Defending Against Disruptive Innovation

EPISODE #203 TRANSCRIPT

Each week, we receive a number of questions about strategy and strategy implementation. Although these questions are probably more about business than leadership, there are many leadership lessons that we can bring to bear in the space of competitive strategy. 

Many moons ago, I released a podcast episode called Strategy Isn't Hard: Don't Overcomplicate It. This episode demystified some of the elements of competitive strategy, and I hope it made strategy a little more accessible to those leaders who don't have much visibility or understanding of what goes on in the higher levels of their organization. 

It’s time to shift focus and look at disruptive innovation. How do you defend against something that you often can't predict or anticipate? How can you prepare for, and respond to disruptive events? Market disruptions don't come very often, but when they do, they can have a devastating effect and severely damage your company's market share and profitability. But there are also some sensible strategies that can be implemented to combat disruption in your market.

STRATEGY ISN’T HARD

Strategy is simply about making the highest order choices for your organization about where and how it competes. Now, the keywords here are choices and competes. Strategy doesn't happen in a vacuum. It's always in the context of an industry, a market and a set of competitors - and this is both existing and potential future competitors. It's about setting the highest order objectives that put a beacon on the hill to guide every decision that needs to be made at the lower levels of your organization.

The nature of strategy is long term, and it needs to describe the principles at a high enough level that it doesn't have to change very often. Events are going to crop up frequently, but if strategy is formulated at the right level, the principles will be able to withstand these shifts. I feel the minimum horizon for strategic planning should be about five years, but in many cultures, it's much longer. For example, in Japan, it's not unusual for a company to have a 50-year, or even a hundred-year, strategy. 

I like to separate strategy formulation from the actual execution of strategy. This helps to avoid any confusion between making strategic choices and getting involved in low level planning tasks. Strategy is brought to life through tactical and operational planning, which both seek to narrow the time window to something a bit more achievable, and that lends itself obviously to much more detailed planning. Remember though, that the choices you make at the strategic level have a much bigger impact than those made at the operational and tactical levels. So getting it right is pretty important, and having the latitude to shift in a fast changing environment is also crucial. Strategic choices imply high levels of ambiguity, and they're based on many assumptions.

THE BIG STRATEGIC CHOICES

There are only three big strategic choices - in actual fact, I think it's really two. They come from Michael E. Porter, the luminary academic who's considered to be the father of modern strategy. About 40 years ago, he released his book Competitive Strategy, which is still as relevant today as it was then. The three strategic choices that he outlined are:

• Differentiation

• Cost Leadership 

• Focus (which is a hybrid strategy)

These strategic choices aren't particularly difficult to understand. Let’s focus on differentiation and cost leadership, as the focus strategy is really about what markets you target, rather than being the fundamental nature of the products and services you sell. 

Differentiation strategy

In this case, it means you have a better product or service than anyone else in the market. Not only that, but you can clearly articulate how and why it's different through your marketing efforts. Most importantly, you can capture additional value because of that difference or uniqueness. You can capture that value from either greater market share, or higher profit margins, or both. 

Differentiation implies that what you are selling is not a commodity. For example, commodities are things like sugar, coal, crude oil, wheat, electricity. Do you care what brand of these you buy? Well, generally not as they are really just inputs for the production of other products. Coal is turned into electricity and steel. Crude oil is refined to produce gasoline or petrol, and sugar - well judging by my waistline, that seems to be in virtually every food that's produced in the US! 

The price that commodities are traded at is based purely on supply and demand dynamics. So if there's lots of supply around to meet the demand, it's going to be relatively cheap. If there isn't enough supply to meet demand, it's going to be relatively more expensive. So the big increases in the price of oil in 2022 came predominantly as supply constraints forced prices upwards, as the Russian war in the Ukraine and the government's green policies that curtailed new supplies from coming online. 

Now, it doesn't mean that commodities can never be differentiated. Occasionally clever marketing can be used to overcome the nature of a commodity to make it appear differentiated. For example, since when do you care what type of silicon is used for the processing chips inside your computer? But the company Intel ran a super clever marketing campaign in the eighties and nineties to differentiate the computers that used their chips. It was the “Intel Inside” campaign. 

There are other examples of pure commodities being differentiated within their category - such as coal. Although coal is a commodity, it is differentiated in the trading market by calorific value and other quality measures like moisture and ash content. And of course, if you go to a fuel pump, you'll have the choice of fuel which is differentiated by the octane level of the fuel itself. It seems there's often a path to differentiation if you think you can pull it off.

Cost Leadership strategy

The other dominant strategy is cost leadership: your product isn't materially different to everyone else's, but you've worked out how to deliver it to the customer at a lower cost than your competitors can. This implies scale, efficiency and continuous improvement. You need to have some advantage in processes or supply chain or perhaps own a privileged asset in order for this to happen. 

