Hamilton Helmer Power + Business - [Invest Like the Best, EP.174]

Automatic TRANSCRIPT

Oh the low and welcome everyone on Patrick Shaughnessy. And this is invest like the best. This show is an open ended exploration of markets ideas methods stories and of strategies. That will help you better. Invest both your time and your money. You can learn more and stay. Up-to-date BUT INVESTOR FIELD GUIDES DOT com Patrick o'shaughnessy CEO of Anisi asset management all opinions expressed by Patrick and podcast guests are solely their own opinions and do not reflect the opinion of o'shaughnessy asset management this podcast informational purposes only and should not be relied upon as a basis for investment decisions. Clients of Shaughnessy. Asset management may maintain positions and the securities discussed in this podcast. I guess today's Hamilton Helmer. The CO founder and chief investment of strategy capital and the author of one of the best business books in history called seven powers. Which is the topic of our conversation. He has spent his career as a practicing business. Strategist advising companies investing based on strategy insights and teaching strategy in the last decades he has also utilized strategy concepts as a public equity investor. In this conversation we cover all seven business powers from counter positioning to scale economies and how companies earn and keep those powers any investor or person should understand these concepts and seven powers. And it's the best work I've seen. That explains them in-depth. Please enjoy our conversation own. Just begin at a very high level with the concept itself perhaps the necessary preconditions power which you described as benefits and barriers. Maybe we could just take these three concepts benefits and barriers and how they relate to what power means specifically to you at a high level before digging into the specifics. If you start a business you put something in your time and investments and all this stuff and you do it maybe for love but you also get get something and that something back to be more than what you put in the first place. You might question whether it was really worthwhile and so the notion of power is when you figure out something about a business you figure out something. That's better than what is currently offered and so might be a better business model might be interesting grand or might be a new product or something like that but then the the specter of competitor arbitrage comes in. If you do something better the question then is okay but for that to be durable and what you want as Gurgle success in business for that could be durable. There has to be something that prevents others from taking all of that away from and so the something better is a benefit and the something that keeps others from getting it is a barrier. And so you need both those conditions and the example used in my book officer is Intel Presents. A great control is so Intel started out with amazing management. I mean the best brilliant triumph business and they started out as a what they call themselves the memory company then they semiconductor members head. Incredible manufacturing technology. Your ship all these things and so the benefit was the these great memory chips better than other people's but the problem was that other people could emulate it and so they're Martin's started to go down. Oh look that attractive. So despite all the wonderful things that they had and they were very very well run business. It just was not going to be an attractive business but then they got into. Cpu's Mark Process and it turned out that there was something that could keep others from quickly emulating that and there are some early things that were particularly strong. In terms of health. Computers are hardwired to that ship and stuff but later on the key thing was that to design one of these things is a very very expensive proposition. And that's a fixed cost design one of these chips and if you have much higher volume. That cost is pro-rated over that. So that's a scale calm you just type of power and so unless other people have your scale. Europe lower cost position. And that's durable so all the nice things they have which are necessary. Good Management of Greg manufacturing good marketing. All that are needed but would not have secured their position and did not in the memory business which they eventually had exit thought. They needed that something else. In addition to all that operational excellence which was power. Which was something that created value escapes lower cost but could not be easily arbitrage by competitors and so if you have a benefit and a barrier then you have a formerly long-term positive cash flow tractor dashboard but just good returns going on and on. And so. That's the nature of the concept. Would you say it's fair to characterize benefits as more commonplace one for people to think about and also for people to actually put into the world then barriers meaning? Barriers are a rarer breed than benefit. Yeah Patrick that's really insightful. An important point benfits are everywhere. A car bumper. He goes from chrome to plastic. That's benefit but the problem is is that lots of people. Even though having corvette at first right as I recall or maybe it was fiber. Daikin American main factor I think others can easily emulate and every time you turn around and a business. You're trying to increase you know this work processes a little better improve this Jig in a manufacturing process. Your code is a little bit better every place you turn there are millions and millions of them and then there are some that are material so they moved the needle from point of today but even so far more common but barriers are rare competitive You know one thing is I have my background. Says is as a Communist and by the background that makes you very respectful of the power of competition long term and so they're all people trying to emulate that and that's how progress takes place is that everybody does but if there's a barrier you get to keep a portion of that part that you can proved barriers are much rare. How early on you mentioned being in Silicon Valley? We're GONNA talk a lot about more established businesses too but the moment of inspiration and the vibe of Silicon Valley is also inspirational term product market fit. Which I think about as having nailed benefit if you've created something that people really want. How early on when you're advising earlier stage founders or thinking about strategy in early technology businesses? Do you think they need to start thinking about barriers because the product market fits all sort of