Introduction

Patrick: [00:00:49] My guest today is Hamilton Helmer, the Co-Founder and Chief Investment Officer of Strategy Capital and the author of one of the best business books in history called 7 Powers, which is the topic of our conversation. He has spent his career as a practicing business strategist, advising companies, investing based on strategy insights, and teaching strategy. In the last three decades, he has also utilized his strategy concepts as a public equity investor. In this conversation, we cover all seven business Powers from Counter-Positioning to Scale Economies and how companies earn and keep those Powers. Any investor or business person should understand these concepts. And 7 Powers is the best work I've seen that explains them in depth. Please enjoy our conversation.

Benefits, Barriers, and Power

Patrick: [00:01:31] I'd love to just begin at a very high level with the concept itself, perhaps the necessary preconditions to Power, which you described as benefits and barriers. Maybe we could just take these kind of three concepts; benefits, and barriers, and how they relate to what Power means specifically to you at a high level before digging into the specifics.

Hamilton: [00:01:50] If you start a business, you put something in, your time and investments and all this stuff, and you do it maybe for love, but you also get something back, and that something back has to hopefully be more than what you put in in the first place. You might question whether it was really worthwhile. And so the notion of Power is that when you figure out something about a business, you figure out something that's better than what is currently offered. And so that might be a better business model, or it might be an interesting grant, or it might be a new product or something like that. But then the spectre of competitive arbitrage comes in. If you do something better, the question then is: okay, but for that to be durable - because what you want is durable success in business - for that to be durable, there has to be something that prevents others from taking all of that away from you.

And so the something better is a benefit and that something that keeps others from getting it is a barrier. And so you need both those conditions. And the example I used in my book, I'll do it here, is Intel because it's a great control case. So Intel started out with amazing management. I mean the best brilliant triumvirate line of business. And they started out as what they call themselves the Memory Company. And they did semiconductor memories, and they had incredible manufacturing and technology leadership - all these things. And so the benefit was these great memory chips, better than other people's, but the problem was that other people could emulate it. And so their margins started to go down. It didn't look that attractive. So despite all the wonderful things that they had, and they were a very, very well-run business, it just was not going to be an attractive business. But then they got into CPU's and it turned out that there was something that could keep others from quickly emulating that.

And there were some early things that were particularly strong in terms of how computers are hardwired to that chip and stuff. But later on, the key thing was that to design one of these things is a very, very expensive proposition, and it's a fixed cost to design one of these chips. And if you have much higher volume, that cost is pro-rated over that. So that's a scale of economy, which is type of power. And so unless other people have your scale, you're at a lower cost position. And that's durable.

So all of the nice things they had, which are necessary: good management, great manufacturing and good marketing - all that are needed, but would not have secured their position and did not in the memory business, which they eventually had to exit. They needed that something else in addition to all that operational excellence, which was power, which was something that created value in this case, lower cost, but could not be easily arbitraged out by competitors. And so if you have a benefit and a barrier, then you have a formally long-term positive cash flow, track of cash flow, but just good returns going on and on. And so that's the nature of the concept.

Patrick: [00:05:04] Would you say it's fair to characterize benefits as the more commonplace one for people to think about it? And also for people to actually put into the world than barriers, meaning barriers are a rarer breed than benefit.

Hamilton: [00:05:18] Yeah, Patrick, that's a really insightful and important point. Benefits are everywhere. A car bumper goes from chrome to plastic. That's a benefit. But the problem is that lots of people - even though having a Corvette at first, as I recall, or maybe it was Firebird, I can't remember it was an American manufacturer - can easily emulate them. And every time you turn around in a business, you're trying to make this work process a little better, you improve this jig in a manufacturing process, your code is a little bit better. Every place you turn, there are millions and millions of them. And then there are some that are material. So they moved the needle from a point of total value, but even so, they are far more common.

Barriers are rare. Competitive, one thing is, my background is as an economist, and the background in that makes you very respectful of the power of competition long-term. And so they're always people trying to emulate that and that's how progress takes place, is that everybody does. But if there's a barrier, you get to keep a portion of that part that you've improved. And so barriers are much rarer.

Patrick: [00:06:28] How early on? You mentioned being in Silicon Valley, we're going to talk a lot about more established businesses too, but the moment of inspiration and the vibe of Silicon Valley is always so inspirational. There's this term product-market fit, which I think about as having nailed a benefit. You've created something that people really want. How early on, when you're advising earlier stage founders or thinking about strategy in early technology businesses, do you think they need to start thinking about barriers because the product-market fit is all sort-of about a benefit that can be great in the early days, but as you pointed out is maybe not sustainable for long-term competitive advantage. Are these things usually the barrier side with these early-stage businesses? Is it usually accidental or intentional when founders create a barrier in your experience?

Hamilton: [00:07:16] In terms of the question of when you should start thinking about these things, it's very important to realize that often when you start a business, you just don't know whether you're going to have Power or not. You just don't know. And yet, it may be a very reasonable bet to proceed knowing that an opportunity may arise.

It's very important to realize that often when you start a business, you just don't know whether you're going to have Power or not. You just don't know. And yet, it may be a very reasonable bet to proceed knowing that an opportunity may arise.

