Transcript lecture 1 - Vanderbilt University

Any Questions from Last
Class?
Chapter 9
How to Keep Profit from
Eroding
COPYRIGHT © 2008
Thomson South-Western, a part of The Thomson Corporation. Thomson,
the Star logo, and South-Western are trademarks used herein under
license.
Chapter 9 – Take Aways

A competitive firm can earn positive or negative profit in the short run
until entry or exit occurs. In the long run, competitive firms are
condemned to earn only an average rate of return.
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Profit exhibits what is called mean reversion, or ‘‘regression toward the
mean.’’
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If an asset is mobile, then in equilibrium, the asset will be indifferent
about where it is used (i.e., it will make the same profit no matter where
it goes). This implies that unattractive jobs will pay compensating wage
differentials, and risky investments will pay compensating risk
differentials (or a risk premium).

The difference between stock and bond yields exhibits mean reversion;
this difference is a useful indicator of whether the market is overvalued.
Chapter 9 – Take Aways

Monopoly firms can earn positive profit for a longer period of time, but entry and
imitation eventually erode their profit as well.

The industrial organization economics (IO) perspective assumes that the
industry structure is the most important determinant of long-run profitability.

According to the resource-based view (RBV), individual firms may exhibit
sustained performance advantages owing to their superior resources. To be the
source of sustainable competitive advantage, those resources should be
valuable, rare, and difficult to imitate/substitute.

Strategy is the art of matching the resources and capabilities of a firm to the
opportunities and risks in its external environment for the purpose of developing
a sustainable competitive advantage.

To stay one step ahead of the forces of competition, a firm can adopt one of
three strategies: cost reduction, product differentiation, or reduction in the
intensity of competition.
Review of Chapter 8
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Demand describes buyer behavior
Supply describes seller behavior in a competitive
market
Increase in “quantity demanded” vs. “increase in
demand”
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“Movement along” vs. “shift of”
Equilibrium price: Qs=Qd
Market making is costly
Effects of devaluations
Explaining changes with shifts in supply and
demand curves
Introductory Anecdote: Oakland A’s
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Oakland A’s won the American League West in
2002, 2003, and 2004 with one of the lowest
payrolls in baseball
The team relied on statistical analysis to analyze
performance
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Found that on-base percentage and slugging percentage
were best performance predictors
But, other teams did not seem to recognize value of onbase percentage
They created an advantage by buying players with
higher on-base percentages at prices lower than
“true” value to team
Unfortunately, the advantage did not last long
Sustainable Competitive Advantage
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Warren Buffett’s most important investment
criterion: “sustainable competitive advantage"
SCA creates a “moat” around the company helping
protect its profits from the forces of competition
A company's prosperity is driven by how powerful
and enduring its competitive advantages are
Stock price = discounted flow of future profits

Challenge: keep profits from eroding
Competitive Forces Erode Profits

Definition: A competitive firm is one that
cannot affect price.
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close substitutes  elastic demand
many rivals and no cost advantage
no barriers to entry
Proposition: In equilibrium, capital is
indifferent between entering this industry or
any other, and P=AC.
Competitive Firms
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Cannot affect price; chooses how much to produce
Can sell all it wants at the competitive price, so the
marginal revenue of another unit is equal to the
price.
Price equals marginal revenue, so if MC<P, produce
more and if MC>P, produce less
Perfect competition is a theoretical benchmark
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But, many industries come close
And, the benchmark is valuable to expose the forces that
move prices and firm profit in the long run
Competitive Firms (cont.)
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A competitive firm can earn positive or
negative profit in the short-run only
Positive profit leads to industry entry driving
profit back down
Negative profit leads to industry exit allowing
profits to rise
In the long-run, competitive firms are
condemned to earn only an average rate of
return
“Mean Reversion” of Profits
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Asset flows force price to average cost, e.g.
economic profits will always revert back to
zero.
Silver lining to dark cloud
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Discussion: If profits recover, what does this say
about EVA® adoption?
Reversion speed is 38% per year.
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if profits are 20% above the mean one year, in the
next year they will be only 12.4% above the mean,
on average.
Mean Reversion of Profits
40
ROI%
30
20
10
0
1
2
3
4
5
6
Year
7
8
9
10
Indifference Principle
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Proposition: In equilibrium, a mobile asset
will be indifferent about where it is used.
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Discussion: Suppose that San Diego is a lot
more attractive than Nashville.
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Discussion: Michael Porter has tried to
convince businesses to re-locate in the inner
city.
Compensating Wage Differentials
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Discussion: Why do embalmers make more
than rehabilitation counselors?
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Discussion: Give example of a compensating
wage differential.
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Is there a compensating marriage differential?
Finance: Risk vs. Return
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Proposition: In equilibrium, differences in the
rate of return reflect differences in the
riskiness of the investment, e.g. risk premium
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return = (Pt+1-Pt)/Pt
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Risk premium on stocks analogous to
compensating wage differential
Earnings “Yields” Must Compete with
Bond Rates
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The yield on stocks (i.e. the E-P ratio)
must compete with the bond yield.