about a benefit that that can be great in the early days but as you pointed out maybe not sustainable for long term competitive advantage? Are these things? Usually the barrier side with these early stage businesses is it usually accidental or intentional when founders create a barrier in your experience in terms of the question of when you should start thinking about these things. It's very important to realize that often when you start a business you just don't know whether you're GonNa power not you just don't know and yet if maybe a very reasonable bet to proceed knowing that an opportunity may arise so I give you an example of net flicks so they had this red envelope business which had his own lovers power which went to but they knew that ultimately this was going to be something that was over the Internet. That's why it's called Netflix. And warehouse and yet it wasn't evidence you know whether there would be any power there because if they just get content from everybody gets content and you buy it on firm basis than kind of anybody can do that. There's some technology involved but it's not you know. It's not that daunting and Amazon web services per you know serves netflixing. Some deals can use them as well and so on. But what did net flicks new? Did they say well? We're not GONNA do this until we have power no not at all. These formative moments are once with lots of options high uncertainty. And if you have the possibility of what food companies do is they put a toe in the water and and take a crack at it and then keep their eyes peeled for the possibility for power so net flicks started off with the distant. Well we're just GONNA give people streaming away for our red envelope customers so they did bad pretty lousy catalog amount water response. But then they they said well. Let's let's up the ante and gives them some good contact so they cut a deal with with stars which had really been content and then all of a sudden subscriptions just skyrocketed and they said wow? That's so people really liked this. But the problem with the star steel was was kind of a one off deal and starts didn't realize what they're giving away and so wasn't clear that this was a source of long term competitive advantage because the next time they want to stars like company they'd ask for the price than fully capitalized value. That netflix be receiving. Wouldn't be all track of and so then. The next phase was they actually deal with angers ethics and that unlike the THIRTY MILLION DOLLAR DEAL STARS. That was a one billion dollar. Feel sorry Oh and that was out of price. Were efforts knew exactly what they were selling. The these rights were valuable and it was an exclusive net flicks and so now all of a sudden they have paid a fixed price. Corey exclusive content. Which is fifty percent of their cost structure. Roughly so anybody else who wants to offer the same stuff doesn't pay per view basis for what have to pay a fixed price and has more streaming customers in the offer per customer is is of course diminished accordingly or. What a shows is that step by step? They worked their way into it. And that's more common but the key thing and this is what my books focused on. Is that along that process? You want to have in your mind the types of structures that might get you to a point where you have a barrier as well benefit and a barrier so that you have power and so my answer your question about when you start thinking about it is very early on you have this framework and you don't slavishly say I'm GonNa not do anything less as power you just constantly sorta check whether or not oh well you know we got on this path. That was kind of interesting so the conversations. I have with founders which are quite a few in Silicon Valley those kinds of conversations that we have. They're sort of thinking about this thinking about that. And and someone and that's the proper perspective is to be experimental but very thoughtful and if my concepts even help a smidgen in additional acuity in zeroing in on the right thing then my goal is accomplished. I would love to explore the powers taking them kind of turn by turn here and discussing what you think has changed about them over time since you originally conceived of them maybe what sorts of powers or most interesting for certain types of business. All ask a lot of questions around each. You've already mentioned this. This fascinating idea of you said step by step. I think about it as path dependency your path. You have to walk that relates an advantage over time because others have to walk a similar path. Brandon could be an interesting example of that like typically brands are built over time. Sometimes they're air-dropped in like dollar shave club or something but it's more common for them to be built through time and I love how you delineate in the book the concept of origination takeoff and stability as sort of different periods of how time interacts with the power. So I'm GONNA use that order to explore these things just for some sequencing and I thought we begin with origination. So the two that you've sort of shaded there's no absolutes here but the shaded and sort of the origination category are this idea of a cornered resource and this idea of counter positioning which of all the powers the counter positioning is the one that that certainly animates me. The most that I think is really unique and fascinating to consider. So maybe we could start there with counter-position can you describe what that power means and ways that you've seen it? Effectively applied so counter. Positioning is if a company originates a new business model and that there is a powerful incumbent with a different business model but the new business model is in some way superior which is to say that it gives you better cash flow than the other business model but for the incumbent to mimic that business model they would need to blow up or they think they would need to blow up their old business model and the pain of that is so great that they wait a long time so great examples. Hbo versus Netflix so Hbo yes hard. Remember back then but it was a much more successful much more visible company the net flicks very profitable at amazing series. Think of the Sopranos Revolutionize. Some television some ways and just a brilliant stuff and that's comes along But HBO's distributed through cable companies but Netflix. What's called over the top Tuesday go directly to consumers and so the issue for? Hbo was could they go over the top versus net flicks? But they're looking at all these very profitable contracts they have with their cable providers and they say wow we changed distribution. Those