So I'll give you an example of Netflix. So they had this red envelope business, which had its own levers of power, which I won't go into, but they knew that ultimately this was going to be something that was over the internet. That's why it's called Netflix and not Warehouseflix. And yet it wasn't evident whether there would be any power there because if they just get content from where everybody gets content and you buy it on a per-view basis, then kind of anybody can do that. There's some technology involved, but it's not that daunting. And Amazon Web Services serves Netflix, and somebody else can use them as well and so on.

But what did Netflix do? Did they say, "Well, we're not going to do this until we have Power." No, no, not at all. These formative moments are ones with lots of options, high uncertainty. And if you have the possibility, what good companies do is they put a toe in the water and take a crack at it and then keep their eyes peeled for the possibility for Power. So Netflix started off with, they just said, "Well, we're just going to give streaming away for our red envelope customers." So they did that. And it was a pretty lousy catalog and not a lot of response. But then they said, "Well, let's up the ante here and give them some good contacts." So they cut a deal with Starz, which had really good content. And then, all of a sudden, subscriptions just skyrocketed. And they said, "Wow, so people really like this," but the problem with the Starz deal was it was kind of a one-off deal when Starz didn't realize what they were giving away. And so it wasn't clear that this was the source of long-term competitive advantage because the next time they went to a Starz-like company, they'd ask for the price that fully capitalized the value that Netflix would be receiving, and it wouldn't be that attractive.

And so then the next phase was, they actually did deal with, I think it was Epix. And unlike the $30 million deal with Starz, that was a $1 billion deal, as I recall. And that was at a price where Epix knew exactly what they were selling. That these rights were valuable and it was an exclusive to Netflix. And so now, all of a sudden, they had paid a fixed price for exclusive content, which is 50% of their cost structure roughly. So anybody else who wants to offer the same stuff, doesn't pay on a per-view basis but would have to pay a fixed price, and if Netflix has more streaming customers the cost per customer is, of course, diminished accordingly.

But what it shows is that step-by-step, they work their way into it, and that's more common. But the key thing, and this is what my book is focused on, is that along that process, you want to have in your mind the types of structures that might get you to a point where you have a barrier as well, so a benefit and a barrier, so that you have Power. And so my answer to your question about when you start thinking about it is; very early on. You have this framework, and you don't slavishly say, "I'm going to not do anything unless it has Power." You just constantly sort of check whether or not, "Oh, well, if we go down this path, that looks kind of interesting." So the conversations I have with founders, which are quite a few in Silicon Valley, those are the kinds of conversations that we have. They're sort of thinking about this, and thinking about that and so on. And that's the proper perspective, is to be experimental, but very, very thoughtful. And if my concepts even help a smidgen in additional acuity and zeroing in on the right thing, then my goal is accomplished.

Patrick: [00:11:22] I would love to explore the powers, taking them kind of turn-by-turn here and discussing what you think has changed about them over time, since you originally conceived of them, maybe what sorts of powers are most interesting for certain types of businesses. I'll ask a lot of questions sort of around each. You've already mentioned this, this fascinating idea of you said, step-by-step, I think about it as path dependency or path you have to walk that accumulates an advantage over time because others have to walk a similar path. Branding could be an interesting example of that. Typically brands are built over time. Sometimes they're airdropped in like a Dollar Shave Club or something, but it's more common for them to be built through time. And I love how you delineate in the book the concept of Origination, Takeoff and Stability, as sort of different periods of how time interacts with the Power.

Source: Hamilton Helmer, 7 Powers

Origination

So I'm going to use that order to explore these things just for some sequencing. And I thought we'd begin with Origination. So the two that you've sort of shaded, there's no absolutes here, but that you've shaded in sort of the Origination category are this idea of a Cornered Resource and this idea of Counter-Positioning, which of all the Powers, Counter-Positioning is the one that animates me the most that I think is really unique and fascinating to consider. So maybe we could start there with Counter-Positioning. Can you describe what that Power means and the ways you've seen it effectively applied?

Hamilton: [00:12:42] Counter-Positioning is if a company originates a new business model and there is a powerful incumbent with a different business model, but the new business model is in some way superior, which is to say that it gives you better cash flow than the other business model. But for the incumbent to mimic that business model, they would need to blow up, or they think they would need to blow up their old business model and the pain of that is so great that they wait a long time.

So a great example is HBO versus Netflix. So HBO, it's hard to remember back then, but it was a much more successful, much more visible company than Netflix. Very profitable, had amazing series. Think of the Sopranos, you know, it revolutionized television in some ways - just brilliant stuff. And Netflix comes along. But HBO is distributed through cable companies, but Netflix is what's called over the top, which means they go directly to consumers.

And so the issue for HBO was, could they go over the top versus Netflix? But they're looking at all these very profitable contracts they have with their cable providers. And they say, "Wow, if we change distribution, those might be at risk." So we're looking at this uncertain upside versus absolutely terrible known downside. We can't go there. And so they wait, and they wait, and they wait, and bit by bit Netflix just gain market share and gain market share and gain market share.

So that's the nature. And one of the things that stimulated this was that I invested in Dell in the '90s, one of my best investments, and they were going direct, and Compaq and everybody else was going through channels like ComputerLand and that kind of stuff and have these contracts again, they didn't want to risk their distribution, which was going famously for them. And so they waited and waited and waited, and Dell took tremendous advantage of that at the time.