Returning to commodities, electricity is a great example. An electron once it's generated is identical, regardless of where it came from. There's no difference between an electron that comes from a coal fired power station or a wind farm. It's probably the most fungible commodity of all. However, a low cost strategy can really help to sell a commodity. 

As an example, CS Energy, the company that I ran, had a cost advantage because it owned a privileged asset, the Kogan Creek Complex. The low-cost nature of the mine and the power station meant that it could produce a megawatt-hour of electricity at a lower cost than pretty much anyone else in the market. That gave it a double-whammy advantage: 

1. Kogan Creek is able to make more profit per megawatt-hour of electricity sold than its like-for-like competitors. 

2. It's going to have a longer useful life, because other more expensive power stations will be forced to close earlier when the economics turns against them. 

Interestingly, low-cost doesn't necessarily mean that everything is done on a shoestring budget. In the case of Kogan Creek, for example, the wages paid to staff are really high by any objective measure. The company doesn’t scrimp and cut corners on maintenance costs, because the highest value can be created when that asset operates reliably over a long period of time. These superior revenues and profit margins dwarf the relative cost of any capital investment decision in pretty much every case. 

Because the asset has such a fundamental advantage in the low cost of the extraction of coal from the mine, and the youthful age and efficiency of the power station itself, that drives a massive cost advantage before anything else comes into play. 

Focus strategy

In the third type of generic strategy, you take either your differentiated product or service or your lower cost product or service, and attack a specific niche market. For example, I may have a software application that I want to differentiate, and I then choose to focus specifically on small accounting firms of between three and thirty people. In my view, the focus strategy lends itself much more to differentiation than it does to low-cost, because you are implicitly limiting your opportunity for cost efficiencies that might come through economies of scale for example.

INNOVATIONS AND DISRUPTIONS

There are two basic types of innovations. There are sustaining innovations and there are disruptive innovations. 

Sustaining innovation is all about continuous improvement. Typically this innovation comes from adding new product features that improve the product and enable you to charge more for it. Sustaining innovations can also come through greater efficiency, so they can absolutely be a source of competitive advantage - particularly if you're in a low-cost world. Rational, mature companies do sustaining innovation really well. 

Disruptive innovation comes in two basic forms. There's low-end disruption and there's new-market disruption. 

Low-end disruption

This is something that satisfies an over-serviced customer. As the large incumbents are improving their products and charging more for them, this creates an opportunity for companies who introduce lower end products that satisfy the need for the basic customer at a lower price point. So less performance than the all-singing, all-dancing version of a product: but the value lies in a product that can do the same job at a lower cost. 

A great example of a low end disruption is the evolution of the steel industry - and this is a key example in Clayton Christensen's business masterpiece, The Innovator’s Dilemma. 

The major steel companies in the US had a monopoly share until the mid-1960s - and then these things called mini-mills started making low-end steel, like rebar. This was manufactured from scrap steel and it was done at a lower cost, both in terms of Opex and Capex. At the time, the big steel companies weren't at all worried about the mini-mills. They were more than happy to surrender the lowest end of the steel value chain, because it wasn't worth competing in, and they were making massive margins on the high-end products. 

But over time, the mini-mills fixed their quality issues and they chased the big steel companies up the value chain, as they learned to make the high quality steel products: steel rod and bar, then structural steel, and then sheet steel. Eventually the impact of this low-end disruption was the undoing of the big steel companies. Bethlehem Steel, one of the 20th century giants, was deregistered in 2003, and US Steel was removed from the S&P 500 Index in 2014.

Another great example of low-end disruption is wrist watches. Quartz watch technology pushed traditional watchmaking to a different segment in the 1980s. The watch market now is almost completely dominated by cheap watches that can cater to a huge variety of consumers. That’s pushed traditional Swiss watches into a completely different category: they are now considered luxury items. They're more like jewelry than time pieces and, as illogical as it might seem, a $20,000 Breitling doesn't keep time as well as a $20 Casio - but that's not why people buy Breitlings. Swiss watchmakers now serve a different purpose in the luxury goods market. 

It's really hard to fight low-end disruption. Rational businesses cede the low-end segments, and they don't fight to win low-margin market share. 

New-market disruption 

Think of products like the iPhone - when it was introduced in 2007, there was nothing else like it, it was a completely new category. The iPhone was effectively competing, not against other companies, but against non-consumption. This means that no one was using a similar product and with no established market, they were able to capture it decisively. Apple had what we call first-mover advantage. 

Now, lots of cellphone businesses, such as Nokia, really struggled when the iPhone was released. But it also disrupted other markets - like the market for global positioning systems and the market for digital cameras. This had a devastating effect on competitive products. Nokia for example, was the leading manufacturer of cell phones, and at the time its share price dropped like a stone. 95 percent of the share price was wiped out in only five years - it went from almost $28 to under $1.50 per share. 