might be at risk. So we're looking at this uncertain upside versus absolutely terrible known downside. We can't go there. And so they wait and they wait and they wait and bit by bit net flicks just gained market share and pitcher. And get much sir. So that's the nature in and one of in one of the things that stimulated was as investor Dell on the nineties one of my best investments and they were going direct and compact and everybody else was going through channel like computer land and that kind of stuff and have these contracts and they didn't want to risk their distribution which was going famously for them and so they waited waited waited and adult tremendous advantage. About time you've mentioned some examples where I was trying to break things. Down into product and distribution as sort of key twin pillars of any business and business model counter positioning is quite clear to me in the distribution examples of different way of getting to your customer that by definition would hurt the incumbent if they tried to mimic it or cannibalize their business great examples there other examples that come to mind more on the product side of counter positioning definitely so. I know you're you're interested in software and I think it was arc. Andriessen famously said the software. It's the world. What a great statement Super Cycle. And if you think about what that means is that companies that used to be hardware oriented now are faced with competitors that are software oriented and I would say in many many of those cases there's counter positioning and the counter. Counter-position comes from the fact that changing company that's well established and large that's hardware based is extremely difficult to move over to software base not impossible but difficult so. I've also seen invest significant for me an apple and if you look at the iphone they were counter position versus Nokia for just those reasons and Nokia asus unbelievably successful company but it was a hardware company basically and they really good off supply chains and their engine teams and everything else and for them to. Germany was essentially a software product. Just they would've had different people in different people in charge different sensibilities different measures value and so very very difficult. So I think that's one that's rather commonly stays says that that hardware. He's of very difficult time. I'll always remember my conversation with Daniel accuse the person that introduced you and I this notion he had early on in spotify of the question was what could possibly be better than free you know. The incumbent was Napster and other companies. Like that like how could I possibly be that and realizing that it was a product innovation around speed of delivery and like having every song in the world in your pocket not limited by discs face or anything like that or by latency? I just think these these counter-position ideas are so fascinating. They are and as I said. They're they're very contrarian simpler used to these incredibly powerful and complex. I mean Nokia was thought thought it was being on sale of Monster Monsters. The negative term. I mean successful very attractive company. Yeah what are your thoughts on incumbents using this against on themselves so I've actually read all the Clayton Christianson ideas of disruption which some of this thinking brings to mind and sometimes companies successfully self disrupt. So how do you think that the incumbents who we've we've used as examples of losers in these stories so far could gainfully apply the counter positioning idea to themselves the nature of the barrier positioning? Which is to say why. A competitor hesitates from taking war on hers. Unable to on what in this case unwilling to is because of the damage to the old business model in the comments so they can't be counter position to themselves but what they are is they're threat and so the use of incumbents is to understand that the nature of the counter edition. They're facing and make a decision about whether they need to reinvent themselves whether they need to adopt this new business model and the reasoning be long-term reasoning behind that because it will inevitably involve a lot of pain by its very nature. And so give you a couple sample so again. Using Netflix stringing was reinventing their rob business and so they were forward thinking enough and understood. The I mean I is one of the most strategically astute. Ceo's I've ever with. He understood that they had to do that. And of course it was sort of in their DNA a little bit to begin with because it was called net flicks but even so they had a very successful business and they had disintermediated if you will and I think if you look at Disney. I'm also huge fan of vigers. I don't know but admire from afar. I think the heavy commitment they made to Disney plus shows what a bit strategic curious that he understood that that was something in the future and the theatrical presentation was not eventually the full picture so that so the key things there are strategic insight leadership ability and loneliness to drive it through an organization. Now sometimes it's just bridge too far. I mean for example. Some of these software cases getting there is just so hard that even if you have the intense. It's such a change. I mean if I think back of Sony Right now I think probably most of their profits comes from video games. I'm not sure that but doing video games almost didn't happen and it took an engineering guy who is crazy about it and some amazing leadership. Sony to actually get digital bill through an analog culture and if they had they would be much less attractive company today but it was extremely difficult. So you know one thing you learn when you study strategy long enough people really matter so you think about how strategy starts of starting by drives results creativity? Creativity comes from individuals and boyish leadership important in this kind of stuff. I mean that's real important second of the powers that is in the sort of origination category. Is this idea of a cornered resource. Which probably people intuitively will understand. But I'd love you to explain it in your context. Why accord resources so powerful or could be so powerful and whether or not they still really exist in the world. Today I won't go through all the exact conditions for something like that. Basically you have some desirable asset which you for some reason gotten at a price that doesn't fully reflect its value and it's so determined to the if another company got it they would also get this tremendous return so leaders usually aren't that it has