#006: 7 Powers: The Foundations of Business Strategy

How to build an unstoppable business and the real reason why Netflix won the market

Happy new year dear reader.

For my first book of the year, I chose 7 Powers by Hamilton Helmer. After reading Poor Charlie’s Almanack, a lesson that stuck with me was the necessity of building competitive advantage in order to create a differential business. I read recommendations on some of the best resources to learn about this. I’m convinced that this book is indeed a good framework when one wants to build a lasting business.

I wish you a fantastic year filled with accomplishments and books.

Enjoy!


Before we start:

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The Book

7 Powers: The Foundations of Business Strategy

By Hamilton Helmer

TLDR

  • Timeless? ⚠️ published in 2016 but arguably can be applied to businesses in decades to come

  • Comprehensive? ⚠️ this is the Author's own framework.

  • Mental model? ✅ Yes

  • Return on investment of reading ✅ 210 pages, it's small and includes images. Easy to read.

  • All in all: ⭐️⭐️⭐️✨(3.5/5)

  • Should you read it: ✅ Yes, if you are running a business.

  • Opinion (if you had to explain it at a dinner party): The book presents well known microeconomic business properties (like economies of scale, network effects or branding) in a framework that helps to explain why certain businesses succeeded over time and why they won. It's specially useful to people who are thinking long term about their businesses. It helped me think about my own business.

Introduction

Motivated by the wish to explain why some companies win markets and why others don’t, the author created a framework to think about competitive advantage. To do this, he had an objective: to create a simple framework that is not simplistic.

The book defines key concepts, important to set the foundation for the rest of the book:

  • Power is defined as a set of conditions creating the potential for persistent differential returns. In other words, it means that there are significant benefits the company reaps while maintaining barriers to hinder competitors to steal market share. From another perspective, it means that there are no competitive arbitrage. When Industry economics support no Power, it's a commodity.

  • Competitive arbitrage happens when companies don't have any meaningful competitive advantage over each other, in which their offering becomes a commodity easily replaced by another. This ultimately drives margins down. From another perspective, competitive arbitrage exists whenever Power doesn't (to create a nice recursive definition).

  • Strategy: study of the fundamental determinants of potential business value. Strategy must be a route to continued Power in significant markets. Strategy has an objective: maximizing potential fundamental business value (which the auth The Value Axiom).

The book is separated in two parts. The first, introduces the 7 Powers (or Statics as the author calls is - "Being there" or why is a business durably valuable). The second explains how to get there or Dynamics (What developments made a company successful).

Let’s first dive into the Powers and explain each one. By now this should be clear: each Power is a method in which companies build competitive advantages around their businesses.

The Powers

Each Power will come with

  • Definition: clear understanding of what that Power is

  • Benefit: what can the owners of said Power take for themselves because they have that Power

  • Barrier: how does that Power hinder players from competing

  • Case study: frame the Power in a real example. This is very important to understand the Power in practice

Ready? Let’s go.

1: Scale Economics

Definition: A business in which per unit costs decline as production volume increases.

Benefit: Lowered costs

Barrier: Prohibitive costs of share gains. A competitor would have to provide more value to customers like reducing prices. The leader, having scale on their side, can fight with their more powerful units of economics. This creates pressure in the challenger's P&L.

Case study: Netflix

Netflix has been growing in the market first by beating Blockbuster and then by being competitive with everyone else. Blockbuster faced in 2003 the difficult choice of losing Market share or eliminate late delivery fees, which were 50% of their income. Netflix took their time and avoided bet-the-company type of tactics. Their long term vision was based on the insight that content will be one day consumed over the internet. They eased into streaming in 2007. They partnered with a number of companies to get the content started.

What really made Netflix win was an insight in 2011: content is king. They started making their own originals, starting with House of Cards in 2012.

By creating content, any new player wanting to compete (by also creating content) would have to increase their cost structure to do this. Netflix with millions of subscribers was able to dilute the cost of the content with the number of subscribers. Their scale enabled this motion but also ensure that any new player coming into the market would have to put the same pressure on their P&L.

Other sources of Economies of scale:

  • Volume/area relationships (costs are tied to area where profit/utility is tied to volume)

  • Distribution network density: as a customer network increases density, the cost of serving each one goes down.

  • Learning economies

  • Purchasing economies: larger scale, better discounts at bulk

More about Scale:

2. Network economies

Definition: A business in which the value realized by a customer increases as the installed base increases. The value of the service is enhanced as new people join the network.