Patrick: [00:14:47] You've mentioned some examples where I always try to break things down into product and distribution as the sort of key twin pillars of any business and business model. That Counter-Positioning is quite clear to me in the distribution examples, the different way of getting to your customer, that by definition would hurt the incumbent if they tried to mimic it or cannibalize their business. Great examples there. Are there examples that come to mind more on the product side of Counter-Positioning?

Hamilton: [00:15:12] Definitely, so I know you're interested in software, and I think it was Marc Andreessen that famously said Software is Eating the World. What a great statement, super insightful. And if you think about what that means is that companies that used to be hardware-oriented now are faced with competitors that are software-oriented. And I would say in many, many of those cases, there's Counter-Positioning, and the Counter-Positioning comes from the fact that changing a company that's well-established and large, that's hardware-based, is extremely difficult to move it over to software-based. It is not impossible but extremely difficult.

So I also made a significant investment, well, significant for me, in Apple. And if you look at the iPhone, they were counter-positioned versus Nokia for just those reasons. And Nokia was just an unbelievably successful company, but it was a hardware company, basically. And they had really good, developed supply chains and their engineering teams and everything else. And for them to turn into, essentially, a software product, just, they would have had that different people and different people in charge, different sensibilities, different measures of value, and so very, very difficult. So I think that's one that's rather common these days, I'd say, that hardware companies have a very difficult time.

Patrick: [00:16:39] I'll always remember in my conversation with Daniel Ek, who's the person that introduced you and I, this notion he had early on in Spotify of the question, what could possibly be better than free? The incumbent was Napster and other companies like that, like how could I possibly beat that? And realizing that it was a product innovation around speed of delivery and like having every song in the world in your pocket, not limited by disc space or anything like that, or by latency. I just think these Counter-Positioning ideas are so fascinating.

Hamilton: [00:17:08] They are. And as I said, they're very contrarian because people are used to these incredibly powerful incumbents. I mean, Nokia was thought of as being this unassailable monster - monster's a negative term - I mean, successful, very attractive company. And yeah, I think that's right.

Patrick: [00:17:26] What are your thoughts on incumbents using this on themselves? So I've obviously read all the Christensen's ideas of disruption, which some of this thinking brings to mind, and sometimes companies successfully self-disrupt. So how do you think that the incumbents who we've used as examples of losers in these stories so far, could gainfully apply the Counter-Positioning idea to themselves?

Hamilton: [00:17:50] The nature of the barrier in Counter-Positioning, which is to say, why a competitor hesitates from taking one or is unable to, or in this case unwilling to, is because of the damage to the old business model on the incumbent. So they can't be counter-positioned to themselves, but what they are, is they're threatened. And so the use of incumbents is to understand that the nature of the counter-position they're facing and make a decision about whether they need to reinvent themselves, whether they need to adopt this new business model and the reasoning, the long-term reasoning, behind that because it will inevitably involve a lot of pain by its very nature.

And so I'll give you a couple of examples. So again, using Netflix, streaming was re-inventing their red envelope business. And so they were forward-thinking enough and understood that. I mean, I have to say Reed Hastings is one of the most strategically astute CEOs I've ever dealt with. He understood that they had to do that. And of course, it was sort of in their DNA a little bit to begin with because it was called Netflix, but even so, they had a very successful business, and they had to disintermediate it if you will.

And I think if you look at Disney, I'm also a huge fan of Bob Iger. I don't know him, but I'm an admirer from afar. I think the heavy commitment that they made to Disney Plus shows what a good strategic thinker he is, that he understood that this was something in the future and the theatrical presentation was not eventually the full picture, and so committed to that. But the key things there are: strategic insight, leadership ability, and willingness to drive it through an organization.

Now, sometimes it's just a bridge too far. I mean, for example, some of these software cases getting there is just so hard that even if you have the intent, it's such a change. I mean, if I think back to Sony right now, I think probably most of their profits come from video games. I'm not sure that, but doing video games almost didn't happen. And it took an engineering guy who was crazy about it and some amazing leadership at Sony to actually get digital through an analog culture. And if they hadn't, they would be a much less attractive company today, but it was extremely difficult. So one thing you learn when you study strategy long enough, people really matter. So if you think about how strategy starts, the starting place for strategy is always creativity. Creativity comes from individuals. And boy is leadership important in this kind of stuff. I mean, it's really important.

One thing you learn when you study strategy long enough: people really matter. So if you think about how strategy starts, the starting place for strategy is always creativity. Creativity comes from individuals. And boy is leadership important in this kind of stuff. I mean, it's really important.

Patrick: [00:20:40] Second of the powers that is in this sort of Origination category is this idea of a Cornered Resource, which probably people intuitively will understand. But I'd love you to explain it in your context, why a Cornered Resource is so powerful, or it could be so powerful, and whether or not they still really exist in the world today?

Hamilton: [00:20:57] I won't go through all the exact conditions for something like that. But basically, you have some desirable asset, which you've for some reason gotten at a price that doesn't fully reflect its value. And it's so determinative that if another company got it, they would also get this tremendous return. So, leaders usually aren't that. It has to be a complete thing. So, somebody like Steve Jobs, probably a cornered resource. You drop him in a variety of types of businesses and this guy was so amazing that he probably would have made something of them. But most leadership is dependent on the particular company they're in. And although they're absolutely critically important, they're not a complete answer to that problem.