to be a complete thing so so somebody like Steve. Jobs probably cornered resource. You drop him in a variety of types of businesses and this guy was so amazing that he probably would have made some but most leadership is dependent on the particular company. They're in and although there absolutely critical importance. They're not a complete answer to that problem. So one of course historical aspect of things like patents. So I think it's much rarer probably done two hundred led two hundred strategy cases maybe my students at Stanford have done one hundred you know and it's it's very rare to see corner resource as the driver but it does happen. One of my posits about Pixar is that actually if you would at their phenomenal string of successes. Movie successes in their first doesn't films. The BAT was a corner. Resource in the corner of resource was a very specific group of people that had been through the wars in doing toy story one and they both develop the chops for inmates films. But also this mutual respect and white working together and stimulate each other. And then if you look at their output of those films all of the first group of films came from that Group of people in the end. They're cornered because look probably weren't paid enough to capitalize fully the value their achieving so. I'm sure lots of these people got offers from other animated company. Ceo come work. Russell hitter Pixar special umbrella. Stay here but it's kind of rare and I think the patent side is rare. It's pretty rare for me to see a patent is big enough in walking enough. There's just a lot of different ways of doing things and one thing. You're observing right now. Of course there's a lot of machine learning AI. Stuff and I don't think I have ever seen an algorithm the defensible. You may be. There is one somewhere but it's a good starting place for product markets. It mean like a patriotic and Google or something but eventually there lots of math. You can do math a lot of different ways and programming a lot of different ways you know that. And so that's extremely rare and knowledge in general is more distributed now rather than less and so I would say that those things are are are rare. So I'd say today's world that's less common than it used to be. How would you think about Google in that context? Where originally pay rank was so much faster and superior but they've continued to enjoy. That seems like from the outside based on casual is a powerful position built mostly on search algorithm search function. Saudi think about Google in in the context of this. I'm not entirely sure. I'll give you a hypothesis but I'm not sure that's right. So the strength of their business depends on you and me choosing to search through them either directly or through android or chrome or something as opposed to using somebody else and then there's sort of a curiosity about which is that if you looked at sort of normal surveys of light being verses who will it seems about the same. There's not a lot of evidence that it's wildly superior surge so the question is kind of what's going on your argue. Maybe they of course they buy a lot of the search from apple for example that they then they purchase that circuits are the search results so fact that things about the same says that. I don't know if it's page rank what uses but it's seems more or less equivalent so the argument about who will say is that it's a network economy and I as I say I'm not. I'm not sure that's true. But the idea one thing that is surprising about search is the percentage of searches that are unique in other words. They just have not done before. And if you and then you can deduce from that that the percentage that are near your unique only been done two three four times. This is even higher so what that means is in the way Google. I think I'm no expert in this. But the way Google if satisfying results is if somebody has done a search like the one you request before when that search was done previously they track what that person then did once they got will search results. Bud Sings did they. Click on that information about exactly what it was. They were really looking for what results would be the most satisfying and if another person doesn't seem search that's what they feedback to so he does almost magically the. Oh my God knew what I was thinking about. And since there are many are nearly unique. It means the tail events matter. It means that for your sense of the efficacy of your search engine. If you do you know even ten percent of your searches unique for those unique searches. Google just seems a lot better and the network effect is when you do that search. That's near unique. That result is contributed to global and they are able to provide better value to me when I do that. Search and so you just get the sense that they're even though on engrossed terms and average searches. They're just no different that survey just US capture that. So that's that's a hypothesis but only one off thing I love it. I I've never heard Google's advantage articulated as a network effect before but it certainly seems plausible. And it's a unique take on a dominant business and it's a great excuse to talk about network economies. This is you know what am I personal obsessions starting with Brian? Arthur and so many great modern businesses that are built on top of network economies of Renault's facebook and other examples like it so we don't we don't need to hit the obvious examples of what this means but I would love to hear your nuances that Google example is Is a fantastic an interesting even zoom that? We're doing this on our sort of interesting unique examples of our economies what interests you most about this power and what are some unique ways that you've seen it applied will never work. Economies are really interesting for a couple of reasons. One is that if the business model that comes from is sufficiently Mon- Eisele. They are very intense there. If not winner take all businesses. Their dominance and Berry returns is active prospect the other aspect of course from investment perspective is that when they first start they look unattractive from a piano because there are not enough network affects to generate enough value charge enough to make the bottom line. Look good right so you get something. That ultimately is very attractive but looks bad to begin with insights that spells a good investment in very interesting business. But there's a cautionary tale here. Which is that the prevalence of network effects that then are sufficient to get to network power. Which means they're sufficiently monetize. -Able is much less than people. Think I think