A 40-Year Debate Over Corporate Strategy Gets Revived by Elon Musk and Warren Buffett
Basically the debate is between “moats” and “innovation”:
When Tesla CEO Elon Musk said that “moats are lame” during the company’s earnings call last week, he was calling out Warren Buffett, the chair of Berkshire Hathaway, who uses “moat” to describe barriers to imitation that stave off competition. “If your only defense against invading armies is a moat, you will not last long,” Musk continued. “What matters is the pace of innovation — that is the fundamental determinant of competitiveness.”
But what if they’re both right?
Take the notion of a “moat”:
Buffett’s notion of moats that prevent competition is nearly as old as the field of strategy itself.
There are three fundamental ways you can build a “moat” in business:
First, you can have a competitive advantage codified in law. Meaning you can create regulatory barriers to entry which make it impossible for competitors to catch up with you.
This method may help guarantee future results–but it has the problem of companies becoming lazy and sclerotic. Middle managers have no incentive to improve and streamline their departments so long as they don’t exceed their budgets, but they do have the incentive to enlarge their departments with extra bloat as the status of middle management is proportional to salary and the size of their department. Budgets eventually bloat to spend the guaranteed profits–and the company is left incredibly inept and unable to innovate (since innovation is risky to profits) and, the moment a whiff of competition appears on the horizon (as competitors figure out how to get around the regulatory barriers), large sclerotic companies fold like a house of cards. And sometimes so quickly it can leave us in shock.
Second, you can enter a field where there is a natural monopoly. Think about social media companies like Facebook, whose economic strength is proportional (rather than inversely proportional) to audience size. Those monopolies can be fickle, however; just see how quickly Facebook’s competitors unraveled as tastes changed.
Third, you can innovate your “moat.”
Look, for example, at Walmart. There is nothing Walmart is doing that couldn’t have been done by Sears, Target, Costco, Dillards, Dollar General, J.C. Penneys or a half dozen other large competitors. That it was done by Walmart was a result of Walmart innovation in the supply chain: streamlining supply to help lower prices to gain audience share, streamlining all the way down to the manufacturer.
But there is nothing Walmart is doing that other companies could not do. There are no regulatory barriers which prevent (for example) J.C. Penneys from doing what Walmart has done: improve internal distribution using just-in-time logistics in order to minimize warehousing costs, and dynamically updating prices as supply prices change.
And in fact, many companies are making serious inroads into Walmart’s market. Further, Walmart’s biggest competitor is Amazon–which is attempting to make the overall process of buying goods as painless as possible. Walmart has found itself in the interesting position of having to sink a small fortune into online e-commerce–and those spending pressures are putting significant pressure on Walmart’s bottom line as they have to catch up with Amazon, a company that has had over 20 years to innovate.
But then, Amazon is in the interesting position of trying to compete with physical brick-and-mortar retail–and Amazon has found itself in the position of having to innovate in an area where Walmart has nearly 50 years of experience.
Perhaps the strategist Musk most sounds like is Columbia’s Rita Gunther McGrath, who in 2013 wrote a book titled The End of Competitive Advantage. McGrath put forward two main ideas: First, companies should give up on the idea of sustainable competitive advantage and admit that any advantage is transient. Second, strategy and innovation are best thought of in conjunction. “The assumption of sustainable advantage creates a bias toward stability that can be deadly,” she writes. Musk couldn’t have tweeted it better.
One of the advantages of innovation is that even when the answers seem apparent to your competitors, a lot of “innovation” really involves “learning from your mistakes”–and that process (ironing out the glitches) can take years.
Elon Musk is learning this lesson the hard way at Tesla, a brand new car company attempting to out-car-comapny the likes of General Motors or Ford, each who have nearly 100 years of experience building cars. And a lot of the things Tesla is ironing out revolve around manufacturing: around figuring out how to mass produce cars, then to improve the production of those cars. (Tesla has confessed to problems in this area, for example, by overly relying on automation without understanding internal manufacturing processes.)
This “learning from your mistakes” happen even with the smallest companies–and is one reason why common wisdom is that you won’t reach profitability until after running your business for three years. Even with something as simple as a flower shop, it takes three years to learn the best places to buy flowers, to store them, what flowers will sell at what time of the year, how to hire the right people and retain the right talent, how to integrate with on-line retailers, how to advertise and the right times to run sales and the right times to raise your prices. And that doesn’t even cover the dozens or hundreds of little issues that come up–ranging from where to buy sales slips and how to accept credit cards to dealing with the thermostat in your refrigerators.
Now if a company has a culture of innovation, even as other companies catch up, you can continue to outpace those other companies. Apple’s new iPhone X form factor, for example, works better than other Android devices made by third party companies which use a similar notch because they have had more time to consider the unusual screen shape. And it has taken at least a year for Android device makers to figure out how to handle the notch; early phones simply displayed a rectangular display with missing pixels.
Meanwhile Apple is spending a lot of time where Tim Cook is most comfortable: streamlining the entire supply chain.
The most interesting part about innovation is that a country’s wealth is proportional to its knowledge.
In a country with no knowledge, the most you can do with a pile of pure sand is to perhaps build a cat litter box. A little knowledge and you may learn adding sand to an adhesive (such as powdered calcium oxide mixed with water) makes a good concrete.
But in a country with a lot of knowledge, instead of using it to make sand boxes or cement, you can make microprocessors which drive an iPad.
Innovation allows us to know how to add value and grow wealth by turning wheat, apples and sugar into an apple pie. Innovation allows us to know how to extract granulated sugar from beats. Innovation allows us to know how to weave cloth–and to build machines which can weave cloth, so we can have cheap clothing. And innovation allows us to know how to make the jigs and machines which cut and shape the components we take for granted–to build houses and cars and pour asphalt and make pencils and build a modern society.
Innovation, in other words, makes wealth. Not money, not property, not material possessions–but innovation.
And a culture of innovation allows companies to both understand their customers and sell them a better product (such as the iPhone; the original version was a sad little toy compared to today’s models), as well as building a world with more wealth than before.
Innovation is why the United States is the wealthiest nation per capita on Earth. And innovation will make us even wealthier.
The problem with Warren Buffet’s “moats” is that, if done wrong, they can lead to stagnation, bloat and eventual economic failure. It’s why its important to allow innovation–and to allow innovation to engage in “creative destruction.” Marx’s observation that capitalists will eat their own is a feature, not a bug.
And the biggest problems we create for our future selves is when we try to save large corporations that should be allowed to go bankrupt and have their assets stripped and sold off to the highest bidder.
Can you imagine where we would be if General Motors was allowed to go into bankruptcy, and had sold off parts of its manufacturing capabilities to Tesla?