So one, of course, historical aspect of it, is things like patents. So I think that it's much rarer. You know, I've probably done 200, led 200 strategy cases, maybe my students at Stanford have done another couple of hundred, and it's very rare to see Cornered Resource as the driver, but it does happen.

One of my posits about Pixar is that actually if you look at their phenomenal string of successes, movie successes in their first dozen films, that that was a Cornered Resource. And the Cornered Resource was a very specific group of people that had been through the wars in doing Toy Story 1. And they both developed the chops for animated films, but also this mutual respect and way of working together and stimulating each other. And then, if you look at their output of those films, all of the first group of films came from that group of people and they're cornered because they probably weren't paid enough to capitalize fully the value of their achievements. I'm sure lots of these people got offers from other animated companies saying, "Oh, come work for us," and they said, "no, no, Pixar is special. I'm going to stay here," but it's kind of rare. And I think the patent side is rare. It's pretty rare for me to see a patent that's big enough and blocking enough. There's just a lot of different ways of doing things.

And one thing you're observing right now, of course, there's a lot of machine learning AI stuff. And I don't think I have ever seen an algorithm be defensible. Maybe, there is one somewhere, but it's a good starting place for product-market fit. I mean, like PageRank in Google or something, but eventually, there are lots of math. You can do math, a lot of different ways and programming a lot of different ways. You know that. And so that's extremely rare, and knowledge, in general, is more distributed now rather than less. And so I would say that those things are rare. So I'd say in today's world, that's less common than it used to be.

Patrick: [00:23:49] How would you think about Google in that context where originally PageRank was so much faster and superior, but they've continued to enjoy that? It seems like from the outside, based on cash flow, it's a powerful position built mostly on search and algorithmic search function. So how do you think about Google in the context of this?

Hamilton: [00:24:06] I'm not entirely sure, I'll give you a hypothesis, but I'm not sure if it's right. So the strength of their business depends on you and me choosing to search through them either directly or through Android or Chrome or something as opposed to using somebody else. And then there's sort of a curiosity about that, which is that if you look at sort of normal surveys of like Bing versus Google, it seems about the same. There's not a lot of evidence that it's wildly superior search.

So the question is kind of, what's going on there? You could argue maybe that, of course, they buy a lot of the search properties from Apple, for example, but then they purchase the search results. So the fact that things are about the same says that I don't know if it's PageRank or what Bing uses, but it seems more or less equivalent.

So the argument about Google, I'd say, is that it's a Network Economy. And as I say, I'm not sure this is true, but the idea, one thing that is surprising about search is the percentage of searches that are unique. In other words, they just have not done before and then you can deduce from that, the percentage that are near unique have only been done two, three, four times, is even higher.

So what that means is, and the way Google I think, I'm no expert in this, but the way Google gives you satisfying results is, if somebody has done a search, like the one you request before when that search was done previously, they track what that person then did once they got Google search results, what things did they click on? And that gives them information about exactly what it was they were really looking for, what results would be the most satisfying. And if another person does the same search, that's what they feedback to them. So it's almost magical. You go, "Oh my God, they knew what I was thinking about." And since many of their searches are nearly unique, it means that tail events matter. It means that for your sense of the efficacy of your search engine if you do, even 10% of your searches are unique, for those unique searches, Google just seems a lot better. And the network effect is when you do that search, that's near unique, that result is contributed to Google. And so they are able provide better value to me when I do that search. And so you just get the sense that they're, even though in gross terms and average searches, they're just no different - a survey just doesn't capture that. So that's a hypothesis, but only one. What do you think?

Takeoff

Patrick: [00:27:01] I love it. I've never heard Google's advantage articulated as a network effect before, but it certainly seems plausible, and it's a unique take on a dominant business. And it's a great excuse to talk about Network Economies. This is one of my personal obsessions, starting with Brian Arthur and so many great modern businesses that are built on top of Network Economies. Everyone knows Facebook and other examples like it. So we don't need to hit the obvious examples of what this means, but I would love to hear your nuance, like that Google example is a fantastic and interesting, even Zoom that we're doing this on are sort of interesting, unique examples of Network Economies. What interests you most about this Power, and what are some unique ways that you've seen it applied?

Hamilton: [00:27:44] Well, Network Economies are really interesting for a couple of reasons. One is that, if the business model that comes from them is sufficiently monetizable, they are very intense. If not winner-take-all businesses, their dominance and very high returns is an attractive prospect. The other aspect, of course, from an investment perspective is that when they first start, they look unattractive from a P&L because there are not enough network effects to generate enough value to charge enough to make the bottom line look good. So you get something that ultimately is very attractive but looks bad, to begin with, and that spells a good investment opportunity in a very interesting business. But there's a cautionary tale here, which is that the prevalence of network effects that are then sufficient to get to network power, which means they're sufficiently monetizable, is much less than people think.

The prevalence of network effects that are then sufficient to get to network power, which means they're sufficiently monetizable is much less than people think.

I mean, if I had a nickel for every time somebody said to me, "Well, you know, I get more data, and that tells me more about customers, and allows me to improve my product, and that allows me to get more customers, which gives me more data and blah, blah, blah, blah, blah, and therefore, I have the sunset." I hear that every day and most cases, it's not strategic. There might be a modest network effect involved. It doesn't get to materiality, so it's not Power.