Now there's a good rule of thumb to think about when deciding on your own strategy: incumbents generally win on sustaining innovation. New entrants generally win on disruptive innovations.

FIVE TIPS TO DEFEND AGAINST DISRUPTION

How do you defend against being disrupted? Do you think companies like Nokia, Kodak and US Steel weren't full of smart people who were schooled in strategy? Do you think they didn't have the resources to prepare against, and to fight disruption? This is truly the innovator’s dilemma. My best tip is to read the two books by Clayton Christensen: The Innovator's Dilemma, and its sequel, The Innovator’s Solution. Apart from reading those books, I have five tips on how you might defend against the disruption that affects pretty much every market at some stage or another:

1. Know thyself

What is it that you do really well? What is it that separates you from your competitors? Now, be realistic here. All the platitudes like “We have the best people” are probably not true. Your average employee is going to be pretty much the same quality as your competitors’ average employee - unless you choose to do something different. 

Think about the Hedgehog Principle, which was a key part of Jim Collins’ classic, Good To Great. A hedgehog is awesome at one thing: when it's threatened, it can curl up and protect itself from predators, with its spiny quills. So what's that one huge insight about your business? What is the one thing that you are really good at that's engraved deeply in your fundamental nature that your competitors don't have? 

You need to know what that is. 

2. Stay awake

You're off being rational, and there's always going to be someone else who wants to take your market share. The bigger you are, the bigger target you are, and incumbency often breeds complacency. Make sure you don't think about strategy just from the perspective of an annual planning meeting with the board. It has to be a constant process. 

This is one of the problems with not working at the right level. While many senior leaders are dipping down, they aren't focusing on their own job - part of which is to scan the horizon for potential disruptions.

Always expect potential disruption, and watch the landscape carefully. 

3. Understand that all competitive advantages are fleeting 

Just try not to believe your own bullsh!t here. You have an advantage for a reason, but it's not like it's unassailable. On average, market leaders revert to the mean in seven years, it's almost inevitable. So don't ever feel safe and secure just because you have a big market share. Remember the cautionary tale of Johnson & Johnson's medical supplies business:

Johnson & Johnson had a stranglehold on the production and supply of cardiac stents. In 1997, J&J had a 95 percent market share, and it was making gross margins of 80 percent on that product. It was a license to print money!

But their customers weren't happy, and cardiac surgeons are a pretty demanding lot. They wanted stents that had greater flexibility, that came in a variety of lengths, and had greater visibility in x-rays. So when Guidant released a competitive product that solved some of these problems in 1997, it managed to capture a 70 percent market share in only 45 days! J&J sales dropped to just 8 percent of market share by the end of 1998. 

Competitive advantages are fleeting.

4. Don’t be afraid to cannibalize your own products 

Believe it or not, Kodak had digital camera technology before anyone else. They had invested heavily in research and development to come up with the disruptive innovations that would see it dominate for another 50 years - but they didn't release and develop the technology. This was because they knew it would cannibalize its most profitable product: 35 millimeter film. 

Now the decision to put today's windfall profits ahead of tomorrow's strategic advantage is another example of the dynamics of business and short-termism. It takes real courage and foresight to follow an investment strategy that secures the long-term, at the expense of some of the short-term profits. 

The moral of the story is: if you don't cannibalize your premium market share, one of your competitors will. 

5. Build the capability to be a fast follower

There's a lot said about first-mover advantages. Apple, of course, had the first-mover advantage with its iPhone and the initial success made it really hard for its competitors to catch up. But these cases are extremely rare. Even now, Samsung is delivering an iPhone equivalent extremely successfully on the Android platform. Despite the success of the iPhone in the US, Android dominates the cellphone market globally with an 87 percent market share. 

Sometimes it's great to be a fast follower. First-movers take all the risk. They make all the investments, and they have to iron out all the bugs in their new product. First movers have to find, reach and establish that new market where there is no consumption at present. Your chances of doing this, if you aren't an Apple are actually really slim - for every successful first mover in the market, there are thousands upon thousands of failures. Sometimes it's just better to be a fast follower: to observe the market closely, and have the capability to respond in kind to any disruptive innovation. 

So, what’s the answer? You have to build the one thing that’s hard to replicate: your advantage in people and culture. As I said, all competitive advantages are fleeting, but the ones that are hardest to replicate, and have the longest lifespan are cultural and organizational advantages. Because they're hard to build, they’re also hard - if not impossible - to copy. 

This comes down to leadership. If you build the high performing teams that only come from strong leadership. If you focus on delivery of excellence for your customers. If you are driven solely by value creation. If you don't take a purely short-term view of the world. If you hold your people to account for stretching to be their best. If you hold every individual to the minimum acceptable standard of performance… Then, and only then, can you have any confidence in your ability to defend against an innovation that you couldn't see coming. 

Do you need any more reasons to work on becoming a strong leader who can build a winning team? All roads lead to Rome - you just need to decide which road you are going to take.

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