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Thinking strategically, part three: industry attractiveness and competitive advantage

In this, our third blog about business strategy, we try to unravel the easily confused difference between the attractiveness of an industry and what I believe to be the foundation of strategy, competitive advantage. You see, what typically passes for business strategy in the lion’s share of business proposals that come my way are industry analyses and precious little about the resources and capabilities that will make a start-up, small business, or going concern profitable.

Let me give you an example. Eight years ago, investors threw money at start-ups in the B2B sphere — startups that sprang up like dandelions in a Minnesota summer. Two years ago, they threw money at social networking sites. This year, the hot new industry is iPhone apps (fast approaching a billion dollars of sales). What primarily attracted (and still attracts) entrepreneurs and investors was the industry and the market itself. Take iPhone apps. The industry is practically hemorrhaging positives: a fast-growing market, low barriers to entry (including the ease of coding), frighteningly low development costs, strong word-of-mouth networks, high margins, and lots and lots of openings — the industry isn’t near saturated yet.

That industry analysis — and the best way to perform industry analysis is through a model called “Porter’s Five Forces — spells lots of opportunities for lots of folks willing to think of an idea and code it into existence. So choosing an “attractive industry” is, needless to say, a viable component of an effective strategy. However, in this case, as in the B2B Web site bubble and the social networking bubble, means that many entrepreneurs, start-ups, and investors take industry attractiveness as the sole leg of their strategy. It’s a great industry, growing market, and I have something that ain’t out there yet. Sometimes — rarely, but sometimes — this is enough to make a viable business. But it’s rarely enough. When you consider the string of B2B failures in 2001 and the equally lengthy string of social networking failures in 2008, then you can justifiably conclude that most iPhone apps companies — and the money invested in them — are headed for the flusher, as well.

It is almost never a matter of luck. In the 80’s, some PC companies got lucky (say, Apple and Microsoft) and some didn’t (Atari and Xerox). Some social networking sites got lucky (Twitter and Facebook) and some didn’t (too numerous to tell). That’s rarely the case. Apple and Microsoft did more than just enter an attractive industry, they had a plan. And they modified that plan when circumstances changed. Microsoft, for instance, built itself on a strategy of dominating coding languages for the PC; when IBM came knocking at the door, they realized that it would be a better strategy to focus on the operating system. Apple designed the Apple IIe computer for small businesses; they changed their strategy when large corporations started snapping them up for the one and only spreadsheet application (VisiCalc), which only worked on Apples. In almost every case, the survivors (the wealthy survivors) had a superior strategy that married the industry and market advantages to internal advantages. The losers didn’t.

Industry attractiveness is always the necessary first step, but “opportunity” is not a business strategy. Strategy is always based on configuring your company’s resources and capabilities in such a way to best exploit opportunity in the short and long runs.

What makes an industry attractive? It really comes down to two things: demand and competition. The higher the demand (or potential demand), the more attractive the industry. The lower the competition, the more attractive the industry. You can see why iPhone apps look so good right now (and may not look good in six months). Industries are attractive based on

  • Low barriers to entry — low initial capitalization costs, low product development costs, lack of regulation, easily accessible distribution channels.
  • Low competition — there are few or no competitors (what are called “blue oceans,” as opposed to “red oceans,” which are red because everyone’s being bloodied by competition), no established brands, no monopolies, no competitors enjoying significant economies through scale or information technology.
  • Market — an identifiable and reachable market of consumers, a growing market (growing demand), an identifiable early adopter market (if you’re in a blue ocean). The more identifiable the market, or the more reachable the market, or the larger the market, or the more underserved the market — or all four — the more attractive the industry.
  • Profitability — some industries (and blue ocean industries) have high profitability, some don’t. Pharmaceuticals, which have enormously high barriers to entry including capitalization costs and regulation, nevertheless as a whole enjoy industry-wide average profit margins of 24%. iPhone apps developers, because capitalization and development costs are so absurdly low, can enjoy profit margins even higher than that (of course, “price per unit’ is not a very attractive aspect of the industry).
  • Differentiation — are all products in the industry alike or are they very different? The more different the products, the more attractive the industry (like iPhone apps). The more similar the products, the more the only strategic advantage that a company can gain is through reducing price. In a blue ocean, like the iPhone apps industry a year ago, the question is whether the industry will allow for differentiated, diverse products (preserving the ability to compete on something other than price) or will become a homogenized commodity industry, like oil. At some point, solar power will become an attractive industry (if it isn’t already), and it’s a more or less blue ocean. However, even with brillliant innovations like solar-powered Stirling engines, solar power will mature into a commodity industry, with the cheapest solar power generators becoming the product of choice.

    In our next installment, we have the rare treat of going over Porter’s Five Forces. You will be an honorary MBA in just ten short paragraphs!

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