So, and you've talked about benefit and barrier early on as the sufficient necessary conditions for Power. There's another way to parse that, which I use sometimes, which is the three S's, which is superiority, significance, and sustainability, and that maps one-to-one to benefit and barriers. Just the benefit is broken up into superior and significant. And the reason that's useful in discussions is it breaks out explicitly materiality - significance. And so I'd say you have to be very, very careful. For example, I'd say the jury is still out on Snapchat about whether or not what they do, I think that the defensible part of their business, their disappearing photos and stuff, is it sufficiently monetizable to be attractive overall? Remember Power is an attractive overall business position, which is that the discounted cash flow going forward far more than offsets all the money that went into the thing in the first place. It's not just, so you can have businesses that have no Power that continue on a long time, but they're lousy from an investment perspective starting out because they don't justify the initial investment, but they can keep going for a long time. And I think their stories, Snap stories, and stuff was less defensible, I think. Instagram went after that pretty hard.

So they're really interesting. The other thing I'd say about them is that they are incredibly complicated, and when we look at network effects at Strategy Capital, the first thing we do is try to develop a flow chart of exactly what's going on because there are all kinds of asymmetries and subtleties that go on in network effects and network effects would often happen for multi-sided platforms, right? And so just be aware of the subtleties, but if you can find one who does clear all that stuff, then they're really interesting. And turn out to be amazing businesses like Facebook.

Patrick: [00:31:18] What are some examples of those subtleties that might disqualify what looks like a network effect but may not be one of the big ones? What are some common things that you see that disqualify?

Hamilton: [00:31:30] I'd say an important one is non-linearity of the benefit. And this happens a lot in data stuff is that as you get more data, you would hope that there's some benefits. So maybe it's better customer awareness, or even lower your costs or something that often is a non-linear relationship. And what happens is that as it scales, that additional incremental benefit becomes less and less and eventually that curve gets rather flat. And if there are enough competitors that are in that flat zone, it means it doesn't make any difference.

And so I would say that, they might get mad at me if I say this but I would say, for example, Netflix's recommendation engine it's like that, that it's terrific. They rightfully spend a huge amount on getting it just right and pleasing you as they should be doing that. But it is probably not strategic. In other words, I probably wouldn't choose Netflix over Amazon Prime because of Netflix's recommendation engine. And Netflix is unbelievably sophisticated about it. I mean, as you probably know this, they even had this Netflix Prize, which AI people look at, the results from that were extremely interesting and cited, but it's an operational excellence thing that they have to do. But a mimic of it is good enough so it is no longer strategic.

Patrick: [00:32:54] The next two Powers are maybe the most traditionally cited ones that you see in strategy books or are in strategic thinking, which are Scale Economies and Switching Costs. We've talked a bit about Scale Economies already. This notion of being able to spread your fixed costs across a higher volume of customers. And you can't just airdrop in a huge fixed cost investment. That's a hard thing to do. Any other nuance there that you think listeners and strategic people running businesses or strategic thinkers should consider in Scale Economies, other than the obvious of it would be great to have one?

Hamilton: [00:33:29] An overall perspective on all this stuff is actually correctly determining the opportunity for Power is complex. And one of my partners, Bill Mitchell, made the comment that the nice thing about 7 Powers is that it turns an essay question into a multiple-choice question, which is very powerful, but there's tremendous granularity in these types of Power. I mean, if I'm looking at an existing business with my team and one that's been out there for a while because we do public companies, it will take us weeks of work to make that determination.

And so just on Scale Economies, there are lots of different flavors. I mean, one is the fixed cost component, and often things seem fixed but they're not really. You have to go through that, but then there are other flavors at upscale economies. So, for example, physical geographical scale density. So if you look at Uber, for example, and wanted to know if they had Power, the question, their source of economic strength - once you get the network populated with users and drivers - is the density in an area of their driver population, which then translates into how quickly you can get a ride. But the problem, of course, is that also is a flattening curve like I mentioned before. And so past a certain point, if there is another competitor in the same ballpark, maybe not as large, but large enough, then the difference in arrived pickup time, it's not that significant. But that one is driven by original physical scale economy. So it would apply to the barrier but being good at it and the barrier tells you nothing about how good you are in London. So there's geographically constrained one that's based on that kind of density.

And then heavy-duty manufacturing, chemicals, and stuff there are things that have to do with volume production equipment and volume relationships. So if you look at dairy farms - I'm from Vermont, so it's an area I know well, there are more cows than people. If you look at both milk tanks, what you'll see is that the cost per gallon of tanks dramatically drops as you go up in volume because there's an area of volume relationship between cost and that's true of warehouses and stuff as well.

Patrick: [00:35:56] What about this notion of learning economy? So, you've talked a lot about technology businesses, physical asset light businesses, as great examples of companies in the modern sphere that have Power. How do you think about the return on learning and whether or not that might accrue to larger players versus upstarts?

Hamilton: [00:36:16] We all hope to be learning all the time. And so that's the benefit. If you learn something, you can do better. And so there's definitely some of the benefits there. And so the question is for it to be Power is, it has to be material. And there are probably lots of things that have matured assessed to be big enough to move the needle, but more important, there has to be a barrier. So that's always the question about learning economies: what is the barrier? And the barrier for me to think of it, you know, as strategic, it probably has to be at least five years, and that's rare because people can change jobs. There's things that are published. As I said competitive arbitrage is powerful. People are always looking to improve, and they're looking at what other people are doing and mimicking it. And so learning is an essential part of operational excellence but it's rarely strategic.

