Sources of Firms' Economic Performance
Based on research on 168 public firms, a model is introduced, where the horizontal axis is the EVA of a firm and the vertical axis is its growth. Two new variables are added to this model: market power and knowledge.
The variable "market power" is an indicator of the level of aggressiveness of the competition in a market. A low level of market power indicates that the competition is intense and the products sold in that market are normally identified as commodities (perfect competition). An average market power indicates that the competition is less intense and companies are able to differentiate for some time (monopolistic competition). A higher market power indicates that the level of competition is even softer as a result of very weak competition (oligopolistic competition). The highest market power indicates complete lack of competition (perfect monopoly).
The variable "knowledge" is a systemic variable indicating the level of IC of a firm in terms of how much knowledge is received from the environment, how much knowledge is incorporated in the value chain, and how much knowledge the firm incorporates in the final product.
The Link between Stock Value Creation and Strategic Management
SVM links the financial dimensions of stock value creation with strategic management drivers. The EVA financial model describes how a firm creates stock value.
In order to create stock value firms need to:
• Have profits, in terms of a positive EVA (profits minus cost of funds or, in other words, the profits of the firm minus the profits of
Figure 12.1. Strategy-Value Model
similar firms), which is produced by the strategic management driver of market power,
• Have sales growth, which is driven by the strategic management driver of innovation (new products, new channels, new businesses, new locations, new technologies, new value chains, etc.), and
• Manage capital, which is driven by the strategic management driver of unique inimitable resources.
Welcome to the strategy-value model, the backbone of SVM. Figure 12.1 introduces one simplified version of the strategy-value model. Throughout the rest of this chapter we will show other layers.
THE FIRST DIMENSION OF SVM: PROFITS DRIVEN BY COMPETITION
During the last few decades, several industrial economists have connected competitive environments with their recommended competitive strategies. As can be seen in Figure 12.2, SVM goes a step further and links competitive environments to the ability to create stock value, producing a model that joins the competitive environment with competitive strategies and expected financial results in terms of profits (EVA). This is a new concept within the literature, showing which strategies produce good or bad financial results and in what environments these strategies are effective. As such, SVM has profound implications.
Firms operating in perfect competition tend to have very low profits (EVA below -2%). Products tend to be standard and undifferentiated. Typical industries operating in perfect competition are commodities, agribusiness, natural resources, metals, and chemicals.
Since firms in perfectly competitive markets cannot determine prices (they are determined by the markets), and products are undifferentiated, key competitive strategies are focused on keeping costs low by raising efficiency, using lean manufacturing, and trying to generate economies of scale. In order to reduce the competitive intensity, firms need to consolidate the industry by way of acquisitions or alliances. Promotion strategies may be risky: the more information, the more perfect the competition becomes, the more power is given to the customer to select the most aggressive competitor. Distribution strategies are limited to push strategy (sell using the channels) with a very frugal low-level channel, combined with low-cost logistics, which attempt to simplify distribution and reduce cost.
Figure 12.2. Environments, Strategies, Results
Firms operating in monopolistic competition have EVAs close to zero. Their products can be differentiated; however, differentiation is based mostly on the lack of ability or willingness of competitors to engage in imitation. Typical industries that tend to operate in monopolistic competition are: manufacturing, food, autos, electronics, consumer products, transportation, and commercial banking.
The strategies in monopolistic competition are what most marketing management textbooks recommend. Product strategies are based on differentiation and positioning with some branding and packaging. Pricing strategies permit some degree of linear and nonlinear pricing (typically, promos, combos, long-term agreements). Promotion strategies are connected to pull strategies such as advertising, personal selling, and customer relationship management. Distribution strategies can rely on more sophisticated push strategies such as using higher-level channels with more value added (insurance, advisory, financing, etc.) as well as advanced logistics and supply chain management.
Firms operating in oligopolistic competition tend to have much higher profits (EVA between 4% and 10%). Some industries operate as true oligopolies: colas, corn flakes, peanut butter, cellular telephony, oil, some branded products, etc.
The core of an oligopoly strategy is that firms do not compete on the basis of some aspects of the marketing mix—typically price.
Figure 12.2 shows that strategies in perfect and monopolistic competition are based on actions, whereas strategies in oligopolies and monopolies are based on resources. For oligopolies the key resource is maturity—the ability of the competitors to avoid competing.
Firms operating as a pure monopoly have much higher profits (EVA above 10%). Typical monopolistic firms include Microsoft (Windows and Office), Intel (in some products), some utilities with market protection, and some pharmaceutical firms (in products protected by patents).
Monopolistic strategies are based on unique inimitable resources. The stronger such resources are, the higher the entry barriers. The word "resources" has a wider meaning here: experience, technology, innovation, capital, relationship with customers or channels, customer switching costs, economies of scale or scope, control of channels, strong image, and government policy such as patents or market protection (utilities).
In some cases new entrants are unavoidable and in such cases it is better for a monopoly to soften the competition and play an oligopolistic "friendly collusion" strategy.
You may wonder how to determine what competitive environment your firm or industry operates in. Porter's five forces model helps to determine where an industry or firm operates in terms of perfect or monopolistic competition. Industrial economics developed a model called "the supergame," based on game theory, which helps to see whether an industry can operate as an oligopoly. Industrial economics and the resource based view (RBV) of the firm developed parallel models to determine whether a firm can operate as an oligopoly or whether a single firm can be a full monopoly.
Figure 12.3 provides a conclusion to this analysis of competition: you can place industries in the strategy-value model according to their life cycle. New products tend to be monopolistic, but when new competitors enter into the segment, competition becomes more intense, and the product may end up as a standard product in perfect competition. This helps us to understand why some industries typically create or destroy stock value.
I suggest that you use the information that has just been explained, to contrast your competitive environment, your strategies, and your financial results. This will help you to critique your firm's past decisions and eventually to have an idea about its future. If you have the time to repeat the same exercise with other firms or industries (my students have done it with thousands), you will be surprised by the consistency of the model. In further pages we will expand these insights. Be careful, EVA is also affected by the resource strategies as discussed below.
Figure 12.3. Strategy-Value Model and Industry Timeline