sustainable competitive advantage" really mean, and why is it so rare? First, let us assume that the desired endgame is to not only survive, but to win consistently over strategically-meaningful periods of time (i.e., at least several periods of reporting to the stockholders.) Let's start by testing your basic economic common sense.

Imagine that you just moved to a new city and were looking to set up your banking. You notice that on each of the four corners of your most convenient intersection, there is a bank - four corners, four banks. You happen to know that the average interest on a savings account in the industry is, say, 3%.

One of the banks offers 2.8%, another 2.9%, another 3.0%, and the fourth 3.1%. That's an average of 2.95%, and also happens to be the average in your new city. "All else constant" such as risk, frills, etc., and assuming that you are a profit-maximizer, which would you choose? Time's up! You probably said 3.1%. It's the best of the four, plus it beats the local and national averages. You've passed Econ 101.

But now, assume that where you just moved from, your money was-and-still-is earning 4%, and the average there was/is 3.5%. Let's just attribute the difference to a better city economy. Now what would you do? Shouldn't you just let your money stay there? Yes. Observing how efficient banking is these days, you should. In the first place your bank is the best performing one of them all; in the second place, even if your old bank slips to being only average in its own economic environment, it will still outperform all four of your local choices. You've passed Econ 102.

Picture yourself now as an investor and you are deciding where to put your money in "the market." With today's efficiencies, you can easily put your money in any firm in any industry, pretty much anywhere. Assume you feel especially comfortable with two industries. In one industry, the average return is 2.95%, and in the other it's 3.5% (the same averages as in the two banking scenarios above.) Just as the economics of two cities can be very different, so can the economics of different industries, resulting in "structurally" different returns on invested capital. You will likely be lured to the more profitable industry. Just as likely, you will be lured to the firm(s) with well-above-average industry profitability.

Get the picture? Firms compete for capital, and so do industries. Experienced investors know what to expect out of an industry, without necessarily learning about the economic forces that determine its inherent/structural profitability. To a point, profitability is environmentally determined, and stubborn. It is a feat to outperform all others where there is such little managerial control, and it can take many years to reach the top. So it is a gross understatement to say that having a competitive advantage helps. Having a competitive advantage is really a statement about a firm's long-term relationship with investment communities, not about this month's product and its delighted consumers.

Remember that we're talking about a period of many years. In the long run, it is not enough to be above average to really prosper. One must be at or near the top to continuously attract low-cost capital from shrewd investors (like you.) Being an investor's darling is a key to long-term survival and profitability. NOW -- when a firm does consistently outperform its industry in this way, we assume that it has something called sustainable competitive advantage. Such a trend cannot be a matter of luck. Something really great is going on inside that company, but the pedestrian, trivialized interpretation of competitive advantage does not come close to suggesting the fullness of the term. That's why I get disgusted with this buzzword more than others.

But now that we better understand what it is, where does sustainable competitive advantage come from? We'll explore that next.