Patrick: [00:37:07] What do you think about the notion of Switching Costs and the ways in which someone can be intentional about those things? So maybe give us an example of what you think is an incredibly powerful example of a Switching Cost in a modern business, but also whether or not you think a leader can intentionally insert that into their product or service.

Hamilton: [00:37:28] The example I give in my book is ERP (Enterprise Resource Planning), like Oracle or SAP. Their software product is so entrenched in every aspect of your business that ripping it out and replacing it is just so painful. I mean, it's just what makes you cry, and no matter how good you are, how careful, it's just painful and so very high Switching Costs.

And so I would say it's very, very rare to be able to, once you have a business up and running, to then introduce Switching Costs because what happens is that customers at that point are smart and they realize what you're up to. For them to go into that relationship, or more to the point, competitive arbitrage works like this, is that every business who then tries to do that will then understand that, with these Switching Costs, there is a payoff. The payoff for high Switching Costs is you can charge more, you can charge the differential that is less than that extra pain of switching. And they'll start to try and acquire customers, and they'll offer discounts and freebies to start and all this stuff, and that will arbitrage out the cash flow stream that comes from it. And so it sort of equalizes over time.

So it's hard to establish it after the fact. And so that's why usually for Switching Costs businesses, you need to get customers during the takeoff phase when things are growing so rapidly that customers are just worried about, "Can they get the product?" And they're not worried about all the things associated with it, like Switching Costs. And so the value of that is not fully arbitraged out in the price.

For Switching Costs businesses, you need to get customers during the takeoff phase when things are growing so rapidly that customers are just worried about, "Can they get the product?" And they're not worried about all the things associated with it, like Switching Costs. And so the value of that is not fully arbitraged out in the price.

Patrick: [00:39:16] So perhaps the way to think about Switching Costs would be, you can get them eventually by being a part of someone that's going through a paradigm shift. So when someone adopted Oracle or SAP or an ERP system long ago, that was a whole new thing, but then there's not a whole new thing to... if there's not a whole new thing to replace the ERP, that's 10X better, no one's going to do it. So it's a fulcrum thing.

Hamilton: [00:39:39] Yeah. So I think if Oracle and SAP compete for a customer they're well aware of it. So Oracle is trying to take a customer away from SAP. They realize that's a hurdle. And so yeah, and in that early phase, people are just wanting to get the product, and they're not too concerned about it. I mean, this will bait me but when I got my first iPod, I didn't really worry about Apple's proprietary song format that much, but guess what, if I tried to take those songs and put them on another device, they disappeared.

Stability

Patrick: [00:40:09] Fascinating. The last two Powers that are in the time phase you call Stability of the Business or Process Power and Branding. Everyone's going to know what a brand means. My favorite example that somebody sent me in anticipation of this call was that to buy a Tiffany box and bag, and little tissue was $250, with nothing in it, which is like the ultimate branding example. But tell me a little bit how you think about Branding, especially in how companies intentionally invest in their brand at the mature stage.

Hamilton: [00:40:39] Yeah. So the first thing I just want to point out is that branding as Power is a far narrower concept than brand awareness and brand awareness is useful and important, but you could buy a Super Bowl ad for Patrick O'Shaughnessy and you would probably have brand awareness, but you would have paid for it. So it's fully arbitraged out. And guess what? Somebody else could do the same thing.

So you can buy brand awareness but Branding as Power is that over a long period of time, you establish an understanding amongst potential customers that either, well understand is probably the incorrect word because it sounds too rational, but you establish a position with customers so that either they feel really good about it - so I'd say, iPhones have Branding in the United States, that there are many segments of customers that would prefer to be seen with an iPhone as opposed to an Android phone, even though they're functionally equivalent.And so it gives them a good feeling some way, or it impresses people or whatever the reason is. And so they're objectively identical but perceived as higher value. The other one is that you get a reputation that assures customers and reduces their uncertainty. So Bayer Aspirin, if you look it up on Amazon, still charges an awful lot more. It may only be cents, but as a percentage, it's an awful lot more than a generic brand, and people are willing to pay it often because they just say, "Oh, Bayer, I know what that is." And so it's an uncertainty direction, but to have that embedded in your customer name takes a long, long period and people have to invest in it. So if you think of Hermes bag, they've been around for 100, more than 100 years, and you have to be very thoughtful about how you develop a brand, and it's not easy.

You can make wrong creative choices. It's a creative exercise, and it can not go well for you. You make choices that hurt your brand, but then there's always this trade-off of course, between - for a branded good most of the time - between volume, if it's something where there's exclusivity involved, you're always tempted to, "Well should I go for this higher volume segment?" But then you know that if you do that, you may pollute your brand in terms of people thinking, "Oh, it's not all that extraordinary anymore."