Benefit: Leader can charge higher prices e.g. Linkedin's HR solutions

Barrier: Unattractive cost/benefit of gaining market share of new players

Case study: Branchout

Branchout was a Linkedin competitor that leveraged Facebook as a network. It grew very fast. Raised $49m in funding. But Facebook closed access to certain growth tactics (like spammy wall posts) which killed their monthly active users. The company folded. There were 2 lessons.

  1. They leveraged Facebook’s network but they didn’t own it. Linkedin on the other hand sustained itself over time.

  2. People wanted to have separation between their work and their personal relationships.

Key attributes:

  • Winner takes all

  • Boundedness: as seen in the case study, there are boundaries to the network.

  • Decisive early product: due to tipping point dynamics, early relative scaling is critical. Who scales the fastest is often determined by who gets the power early on. If another company gets to the tipping point, assuming there are network effects, it's over.

There are also Indirect networks / demand side network effects. These are complements that are exclusive to each offering. Example: Apple App Store has network effects because the more developers it has, the more valuable the ecosystem becomes (making it more likely new apps will be built), the more value it is for the end customer.

3. Counter-positioning

Definition: newcomer adopts a new, superior business model and the incumbent does not mimic due to anticipating damage to their existing business.

Benefit: The new business model is better because it has lower costs or can charge higher prices.

Barrier: Shifting resources cause damage to current business (also known as Innovator’s dilemma)

Case studies: Kodak

Kodak had a great business selling photography film. Then digital photos came along. Kodak was very high in the market. Kodak was aware of this new trend but this new business model was not attractive to them. Kodak had Power in film but had no advantage in digital storage. This was, in part, because they had no particular knowledge or competence in digital storage (it was not in their Circle of Competence).

Kodak could have made a choice to see their business as "image storage" instead of focusing on the film medium. But focusing on other business areas would impact their main business.

How an incumbent business addresses counter positioning

An established business in the market can react differently when a new player comes in with a new business model

There are several ways for an incumbent business to react:

  • If the new business model of the challenger is not attractive enough for the incumbent to invest, then there everything will remain the same and there will be no counter-positioning. As an example: Kodak had the opportunity to invest in digital cameras but it was not at the time an appealing opportunity for them.

  • If the company decides to invest then it must measure the potential impact of both businesses' NPV:

    • If the total Joint (i.e. of the two businesses together) NPV is negative, then the company won't invest and will therefore Milk the declining business despite the new attractive business model. Here lies the innovator’s dilemma and the barrier of counter positioning

      • As the incumbent business gets milked, it reduces the opportunity cost to invest in the new business model making it more attractive over time. This means that when you see a business doing nothing about being disrupted, that might be a valid approach as over time.

    • If the total Joint NPV is positive, there are still considerations to have:

      • The incumbent can decide to not invest because of the uncertainty around the new business model (aversion to change). “The current business is working fine, why change?”. Charlie Munger would call this a combination of Inconsistency avoidance tendency, Influence-from-mere-association Tendency/Survivorship bias (for more on this).

      • The incumbent (represented by the CEO) might suffer from incentive bias (also called agency cost) applied to job security. “Changing affects the security of my role, I feel uncomfortable doing so).

      • If, after all of this, the incumbent decides to move forward, there will be a move to the new business model.

Successful Counter positioning, can make this happen:

More considerations on counter-positioning

  • Counter-positioning is highly comparative and does not guarantee success. Example: In-n-out has Power over McDonalds (focus on freshness and quality over scale) but not over FiveGuys.

  • A way for the challenger to increase chances of Cognitive bias in the incumbent (aversion to change or agency cost), is by having a tone of respect instead of arrogance when dealing with the competitor. This delays the incumbents objectivity.

  • Counter-positioning is not exclusive, many players in the market can have it.

For the challenger, the only bet worthwhile is one in which, even if the incumbent plays its best game, it can lose.

Going deeper:

4: Switching cost

Definition: The value loss expected by a customers that would be incurred from switching to an alternative supplier for additional purchases. Switching Costs arise when a consumer values compatibility across multiples purchases from a specific firm over time. These include repeat purchases of the same product of complementary products.

Benefit: Company with SC can charge higher prices than competitors. This accrues as the company can sell further products to convert customers.

Barrier: Competitors must compensate customers for the switching costs. The firms with SC can adjust prices that make competing unattractive. Cost/benefit of share gains for the challenger.

