Of 'competitive advantage' and more... - Views on News from Equitymaster

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Of 'competitive advantage' and more...

Jan 16, 2006

Ever imagined 'why Infosys is what Infosys is', or for that matter 'why HLL is what HLL is'? What is that 'edge' that separates these companies from the rest in their respective industries? What 'competitive advantages' do these companies hold, and hold them tight, which have helped them grow in both good times and bad? Well, we are here to discuss about what 'competitive advantages' should companies have for them to grow with sustainability over the long term and create wealth for their stakeholders. And in this course, we shall try and understand the 'Competitive Advantage' model of the legendary management guru, Michael Porter. Competitive advantages can come from ethical leadership and execution strengths such as those held by Infosys, or from distribution systems and scale like those enjoyed by HLL, which also enjoys a recognizable brand. All of these qualities allow companies to maintain high returns on capital and equity, and stay profitable over the long term (while there might be occasional blips in performance due to changing dynamics of the company/industry in which they operate.

Porter's model for Competitive Advantage
In his famous book, "Competitive Advantage: Creating and Sustaining Superior Performance", Porter describes how a firm can put the three dynamic yet generic competitive strategies of cost leadership, differentiation and focus into practice. It highlights, for example, how a firm can differentiate itself from its rivals and create a superior business model that lasts over a long period of time.

Cost leadership: This advantage is often achieved by economies of scale. Companies that have the ability to manage growth while building up scale are the ones that are able to hold fort higher than their competitors. A business achieves economies of scale as a result of producing (or selling) more for a reduced average cost. This is gained by distributing fixed costs (costs that do not change as a result in a change of production, like rent, salaries and insurance premium) over an increased number of products. Economies of scale are often incentives for businesses to grow. This is because many small businesses cannot compensate for a sufficient increase in production and sales because of current resources (production space, number of employees and budget) and, therefore, cannot practice economies of scale. Because of reduced costs, businesses can price their products to be more profitable. Examples of Indian companies that benefit from this competitive advantage are Bharat Forge (second biggest forging company in the world), Tata Steel (India's largest steel producer) and Hero Honda (world's largest motorcycle manufacturer).

Differentiation: This involves creating a product that is perceived as unique by its consumers. For this strategy to be successful, the unique features or benefits should provide superior value to customers. And since they (customers) see the product as unrivaled and unequaled, the price elasticity of demand (changes in demand relative to changes in prices) tends to be reduced. Differentiation also tends to make customers more loyal towards 'the' brand. This can provide considerable insulation from competition. Areas of differentiation can be product (i-flex's Flexcube core banking solution), distribution and sales (HLL), marketing and services (Bharti Tele). Now, while maintaining the differentiation advantage, a company cannot ignore its cost position. In all areas that do not affect its differentiation, it should try to decrease costs.

Focus: Following a 'focused' strategy, a company sets out to be 'the' best in a business segment or a group of business segments. A company typically looks to gain a competitive advantage through effectiveness rather than efficiency. This strategy of making a mark in the industry is most suitable for relatively small firms but can be used by any company across any value chain. Examples of 'focus' are well entrenched in companies like Geometric Software (PLM solutions) and IDFC (infrastructure financing).

Conclusion
We believe that gaining a competitive advantage is the key especially for mid-size Indian companies to perform well and survive in today's highly globalised and intensely competitive markets. Gaining an upper hand in any of the three advantages mentioned above is very important in today's global markets when firms face global competition. Moreover, as Indian companies (both big and small) take their first steps forward towards becoming global giants, there is an ardent need for them to effectively translate their broad competitive strategies into specific actions required to gain competitive advantage. And that will consequently provide a competitive advantage to 'long-term' investors in the 'long-term' India growth story.

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