I've told this story before, but I have in my liquor cabinet at home a bottle of Hermes Cognac, and a friend of mine was one of the Hermes family that ran it. And he was head of the Hermes in the US. And he brought it over for dinner one night, and Hermes tried to go into cognac, and they failed. And so I have a rare thing that isn't available anymore. And Hermes is an incredibly powerful brand but didn't extend into cognac. It didn't work. And so those issues about what's covered by your brand. What do you do to maintain it? Obviously, if you're thinking of somebody like Hermes, who you pick as your lead designer and how that goes forward, which celebrities you involve, how you curate that, these are all difficult to manage important business decisions and that's what builds it over time. The key issue here is that for it to be Power, it has to be something that isn't easily emulated. And the reason that it's not easily emulated is that it takes a long time for those kinds of understandings to be embedded in potential customers. If it could happen quickly, others can do it, it's not Power.

Patrick: [00:44:27] I love the distinction between awareness and Power as it pertains to brand. The final Power is Process Power, which again, I think requires a pretty subtle description, sort of like Counter-Positioning, and maybe it isn't obvious what exactly Process Power means in a business. So I'd love you to describe it for us and also distinguish how it differs from Scale Economies.

Hamilton: [00:44:47] Process Power comes from, if a company has a process that is highly complex, that over time they incrementally step by step by step by step, improve it in a way that the outcome is material and is so complex that exactly what they did is either unknown - the company itself may not even be able to articulate it - or if not unknown, at least opaque in one way or another. And the only way they got there, this comes back to sort of your path dependency thing. The only way they got there is this process of step by step by step by step doing it. And it can't be emulated by hiring a bunch of people from the company or something like that. So it has to be something very, very complex. And so it's very rare.

Most of the time in process improvements can be emulated in a reasonable amount of time. And there are all kinds of consulting firms that'll help you do that. When you think of just best practices and stuff, that's eliminating Process Power, and it's good for the country. Maybe not necessarily good for the leader but it's good for the world. And so it's very rare. The example I give in the book is the Toyota production system. And that took a long, long, long time to develop, and they were sort of open about it. They let other people tour their plants and so on, but emulating it meant a step by step by step in the manufacturing process, changing and automobile manufacturing is really complicated. And so it was very, very hard to do, but it's really rare for things to be that complicated, that you can't hire some people, hire a consulting firm and more than two or three years kind of get up to speed. So it's extremely uncommon.

Source: Hamilton Helmer, 7 Powers

General Questions About the Powers

Patrick: [00:46:40] Having now explored the Powers. I'd love to ask some more general questions about how all these things manifest in businesses and become apparent to those looking for the Power, the first of which is the notion of the time-lag between Power and cash flow. So I think looking backwards in hindsight, you could probably say companies that have high sustained ROICs or something with a lot of positive free cash flow, there must be some Power there that's generating that. But what do you think about prospectively, thinking about the time-lag between establishment of a good strategy and therefore Power and the realization of cash flow or free cash flow?

Hamilton: [00:47:17] Going back to, you alluded earlier to my Power Progression, which sort of divided up when each type of power would be first available over the life cycle of the business and the middle group, which is in takeoff, there are three types of Power: Scale Economies, Switching Costs and Network Economies. And those are what are aggregative types of Power in that they depend on the number of customers that you have and in Scale Economies it's relative number and Networks it's absolute number. So the key strategic thing in those businesses is scaling really rapidly. It's getting those customers. That's the key strategic thing. So if you look back, the metric that will tell you whether you're doing it, is how you scaled either relatively or absolutely. And if you get a customer, that customer by being in your portfolio, adds value. And so it often makes sense in those businesses to acquire customers in a way that at first is not profitable.

You might give away stuff for free, or you might subsidize them or, or just price it lower than you would otherwise. And so it's quite possible that you might run an ugly P&L. And the trick here is that there are lots of businesses that do that, that don't have Power and you get to the end game, and it's the emperor has no clothes, and you go, "Oh my God." And early on in my work, this phenomenon was so obvious or so frequent that I actually had a name for it which I called Product Power (but I later realized it wasn't a Power because it didn't last long enough), which is that in a very fast-growing market the fundamental differences in company A and company B's economics aren't yet expressed in their P&L's because people are pricing, there's all different segments and different prices, and you're really not meeting your competitor head-on yet at arbitrage. And so it's later on these things get settled down. So you can actually have a very unattractive P&L and end up with nothing, or it can go the other way.

Tell you a funny story. I came out to California before I moved my business out here, just to network, and I met with the founder of what was then an early PC company that was growing at phenomenal clips. And they were actually cash positive. And I toured the plant with the founder and he was rightfully very proud of what was going on. And they'd just gotten this big contract with Sears, for distribution, and things were looking really rosy. I got into his office, and I said, "Well, Roger, thanks so much. This is terrific stuff but what's your thoughts on when you hit a shakeout?" And he almost threw me out of his office. He said, "Shake out, and he sort of muttered, it's not going to happen. Ever." And that was the case where there's absolutely no Power, but actually, their P&L looked good because arbitrage hadn't really set in. People were just, "If I can get a PC, I'm happy to pay whatever."

And so the difference is if you have a PC and even IBM with their amazing IBM PC rollout, wasn't immune to this in the end. They ended up being an unattractive business because they gave away the notes, power of the CPU and the operating system.

Patrick: [00:50:42] Why do you think so much of the apparent Power has concentrated today in technology businesses?