Case study: SAP

SAP has had customers complain about their solution while maintaining high retention rates. When surveyed, 43% were unhappy with SAP's response times. However, 89% expected to continue to pay SAP.

“No one ever got fired for buying IBM”

Despite other superior solutions, customers become "hopelessly hooked" in solutions. SC is worthless without up-selling which means that it's crucial to develop add-on products/services. Acquisitions can be a tactic to achieve this (SAP is a great example)

Why Switching costs exist:

Any decision to replace critical systems, like ERPs, carries high cost.

Why:

  • Employees have sunk the cost of learning the system

  • Relationships with support and sales have been made

  • Compatibility/customization has been made

Switching requires:

  • Time and effort to research alternatives

  • Cost of a new solution (+ services to deploy)

  • Complementary software required (to cover use cases)

  • Data migration

  • Retraining

  • Establishing new relationships

  • Risk of service disruption

5: Branding

Definition: the durable attribution of higher value to an objectively identical offering that arises from historical information about the seller. Branding is an asset that communicates information and evokes positive emotions in the customer, leading to an increased willingness to pay for the product.

Benefit: Charge higher pricing due to

  1. Affective valence (good feelings)

  2. Uncertainty reduction (peace of mind when buying)

Barrier: Lengthy period of reinforcing actions - hysteresis

Case study: Tiffany & Co

Tiffany & Co built a brand of exclusivity and quality. This allows them to charge 2x for the similar jewelry from Costco. Tiffany, created in 1837, created a carefully curated track record of quality. They are also quite protective of their brand.

Challenges to a company's branding:

  • Dilution: Product releases can damage the brand. Also going down market can reduce affective valence. Actions can reset the hysteresis clock.

  • Counterfeiting: It's the label and not the product. Companies may try to associate their fake products with the good brand. This can undermine it. Tiffany sues companies because damaging their brand is a serious risk. A personal cool example of this: in the 90's, my father, who was managing director of Levi's Strauss in Portugal, would crack down counterfeiting as much as possible.

  • Changing customer preferences: what makes Branding a power also make it hard to change. Nintendo had a brand targeted to children and, when that demographic grew up, they had to adapt.

  • Geographic boundaries: a brand might be dependent on a region

  • Narrowness: branding is more restricted than Marketing

  • Non exclusivity: Many players can have equally powerful brands targeting the same segment.

  • Type of good: Only a few products can apply. Examples:

    1. B2B fails to have valence price as it tends to be a more cold logical buying decision

    2. When the uncertainty drives the selection, it tends to be associated with Safety, medicine, food, transport

6: Cornered Resource

Definition: preferential access at attractive terms to a coveted asset that can independently increase value

Benefit: having the right people delivering superior deliverable. It might also be access to a patent, some physical resource like limestone for cement

Barrier: In case of people, it's personal choice as individuals choose to "make history". It can also be by formality (or decree - fiat - like a patent).

Case study: Pixar

Pixar pioneered 3D animation movies and was in unique in creating hit after hit. Each movie (with exception to Wall-E) had higher margins than industry average. Fun fact: it was Pixar that created most of Steve Job's Net Worth.

In 1986, George Lucas sold the Graphics Group of Lucasfilm as he was finantially stressed from his divorce. This new company brought in:

  • John Lasseter - Creative

  • Ed Catmull - Technical

  • Steve Jobs - Business

The group making these landmark movies (referred to as the Brain Trust), which accrued further talent over time, became a strong unit, specially after the development and release of Toy Story. This group was the cornered resource.

The 5 tests of a cornered resource

  • Idiosyncratic: what is the reason being being able to acquire some assets?

  • Non-arbitraged: Can't pay highly for the resource so much that it kills the margin.

  • Transferable: needs to be coveted. In the case of Pixar, the team could go to Dreamworks and make their movies there. This team was so important that Bob Iger understood he had to bring them into Disney (he actually talks about it in his biography).

  • Ongoing: Needs to be continuous and dependent. Steve Jobs was important at the start but he stopped being critical afterwards. The Brain Trust at Pixar was.

  • Sufficient: It shouldn't depend on other variables.

7: Process Power

Definition: embedded company organization and activity sets which enable lower costs and/or superior products and which can only be matched by extended commitment (hysteresis). Process Power is not the same as operational excellence. Operational excellence is easily copied. This is operational excellence over a long period of time. In other words: evolutionary bottom-up improvement.

