This Saturday is the biggest day of the year for the city of Louisville, it's the day The Kentucky Derby will be run at Churchill Downs. Many things factor into the race – jockeys, post position, strategy for running such a long race. But the real key to winning is to have the fastest horse. Warren Buffett has said
When a management with a reputation for brilliance tackles a business with a reputation for bad economics, it is the reputation of the business that remains intact.
The flip side of that statement might best be represented by Peter Lynch's investment philosophy.
Go for a business that any idiot can run – because sooner or later, any idiot probably is going to run it.
The point is that just like winning the Derby boils down to having the best horse, business performance boils down to having favorable economics. Don't get me wrong, I think other things matter, just not as much as the underlying economics of an industry.
What drives industry economics? Well, according to strategy guru Michael Porter, there are five forces that matter: supplier power, buyer power, degree of rivalry, threat of substitutes, and barriers to entry. The details of these five forces will determine what the risk adjusted return is for your industry. Now listen up, this is a very important point that many people never understand…return on investment is not the same for every business or every industry. When you think about starting a business, you have to think about that.
Some types of businesses inherently return more than other types because of the underlying economics. The oil business will always return more than the web design business, because the barrier to entry to starting an oil business is extremely high, and the barrier to entry to starting a web business is the cost of a computer and the time to learn HTML. In fact, another strategy guru, Bruce Greenwald, has argued that barriers to entry dramatically overshadow the other four forces, and that the focus of any business strategy should be on building barriers to entry. Now, here is the interesting point that Greenwald makes – as competitive advantages erode, geography becomes more important.
In an increasingly global environment, with lower trade barriers, cheaper transportation, faster flow of information and relentless competition from both established rivals and newly liberalized economies, it might appear that competitive advantages and barriers to entry will diminish. But this macro view misses one essential feature of competitive advantages – that competitive advantages are almost always grounded in what are essentially "local" circumstances.
Competitive advantages that lead to market dominance, either by a single company or by a small number of essentially equivalent firms, are much more likely to be found when the arena is local – bounded either geographically or in product space – than when it is large and scattered. That is because the sources of competitive advantage tend to be local and specific, not general and diffuse.
Paradoxically, in an increasingly global world, the key strategic imperative in market selection is to think locally.
Interesting. Does this mean that "local" is the next competitive advantage? Possibly. But it won't work the way people think it does.
I've spent the last 6 months looking seriously at local digital media. There is a significant amount of interest by local investors wanting to get into that space, and despite the fact that local may be the next form of competitive advantage, I don't think it makes sense for most forms of media because the returns will be lousy. Media is primarily supported by advertising, and local media has enjoyed fantastic returns over the last few decades. But it wasn't because of the content, it was because of the monopoly on distribution. That barrier to entry has gone away. Local media is a business that can now be entered at will, by almost anyone. The winners will most likely be those that spend the most on marketing. But the proliferation of companies and the transparency of ROI for digital advertising will take the historically high margins of media and bring them down to earth.
So where does this leave us? We've learned that returns are driven by underlying industry economics, that industry economics are dominated by barriers to entry, and that barriers to entry are eroding and making geography more important. It seems like local really should be the new competitive advantage, but looking at digital media, it isn't.
Here is what I think. Local is an increasingly important form of competitive advantage, but not for businesses that rely on advertising for support (at least, not for most of those businesses). The advantage of local is not in content creation, it's in information and services. Search is the fat part of the web value chain, and that won't change as things move local. Other business models that can harness the computational power, rapid change, and cheap distribution of the web but can combine that with information gathering capabilities, face to face contact, and experiential knowledge that comes from a real local presence – those are the businesses with high potential. And when it comes down to that, I think web startups outside the valley will have a much better shot than the myopic startups that tend to come out of San Jose.
The picture at the top of this post is from a local movement called Keep Louisvile Weird that encourages people to support local. I think several other cities have similar "keep this city weird" movements.