so. I mean if I had a nickel for every time somebody said to me. Well you know I get more data than that tells me more about customers now allows me to improve my product in that allows me to get work customers which just be more data and Blah Blah Blah and therefore some so. I hear that you know. And in most cases it's not strategic there might be a modest network affect involved it doesn't get to materiality so it's not power so why you know you've talked about benefit and barrier in early on as are the sufficient necessary conditions for power there's another way to Parse that which I use sometimes which is other three SS which is spirit already significance in sustainability and that maps one to one event and various just benefits broken up into superior and significant and the reason that's useful in discussions is it breaks out explicitly materiality significance and so. I'd say you have to be very very careful. For example a so the jury is still out on snapchat whether or not what they do. I think the the defensible part of their business. They're disappearing photos and stuff. Is it sufficiently monetize? -able to be attractive. Overall number power is unattractive overall business position. Which is the the the discounted cash flow going forward far more than offsets. All the money that went into a thing in the first place is not just seeking a businesses that have no power that continue on a long time but their housing brother investment perspective starting out because they don't justify initial investment. But you're going for time and I think their stories snap stories stuff woods lest I think you know instagram. No after that pretty hard. So they're really interesting. The other thing I'd say about them is that they are incredibly complicated. That when we look at strive to Kaplan what network affect the first thing we do try to all the flow chart of exactly. What's going on? Because there are all kinds of symmetry and subtleties that go on in in network effects and network affects often happened for multisided platforms right and so. Just beware of the subtleties. But if you can find one does clear all that stuff than than they're they're really interesting and and and turn out to be amazing businesses like baseball. What are some examples of those subtleties? That might disqualify. What looks like a network effect but may not be one of the big ones. What are some common things that you see that disqualify? I'd say an important one is non linear already of the benefit and this happens a lot and data stuff is that as you get more data you would hope that there some benefit so maybe it's better customer awareness or even lower your costs or something that often that's a non year relationship and what happens. Is that as it scales. The additional incremental benefit becomes less and less and eventually gets that crocus rather flat and if there are enough competitor occurs that are in that flat zone. It means that doesn't make any difference. And so so I would say that he might get mad at me if I said this but I would say. For example Net flicks recommendation. Engine is like that that it's terrific. They rightfully spend a huge amount on getting just right and pleasing us. They should be doing that but it is probably not strategic in other words. I probably wouldn't choose Netflix Amazon crime because of Netflix recommendation. Engine and Netflix is unbelievably sophisticated about I mean as you probably even have this net flicks prize which you know people look at. You know that results from our extremely interesting and inside but it's an operational excellence thing that they have to do but a mimic of is good enough so it is no longer accusing. The next two powers are maybe the most traditionally cited ones that you see in strategy books or are in strategic thinking which are scale economies and switching costs. We've talked a bit about scale economies already. This notion of being the spread. Your fixed costs across a a higher volume of customers. And you can't just airdrop in huge fixed cost investment. That's a hard thing to do any other nuance there that you think listeners. And strategic people running businesses or strategic thinker should consider in scale economies other than the obvious of it would be great to have one ochre all perspective on all. This stuff of is actually correct cleaned. The terminating the opportunity for power is complex and one earners bill. Mitchell's made the comment. That the nice thing about some powers is that it turns a essay question into multiple choice question which is very powerful. But there's tremendous granularity in these types of power. I mean if I'm looking at an existing business with my team and one that's been out there for a while as we over companies it will take us weeks for work to make that determination. That's not an you. Just look at you say and so just on scale economies there lots of different flavors. I mean the one is the fixed cost component and an often things seem fixed. But they're not really to. You have to go through that. But then there are other flavors a upscale economies so for example physical geographical scaled density. So if you looked at Uber for example and wanted to know if they had power the question the there source of economic strength wants to once you get a network populated users drivers is the density in an area of population which which then translates into how quickly and get a ride but the problem of course with that is is that that also is a flattening for like a mention who are and so past a certain point if there is another competitor in the same ball art not as large the large enough than the difference in ride up time is not that significant but that one is driven by a regional physical scale economy so it would apply to the bay area but being good at bury it tells you nothing about how good you are at London. So there's geographically constrained a one that's based on that kind of destined than in heavy duty manufacturing chemicals and stuff there things have to do with volume production equipment volume relationships of you have dairy farms. I'm from Vermont so scenario I know well more thousand people if you look at both milk tanks. What you'll see is that the cost per gallon of tanks dramatically drops as you in in them because there's an area between train costs and that stroke warehouse stop was well. What about this notion of learning economy? So you talked a lot about technology. Businesses physical asset light businesses as great examples of companies in the modern sphere. That have power. Do you think about the return on learning. And whether or not