WCM Educational Recap #4 — Intro to Business Strategy and Accounting

Recapped by Naveed Pirouzmand

Welcome back to the Western Capital Markets blog! This week, we dive into business strategy, competitive advantages, and game theory.

The Financial Statements

Income Statement: Utilizes accrual accounting to evaluate company’s operating performance

Cash Flow Statement: Illustrates all changes (operating, investing, and financing) in company’s overall cash position

Balance Sheet: Displays company’s financial position (assets and liabilities) at a specific point in time

What Makes a Good Business?

A good investment is a good business at a good price with a 20%+ margin of safety.

• Economic Moat (ability to maintain competitive advantages over its competitors)
• Growth Potential
• Strong Management Team

Competitive Advantage

A competitive advantage is a unique characteristic allowing a company to operate in a superior way compared to its peers

• One type of competitive advantage is a barrier to entry, an obstacle preventing potential competitors from entering the industry or competing at the same tier
• Competitive advantages must be sustained by adaptation and strategic decisions because competitors will try to replicate the business. For example, BlackBerry was once very successful but struggled to understand how consumers’ tastes were changing and so its competitive advantage eroded

Applications of Competitive Advantages

• Investing: Buying quality businesses for less than they are worth (capitalizing on the difference in market price & intrinsic value)
• Value investing: A form of investing where the goal is preserving capital and growing it at a faster rate than the market; competitive advantages enable a company to outperform the market
• Market Knowledge: Provides context for strategic decisions, a lens to analyze current events
• Valuation: Affects inputs and assumptions used in the company’s valuation. For example, if you think Uber can use its competitive advantage to achieve economies of scale, your projected margins and thus valuation will improve
• Entrepreneurship: Make and assess strategic business decisions by understanding your own and your competitors’ competitive advantages

Identifying Competitive Advantages

There are two common attributes used to test for competitive advantages

• Stable Market Share (market share shifts < 2% over 5–8 years): Neither incumbents nor entrants are eating away at the market share
• High Return on Capital (15–25% after-tax returns): Efficient use of investment, maximizes return

Primary Types of Competitive Advantages

There are three main competitive advantages including supply advantages, demand advantages, and economies of scale

Supply Advantages: enable a company to deliver its goods more cheaply than competitors

Strong supply advantages:

• Complicated industries have natural barriers due to the learning & experience curve, for example, complicated software
• Patents that legally protect output or critical processes
• Proprietary access to inputs including a strong vertically integrated supply chain

Weak supply advantages:

• Simple products and processes are hard to patent and easy to replicate
• Access to cheap capital & raw materials typically isn’t strong either

Over time, companies can reinvest their higher margins to outperform the market and sustain their competitive advantage

Note: There is a difference between price and cost. A low cost of producing goods is a supply advantage, while any company can lower the prices of their goods without having a competitive advantage

Demand Advantages: revolve around customer captivity, acquiring, and keeping consumers

• Habit: When customers spend a long time frequently doing something, they become captive and are unlikely to switch. Western students getting Starbucks at the UCC every morning is a good example of a habit
• Searching Costs: There is a cost to locate an acceptable replacement, especially if it is a good/service that is customized, complicated, or crucial
• Switching Costs: Substantial money, time, and effort are required to switch between suppliers. This can be inherent in the product (software), generated from the structure of contracts and exit fees (mutual funds), or reinforced with network effects (If all of your friends have an iMessage group chat, you’re incentivized to keep using an iPhone

Economies of Scale: As firms grow larger compared to their initial size, their cost per unit declines as volume increases, and fixed costs make up a large share of total costs.

Key Terms:

• Variable Costs: Costs that vary with the level of output
• Fixed Costs: Costs that are constant whatever the quantity of goods produced
• Operating Leverage: The degree to which a firm can increase operating income by increasing revenue. This increases in companies with a high percentage of fixed costs

This is common in low margin, high volume businesses where goods are commoditized (Ex: natural resources).

Note: This doesn’t depend on a company’s absolute size, but rather the size difference between the company and its rivals

Common Misconceptions Around Competitive Advantages

Branding & Product Differentiation: Can be replicated easily; similar products can be developed.

“First-Mover” Advantage (being the first to enter a new market): If not accompanied by cost advantages, rapid accumulation of scale, or customer captivity, early market leaders can fall. Skype didn’t capitalize on its advantage during COVID-19, creating opportunities for Zoom to enter and take over significant market share.