“mean reversion” of difference
Spread
16%
Earnings/Price Ratio
10-Year Bond Rate
14%
average spread
12%
10%
8%
6%
4%
2%
0%
1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000
Can you Use This to Predict Stock
Prices?
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Would have missed big structural change in 1980
Discussion: Why did risk premium on stocks fall?
Spread
Earnings/Price Ratio
10-Year Bond
20%
15%
10%
5%
0%
-5%
-10%
-15%
1871
1891
1911
1931
1951
1971
1991
Monopoly (Different Story, Same
Ending)
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Definition: A monopoly firm is one that faces a
downward sloping demand curve.
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They produce a product or service with no close
substitutes;
They have no rivals; and
There are barriers to entry, so no other firms can enter the
industry.
Proposition: In the very long run, monopoly profits
are driven to zero by the same competitive forces.
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Example: 1983 Macintosh
Strategy – Trying to Slow Erosion
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What is the key to competitive advantage and positive
economic profit?
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Two schools of thought
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Industrial organization economics – industry is the key!
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Resource-based view – firm resources are the key!
IO View of Strategy
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Industry is the key issue – focus on the
external environment
Industry structure determines the conduct of
firms, which in turn determines their
performance.
Typical structural characteristics that are of
interest to IO researchers include barriers to
entry, product differentiation among firms,
and the number and size distribution of firms.
IO View of Strategy (cont.)
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The key to generating economic profit for a business
is its selection of industry. According to the Five
Forces model of Michael Porter, the best industries
are characterized by:
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High barriers to entry
Low buyer power
Low supplier power
Low threat from substitutes
Low levels of rivalry between existing firms
So, the advice is to pick a good industry and work to
make it even more attractive
Support for the IO View
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Profitability differences do exist across
industries
Airlines
Motor vehicles
Cable TV service
Computer system design
Engineering services
Trucking except local
Race track operations
Petroleum / natural gas
Drug stores
Eating places
Dental equipment
Women's clothing stores
Semiconductors
Prepackaged software
Pharmaceuticals
0.00%
5.00%
10.00%
15.00%
20.00%
25.00%
The Resource-Based View
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According to the resource-based view,
individual firms may exhibit sustained
performance advantages due to the superiority
of their resources (internal focus)
Resources are defined as “the tangible and
intangible assets firms use to conceive of and
implement their strategies”
If a resource is both valuable and rare, it can
lead to at least a temporary competitive
advantage over rivals.
The Resource-Based View (cont.)
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Resources that may generate temporary
competitive advantage do not necessarily lead
to a sustainable competitive advantage.
 SCA requires that resources must be difficult
to imitate or substitute for
So from the resource based view perspective,
resources and capabilities that are valuable,
relatively rare, and difficult to successfully
imitate/substitute are at the core of sustained,
excellent firm performance.
Generic Strategies
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Reduce costs
Reduce intensity of competition
Differentiate product
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Example: Frank Purdue
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Example: Prelude Lobster
Alternate Intro Anecdote
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In 1924, Kleenex tissue was invented as a means to
remove cold cream.
After studying customer usage habits, however, the
manufacturer (Kimberly-Clark) realized that many
customers were using the product as a disposable
handkerchief. The company switched its advertising
focus, and sales more than doubled.
Kimberly-Clark built a leadership position by creating
an innovative use for a relatively common product.
Alternate Intro Anecdote (cont.)
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As others saw the profits, however, they moved into the
market.
The managers of the company maintained profitability through
a continuing stream of innovations and investment in
advertising/promotion
 Printed tissue in the 1930’s
 Eyeglass tissue in the 1940’s
 Space-saving packaging in the 1960’s
 Lotion-filled tissue in the 1980’s.
Without this continuing stream of innovations and brand
support, the product’s profits would have been slowly eroded
away by the forces of competition.