that might accrue larger players versus upstarts. We all hope to be learning all the time and so. That's the benefit if you learn something you can do better and so there's Douglas of the benefits there and so the question is for it to be power is it has to be material. And they're probably thinks that cheered accessibility to the kneel but more important there has to be a barrier. So that's all the question about learning economies is what is the barrier and the barrier for me to think of it you know strategic. It probably has to be at least five years and that's rare because people can change jobs. There's things that are published. I say competitive arbitrage are people always looking to improve and and they're looking at what other people are doing and making it and so learning is essential art of operational excellence. But it's rarely strategic. What do you think about the notion of switching costs and the ways in which someone can be intentional about those things so maybe give us an example of what you think is an incredibly powerful example of switching cost in a in a modern business but also whether or not you think a leader can intentionally insert that into their product or service? The example I give my book is paid knowledge Oracle Their software product is so entrenched in every aspect of your business the ripping it out and replacing his chest so painful I made is what makes you cry. The no matter how good you are no out careful just ankle and so very high switching costs and so I would say it's very very rare to be able to once you have a business and running to then introduce switching costs because what happens. Is that customers. That point are smart and they realized you know what you're up to for them to go into that relationship fell or more to the point competitive arbitrage works like this. Is that every business who then tries to do that? Will then understand the with the switching costs. There is a payoff. The payoff for sidearm. Certain causes you can charge more. Trust the differential that is less than that extra pain of switching and they'll start to try and acquire customers and they'll offer discounts and FREEBIES DISCARD. And all this stuff and that will arbitrage out the cash flow stream that comes from it and so it's very clauses over time so it's hard to establish it after the fact and so that's why usually switching costs businesses. You need to get the customers during the takeoff face. When things are growing so rapidly that customers are just worried about. Can they get the product and they're not worried about all the things associated with switching costs so value Out in the price so perhaps way to think about switching costs would be you can get them eventually by being a part of someone that's going through a paradigm shift so when someone adopted Oracle or sap or an earpiece system long ago that was a whole new thing but then there's not a whole new thing to replay if there's not a whole new thing to replace the AARP that's ten x better. No one's going to do it so it's a fulcrum thing. Yes thank God oracle and sap competing for customer. There are well aware of so Oracle's trying to take a customer away from the realize that that's a hurdle and so so young in early phase people just wanted to get the product and they're not too concerned about. I mean you know it's this will be a but but when I got my first I thought I didn't really worry about apple's proprietary song format but guess what if I tried to take those songs and put them on another device they disappeared fascinating the last two powers that are in the time phase. You call stability of business process power and branding. Everyone's going to know what a brand means my favorite example that somebody sent me in anticipation of this call. Was that to buy a tiffany box and bag and little tissue was two hundred fifty dollars with nothing in it which is like the ultimate branding example. But tell me a little bit how you think about branding. Especially in. How companies intentionally invest in their brand at the mature stage. Yes so the first thing I just want to point out is that brandy as power is a far narrower concept than brand awareness and brand laurence's useful when important but you could buy a super bowl ad. Patrick Shaughnessy in. You would probably out brand awareness. But you would have paid for it. So it's fully arbitrage Dow and guess what somebody else could do the same thing and so you can buy brand awareness but branding is power. Is that over a long period of time. You establish an understanding amongst potential customers that either while understand. He's probably incorrect. Working sounds to rational that you establish a position with customers so either they feel really good about it. So I'd say iphones branding. In the United States that there are many segments of their customers that would prefer to be seen with an iphone as opposed to an ANDROID PHONE. Even though they're functionally equivalent and so it gives them a good feeling some way or impresses people or whatever the reason that and so they're objectively identical but perceived as higher value. The other one is that you get a reputation that assures customers and reduces their uncertainties so Bayer Aspirin fuel look it up in Amazon. Still CHARGES ON AWFUL LOT. More may only be sense but as a percentage of an awful lot more than a generic brand and people willing to pay often because they say all bear you know. I I know that that is. It's an uncertain direction. But to have that embedded in your custom and takes a long on courage and people have to invest in it so of Air Maze Bag. You know they've been around for you know hundred more years and you have to be very thoughtful about how you develop a brand and it's not easy you can make wrong creative choices. It's IT'S A it's creative exercise and it cannot go well for you make choices to hurt your brand. And there's always this tradeoff of course between were branded. Good off most of the time between volume if it's something where there's exclusivity involved you're all tempted to well. You know. Should I go for this higher volume segment but then if you know if you do that you may pollute your brand in terms of people? Think you know it's not all extraordinary and more told destroyed before but I have in my liquor. Chapman home a bottle of Air Mace Cognac. And a friend of mine was one of the air. Mace family there in he was had its commission the US and he and he brought over for dinner one and try to go into Cognac and they failed and so rare that doesn't available anymore and air macy's incredibly carful brand but didn't extend into