Regulatory Barriers to Entry: Governments and policies change quickly — don’t rely on these artificial barriers.

Introduction to Game Theory & Strategy

Strategic decisions depend on the actions and reactions of other entities. Game theory is the study of mathematical models of strategic interactions among rational decision-makers

• A game is a situation involving players who each have a set of possible choices, in which the outcome for any individual player depends partially on the choices made by other players
• Game theory sets up “games” with multiple “players” that follow the same rules with the same information to achieve an optimal outcome
• A Nash Equilibrium occurs when no player can gain an advantage by unilaterally changing their strategy

We will now discuss three examples of common games and their implications

Scenario 1: The Prisoner’s Dilemma

Two bank robbers (A & B) are arrested and charged, but they can only be prosecuted if one testifies against the other

• Each robber is provided a choice: remain silent, or testify
• If both remain silent, they will each receive only 1 year in jail for petty crimes
• If one testifies while the other remains silent, the prisoner testifying will receive 0 years while the defendant will receive 3 years
• If both testify, each will get 2 years in jail for sharing responsibility for the crime

This is a paradox demonstrating how two players acting in their own self-interests do not produce the optimal outcome. This can be applied to businesses’ strategic actions

Scenario 1 Example: Barakat vs. Osmow’s Dilemma

Both serve similar food within the same geography to the same target market; customers are price-sensitive and brand loyalty is low. Assuming they both start at $7 per meal:

• Each business can either maintain its prices or lower them to $5
• If both maintain their prices, there will be no change in the total demand or total profit for either business
• If one lowers their prices while the other doesn’t, that business will see an increase in demand and profit while the other will see a decrease
• If both lower their prices, there will be no change in the total demand but a decrease in the total profit

Businesses must try to maximize their profit by balancing price and volume while considering their competitors’ actions

Necessities to Maintain a Cooperative Equilibrium

Price competition is the most common form among a small number of competitors. Ideally, businesses want to maintain a cooperative equilibrium with everyone charging higher prices

This allows for stability of expectations (all players adhere to current choices) and stability of behavior (no player can improve its outcome further)

Ways to Structurally Avoid the Prisoner’s Dilemma

Due to the complications summarized earlier, businesses want to avoid the Prisoner’s Dilemma situation

• Avoid Direct Product Competition: Osmow’s uses a special sauce that differentiates their product
• Customer Loyalty Programs: After 9 orders, the 10th meal is free
• Universal Cost Clauses: Agreement to maintain prices at a specified value
• Incentivize Profit Over Growth: Raising prices to maximize their current revenue

Scenario 2: Entry / Pre-Emption

The decision in this scenario is whether to enter a market or expand in an existing market. There are two main players:

• Entrant: Company attempting to enter the market
• Incumbent: Company attempting to preserve market share

Key Characteristics of this Scenario

• Timing: The decision requires significant time
• Clarity: There are different strategies for the aggressor and the defender
• Longevity of Mistakes: There are lasting consequences of mistakes

Strategies for the Entrant

• Avoid head-to-head competition, instead of focusing on spreading its impact widely across the market using a variety of ways
• Moving slowly and steadily is crucial, as one poor decision could lead to the company’s fall

Strategies for the Incumbent

• Maintain a large excess capacity for confrontation and a large war chest (extra funds that they can pull from to preserve market share) for financing
• Maintain focus on a given product such as Apple focusing on iPhones

Scenario 3: Cooperation

Cooperation is when multiple companies work together for the purpose of collective reward-sharing

• Difficult to implement due to antitrust concerns (regulations limiting the market power of any particular firm) and accusations of collusion
• A monopoly is damaging to consumer rights and benefit

Steps in Cooperation

• The key parties first determine what joint goals are attainable through this partnership
• They determine the optimal choice framework to achieve these goals
• They work together to maximize joint rewards within this framework
• They agree on how to divide the gains

Cooperation Case Study: Nintendo

• Nintendo once dominated its industry due to its substantial installed base (More users -> More Games -> More Users)
• Refused to co-operate with players up & down stream
• As advancements in technology allowed other consoles to enter the market, developers and retailers flocked to support the competition
• Aimed to improve their returns, which Nintendo compressed

Key Takeaways

Good Business vs. Good Investment: overlapping, but not necessarily the same; good investments are good businesses at a good price with a 20%+ margin of safety.

Identifying Competitive Advantages: What keeps their market captive or position stable?

Game Theory: A firm’s decisions are made relative to their environment and competitors.