Hamilton: [00:50:47] I think the term technology business is a misnomer because if you went back to 1920, Ford was a technology business. Consolidated Edison was a technology businesso. Monsanto chemicals was the technology business in 1950. All it's saying is that the technology frontier is constantly moving forward. And that is the most important driver of opportunity influx. Yeah, there may be demographic changes and this and that. But they're slow. Technology is really driving it.

The technology frontier is constantly moving forward. And that is the most important driver of opportunity influx. Yeah, there may be demographic changes and this and that. But they're slow. Technology is really driving it.

And so when something new happens that presents an opportunity and new usually, almost always, means technology, what happens is that then somebody figures out how to capitalize on that. That looks like an attractive business that displaces the old model. They call it a technology business until later on it gets reclassified. So I think Netflix was originally a technology business, now it's an entertainment business. I think Amazon was probably a technology business, now it's a retail business. And so saying that technology firms have more Power is just simply acknowledging that the firms which replace the old ones are replacing them for a reason. That is, they're better business models.

Patrick: [00:52:07] Do you think that Power is inherently bad for customers because companies are generating outsized returns? They're keeping them by definition? The customer maybe is paying more than the value that they're getting.

Hamilton: [00:52:19] Yeah. It's an important question. And as an economist it's an important policy question. So I think there's a static answer and a dynamic answer. The static answer is, you sort of look at it and you say, "Well, gee, if you take this point in time and you took this amount that Facebook was getting in extra returns and returned it to customers, maybe that would somehow improve the world." But the dynamic thing is that it is the potential to have differential returns, to have an attractive business that causes the investment to happen in the first place. If there weren't the prospect of the differential returns, the VC industry would not exist, period. And so you need that potential to drive that.

Then if you think about the welfare aspect of what's happening over time, remember it's a benefit and a barrier. So the benefit means that actually you are doing something better, typically, and Power just simply means that you get to keep part of that. Not all of it, or else it won't be attractive to other people, but you get to keep part of it. So I think from the long-term vitality of an economy that being able to hope for that is a good thing. And of course, as Anti-trust Law does, it is appropriate for governments to prevent abuse of that, but you wouldn't want to prevent the actual attainment of power.

Patrick: [00:53:42] Would you think that it's fair to say that though you've reduced an essay question to a multiple-choice question, that still the creation of those powers is more of an art form than a science? And if you do agree, who are the best artists that you've ever seen?

Hamilton: [00:53:56] The starting place for strategy and the starting place for Power is creativity. Period. And so if that's how you define an art form, then I completely agree with that. And any attempts to try to convince one that this is something that you can deduce logically is, in my view, completely mistaken. So it involves invention, not discovery. So the people that I think are really great. I mean, I've mentioned before Reed Hastings is amazing. He even corrective me. I remember when I was working on my book, I was thinking of various subtitles and, at one point, I was thinking about using, as a subtitle, something about agile strategies or, no, nimble strategy that was sort of like agile development. It sounded catchy, and I even had the web address for nimble strategy. And he said, "Hamilton, that's completely wrong." Nimble implies you're constantly sort-of moving from space to space and strategy is something that you've developed over a long period of time and you sort of refine it and change it in this and that way, but it's sort of this deliberative creative effort over a long period of time. And he was right.

Patrick: [00:55:08] Closing question for everybody is to ask you for the kindest thing that anyone's ever done for you.

Hamilton: [00:55:13] There are so many people that have been instrumental in terms of my life. I'd say one that stands out. I don't know if it's the kindest, but I remember when I was in grad school, I went through sort of, I don't know if you'd call it existential crisis, but I went into economics in grad school just because I loved the subject, which is a good motivation long-term, but the idea of what it meant to be an economist had never even really occurred to me. I wasn't thinking about a career or anything. And then, as I got into it, I sort of had to think about those things. And then I was also doing some early-stage business stuff with my brother. My wife's quip about that period was; today we would've called it a social enterprise, and back then, you just called it a failure.

And so it was a hard period for me. And I sort-of had to do, eventually, sort-of had to do a full stop. And I just essentially stopped, I mean, I got through my comprehensive exams for my PhD, just sort of stopped and did other things and really couldn't get any real traction and looking forward with my thesis. And then, after about two or three years of that, I finally got to the point where I said, "Okay, it's time. If I'm going to do this, I should really do it." And I had a dear friend and mentor at Yale, a guy by the name of Bill Parker who's one of the most eminent economic historians in the world and an incredibly warm-hearted, caring person, aside from being just brilliant. And I came back to him. I said, "Bill, I've got to get back to this. I'm going to start over. I'm going to start my thesis from scratch. I'd like you to be the chair of my thesis committee, and we'll just start over." And he said, "Fine." And kind of supported me all the way but actually finishing my thesis, probably the hardest thing I've ever done, even harder than starting a business, and his unwavering support and good humor during that process was just instrumental, and had he not done that, my life would've been different. So it was really important.

Patrick: [00:57:22] Fantastic. Well, I love the answer. It's my favorite question every time, and in your case, I think your work reflects what I am trying to do, which is just to get ideas, useful ideas out into the world. I really appreciate the book. I appreciate your willingness to share what you've learned with people. Please know that it does help us out here trying to build businesses and do it in a smart way. So, thank you for the book, and thank you for all your time today.

Hamilton: [00:57:48] Oh, yeah. My pleasure, Patrick. Thank you so much. I really enjoyed this.

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