To have any hope of delivering above average returns, a company must be able to answer one very critical question: What is our competitive advantage? What do we do better than the competition that will allow us to deliver superior returns? You simply cannot deliver returns that are above average by doing things in an average way.
Michael Porter, a Harvard Business School professor, wrote in his book Competitive Advantage, "Though a firm can have a myriad of strengths and weaknesses vis-à-vis its competitors, there are only two basic types of competitive advantage a firm can possess: low cost or differentiation." To achieve above average performance a business must either have a cost structure that is significantly lower than that of its competitors or it must offer a product/service package that is different than that offered by others.
AMF manufactured the equipment used to operate bowling centers. There was only one meaningful competitor, Brunswick. Both companies were unionized and had approximately the same cost structure. There was no meaningful difference between the products of the two companies and pricing was similar. Each enjoyed a similar share of the market. Both businesses had about $500 million in annual revenue. Each of the companies was profitable, but neither delivered remarkable returns.
Then, AMF was purchased by an aggressive entrepreneur named Bill Goodwin. After negotiations with the union broke down, the manufacturing facility in Ohio was closed. AMF opened a new plant in the suburbs of Richmond, Virginia, but the company was no longer unionized. Almost overnight,AMF's cost structure was more than 20 percent less than that of its only competitor. Rather than reducing price, senior management decided to let the benefit of its newly found competitive advantage flow directly to the bottom line. For the next decade the owner pulled well in excess of $100 million of cash out of the business each year. A competitive advantage based on a lower cost structure can be a very powerful thing.
Like most local or regional banks, Signet had a small credit card business. In the early 90s the interest rate on essentially all credit cards in this country was the same, 18.9%. When two ex-consultants, Rich Fairbank and Nigel Morris, took over Signet's credit card operation, they made a very insightful observation about the market. There were a large numbers of customers revolving balances at 18.9% that were actually quite low risk. While an 18.9% interest rate may have been necessary to run a profitable credit card operation on average, there was a segment that could be served very profitably at rates well below this.
Rich, Nigel, and their team invented the balance transfer and targeted the low risk segment with a differentiated product; one that had an interest rate of only 14.9%. Even at this lower rate, the low risk segment could be served quite profitably. The result was what Nigel Morris called a "Balance vacuum cleaner." The assets of Signet's small credit operation began to grow exponentially. The division was spun off and Capital One was born. While there is certainly more to the story, the insight to offer a differentiated product to a specific market segment led directly to the creation of one of the largest financial institutions in the world. What's your competitive advantage? Why will customers buy your product or service rather than the offerings of your competitors? It's a simple question, but often one where the answer isn't immediately obvious. We've seen the bottom line of many businesses explode when this question was answered correctly. Getting this right can be hard work, but it's worth the effort.