Benefit: improve product attributes and for lower costs as a result of process improvements

Barrier: Hysteresis. Difficult to replicate, only achieved over a long time. Because of 2 factors:

  1. Complexity

  2. Opacity (Knowledge is tacit and not easily transferred). Even Toyota did not have a full understanding of how things worked in their plants.

Case study: Toyota

Toyota developed an operational system (TPS: Toyota Production System) that was unreproducible.

In 1969 Toyota had 0.1% of market share (vs GM's 48.5%). They then developed the TPS. Toyoda-san, the founder, first influenced by Ford, took influence from supermarkets and their systems to restock shelves specially how to reduce waste. Because of TPS, Toyota managed to grow their market share.

Companies could not replicate their system. GM even did a joint venture with Toyota to train their employees in their system. But to no avail. They couldn't copy it.

You do have the Powers now. 👍

More on these Powers

Crafting over design

It's easy to look back on the success of companies and think their path to be logical. But it's many times the result of consistent improvement and luck and not of intentional masterplanning. It is crafting and not design.

Intelligent adaptation over an extended period of time.

When companies were started, their founders did not set up to create Network effects or Switching costs. These came as a by-product of constant and evolutive work - hysteresis. In order to create and leverage opportunities to create Power, a company should:

  • Seek invention.

  • Be operationally excellent.

Example:

  • When Netflix started, after their period of battling against Blockbuster using Counter positioning, their true inflection point came from their focus on content. First they focused on getting exclusives. However, these could be negotiated by other competitors so they were arbitraged. Their true growth came when they started producing originals. In hindsight it was obvious that originals was a great move, as it created scale economics, but Netflix did not know this when they first started the company. They had to go through all phases of development to get there.

On creating Power

The different Powers can be achieved in different times in a company lifecycle. While Counter-positioning, for example, naturally happens in the genesys of a business, Switching cost can only happen when there is already growth happening.

This means that as you go about thinking about guiding your company to Power, there are certain Powers you can only get after some time. Example: Process Power can only happen after a long period of time dedicated to evolutive and incremental operational excellence

The route to power is invisible to everyone, including management, as people confuse Statics (being there) with Dynamics (getting there). This happens because it’s easy to suffer from survivor bias (losers don’t show up). It also happens because we don't easily understand non linear dynamics (more on this).

Action is the first principle of strategy. Action and creativity must come first. Strategy is a compass through which you can be lead to power by way of crafting and invention. A key component of building any Power is the value provided by the product: how compelling it is and how much of the market can it capture. Is it 10x better than the competition? The period of invention is critical to define this value moment. But because it is non linear, it's very hard to forecast and plan.

What is NOT a Power?

There are attributes that businesses often associate as key differentiators VS their competitors. However, these are not sources of Power because they don't lead to long term differentiated margins (i.e. they can be arbitraged and built by others).

These include:

  • Recommendation engines. Netflix had a better recommendation engine than other players. However, this is not a power because even a small competitor with a small enough user base could replicate it

  • UI. Companies like to boast their great UI and UX. However, this is easily replicated by a faster growing competitor and there's nothing that could stop them from doing so

  • IT Infrastructure or scalability. Software and scalability are commodities because a player with enough resources and time can become effective and efficient at serving services online.

Review thoughts

I enjoyed this book. I normally reflect on how much I enjoy a non-fiction book by the amount of times I have ideas that I write about related to what I’m reading (in this case, applied to my business).

As a note, in certain Powers, like in Counter positioning, I miss scenarios where challengers lose and incumbents win.

I also can't help but think that this book goes tries to prove itself more than it needed. The ideas are timeless and true (because they are logical). However, the book goes into a level of mathematical definition for each Power that made me confused. For each Power there’s an associated formula that could be used to calculate a value for that Power. I wished I understood how to apply the formulas to evaluate businesses. But since there are no practical quantifiable case studies to help to apply the formulas, this appears to me to be impractical (i.e. it’s difficult for me to understand if any persona will measure how much they are winning by network effects). It’s possible I’m missing something.

Charlie Munger called this “Physics envy”

Physics Envy: The unattainable precision of physics is not going to happen in Economics as it's too complex. So this gets you in trouble: following false precision

A serving quote for this situation:

Better roughly right than precisely wrong Keynes

The author, following his framework, was able to beat the market and create differentiated returns for himself compared to other firms. It seems to me that this book, without the mathematical precision, is roughly write and that is all that matters.

Congrats, you officially have the Powers 🔌

Since you finished reading, could you give me feedback? This helps me improve

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References and further reading