Cognac. That didn't work and so those issues about what's covered by brand. What do you do to maintain it? Obviously if you're thinking of something remains you know who you pick as your lead designer and how that goes forward which celebrities you in ball curate that Israel difficult to manage important business decisions and and that's what builds it over time and the the key issue here is that for to power. It has to be something that isn't easily emulated. So the reason that is not easily undulated is takes a long time for those kinds of understandings to be embedded in potential customers. If it could happen quickly others can go up power. I love the distinction between awareness and power as it pertains to brand the final power is process power. Which again I think requires a pretty settled description. Sort of counter positioning may be as an obvious. What exactly process power in business. Let me describe it for us and also distinguish how it differs from scale economies process. Power comes from if a company has a process that is highly complex. That over time the incrementally step by step by step by step improve it in a way that the outcome is material and the so complex. That exactly what they did is either unknown. The company itself may not even be able to articulate it or if not unknown at least opaque in one way or another and the only way they got there. This comes back to sort of your bath. And the only way they got there is this process of step by step by step by step doing it and it can't be emulated by hiring a bunch of people from the company or something like that so it has to be something very very complex and so it's very rare so most of the time in process improvements can be emulated in a reasonable amount of time and they're all kinds of consulting firms to help you do that when you think of just best practices stuff that's eliminating process and it's good for the country. Maybe not miserable for the leader. But it's good for or the the world And so it's it's very rare. The example from the book is the Toyota Production System and that took a long long long time to develop and they were sort of open about it. They let other people toward their plants. And so on but emulating. It meant a step by step by step in. The manufacturing process change in automobile manufacturing is really complicated and so and so it was very very hard to do. But it's really rare for things to be that complicated that you can't hire. Some people are insulting firm and within two or three years to get up to speed on. So it's it's extremely off having now explored the powers to ask some more general questions. About how all these things manifest in businesses and become apparent to those looking for the power first of which is the notion of the time lag between our cash flow so I think looking backwards. In hindsight you could probably say companies that have high sustained. Ric's or something with a lot of positive free cash flow. There must be some power there. That's generating that. But what do you think about prospectively thinking about the time lag between establishment of a good strategy in overpower and the realization of cash? Lower Freak actual going back to you alluded earlier to our progression which sort of divided up when each type our would be first available over the life cycle of the business and the Middle Group which does take off with three types of power scale economies switching costs network economies and those are what are additive types power. They they depend on the number of customers that you have in scale economies is relative number now works. It's absolute number so the key strategic thing in those businesses is scaling really rapidly. It's getting those customers. That's the key. Strategic thing so if you look back the metric that will tell you whether you're doing is how scaled either relatively you're absolutely and if you get a customer that customer by being in your portfolio adds value and so so it's awesome makes sense in those businesses to acquire customers in a way that at first is not profitable. You might give away stuff for free or you might subsidize them or just price it lower than you would otherwise and so. It's quite possible that you might run ugly. Pnl and the trick here is that there are lots of businesses that do that. Don't have power and you get to the end game and the emperor has no clothes and you go. Oh my you know and early on in my work. This phenomenon was so obvious or so so frequent that I actually named for recycled products. Power later realized. It wasn't power of student last long which is very fast growing market. The FUNDAMENTAL DIFFERENCES IN COMPANY. A and company B's economics aren't yet expressed yet in that PNL's because Peop- Lord pricing you know there's all different segments in different prices and it really not meeting your competitor on yet at arbitrage and so it's later on these things get settled down. So you can. You can actually have a very unattractive and end up with nothing or it can go the other way till you find story. I came out to California before my business out here that just a network and I met with the founder of what was then an early. Pc company that was growing at phenomenal clips and they were actually cash positive and I toured the plan with founder and he was rightfully very proud of what was going on. And they just got gotten this big contract with sears distribution and things were looking really rosie. I got into his office and I said Will Roger. Thanks so much as terrific. What's your thoughts on when you hit a Shakeout? And he almost threw me out of my office As office he's easing shakeout. Sort a muttered you know. And it's not gonNA happen ever and that was the case where there's absolutely no power. But actually they're pl with good because arbitrage hadn't really said end people were just if I can get a PC. I'm happy pay whatever and so the difference is if you have a PC and and you know even IBM with amazing IBM PC roll wasn't immune to this. In the end they ended up being an unattractive doesn't because they give away the notes power of CPU in the operating system. Why do you think so? Much of the apparent power has concentrated today in technology business alison the term technology. Businesses is a misnomer because if you went back to nineteen twenty four was technology business consolidated. Edison was technology business. Nano Monsanto Chemical Technology Business Nineteen fifty all at saying is that the technology frontier is constantly moving forward in that is the ECZEMA driver of opportunity. Influx yeah there may be demographic changes in the snap but that stuff slow is technology is really driving it and so when something new happens that presents an opportunity and new usually almost always means as technology. What happens is that then? Somebody figures out how to capitalize on that that looks like the tractor business that displaces the old model they call it a technology business until later on it gets Reclassified so I think Netflix was originally technology. Business Announced Entertainment Business Amazon. Probably Technology business now. It's retail business and so it's saying that technology firms have more powers just simply acknowledgement that the firms that replaced the old ones are replacing them for a reason. Which is they're better business models. Do you think that power is inherently bad for customers because companies are generating outside returns? They're keeping them by definition. You know the customer may be paying more than the value that they're getting. It's an important question and as an economist is important policy question so I think there's a static answer name against a static cancer. Is You sort of look at say? Well Gee if you take this point in time and you took this amount that they put was getting an extra returns returned to customers. You know maybe that would somehow improve the world but the dynamic thing is that it has the potential to have differential returns to have an attractive business. The causes the investment to happen in the first place if there weren't the prospect of potential returns to industry without exists period. And so so you need that the central to drive that and then if you think about the welfare aspect of what's happening over time remember it's a benefit and a barrier so the benefit means that. Actually you are doing something better to late and power just simply means that you get to keep part of that. Not all of it or else won't be attractive to other people but but you get to keep part of it so I think from the long-term vitality economy that being able to hope for that is a good thing and of course the US as any crisslow does it is appropriate for us to prevent a piece of that now. But you wouldn't want to prevent the actual of our. Would you think that it's fair to say that though you've reduced at NASA question to multiple choice question that still the creation of those powers is more of an art form than science and initially do agree? You're the best artists that you've ever seen. The starting for strategy in starting place for powers is creativity period. And so that's how you define an art form. I completely to any attempts to try to convince on the. This is something that you can deduce logically is in my view completely mistaken so it involves invention discovery so people that I think are really great. I mean I I mentioned before releasing says Mason that even corrective me I remember is one is working on my book. I was thinking of very subtitles and at one point I was thinking about using them as a subtitle. Something about agile strategies or no nimble strategy. That was sort of like edge. All that sounded catchy and south the web address for for strategy and he said Hamilton's completely wrong. It's a nimble implies you're constantly sort of moving space to face strategy is something you've developed over a long period of time you know and these sort of refinements and changes in the Sanath but it's sort of a spillover of creative effort over long time and he was right closing question for. Everybody has to ask you for the kindest thing that anyone's ever done you. There's so many people that have been instrumental in sort of my life. Let's say one that stands out. I don't know if it's the the kindest but I remember. When I was in Grad School I went through sort of A. I don't know if you'd call existential crisis but I I went into economics in Grad School. Just because the subject you know which is a good motivation long-term but but I had the idea of what it meant to be. An economist. Never remain really occurred to me. You know it was about a career and then as I got into it you know I sort of had to think about those things and then I also was doing some early stage business stuff with my brother. Eye Wife's quip about that period was today. We would call this a underpricing back. Then you just all the failure and so it was. It was a hard period for me and I sort of had to do eventually sort of had to do kind of full stop and just I just essentially stopped bread. I got through my comprehensive exams. Itchy to sorta stopped and did other things and really couldn't get any any real traction and looking for my thesis and then and then after about two or three years that I finally I finally got the point where I said okay. You know it's it's time you know if I'm going to do this. I should really do it and I had a dear friends on mentor. Yale by them. Built Parker who one of the most prominent economic historians in the world and credibly warm-hearted. Caring Person Aside for being just brilliant and you know when I came back to him. I said Bill. I've got to get back to this. I'm I'm just going to I. I'm going to start over and start from scratch like you to share. My Thesis Committee will start over and he said fine and of supported me all the way actually finishing. Isa's probably the hardest thing I've ever done even hard. Starting a business and his unwavering support in good humor during that process was just instrumental and not done that. You know my life would have been different so it was really important fantastic. Well I love the answer I I. It's my favorite question every time and in your case you know I think I it your worker flex what I am trying to do which is just to get ideas useful ideas out into the world. I really appreciate the book. I appreciate your willingness to share what you've learned with people Please know that it does. It does help us out here trying to build businesses and do it in a smart way. So thank you for the book and thank you for all your time today. Oh Yeah my Patrick. Thank you so much enjoyed this. Everyone Patrick you. Again to find more episodes of invest like the best to investor field guide dot com forward slash podcast. If you're a book lover you can also sign up for my book. Club INVESTOR FIELD GUIDE DOT COM Slash Book Club after you sign up to receive a full investor curriculum right away and then three to four suggestions of new books every off you can also follow me on twitter at Patrick Underscore Osieck S. H. G. If you enjoy the show please leave a quick review for us on itunes which will help more people discover invest like the best. Thanks so much for listening.

Coming up next